{"text": "4\nA Complete Guide to the Futures mArket\nThe essence of afutures market is in its name: Trading involves acommodity or financial \ninstrument for afuture delivery date, as opposed to the present time. Thus, if acotton farmer \nwished to make acurrent sale, he would sell his crop in the local cash market. However, if the \nsame farmer wanted to lock in aprice for an anticipated future sale (e.g., the marketing of astill \nunharvested crop), he would have two options: He could locate an interested buyer and negotiate \nacontract specifying the price and other details (quantity, quality, delivery time, location, etc.). \nalternatively, he could sell futures. some of the major advantages of the latter approach are the \nfollowing:\n 1. The futures contract is standardized; hence, the farmer does not have to find aspecific buyer.\n 2. The transaction can be executed virtually instantaneously online.\n 3. The cost of the trade (commissions) is minimal compared with the cost of an individualized \nforward contract.\n 4. The farmer can offset his sale at any time between the original transaction date and the final \ntrading day of the contract. The reasons this may be desirable are discussed later in this chapter.\n 5. The futures contract is guaranteed by the exchange.\nUntil the early 1970s, futures markets were restricted to commodities (e.g., wheat, sugar, \ncopper, cattle). since that time, the futures area has expanded to incorporate additional market sec-\ntors, most significantly stock indexes, interest rates, and currencies (foreign exchange). The same \nbasic principles apply to these financial futures markets. Trading quotes represent prices for afuture \nexpiration date rather than current market prices. For example, the quote for December 10-year \nT -note futures implies aspecific price for a $100,000, 10-year U.\ns. Treasury note to be delivered \nin December. Financial markets have experienced spectacular growth since their introduction, and \ntoday trading volume in these contracts dwarfs that in commodities. \nnevertheless, futures markets \nare still commonly, albeit erroneously, referred to as commodity markets, and these terms are \nsynonymous.\n ■ Delivery\nshorts who maintain their positions in deliverable futures contracts after the last trading day \nare obligated to deliver the given commodity or financial instrument against the contract. similarly, \nlongs who maintain their positions after the last trading day must accept delivery. in the com-\nmodity markets, the number of open long contracts is always equal to the number of open short \ncontracts (see section Volume and Open \ninterest). Most traders have no intention of making \nor accepting delivery, and hence will offset their positions before the last trading day. (The \nlong offsets his position by entering asell order, the short by entering abuy order.) \nit has been \nestimated that fewer than 3 percent of open contracts actually result in delivery. some futures \ncontracts (e.g., stock indexes, eurodollar) use acash settlement process whereby outstanding long \nand short positions are offset at the prevailing price level at expiration instead of being physically \ndelivered.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:22", "doc_id": "73e86775887e43fbb451ee786edc38e544aba45fc138117d8e2a74bd880477ea", "chunk_index": 0}
{"text": "5FOr Beginners Only\n ■ Contract Specifications\nFutures contracts are traded for awide variety of markets on anumber of exchanges both in the \nUnited states and abroad. The specifications for these contracts, especially details such as daily price \nlimits, trading hours, and ticker symbols, can change over time; exchange web sites should be con-\nsulted for up-to-date information. Table 1.1 provides the following representative trading details for \nsix futures markets (\ne-mini s&P 500, 10-year T -note, euro, Brent crude oil, corn, and gold): \n 1. exchange. note that some markets are traded on more than one exchange. in some cases, \ndifferent contracts for the same commodity (or financial instrument) may even be traded on the \nsame exchange.\n 2. ticker symbol. The quote symbol is the letter code that identifies each market (e.g., es for \nthe e-mini s&P 500, Cfor corn, eC for the euro), combined with an alphanumeric suffix to \nrepresent the month and year.\n 3. Contract size. The specification of auniform quantity per contract is one of the key ways in \nwhich afutures contract is standardized. By multiplying the contract size by the price, the trader \ncan determine the dollar value of acontract. For example, if corn is trading at $4.00/bushel (bu), \nthe contract value equals $20,000 ($4 × 5,000 bu per contract). \nif Brent crude oil is trading at \n$48.30, the contract value is $48,300 ($48.30 × 1,000 barrels). although there are many impor-\ntant exceptions, very roughly speaking, higher per-contract dollar values will imply agreater \npotential/risk level. (The concept of contract value has no meaning for interest rate contracts.)\n 4. Price quoted in. This row indicates the relevant unit of measure for the given market.\n 5. Minimum price fluctuation (“tick”) size and value. This row indicates the minimum \nincrement in which prices can trade, and the dollar value of that move. For example, the mini-\nmum fluctuation for the \ne-mini s&P 500 contract is 0.25 index points. Thus, you can enter an \norder to buy December e-mini s&Pfutures at 1,870.25 or 1,870.50, but not 1,870.30. The \nminimum fluctuation for corn is 1\n4 ¢/bu, which means you can enter an order to buy December \ncorn at $4.01 1\n2 or $4.01 3\n4 , but not $4.01 5\n8 per bushel. The tick value is obtained by multiply-\ning the minimum fluctuation by the contract size. For example, for Brent crude oil, one cent \n($0.01) per barrel × 1,000 barrels = $10. For corn, \n1\n4 50 00 12 50¢/bu ×=,$ ..\n 6. Contract months. each market is traded for specific months. For example, the e-mini s&P \n500 futures contract is traded for March, June, september, and December. Corn is traded for \nMarch, May, July, september, and December. Table 1.2 shows the letter designations for each \nmonth of the year, which are added (along with the contract year) to amarket’sbase ticker \nsymbol to create acontract-specific ticker symbol. For example, December 2017 \ne-mini s&P \n500 futures have aticker symbol of esZ17, while the symbol for the March 2018 contract is \nesH18. The symbol for May 2017 corn is CK17. The last trading day for acontract typically \noccurs on aspecified date in the contract month, although in some markets (such as crude oil), \nthe last trading day falls in the month preceding the contract month. For most markets, futures \nare listed for contract months at least one year forward from the current date. However, trading \nactivity is normally heavily concentrated in the nearest two contracts.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:23", "doc_id": "a8c92352d980fffe97ad710f6edd5844ad5dace8bfd7b838d12daa0ff9792c15", "chunk_index": 0}
{"text": "7FOr Beginners Only\nDaily Price limit 7%, 13%, and 20% \nlimits are applied \nto the futures fixing \nprice, effective 8:30 \na.m. to 3 p.m. CT , \nMon–Fri.\n7%, 13%, and 20% limits are \napplied to the futures fixing \nprice, effective 8:30 a.m. to \n3 p.m. CT , Mon–Fri. (\nsee \nexchange for specifics.)\nn/an/a $0.25 n/a\nSettlement type Cash settlement Deliverable Deliverable Physical delivery based \non eFP delivery, with \nan option to cash settle \nagainst the \niCe Brent \nindex price for the \nlast trading day of the \nfutures contract.\nDeliverable Deliverable\nFirst Notice Day\nn/a Final business day of the \nmonth preceding the \ncontract month.\nn/an/alast business day of \nmonth preceding \ncontract month.\nThe last business day of the \nmonth preceding the delivery \nmonth.\nlast Notice Day n/a Final business day of the \ncontract month.\nn/an/a The business day after \nthe last contract’slast \ntrading day.\nThe second-to-last business \nday of the delivery month.\nlast trading Day Until 8:30 a.m. on \nthe 3rd Friday of the \ncontract month.\n12:01 p.m. on the 7th \nbusiness day preceding \nthe last business day of the \ndelivery month.\n9:16 a.m. CT on \nthe second business \nday immediately \npreceding the \nthird Wed of the \ncontract month.\nThe last business day \nof the second month \npreceding the relevant \ncontract month.\nBusiness day prior to \nthe 15th calendar day of \nthe contract month.\nThe third-to-last business day \nof the delivery month.\nDeliverable \nGrade\nn/a U.s. T -notes with aremaining \nterm to maturity of 6.5 to 10 \nyears from the first day of the \ndelivery month.\nn/an/a #2 yellow at contract \nprice, #1 yellow at \na 1.5 cent/bushel \npremium, #3 \nyellow \nat a 1.5 cent/bushel \ndiscount.\ngold delivered under this \ncontract shall assay to aminimum of 995 fineness.\n7", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:25", "doc_id": "96fe58b440ae7efe77ddff4805dbac1951d3fb6f8609a771511bff95ca9a276a", "chunk_index": 0}
{"text": "9FOr Beginners Only\napproaching expiration (frequently first notice day—see item 10). Daily price limits can change \nfrequently, so traders should consult the exchange on which their products trade to ensure they \nare aware of current thresholds.\n 9. Settlement type. Markets are designated either as physically deliverable or cash settled. in \nTable 1.1, the e-mini s&P 500 futures are cash settled, while all the other markets can be physi-\ncally delivered.\n 10. First notice day. This is the first day on which along can receive adelivery notice. First notice \nday presents no problem for shorts, since they are not obligated to issue anotice until after the \nlast trading day. Furthermore, in some markets, first notice day occurs after last trading day, \npresenting no problem to the long either, since all remaining longs at that point presumably \nwish to take delivery. However, in markets in which first notice day precedes last trading day, \nlongs who do not wish to take delivery should be sure to offset their positions in time to avoid \nreceiving adelivery notice. (Brokerage firms routinely supply their clients with alist of these \nimportant dates.) \nalthough longs can pass on an undesired delivery notice by liquidating their \nposition, this transaction will incur extra transaction costs and should be avoided. Last notice \nday is the final day along can receive adelivery notice.\n 11. last trading day. This is the last day on which positions can be offset before delivery becomes \nobligatory for shorts and the acceptance of delivery obligatory for longs. as indicated previously, \nthe vast majority of traders will liquidate their positions before this day.\n 12. Deliverable grade. This is the specific quality and type of the underlying commodity or finan-\ncial instrument that is acceptable for delivery.\n ■ Volume and Open Interest\nVolume is the total number of contracts traded on agiven day. Volume figures are available for each \ntraded month in amarket, but most traders focus on the total volume of all traded months.\nOpen interest is the total number of outstanding long contracts, or equivalently, the total number \nof outstanding short contracts—in futures, the two are always the same. When anew contract begins \ntrading (typically about 12 to 18 months before its expiration date), its open interest is equal to zero. \nif abuy order and sell order are matched, then the open interest increases to 1. Basically, open interest \nincreases when anew buyer purchases from anew seller and decreases when an existing long sells to \nan existing short. The open interest will remain unchanged if anew buyer purchases from an existing \nlong or anew seller sells to an existing short.\nVolume and open interest are very useful as indicators of amarket’sliquidity. \nnot all listed futures mar-\nkets are actively traded. some are virtually dormant, while others are borderline cases in terms of trading \nactivity. illiquid markets should be avoided, because the lack of an adequate order flow will mean that the \ntrader will often have to accept very poor trade execution prices if he wants to get in or out of aposition.\ngenerally speaking, markets with open interest levels below 5,000 contracts, or average daily \nvolume levels below 1,000 contracts, should be avoided, or at least approached very cautiously. \nnew markets will usually exhibit volume and open interest figures below these levels during their", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:27", "doc_id": "fcd7ce075e7f12ed82da69d5445c3063d88507d4054265dafa8b13c35177480c", "chunk_index": 0}
{"text": "10a COMPleTe gUiDe TO THe FUTUres MarKeT\ninitial months (and sometimes even years) of trading. By monitoring the volume and open interest \nfi gures, atrader can determine when the market’slevel of liquidity is suffi cient to warrant participa-\ntion. Figure 1.1 shows February 2016 gold (top) and april 2016 gold (bottom) prices, along with \ntheir respective daily volume fi gures. February gold’svolume is negligible until november 2015, \nat which point it increases rapidly into December and maintains ahigh level through January (the \nFebruary contract expires in late February). Meanwhile, april gold’svolume is minimal until Janu-\nary, at which point it increases steadily and becomes the more actively traded contract in the last \ntwo days of January—even though the February gold contract is still amonth from expiration at \nthat point. \n The breakdown of volume and open interest fi gures by contract month can be very useful in \ndetermining whether aspecifi cmonth is suffi ciently liquid. For example, atrader who prefers to \ninitiate along position in anine-month forward futures contract rather than in more nearby con-\ntracts because of an assessment that it is relatively underpriced may be concerned whether its level \nof trading activity is suffi cient to avoid liquidity problems. in this case, the breakdown of volume and \nopen interest fi gures by contract month can help the trader decide whether it is reasonable to enter \nthe position in the more forward contract or whether it is better to restrict trading to the nearby \ncontracts. \n Traders with short-term time horizons (e.g., intraday to afew days) should limit trading to the \nmost liquid contract, which is usually the nearby contract month. \n FIGURE  1.1 Volume shift in gold Futures\nChart created using Tradestation. ©Tradestation Technologies, inc. all rights reserved.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:28", "doc_id": "aacce633c040a586e9047c118559f1ebee5fced1fc787b37e085d6878a18023b", "chunk_index": 0}
{"text": "15FOr Beginners Only\nthis wide discount, the hedge is still very profitable because the price differential is ultimately \nfar outweighed by the intervening price decline. Thus, the relevant question is not whether the \nfutures-implied cash price is attractive relative to the current cash price, but rather whether it is \nattractive relative to the expected future cash price.\n 6. The hedger does not precisely lock in atransaction price. His effective price will depend on \nthe basis. For example, if the cotton producer sells futures at 85¢/lb, assuming a −3¢ basis, his \neffective sales price will be 80¢/lb, rather than the anticipated 82¢/lb, if the actual basis at the \ntime of offset is −5¢. However, it should be emphasized that this basis-price uncertainty is far \nsmaller than the outright price uncertainty in an unhedged position. Furthermore, by using \nreasonably conservative basis assumptions the hedger can increase the likelihood of achieving, \nor bettering, the assumed locked-in price.\n 7. although ahedger plans to buy or sell the actual commodity, it will usually be far more efficient \nto offset the futures position and use the local cash market for the actual transaction. Futures \nshould be viewed as apricing tool, not as avehicle for making or taking delivery.\n 8. Most standard discussions of hedging make no mention whatsoever of price forecasting. \nThis omission seems to imply that hedgers need not be concerned about the direction of \nprices. \nalthough this conclusion may be valid for some hedgers (e.g., amiddleman seek-\ning to lock in aprofit margin between the purchase and sales price), it is erroneous for \nmost hedgers. There is little sense in following an automatic hedging program. \nrather, \nthe hedger should evaluate the relative attractiveness of the price protection offered by \nfutures. Price forecasting would be akey element in making such an evaluation. \nin this \nrespect, it can easily be argued that price forecasting is as important to many hedgers as it \nis to speculators.\n ■ Trading\nThe trader seeks to profit by anticipating price changes. For example, if the price of December gold \nis $1,150/oz, atrader who expects the price to rise above $1,250/oz will go long. The trader has \nno intention of actually taking delivery of the gold in December. \nright or wrong, the trader will \noffset the position sometime before expiration. For example, if the price rises to $1,275 and the \ntrader decides to take profits, the gain on the trade will be $12,500 per contract (100 oz × $125/\noz). \nif, on the other hand, the trader’sforecast is wrong and prices decline to $1,075/oz, with the \nexpiration date drawing near, the trader has little choice but to liquidate. in this situation, the loss \nwould be equal to $7,500 per contract. note that the trader would not take delivery even given \nadesire to maintain the long gold position. in this case, the trader would liquidate the December \ncontract and simultaneously go long in amore forward contract. (This type of transaction is called \narollover and would be implemented with aspread order—defined in the next section.) Traders \nshould avoid taking delivery, since it can often result in substantial extra costs without any com-\npensating benefits.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:33", "doc_id": "3ffeb5c2f1ef468ff0744046271b86a5d8eb571b928eaa1e283d13e7cc584ff5", "chunk_index": 0}
{"text": "19FOr Beginners Only\nSpread\naspread involves the simultaneous purchase of one futures contract against the sale of another futures \ncontract, either in the same market or in arelated market. in essence, aspread trader is primarily \nconcerned with the difference between prices rather than the direction of price. an example of aspread \ntrade would be: Buy 1 July cotton/sell 1 December cotton, July 200 points premium December. \nThis order would be executed if July could be bought at aprice 200 points or less above the level at \nwhich December is sold. \nsuch an order would be placed if the trader expected July cotton to widen \nits premium relative to December cotton.\nnot all brokerages will accept all the order types in this section (and may offer others not listed here). \nTraders should consult with their brokerage to determine which types of orders are available to them.\n ■ Commissions and Margins\nin futures trading, commissions are typically charged on aper-contract basis. in most cases, large \ntraders will be able to negotiate areduced commission rate. although commodity commissions are \nrelatively moderate, commission costs can prove substantial for the active trader—an important rea-\nson why position trading is preferable unless one has developed avery effective short-term trading \nmethod.\nFutures margins are basically good-faith deposits and represent only asmall percentage of the con-\ntract value (roughly 5 percent with some significant variability around this level). Futures exchanges \nwill set minimum margin requirements for each of their contracts, but many brokerage houses will \nfrequently require higher margin deposits. \nsince the initial margin represents only asmall portion of \nthe contract value, traders will be required to provide additional margin funds if the market moves \nagainst their positions. These additional margin payments are referred to as maintenance.\nMany traders tend to be overly concerned with the minimum margin rate charged by abroker-\nage house. \nif atrader is adhering to prudent money management principles, the actual margin level \nshould be all but irrelevant. as ageneral rule, the trader should allocate at least three to five times \nthe minimum margin requirement to each trade. Trading an account anywhere near the full margin \nallowance greatly increases the chances of experiencing asevere loss. Traders who do not maintain at \nleast several multiples of margin requirements in their accounts are clearly overtrading.\n ■ Tax Considerations\n Tax laws change over time, but for the average speculator in the United states, the essential elements \nof the futures contract tax regulations can be summarized in three basic points:\n 1. There is no holding period for futures trades (i.e., all trades are treated equally, regardless of the \nlength of time aposition is held, or whether aposition is long or short).", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:37", "doc_id": "aa8e55c340d401f9dba293646b96abc27956122e4fce1e9b3719ef24d97ac6fa", "chunk_index": 0}
{"text": "45\nChapter 5\n ■ The Necessity of Linked-Contract Charts\nMany of the chart analysis patterns and techniques detailed in Chapters 6 through 9 require long-\nterm charts—often charts of multiyear duration. This is particularly true for the identification of top \nand bottom formations, as well as the determination of support and resistance levels.\nAmajor problem facing the chart analyst in the futures markets is that most futures contracts \nhave relatively limited life spans and even shorter periods in which these contracts have significant \ntrading activity. For many futures contracts (e.g., currencies, stock indexes) trading activity is almost \ntotally concentrated in the nearest one or two contract months. For example, in Figure 5.1, there \nwere only about two months of liquid data available for the March 2016 Russell 2000 Index Mini \nfutures contract when it became the most liquid contract in this market as the December 2015 con -\ntract expiration approached. This market is not particularly unusual in this respect. In many futures \nmarkets, almost all trading is concentrated in the nearest contract, which will have only afew months \n(or weeks) of liquid trading history when the prior contract approaches expiration.\nLinking Contracts \nfor Long- Term \nChart Analysis: \nNearest versus \nContinuous Futures", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:63", "doc_id": "2da12bb63334713381ab16978d56ec085ea70b340d6ae80a291437981f061425", "chunk_index": 0}
{"text": "46A COMPLETE GUIDE TO THE FUTURES MARKET\n The limited price data available for many futures contracts—even those that are the most actively \ntraded contracts in their respective markets—makes it virtually impossible to apply most chart analy-\nsis techniques to individual contract charts. Even in those markets in which the individual contracts \nhave ayear or more of liquid data, part of athorough chart study would still encompass analyzing \nmultiyear weekly and monthly charts. Thus, the application of chart analysis unavoidably requires \nlinking successive futures contracts into asingle chart. In markets with very limited individual con-\ntract data, such linked charts will be anecessity in order to perform any meaningful chart analysis. In \nother markets, linked charts will still be required for analyzing multiyear chart patterns. \n ■ Methods of Creating Linked-Contract Charts \n Nearest Futures \n The most common approach for creating linked-contract charts is typically termed nearest futures. This \ntype of price series is constructed by taking each individual contract series until its expiration and \nthen continuing with the next contract until its expiration, and so on. \n Although, at surface glance, this approach appears to be areasonable method for constructing \nlinked-contract charts, the problem with anearest futures chart is that there are price gaps between \nexpiring and new contracts—and quite frequently, these gaps can be very substantial. For exam-\nple, assume the September coff ee contract expires at 132.50 cents/lb and the next nearest con-\ntract (December) closes at 138.50 cents/lb on the same day. Further assume that on the next day \n FIGURE  5.1 March 2016 Russell 2000 Mini Futures\nChart created using TradeStation. ©TradeStation Technologies, Inc. All rights reserved.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:64", "doc_id": "86080f566e12f03aaf43560212630b058bced08d4f56ad9abe64f88ba48daabb", "chunk_index": 0}
{"text": "47\nLinking ContraCts for Long-term Chart anaLysis\nDecember coffee falls 5 cents/lb to 133.50—a 3.6 percent drop. Anearest futures price series will \nshow the following closing levels on these two successive days: 132.50 cents, 133.50 cents. In other \nwords, the nearest futures contract would show aone-cent (0.75 percent) gain on aday on which longs \nwould actually have experienced ahuge loss. This example is by no means artificial. Such distortions—\nand indeed more extreme ones—are quite common at contract rollovers in nearest futures charts.\nThe vulnerability of nearest futures charts to distortions at contract rollover points makes it desir-\nable to derive alternative methods of constructing linked-contract price charts. One such approach \nis detailed in the next section.\nContinuous (Spread-adjusted) price Series\nThe spread-adjusted price series known as “continuous futures” is constructed by adding the cumulative dif-\nference between the old and new contracts at rollover points to the new contract series.\n1 An example should \nhelp clarify this method. Assume we are constructing aspread-adjusted continuous price series for gold \nusing the June and December contracts.\n2 If the price series begins at the start of the calendar year, initially the \nvalues in the series will be identical to the prices of the June contract expiring in that year. Assume that on the \nrollover date (which need not necessarily be the last trading day) June gold closes at $1,200 and December \ngold closes at $1,205. In this case, all subsequent prices based on the December contract would be adjusted \ndownward by $5—the difference between the December and June contracts on the rollover date.\nAssume that at the next rollover date December gold is trading at $1,350 and the subsequent June \ncontract is trading at $1,354. The December contract price of $1,350 implies that the spread-adjusted \ncontinuous price is $1,345. Thus, on this second rollover date, the June contract is trading $9 above the \nadjusted series. Consequently, all subsequent prices based on the second June contract would be adjusted \ndownward by $9. This procedure would continue, with the adjustment for each contract dependent on the \ncumulative total of the present and prior transition point price differences. The resulting price series would \nbe free of the distortions due to spread differences that exist at the rollover points between contracts.\nThe construction of acontinuous futures series can be thought of as the mathematical equivalent \nof taking anearest futures chart, cutting out each individual contract series contained in the chart, \nand pasting the ends together (assuming acontinuous series employing all contracts and using the \nsame rollover dates as the nearest futures chart). Typically, as alast step, it is convenient to shift the \nscale of the entire series by the cumulative adjustment factor, astep that will set the current price \nof the series equal to the price of the current contract without changing the shape of the series. The \nconstruction of acontinuous futures chart is discussed in greater detail in Chapter 18.\n1 Toavoid confusion, readers should note that some data services use the term continuous futures to refer to linking \ntogether contracts of the same month (e.g., linking from March 2015 corn when it expires to March 2016 corn, \nand so on). Such charts are really only avariation of nearest futures charts—one in which only asingle contract \nmonth is used—and will be as prone to wide price gaps at rollovers as nearest futures charts, if not more so. \nThese types of charts have absolutely nothing in common with the spread-adjusted continuous futures series \ndescribed in this section—that is, nothing but the name. It is unfortunate that some data services have decided \nto use this same term to describe an entirely different price series than the original meaning described here.\n2 The choice of acombination of contracts is arbitrary. One can use any combination of actively traded months \nin the given market.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:65", "doc_id": "f08075f78e93c39af1b30badcb450e4d6cfe5f885761502917d27ed660519ee9", "chunk_index": 0}
{"text": "280\nA Complete Guide to the Futures mArket\nseries. For example, a 15year test run for atypical market would require using approximately 60 to \n90 individual contract price series. Moreover, using the individual contract series requires an algo\nrithm for determining what action to take at the rollover points. As an example of the type of problem \nthat may be encountered, it is entirely possible for agiven system to be long in the old contract and \nshort in the new contract or vice versa. These problems are hardly insurmountable, but they make the \nuse of individual contract series asomewhat unwieldy approach.\nThe awkwardness involved in using amultitude of individual contracts is not, however, the main \nproblem. The primary drawback in using individual contract series is that the period of meaningful \nliquidity in most contracts is very short—much shorter than the already limited contract life spans. \nTosee the scope of this problem, examine across section of futures price charts depicting the price \naction in the one\nyear period prior to expiration. In many markets, contracts don’tachieve meaning\nful liquidity until the final five or six months of trading, and sometimes even less. This problem was \nillustrated in Chapter 5. The limited time span of liquid trading in individual contracts means that any \ntechnical system or method that requires looking back at more than about six months of data—as \nwould be true for awhole spectrum of longer\nterm approaches—cannot be applied to individual \ncontract series. Thus, with the exception of shortterm system traders, the use of individual contract \nseries is not aviable alternative. It’snot merely amatter of the approach being difficult but, rather, its \nbeing impossible because the necessary data simply do not exist.\n ■ Nearest Futures\nThe problems in using individual contract series as just described has led to the construction of vari\nous linked price series. The most common approach is almost universally known as nearest futures. \nThis price series is constructed by taking each individual contract series until its expiration and then \ncontinuing with the next contract until its expiration, and so on. This approach may be useful for \nconstructing long\nterm price charts for purposes of chart analysis, but it is worthless for providing aseries that can be used in the computer testing of trading systems.\nThe problem in using anearest futures series is that there are price gaps between expiring and new \ncontracts—and quite frequently these gaps can be very substantial. For example, assume the July corn \ncontract expires at $4 and that the next nearest contract (September) closes at $3.50 on the same day. \nAssume that on the next day September corn moves from $3.50 to $3.62. Anearest futures price series \nwill show the following closing levels on these two successive days: $4, $3.62. In other words, the near\nest futures contract would imply a 38\ncent loss on aday on which longs would have enjoyed (or shorts \nwould have suffered) aprice gain of 12 cents. This example is by no means artificial. In fact, it would \nbe easy to find aplethora of similarly extreme situations in actual price histories. Moreover, even if the \ntypical distortion at rollover is considerably less extreme, the point is that there is virtually always some \ndistortion, and the cumulative effect of these errors would destroy the validity of any computer test.\nFortunately, few traders are naive enough to use the nearest futures type of price series for computer \ntesting. The two alternative linked price series described in the next sections have become the approaches \nemployed by most traders wishing to use asingle price series for each market in computer testing.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:298", "doc_id": "b5ac040fb6bff1d4e944e53412cb5b039367831a2d28d8f822b910addce05423", "chunk_index": 0}
{"text": "281\nSElECTINg THE BEST FuTurES PrICE SErIES For SySTEM TESTINg\n ■ Constant-Forward (“Perpetual”) Series\nThe constantforward (also known as “perpetual”) price series consists of quotes for prices aconstant \namount of time forward. The interbank currency market offers actual examples of constantforward \nprice series. For example, the threemonth forward price series for the euro represents the quote for \nthe euro three months forward from each given day in the series. This is in contrast to the standard \nu.S. futures contract, which specifies afixed expiration date.\nAconstant forward series can be constructed from futures price data through interpola\ntion. For example, if we were calculating a 90 day constant forward (or perpetual) series and \nthe 90day forward date fell exactly one third of the way between the expirations of the nearest \ntwo contracts, the constant forward price would be calculated as the sum of two thirds of the \nnearest contract price and one third of the subsequent contract price. As we moved forward in \ntime, the nearer contract would be weighted less, and the weighting of the subsequent contract \nwould increase proportionately. Eventually, the nearest contract would expire and drop out of \nthe calculation, and the constant\nforward price would be based on an interpolation between the \nsubsequent two contracts.\nAs amore detailed example, assume you want to generate a 100day forward price series based on \neuro futures, which are traded in March, June, September, and December contracts. Toillustrate the \nmethod for deriving the 100\nday constantforward price, assume the current date is January 20. In \nthis case, the date 100 days forward is April 30. This date falls between the March and June contracts. \nAssume the last trading dates for these two contracts are March 14 and June 13, respectively. Thus, \nApril 30 is 47 days after the last trading day for the March contract and 44 days before the last trad\ning day for the June contract. Tocalculate the 100\nday forward price for January 20, an average price \nwould be calculated using the quotes for March and June euro futures on January 20, weighting each \nquote in inverse proportion to its distance from the 100\nday forward date (April 30). Thus, if on Janu\nary 20 the closing price of March futures is 130.04 and the closing price of June futures is 130.77, the \nclosing price for the 100\nday forward series would be:\n44\n91 1300 4 130 77 130 42(. )( .) .+=47\n91\nNote that the general formula for the weighting factor used for each contract price is:\nW CF\nCC W FC\nCC1\n2\n21\n2\n1\n21\n= −\n− = −\n−\nwhere C1 = number of days until the nearby contract expiration\n C2 = number of days until the forward contract expiration\n F = number of days until forward quote date\n W1 = weighting for nearby contract price quote\n W2 = weighting for forward contract price quote", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:299", "doc_id": "e94783984c065645cc3f641c8f6e1169641f3ef94f7e7fccf18ead2db4467fbb", "chunk_index": 0}
{"text": "282\nA Complete Guide to the Futures mArket\nSo, for example, the weightings of the March and June quotes that would be used to derive a \n100day forward quote on March 2 would be as follows:\nWeighting for March quot e\nWeighting for \n = −\n− =1031 00\n103 12\n3\n91\nJJune quote = −\n− =100 12\n103 12\n88\n91\nAs we move forward in time, the nearer contract is weighted less and less, but the weighting for \nthe subsequent contract increases proportionately. When the number of days remaining until the \nexpiration of the forward contract equals the constant forward time (100 days in this example), the \nquote for the constant forward series would simply be equal to the quote for the forward contract \n(June). Subsequent price quotes would then be based on aweighted average of the June and Septem\nber prices. In this manner, one continuous price series could be derived.\nThe constant\nforward price series eliminates the problem of huge price gaps at rollover points and \nis certainly asignificant improvement over anearest futures price series. However, this type of series \nstill has major drawbacks. Tobegin, it must be stressed that one cannot literally trade aconstant\n\nforward series, since the series does not correspond to any real contract. An even more serious \ndeficiency of the constant\nforward series is that it fails to reflect the effect of the evaporation of time \nthat exists in actual futures contracts. This deficiency can lead to major distortions—particularly in \ncarrying\ncharge markets.\nToillustrate this point, consider ahypothetical situation in which spot gold prices remain stable at \napproximately $1,200/ounce for aoneyear period, while forward futures maintain aconstant pre\nmium of 1 percent per twomonth spread. given these assumptions, futures would experience asteady \ndowntrend, declining $73.82/ounce1 ($7,382 per contract) over the oneyear period (the equivalent \nof the cumulative carryingcharge premiums). Note, however, the constantforward series would com\npletely fail to reflect this bear trend because it would register an approximate constant price. For \nexample, atwo\nmonth constantforward series would remain stable at approximately $1,212/ounce \n(1.01 × $1,200 = $1,212). Thus, the price pattern of aconstant forward series can easily deviate \nsubstantially from the pattern exhibited by the actual traded contracts—ahighly undesirable feature.\n ■ Continuous (Spread-Adjusted) Price Series\nThe spreadadjusted futures series, commonly known as continuous futures, is constructed to elimi\nnate the distortions caused by the price gaps between consecutive futures contracts at their transi\ntion points. In effect, the continuous futures price will precisely reflect the fluctuations of afutures \nposition that is continuously rolled over to the subsequent contract Ndays before the last trading \nday, where Nis aparameter that needs to be defined. If constructing their own continuous futures \ndata series, traders should select avalue of Nthat corresponds to their actual trading practices. \n1 This is true since, given the assumptions, the oneyear forward futures price would be approximately $1,273.82 \n(1.016 × $1,200 = $1,273.82) and would decline to the spot price ($1,200) by expiration.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:300", "doc_id": "2fe8eb9af68ea11908e4aa10ee3910dfabffdea7f54014c582e868546e560444", "chunk_index": 0}
{"text": "283\nSElECTINg THE BEST FuTurES PrICE SErIES For SySTEM TESTINg\nFor example, if atrader normally rolls aposition over to anew contract approximately 20 days before \nthe last trading day, Nwould be defined as 20. The scale of the continuous futures series is adjusted so \nthe current price corresponds to acurrently traded futures contract.\nTable 18.1 illustrates the construction of acontinuous futures price for the soybean market. For \nsimplicity, this example uses only two contract months, July and November; however, acontinuous \nprice could be formed using any number of traded contract months. For example, the continuous futures \nprice could be constructed using the January, March, May, July, August, September, and November \nsoybean contracts.\ntable 18.1 Construction of a Continuous Futures price Using July and November Soybeans \n(cents/bushel)*\nDate Contract actual price\nSpread at rollover \n(Nearby Forward)\nCumulative \nadjustment \nFactor\nUnadjusted \nContinuous Futures \n(Col. 3 + Col. 5)\nContinuous \nFutures price \n(Col. 6 – 772.5)\n6/27/12 Jul 12 1,471 1,471 698.5\n6/28/12 Jul 12 1,466 1,466 693.5\n6/29/12 Jul 12 1,512.75 1,512.75 740.25\n7/2/12 Nov 12 1,438 85 85 1,523 750.5\n7/3/12 Nov 12 1,474.75 85 1,559.75 787.25\n***\n10/30/12 Nov 12 1,533.75 85 1,618.75 846.25\n10/31/12 Nov 12 1,547 85 1,632 859.5\n11/1/12 Jul 13 1,474 86.25 171.25 1,645.25 872.75\n11/2/12 Jul 13 1,454 171.25 1,625.25 852.75\n***\n6/27/13 Jul 13 1,548.5 171.25 1,719.75 947.25\n6/28/13 Jul 13 1,564.5 171.25 1,735.75 963.25\n7/1/13 Nov 13 1,243.25 312.5 483.75 1,727 954.5\n7/2/13 Nov 13 1,242.5 483.75 1,726.25 953.75\n***\n10/30/13 Nov 13 1,287.5 483.75 1,771.25 998.75\n10/31/13 Nov 13 1,280.25 483.75 1,764 991.5\n11/1/13 Jul 14 1,224.5 45.5 529.25 1,753.75 981.25\n11/4/13 Jul 14 1,227.75 529.25 1,757 984.5\n***\n6/27/14 Jul 14 1,432 529.25 1,961.25 1,188.75\n6/30/14 Jul 14 1,400.5 529.25 1,929.75 1,157.25\n7/1/14 Nov 14 1,147.5 243.25 772.5 1,920 1,147.5\n7/2/14 Nov 14 1,141.5 772.5 1,914 1,141.5\n*Assumes rollover on last day of the month preceding the contract month.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:301", "doc_id": "6824e225432436455dd505207aad9b1cf9d9d223dbedc06b4ef92602b9dfe261", "chunk_index": 0}
{"text": "284\nA Complete Guide to the Futures mArket\nFor the moment, ignore the last column in Table 18.1 and focus instead on the unadjusted con\ntinuous futures price (column 6). At the start of the period, the actual price and the unadjusted \ncontinuous futures price are identical. At the first rollover point, the forward contract (November \n2012) is trading at an 85\ncent discount to the nearby contract (July 2012). All subsequent prices of \nthe November 2012 contract are then adjusted upward by this amount (the addition of apositive \nnearby/forward spread), yielding the unadjusted continuous futures prices shown in column 6. At \nthe next rollover point, the forward contract (July 2013) is trading at an 86.25\ncent discount to the \nnearby contract (November 2012). As aresult, all subsequent actual prices of the July 2013 contract \nmust now be adjusted by the cumulative adjustment factor—the total of all rollover gaps up to that \npoint (171.25 cents)—in order to avoid any artificial price gaps at the rollover point. This cumulative \nadjustment factor is indicated in column 5. The unadjusted continuous futures price is obtained by \nadding the cumulative adjustment factor to the actual price.\nThe preceding process is continued until the current date is reached. At this point, the final cumu\nlative adjustment factor is subtracted from all the unadjusted continuous futures prices (column 6), \nastep that sets the current price of the series equal to the price of the current contract (November \n2014 in our example) without changing the shape of the series. This continuous futures price is indi\ncated in column 7 of Table 18.1. Note that although actual prices seem to imply anet price decline of \n329.50 cents during the surveyed period, the continuous futures price indicates a 443\ncent increase—\nthe actual price change that would have been realized by aconstant long futures position.\nIn effect, the construction of the continuous series can be thought of as the mathematical equiva\nlent of taking anearest futures chart, cutting out each individual contract series contained in the \nchart, and pasting the ends together (assuming acontinuous series employing all contracts and using \nthe same rollover dates as the nearest futures chart).\nIn some markets, the spreads between nearby and forward contracts will range from premiums to \ndiscounts (e.g., cattle). However, in other markets, the spread differences will be unidirectional. For \nexample, in the gold market, the forward month always trades at apremium to the nearby month.\n2 In \nthese types of markets, the spreadadjusted continuous price series can become increasingly disparate \nfrom actual prices.\nIt should be noted that when nearby premiums at contract rollovers tend to swamp nearby dis \ncounts, it is entirely possible for the series to eventually include negative prices for some past periods \nas cumulative adjustments mount, as illustrated in the soybean continuous futures chart in Figure 18.1. \nThe price gain that would have been realized by acontinuously held futures position during this period \n2 The reason for this behavioral pattern in gold spreads is related to the fact that world gold inventories exceed \nannual usage by many multiples, perhaps even by as much as ahundredfold. Consequently, there can never ac\ntually be a “shortage” of gold—and ashortage of nearby supplies is the only reason why astorable commodity \nwould reflect apremium for the nearby contract. (Typically, for storable commodities, the fact that the forward \ncontracts embed carrying costs will result in these contracts trading at apremium to more nearby months.) \ngold prices fluctuate in response to shifting perceptions of gold’svalue among buyers and sellers. Even when \ngold prices are at extremely lofty levels, it does not imply any actual shortage, but rather an upward shift in the \nmarket’sperception of gold’svalue. Supplies of virtually any level are still available—at some price. This is not \ntrue for most commodities, in which there is adefinite relevant limit in total supplies.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:302", "doc_id": "48c42d4b2313ad7300345fa70fdb6ce20d087742550ea620469ae30594b7d0ba", "chunk_index": 0}
{"text": "286\nA Complete Guide to the Futures mArket\nseries means that past prices in acontinuous series will not match the actual historical prices that \nprevailed at the time. However, the essential point is that the continuous series is the only linked \nfutures series that will exactly reflect price swings and hence equity fluctuations in an actual trading \naccount. Consequently, it is the only linked series that can be used to generate accurate simulations in \ncomputer testing of trading systems.\nThe preceding point is absolutely critical! Mathematics is not amatter of opinion. There is one \nright answer and there are many wrong answers. The simple fact is that if acontinuous futures price \nseries is defined so that rollovers occur on days consistent with rollovers in actual trading, results \nimplied by using this series will precisely match results in actual trading (assuming, of course, accu\nrate commission and slippage cost estimates). In other words, the continuous series will exactly paral\nlel the fluctuations of aconstantly held (i.e., rolled over) long position. All other types of linked series \nwill not match actual market price movements.\nToillustrate this statement, we compare the implications of various price series using the sideways \ngold market example cited earlier in this chapter (i.e., gold hovering near $1,200 and aforward/\nnearby contract premium equal to 1 percent per two\nmonth spread). Atrader buying aoneyear for\nward futures contract would therefore pay approximately $1,273.82 (1.016 × $1,200 = $1,273.82). \nThe spot price would reflect asideways pattern near $1,200. As previously seen, a 60day constant\nforward price would reflect asideways pattern near $1,212 (1.01 × $1,200). Anearest futures \nprice series would exhibit ageneral sideways pattern, characterized by extended minor downtrends \n(reflecting the gradual evaporation of the carrying charge time premium as each nearby contract \napproached expiration), interspersed with upward gaps at rollovers between expiring and subsequent \nfutures contracts.\nThus the spot, constant\nforward, and nearest futures price series would all suggest that along \nposition would have resulted in abreakeven trade for the year. In reality, however, the buyer of the \nfutures contract pays $1,273.82 for acontract that eventually expires at $1,200. Thus, from atrading \nor real\nworld viewpoint, the market actually witnesses adowntrend. The continuous futures price is \nthe only price series that reflects the market decline—and real dollar loss—atrader would actually \nhave experienced.\nIhave often seen comments or articles by industry “experts” arguing for the use of constant\n\nforward (perpetual) series instead of continuous series in order to avoid distortions. This argument \nhas it exactly backwards. Whether these proponents of constant\nforward series adopt their stance \nbecause of naïveté or self interest (i.e., they are vendors of constant forwardtype data), they are \nsimply wrong. This is not amatter of opinion. If you have any doubts, try matching up fluctuations \nin an actual trading account with those that would be implied by constant\nforwardtype price series. \nyou will soon be abeliever.\nAre there any drawbacks to the continuous futures time series? of course. It may be the best \nsolution to the linked series problem, but it is not aperfect answer. Aperfect alternative simply \ndoes not exist. \none potential drawback, which is aconsequence of the fact that continuous futures \naccurately reflect only price swings, not price levels, is that continuous futures cannot be used for any \ntype of percentage calculations. This situation, however, can be easily remedied. If asystem requires \nthe calculation of apercentage change figure, use continuous futures to calculate the nominal price", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:304", "doc_id": "b38517fb5508e4a7ddc8b72a255f4da7f4bc0e3819a71f5fd5d587ca4b4863cc", "chunk_index": 0}
{"text": "440\nA Complete Guide to the Futures mArket\n ■ Spreads—Definition and Basic Concepts\nAspread trade involves the simultaneous purchase of one futures contract against the sale of another \nfutures contract either in the same market or in arelated market. normally, the spread trader will \ninitiate aposition when he considers the price difference between two futures contracts to be out of \nline rather than when he believes the absolute price level to be too high or too low . \nin essence, the \nspread trader is more concerned with the difference between prices than the direction of price. For \nexample, if atrader buys October cattle and sells February cattle, it would not make any difference to \nhim whether October rose by 500 points and February by only 400 points or October fell by 400 and \nFebruary fell by 500. \nin either case, October would have gained 100 points relative to February, and \nthe trader’sprofit would be completely independent of the overall market direction.\nHowever, this is not to say the spread trader will initiate atrade without having some definitive \nbias as to the future outright market direction. in fact, very often the direction of the market will \ndetermine the movement of the spread. in some instances, however, aspread trader may enter aposi-\ntion when he has absolutely no bias regarding future market direction but views agiven price differ-\nence as being so extreme that he believes the trade will work, or at worst allow only amodest loss, \nregardless of market direction. Wewill elaborate on the questions of when and how market direction \nwill affect spreads in later sections.\n ■ Why Trade Spreads?\nthe following are some advantages to not exclusively restricting one’strading to outright positions:\n 1. In highly volatile markets, the minimum outright commitment of one contract \nmay offer excessive risk to small traders. \nin such markets, one-day price swings in excess \nof $1,500 per contract are not uncommon, and holding aone-contract position may well be \novertrading for many traders. \nironically, it is usually these highly volatile markets that provide \nthe best potential trading opportunities. spreads offer agreat flexibility in reducing risk to \nadesirable and manageable level, since aspread trade usually presents only afraction of the \nrisk involved in an outright position.\n1 For example, assume agiven spread is judged to involve \napproximately one-fifth the risk of an outright position. in such acase, traders for whom aone-\ncontract outright position involves excessive risk may instead choose to initiate aone-, two-, \nthree-, or four-contract spread position, depending on their desired risk level and objectives.\n 2. there are times when spreads may offer better reward/risk ratios than outright \npositions. Of course, the determination of areward/risk ratio is asubjective matter. never-\ntheless, given atrader’smarket bias, in agiven situation spreads may sometimes offer abetter \nmeans of approaching the market.\n1 For some markets, reduced-size contracts are available on one or more exchanges.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:458", "doc_id": "fd9a70a888d0cd005e629549b63de121ad0b80ea6f3455577ef740c21b90eb56", "chunk_index": 0}
{"text": "441\ntHe COnCepts And MeCHAniCs OF spreAd trAding \n 3. Spreads often offer some protection against sudden extreme losses due to dra-\nmatic events that may spark astring of limit-up or limit-down moves counter to \none’sposition (e.g., freeze, large export deal). \nsuch situations are not all that infrequent, \nand traders can sometimes lose multiples of the maximum loss they intended to allow (i.e., as \nreflected by aprotective stop) before they can even liquidate their positions. \nin contrast, during \natime of successive limit moves, the value of aspread might not even change as both months \nmay move the limit. Of course, eventually the spread will also react, but when it does, the \nmarket may well be past its frenzied panic stage, and the move may be gradual and moderate \ncompared with the drastic price change of the outright position.\n 4. aknowledge and understanding of spreads can also be avaluable aid in trading \noutright positions. For example, afailure of the near months to gain sufficiently during arally (in those commodities in which again can theoretically be expected) may signal the trader \nto be wary of an upward move as apossible technical surge vulnerable to retracement. \nin other \nwords, the spread action may suggest that no real tightness exists. this scenario is merely one \nexample of how close observation of spreads can offer valuable insights into outright market \ndirection. \nnaturally, at times, the inferences drawn from spread movements may be mislead-\ning, but overall they are likely to be avaluable aid to the trader. Asecond way an understanding \nof spreads can aid an outright-position trader is by helping identify the best contract month in \nwhich to initiate aposition. \nthe trader with knowledge of spreads should have adistinct advan-\ntage in picking the month that offers the best potential versus risk. Over the long run, this factor \nalone could significantly improve trading performance.\n 5. trading opportunities may sometimes exist for spreads at atime when none is \nperceived for the outright commodity itself.\n ■ Types of Spreads\nthere are three basic types of spreads:\n 1. the intramarket (or interdelivery) spread is the most common type of spread and con-\nsists of buying one month and selling another month in the same commodity. An example of an \nintramarket spread would be long \ndecember corn/short March corn. the intramarket spread \nis by far the most widely used type of spread and will be the focus of this chapter’sdiscussion.\nthe intercrop spread is aspecial case of the intramarket spread involving two different \ncrop years (e.g., long an old crop month and short anew crop month). the intercrop spread \nrequires special consideration and extra caution. intercrop spreads can often be highly volatile, \nand price moves in opposite directions by new and old crop months are not particularly uncom-\nmon. \nthe intercrop spread may often be subject to price ranges and patterns that distinctly \nseparate it from the intracrop spread (i.e., standard intramarket spread).\n 2. the intercommodity spread consists of along position in one commodity and ashort \nposition in arelated commodity. in this type of spread the trader feels the price of agiven", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:459", "doc_id": "448a0d29339b779108fed487162855c1fb654ed9feccb4f4d9f075980b5d6521", "chunk_index": 0}
{"text": "442\nA Complete Guide to the Futures mArket\ncommodity is too high or low relative to aclosely related commodity. some examples of this \ntype of spread include long december cattle/short december hogs and long July wheat/short \nJuly corn. The source/product spread, which involves acommodity and its by-product(s)—for \nexample, soybeans versus soybean meal and/or soybean oil—is aspecific type of intercommod-\nity spread that is sometimes classified separately.\nusually, an intercommodity spread will involve the same month in each commodity, but \nthis need not always be the case. ideally, traders should choose the month they consider the \nstrongest in the market they are buying and the month they consider the weakest in the market \nthey are selling. Obviously, these will not always be the same month. For example, assume the \nfollowing price configuration:\nDecember February april\nCattle 120.00 116.00 118.00\nHogs 84.00 81.00 81.00\ngiven this price structure, atrader might decide the premium of cattle to hogs is too small \nand will likely increase. this trading bias would dictate the initiation of along cattle/short hog \nspread. However, the trader may also believe February cattle is underpriced relative to other \ncattle months and that december hogs are overpriced relative to the other hog contracts. in \nsuch acase, it would make more sense for the trader to be long February cattle/short decem-\nber hogs rather than long december cattle/short december hogs or long February cattle/short \nFebruary hogs.\nOne important factor to keep in mind when trading intercommodity spreads is that contract \nsizes may differ for each commodity. For example, the contract size for euro futures is 125,000 \nunits, whereas the contract size for British pound futures is 62,500 units. \nthus, aeuro/British \npound spread consisting of one long contract could vary even if the price difference between \nthe two markets remained unchanged. \nthe difference in price levels is another important fac-\ntor relevant to contract ratios for intercommodity spreads. the criteria and methodology for \ndetermining appropriate contract ratios for intercommodity spreads are discussed in the next \nchapter.\n 3. the intermarket spread. this spread involves buying acommodity at one exchange and sell-\ning the same commodity at another exchange, which will often be another country. An example \nof this type of spread would be long \nnew York March cocoa/short London March cocoa. trans-\nportation, grades deliverable, distribution of supply (total and deliverable) relative to location, \nand historical and seasonal basis relationships are the primary considerations in this type of \nspread. \nin the case of intermarket spreads involving different countries, currency fluctuations \nbecome amajor consideration. intermarket spread trading is often referred to as arbitrage. As \narule, the intermarket spread requires agreater degree of sophistication and comprehensive \nfamiliarity with the commodity in question than other types of spreads.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:460", "doc_id": "53a1a8564352ac9839e17a54cef411fa8fa4432312da0b461ac46c82dfedbcce", "chunk_index": 0}
{"text": "443\ntHe COnCepts And MeCHAniCs OF spreAd trAding \n ■ The General Rule\nFor many commodities, the intramarket spread can often, but not always, be used as aproxy for an \noutright long or short position. As ageneral rule, near months will gain ground relative to distant \nmonths in abull market and lose ground in abear market. \nthe reason for this behavior is that abull \nmarket usually reflects acurrent tight supply situation and often will place apremium on more imme-\ndiately available supplies. \nin abear market, however, supplies are usually burdensome, and distant \nmonths will have more value because they implicitly reflect the cost involved in storing the com-\nmodity for aperiod of time. \nthus, if atrader expects amajor bull move, he can often buy anearby \nmonth and sell amore distant month. if he is correct in his analysis of the market and abull move \ndoes materialize, the nearby contract will likely gain on the distant contract, resulting in asuccess-\nful trade. \nit is critical to keep in mind that this general rule is just that, and is meant only as arough \nguideline. there are anumber of commodities for which this rule does not apply, and even in those \ncommodities where it does apply, there are important exceptions. Wewill elaborate on the question \nof applicability in the next section.\nAt this point the question might legitimately be posed, “\nif the success of agiven spread trade is \ncontingent upon forecasting the direction of the market, wouldn’tthe trader be better off with an \noutright position?” Admittedly, the potential of an outright position will almost invariably be consid-\nerably greater. But the point to be kept in mind is that an outright position also entails acorrespond-\ningly greater risk. \nsometimes the outright position will offer abetter reward/risk ratio; at other \ntimes the spread will offer amore attractive trade. Adetermination of which is the better approach \nwill depend upon absolute price levels, prevailing price differences, and the trader’ssubjective views \nof the risk and potential involved in each approach.\n ■ The General Rule—Applicability and Nonapplicability\nCommodities to Which the General rule Can Be applied\nCommodities to which the general rule applies with some regularity include corn, wheat, oats, \nsoybeans, soybean meal, soybean oil, lumber, sugar, cocoa, cotton, orange juice, copper, and heating \noil. (\nthe general rule will also usually apply to interest rate markets.) Although the general rule will \nusually hold in these markets, there are still important exceptions, some of which include:\n 1. At agiven point in time the premium of anearby month may already be excessively wide, and \nconsequently ageneral price rise in the market may fail to widen the spread further.\n 2. since higher prices also increase carrying costs (see section entitled “the Limited-risk spread”), \nit is theoretically possible for aprice increase to widen the discount of nearby months in asurplus market. Although such aspread response to higher prices is atypical, its probability of \noccurrence will increase in ahigh-interest-rate environment.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:461", "doc_id": "4926facc6cd37626d8eedb484412f057455b0d1b9d8ff91133288f44ba52ef9e", "chunk_index": 0}
{"text": "444\nA Complete Guide to the Futures mArket\n 3. spreads involving aspot month near expiration can move independently of, or contrary to, the \ndirection implied by the general rule. the reason is that the price of an expiring position is criti-\ncally dependent upon various technical considerations involving the delivery situation, and wide \ndistortions are common.\n 4. Abull move that is primarily technical in nature may fail to influence awidening of the nearby \npremiums since no real near-term tightness exists. (\nsuch aprice advance will usually only be \ntemporary in nature.)\n 5. government intervention (e.g., export controls, price controls, etc.), or even the expectation \nof government action, can completely distort normal spread relationships.\ntherefore, it is important that when initiating spreads in these commodities, the trader keep in \nmind not only the likely overall market direction, but also the relative magnitude of existing spread \ndifferences and other related factors.\nCommodities Conforming to the Inverse of the General rule\nsome commodities, such as gold and silver, conform to the exact inverse of the general rule: in aris-\ning market distant months gain relative to more nearby contracts, and in adeclining market they lose \nrelative to the nearby positions. In fact, in these markets, along forward/short nearby spread is often agood \nproxy for an outright long position, and the reverse spread can be asubstitute position for an outright short. \nin \neach of these markets nearby months almost invariably trade at adiscount, which tends to widen in \nbull markets and narrow in bear markets.\nthe reason for the tendency of near months in gold and silver to move to awider discount in abull market derives from the large worldwide stock levels of these metals. generally speaking, price \nfluctuations in gold and silver do not reflect near-term tightness or surplus, but rather the market’schanging perception of their value. \nin abull market, the premium of the back months will increase \nbecause higher prices imply increased carrying charges (i.e., interest costs will increase as the total \nvalue of the contract increases). Because the forward months implicitly contain the cost of carrying \nthe commodity, their premium will tend to widen when these costs increase. Although the preced-\ning represents the usual pattern, there have been afew isolated exceptions due to technical factors.\nCommodities Bearing Little or No relationship to the General rule\nCommodities in which there is little correlation between general price direction and spread differ-\nences usually fall into the category of nonstorable commodities (cattle and live hogs). Wewill exam-\nine the case of live cattle to illustrate why this there is no consistent correlation between price and \nspread direction in nonstorable markets.\nLive cattle, by definition, is acompletely nonstorable commodity. When feedlot cattle reach mar-\nket weight, they must be marketed; unlike most other commodities, they obviously cannot be placed \nin storage to await better prices. (\nto be perfectly accurate, cattle feeders have asmall measure of \nflexibility, in that they can market an animal before it reaches optimum weight or hold it for awhile \nafter. However, economic considerations will place strong limits on the extent of such marketing", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:462", "doc_id": "049adfde8b6250d803eae4543efe806dcf3491f48bd03c0df532569fd8188c76", "chunk_index": 0}
{"text": "445\ntHe COnCepts And MeCHAniCs OF spreAd trAding \nshifts.) As aconsequence of the intrinsic nature of this commodity, different months in live cattle are, \nin asense, different commodities. June live cattle is avery different commodity from december live \ncattle. the price of each will be dependent on the market’sperception of the supply-demand picture \nthat it expects to prevail at each given time period. it is not unusual for akey cattle on feed report to \ncarry bullish implications for near months and bearish connotations for distant months, or vice versa. \nin such acase, the futures market can often react by moving in opposite directions for the near and \ndistant contracts. the key point is that in abullish (bearish) situation, the market will sometimes view \nthe near-term supply/demand balance as being more bullish (bearish) and sometimes it will view the \ndistant situation as being more bullish (bearish). Asimilar behavioral pattern prevails in hogs. \nthus, \nthe general rule would not apply in these types of markets.\nin these markets, rather than being concerned about the overall price direction, the spread trader \nis primarily concerned with how he thinks the market will perceive the fundamental situation in dif-\nferent time periods. For example, at agiven point in time, June cattle and \ndecember cattle may be \ntrading at approximately equal levels. if the trader believes that marketings will become heavy in the \nmonths preceding the June expiration, placing pressure on that contract, and further believes the \nmarket psychology will view the situation as temporary, expecting prices to improve toward year-\nend, he would initiate along \ndecember/short June cattle spread. note that if he is correct in the \ndevelopment of near-term pressure but the market expects even more pronounced weakness as time \ngoes on, the trade will not work even if his expectations for improved prices toward year-end also \nprove accurate. One must always remember that aspread’slife span is limited to the expiration of the \nnearer month, and substantiation of the spread idea after that point will be of no benefit to the trader. \nthus, the trader is critically concerned, not only with the fundamentals themselves, but also with the \nmarket’sperception of the fundamentals, which may or may not be the same.\n ■ Spread Rather Than Outright—An Example\nFrequently, the volatility of agiven market may be so extreme that even aone-contract position may \nrepresent excessive risk for some traders. \nin such instances, spreads offer the trader an alternative \napproach to the market. For example, in early 2014, coffee futures surged dramatically, gaining more \nthan 75 percent from late January to early March, with average daily price volatility more than tri-\npling during that period. \nprices swung wildly for the next several months—pushing to ahigher high \nin April, giving back more than half of the rally in the sell-off to the July low , and then rallying to yet \nanother new high in October (see Figure 30.1). At that juncture, assume alow-risk trader believed \nthat prevailing nearest futures prices near $2.22 in mid-October 2014 were unsustainable, but based \non the market’svolatility (which was still around three times what it had been early in the year) and his \nmoney management rules felt he could not assume the risk of an outright position. \nsuch atrader could \ninstead have entered abear spread (e.g., short July 2015 coffee/long december 2015 coffee) and \nprofited handsomely from the subsequent price slide. Figure 30.1 illustrates the close correspondence \nbetween the spread and the market. \nthe fact that an outright position would have garnered amuch \nlarger profit is an irrelevant consideration, since the trader’srisk limitations would have prevented him \nfrom participating in the bear move altogether had his market view been confined to outright trades.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:463", "doc_id": "aac8bf54235368fe647e0efa7e7089523167a857a4d42bbfedb08af4ed81d988", "chunk_index": 0}
{"text": "446A COMpLete guide tO tHe Futures MArKet\n ■ The Limited-Risk Spread \n the limited-risk spread is atype of intracommodity spread involving the buying of anear month \n(relatively speaking) and the selling of amore distant month in astorable commodity in which the \nprocess of taking delivery, storing, and redelivering at alater date does not require reinspection or \ninvolve major transportation or storage complications. this defi nition would exclude such commodi-\nties as live cattle, which by defi nition are nonstorable, and sugar, which involves major complications \nin taking delivery and storing. Commodities that fall into the limited-risk category include corn, \nwheat, oats, soybeans, soybean oil, copper, cotton, orange juice, cocoa, and lumber. \n2 \n in acommodity fulfi lling the above specifi cations, the maximum premium that amore distant \nmonth can command over anearby contract is roughly equal to the cost of taking delivery, holding \nthe commodity for the length of time between the two expirations, and then redelivering. the cost \nfor this entire operation is referred to as full carry. the term limited risk will be used only when the \nnearby month is at adiscount. For example, assuming full carry in the October/december cotton \n FIGURE  30.1 July and december 2015 Coff ee Futures vs. July/december 2015 Coff ee spread\nChart created using tradestation. ©tradestation technologies, inc. All rights reserved. \n 2 Although precious metals can easily be received in delivery, stored, and redelivered, they are not listed here \nbecause spreads in precious metals are almost entirely determined by carrying charges. thus, the only motivation \nfor implementing an intramarket precious metals spread is an expectation for achange in carrying charges. in \ncontrast, the purpose of alimited-risk spread is to profi tfrom an expected narrowing of the spread relative to \nthe level implied by carrying charges (which are assumed to remain constant).", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:464", "doc_id": "4bb4956f0f38d49dab01f4d970b115eef943945038cdaaef54916a44535e908d", "chunk_index": 0}
{"text": "447\ntHe COnCepts And MeCHAniCs OF spreAd trAding \nspread is equal to 200 points, along October/short december spread initiated at October 100 points \nunder might be termed alimited-risk spread. However, the same long October/short december \ncotton spread would not be termed limited risk if, for example, October were at a 300-point pre-\nmium. nevertheless, it should be noted that even in this latter case, the maximum risk would still be \ndefined—namely, 500 points—and in this respect the spread would still differ from spreads involving \nthe selling of the nearby contract, or spreads in markets that do not fulfill the limited-risk specifica-\ntions detailed above.\nthe best way to understand why it is unlikely for the premium of adistant month to exceed car-\nrying costs is to assume the existence of asituation where this is indeed the case. in such an instance, \natrader who bought anearby month and sold amore distant month would have an opportunity for \nspeculative gain and, at worst, would have the option of taking delivery, storing, and redelivering at \nalikely profit (since we assumed asituation in which the premium of the distant month exceeded \ncarrying charges). \nsounds too good to be true? Of course, and for this reason differences beyond full \ncarry are quite rare unless there are technical problems in the delivery process. in fact, it is usually \nunlikely for aspread difference to even approach full carry since, as it does, the opportunity exists for \naspeculative trade that has very limited risk but, theoretically, no limit on upside potential. \nin other \nwords, as spreads approach full carry, some traders will initiate long nearby/short forward spreads \nwith the idea that there is always the possibility of gain, but, at worst, the loss will be minimal. For \nthis reason, spreads will usually never reach full carry.\nAt asurface glance, limited-risk spreads seem to be highly attractive trades, and indeed they often \nare. However, it should be emphasized that just because aspread is relatively near full carry does not neces-\nsarily mean it is an attractive trade. Very often, such spreads will move still closer to full carry, resulting \nin aloss, or trade sluggishly in anarrow range, tying up capital that could be used elsewhere. How-\never, if the trader has reason to believe the nearby month should gain on the distant, the fact that the \nspread has alimited risk (the difference between full carry and the current spread differential) makes \nthe trade particularly attractive.\nthe components of carrying costs include interest, storage, insurance, and commission. Wewill \nnot digress into the area of calculating carrying charges. ( such information can be obtained either \nthrough the exchanges themselves or through commodity brokers or analysts specializing in the given \ncommodity.) However, we would emphasize that the various components of carrying charges are \nvariable rather than fixed, and consequently carrying charges can fluctuate quite widely over time. \ninterest \ncosts are usually the main component of carrying charges and are dependent on interest rates and \nprice levels, both of which are sometimes highly volatile. \nit is critical to keep changes in carrying costs \nin mind when making historical comparisons.\nCan atrader ever lose more money in alimited-risk spread than the amount implied by the differ-\nence between full carry and the spread differential at which the trade was initiated? the answer is that \nalthough such an occurrence is unlikely, it is possible. For one thing, as we indicated above, carrying \ncharges are variable, and it is possible for the theoretical maximum loss of aspread trade to increase \nas aresult of fluctuations in carrying costs. For example, atrader might enter along October/short \ndecember cotton spread at 100 points October under, at atime when full carry approximates 200 \npoints—implying amaximum risk of 100 points. However, in ensuing months, it is possible higher", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:465", "doc_id": "17c18043ca4ac9161425fc966213ac42f3a49897e77021cf34ef903f8d23c82a", "chunk_index": 0}
{"text": "448\nA Complete Guide to the Futures mArket\nprices and rising interest rates could cause full carry to move beyond 200 points, increasing the trad-\ner’srisk correspondingly. in such an instance, it is theoretically possible for the given spread to move \nsignificantly beyond the point the trader considered the maximum risk point. Although such an event \ncan occur, it should be emphasized that it is rather unusual, since in alimited-risk spread increased \ncarrying costs due to sharply higher price levels will usually imply larger gains for the nearby months. \nAs for interest rates, changes substantial enough to influence marked changes in carrying costs will \nusually take time to develop.\nAnother example of alimited-risk spread that might contain hidden risk is the case in which \nthe government imposes price ceilings on nearby contracts but not on the more distant contracts. \nAlthough highly unusual, this situation has happened before and represents apossible risk that the \nspread trader should consider in the unlikely event that the prevailing political environment is condu-\ncive to the enactment of price controls.\nAlso, for short intervals of time, spread differences may well exceed full carry due to the absence \nof price limits on the nearby contract. For anumber of commodities, price limits on the nearby \ncontract are removed at some point before its expiration (e.g., first notice day, first trading day of \nthe expiring month, etc.). Consequently, in asharply declining market, the nearby month can move \nto adiscount exceeding full carry as the forward month is contained by price limits. Although this \nsituation will usually correct itself within afew days, in the interim, it can generate asubstantial mar-\ngin call for the spread trader. \nit is important that spread traders holding their positions beyond the \nremoval of price limits on the nearby contract are sufficiently capitalized to easily handle such possible \ntemporary spread aberrations.\nAs afinal word, it should be emphasized that although there is atheoretical limit on the premium that \nadistant month can command over anearby contract in carrying-charge markets, there is no similar limit on the \npremium that anearby position can command. \nnearby premiums are usually indicative of atight current \nsupply situation, and there is no way of determining an upper limit to the premium the market will \nplace on more immediately available supplies.\n ■ The Spread Trade—Analysis and Approach\nStep 1: Straightforward historical Comparison\nAlogical starting point is asurvey of the price action of the given spread during recent years. Histori-\ncal spread charts, if available, are ideal for this purpose. if charts (or historical price data that can be \ndownloaded into aspreadsheet) are unavailable, the trader should, if possible, scan historical price \ndata, checking the difference of the given spread on abiweekly or monthly basis for at least the past \n5 to 10 years. \nthis can prove to be atime-consuming endeavor, but aspread trade initiated without \nany concept of historical patterns is, in asense, ashot in the dark. Although spreads can deviate \nwidely from historical patterns, it is still important to know the normal range of aspread, as well as \nits “average” level.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:466", "doc_id": "778e2d5529b35f1748a024fd8c371b0e6d24ec4cbf55bed4aa1bb1c5352434c7", "chunk_index": 0}
{"text": "449\ntHe COnCepts And MeCHAniCs OF spreAd trAding \nStep 2: Isolation of Similar Periods\nAs arule, spreads will tend to act similarly in similar situations. thus, the next step would be arefine-\nment of step 1 by means of isolating roughly similar periods. For example, in ahigh-priced year, we \nmight be interested in considering the spread action only in other past bull seasons, or we can cut the \nline still sharper and consider only bull seasons that were demand oriented or only those that were \nsupply oriented. An examination of the spread’sbehavior during different fundamental conditions in \npast years will usually reveal the relative comparative importance of similar and dissimilar seasons.\nStep 3: analysis of Spread Seasonality\nthis step is afurther refinement of step 1. sometimes aspread will tend to display adistinct seasonal \npattern. For example, agiven spread may tend to widen or narrow during aspecific period. Knowledge \nof such aseasonality can be critically important in deciding whether or not to initiate agiven spread. \nFor example, if in nine of the past 10 seasons the near month of agiven spread lost ground to the distant \nmonth during the March–June period, one should think twice about initiating abull spread in March.\nStep 4: analysis and Implications of relevant Fundamentals\nthis step would require the formulation of aconcept of market direction (in commodities where \napplicable), or equivalent appropriate analysis in those commodities where it is not. this approach is \nfully detailed in the sections entitled “the general rule” and “the general rule—Applicability and \nnonapplicability.”\nStep 5: Chart analysis\nAkey step before initiating aspread trade should be the examination of acurrent chart of the spread \n(or the use of some other technical input). As in outright positions, charts are an invaluable informa-\ntional tool and acritical aid to timing.\n ■ Pitfalls and Points of Caution\n ■ do not automatically assume aspread is necessarily alow-risk trade. in some instances, aspread \nmay even involve greater risk than an outright position. specifically, in the case of intercommodity \nspreads, intercrop spreads, and spreads involving nonstorable commodities, the two legs of the \nspread can sometimes move in opposite directions.\n ■ Be careful not to overtrade aspread because of its lower risks or margin. A 5- to 10-contract \nspread position gone astray can often prove more costly than abad one-contract outright trade. \nOvertrading is avery common error in spread trading.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:467", "doc_id": "bc586be8ef4ec4766cd8f58fcacbd36122175ce59b67686c19b8a4662e445837", "chunk_index": 0}
{"text": "450\nA Complete Guide to the Futures mArket\n ■ As ageneral rule, traders should avoid trading spreads in markets in which they are unfamiliar \nwith the fundamentals.\n ■ Check the open interest of the months involved to ensure adequate liquidity, especially in spreads \ninvolving distant back months. Alack of liquidity can significantly increase the loss when getting \nout of aspread that has gone awry. At times, of course, agiven spread may be sufficiently attrac-\ntive despite its less-than-desirable liquidity. \nnevertheless, even in such acase, it is important that \ntraders be aware of the extra risk involved.\n ■ place aspread order on aspread basis rather than as two separate outright orders. some traders \nplace their spread orders one leg at atime in the hopes of initiating their position at abetter price \nthan the prevailing market level. \nsuch an approach is inadvisable not only because it will often \nbackfire, but also because it will increase commission costs.\n ■ When the two months of the spread are very close in price, extra care should be taken to specify \nclearly which month is the premium month in the order.\n ■ do not assume that current price quotations accurately reflect actual spread differences. time lags \nin the buying and selling of different contracts, as well as amomentary concentration of orders in \nagiven contract month, can often result in outright price quotations implying totally unrepresen-\ntative spread values.\n ■ do not liquidate spreads one leg at atime. Failing to liquidate the entire spread position at one \ntime is another common and costly error, which has caused many agood spread trade to end in \naloss.\n ■ Avoid spreads involving soon-to-expire contracts. expiring contracts, aside from usually being \nfree of any price limits, are subject to extremely wide and erratic price moves dependent on \ntechnical delivery conditions.\n ■ do not assume the applicability of prior seasons’ carrying charges before initiating alimited-risk \nspread. Wide price swings and sharply fluctuating interest costs can radically alter carrying costs.\n ■ try to keep informed of any changes in contract specifications, since such changes can substan-\ntially alter the behavior of aspread.\n ■ properly implemented intercommodity and intermarket spreads often require an unequal num-\nber of contracts in each market. the methodology for determining the proper contract ratio be-\ntween different markets is discussed in the next chapter.\n ■ do not use spreads to protect an outright position that has gone sour—that is, do not initiate an \nopposite direction position in another contract as an alternative to liquidating alosing position. \nin most cases such amove amounts to little more than fooling oneself and often can exacerbate \nthe loss.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:468", "doc_id": "b5c2754c37030c94650ecd062e44c4565f2fa4fbaefbd93db9b6135841cb21d9", "chunk_index": 0}
{"text": "451\ntHe COnCepts And MeCHAniCs OF spreAd trAding \n ■ Because it is especially easy to procrastinate in liquidating alosing spread position, the spread \ntrader needs to be particularly vigilant in adhering to risk management principals. it is advisable \nthat the spread trader determine amental stop point (usually on the basis of closing values) prior \nto entering aspread and rigidly stick to liquidating the spread position if this mental stop point is \nreached.\n ■ Avoid excessively low-risk spreads because transaction costs (slippage as well as commission) will \nrepresent asignificant percentage of the profit potential, reducing the odds of anet winning out-\ncome. \nin short, the odds are stacked against the very-low-risk spread trader.\n ■ As acorollary to the prior item, atrader should choose the most widely spaced intramarket \nspread consistent with the desired risk level. \ngenerally speaking, the wider the time duration in \nan intramarket spread, the greater the volatility of the spread. this observation is as true for mar-\nkets conforming to the general rule as for markets unrelated or inversely related to the general \nrule. \ntraders implementing agreater-than-one-unit intramarket spread position should be sure to \nchoose the widest liquid spread consistent with the trading strategy. For example, it usually would \nmake little sense to implement atwo-unit March/May corn spread, since aone-unit March/July \ncorn spread would offer avery similar potential/risk trade at half the transaction cost.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:469", "doc_id": "9154fdbc6b204ce9ba58934f589bdb8385a616831ef0d627f85701a9f98aca51", "chunk_index": 0}
{"text": "453\n. . . many more people see than weigh.\n—Philip Dormar Stanhope, Earl of Chesterfield\nBydefinition, the intention of the spread trader is to implement aposition that will reflect changes \nin the price difference between contracts rather than changes in outright price levels. Toachieve \nsuch atrade, the two legs of aspread must be equally weighted. As an obvious example, long 2 \nDecember corn/short 1 March corn is aspread in name only. Such aposition would be far more \ndependent on fluctuations in the price level of corn than on changes in the price difference between \nDecember and March.\nThe meaning of equally weighted, however, is by no means obvious. Many traders simply assume \nthat abalanced spread position implies an equal number of contracts long and short. Such an assump-\ntion is usually valid for most intramarket spreads (although an exception will be discussed later in this \nchapter). However, for many intermarket and intercommodity\n1 spreads, the automatic presumption \nof an equal number of contracts long and short can lead to severe distortions.\nConsider the example of atrader who anticipates that demand for lower quality Robusta coffee \nbeans (London contract) will decline relative to higher quality Arabica beans (New York contract) and \nIntercommodity \nSpreads: Determining \nContract Ratios\nChapter 31\n1 The distinction between intermarket and intercommodity spreads was defined in Chapter 30. An intermarket \nspread involves buying and selling the same commodity at two different exchanges (e.g., New York vs. London \ncocoa); the intercommodity spread involves buying and selling two different but related markets (e.g., wheat vs. \ncorn, cattle vs. hogs).", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:471", "doc_id": "dfce3c0befbc21ad921629e03c7a7f62c1361fcae69142592532f69a27343a6b", "chunk_index": 0}
{"text": "454\nA Complete Guide to the Futures mArket\nattempts to capitalize on this forecast by initiating a 5-contract long New York coffee/short London \ncoffee spread. Assume the projection is correct, and London coffee prices decline from $0.80/lb to \n$0.65/lb, while New York coffee prices simultaneously decline from $1.41/lb to $1.31/lb. At sur-\nface glance, it might appear this trade is successful, since the trader is short London coffee (which has \ndeclined by $0.15/lb) and long New York coffee (which has lost only $0.10/lb). However, the trade \nactually loses money (even excluding commissions). The explanation lies in the fact that the contract \nsizes for the New York and London coffee contracts are different: The size of the New York coffee \ncontract is 37,500 lb, while the size of the London coffee contract is 10 metric tonnes, or 22,043 lb. \n(Note: In practice, the London coffee contract is quoted in dollars/tonne; the calculations in this sec-\ntion reflect aconversion into $/pound for easier comparison with the New York coffee contract.) \nBecause of this disparity, an equal contract position really implies alarger commitment in New York \ncoffee. Consequently, such aspread position is biased toward gaining in bull coffee markets (assuming \nthe long position is in New York coffee) and losing in bear markets. The long New York/short London \nspread position in our example actually loses $2,218 plus commissions, despite the larger decline in \nLondon coffee prices:\nProfit/los so fco ntractso funits per contrac tg ain/loss=× ×## per un it\nProfit/loss in long New York coffee positio n5 37 5000=× ×−,( $. .) $,10/lb1 8 750=−\nProfit/loss in short London coffee position = 52 20 43×× +,( $001 5/lb 16 532.) $,=+\nNet profit/loss in sprea d2 218=− $,\nThe difference in contract size between the two markets could have been offset by adjusting the \ncontract ratio of the spread to equalize the long and short positions in terms of units (lb). The gen-\neral procedure would be to place U1/U2 contracts of the smaller-unit market (i.e., London coffee) \nagainst each contract of the larger-unit contract (i.e., New York coffee). (U1 and U2 represent the \nnumber of units per contract in the respective markets—U1 = 37,500 lb and U2 = 22,043 lb.) Thus, \nin the New York coffee/London coffee spread, each New York coffee contract would be offset by \n1.7 (37,500/22,043) London coffee contracts, implying aminimum equal-unit spread of five London \ncoffee versus three New York coffee (rounding down the theoretical 5.1-contract London coffee posi-\ntion to 5 contracts.) This unit-equalized spread would have been profitable in the above example:\nProfit/los so fco ntractso funits per contrac tg ain/loss=× ×## per un it\nProfit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,10/lb1 1 250=−\nProfit/loss in short London coffee position 52 20 43 0=× ×+,( $. 115/lb +1 6 532)$ ,=\nNet profit/loss in sprea d+ 5 282= $,\nThe unit-size adjustment, however, is not the end of our story. It can be argued that even the \nequalized-unit New York coffee/London coffee spread is still unbalanced, since there is another signifi-\ncant difference between the two markets: London coffee prices are lower than New York coffee prices. \nThis observation raises the question of whether it is more important to neutralize the spread against \nequal price moves or equal-percentage price moves. The rationale for the latter approach is that, all \nelse being equal, the magnitude of price changes is likely to be greater in the higher-priced market.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:472", "doc_id": "04276e0c51b3782348be5825df8f3bb857abac41b3412bb6264bf993dc223161", "chunk_index": 0}
{"text": "455\nIntercommodIty SpreadS: determInIng contract ratIoS\nThe fact that percentage price change is amore meaningful measure than absolute price change is \nperhaps best illustrated by considering the extreme example of the gold/silver spread. The equal-unit \napproach, which neutralizes the spread against equal-dollar price changes in both markets, would \nimply the rather ludicrous spread position of 50 gold contracts versus 1 silver contract. (The contract \nsize of silver is 5,000 oz; the contract size of gold is 100 oz.) Obviously, such aposition would be \nalmost entirely dependent upon changes in the price of gold rather than any movement in the gold/\nsilver spread. The disparity is due to the fact that since gold is far higher priced than silver (by aratio \nof 32-101:1 based on the past 30-year range), its price swings will also be far greater. For example, if \ngold is trading at $1,400/oz and silver at $20/oz, a $2 increase in silver prices is likely to be accom-\npanied by far more than a $2 increase in gold prices. Clearly, the relevant criterion in the gold/silver \nspread is that the position should be indifferent to equal percentage price changes rather than equal \nabsolute price changes. Although less obvious, the same principle would also appear preferable, even \nfor intercommodity or intermarket spreads between more closely priced markets (e.g., New York \ncoffee/London coffee).\nThus we adopt the definition that abalanced spread is aspread that is indifferent to equal percentage \nprice changes in both markets. It can be demonstrated this condition will be fulfilled if the spread is \ninitiated so the dollar values of the long and short positions are equal.\n2 An equal-dollar-value spread \n2 If the spread is implemented so that dollar values are equal, then:\nNU PN UPtt11 10 22 20,,== =\nwhere N1 = number of contracts in market 1\n N2 = number of contracts in market 2\n U1 = number of units per contract in market 1\n U2 = number of units per contract in market 2\n P1,t=0 = price of market 1 at spread initiation\n P2,t=0 = price of market 2 at spread initiation\nAn equal-percentage price change implies that both prices change by the same factor k. Thus,\nPk PP kPtt tt11 10 21 20,, ,,== ==== and\nwhere Pl,t = 1 = price of market 1 after equal-percentage price move\n P2,t = 1 = price of market 2 after equal-percentage price move\nAnd the equity changes (in absolute terms) are:\nEquity change in market 1 positio n =− ===NU kP PN UPtt11 10 10 11 1|| ,, ,tttt\nk\nNU kP P\n=\n==\n−\n=−\n0\n22 20 20\n1 |\n| ,,\n|\nEquity change in market 2 positio n| || ,=− =NU Pkt22 20 1 |\nSince, by definition, an equal-dollar-value spread at initiation implies that N1U1P1,t = 0 = N2U2P2,t = 0, the equity \nchanges in the positions are equal.\nIt should be noted that the equal-dollar-value spread only assures that equal-percentage price changes will \nnot affect the spread if the percentage price changes are measured relative to the initiation price levels. However, \nequal-percentage price changes from subsequent price levels will normally result in different absolute dollar \nchanges in the long and short positions (since the position values are not necessarily equal at any post-initiation \npoints of reference).", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:473", "doc_id": "e5b82b840731b2d62393cdb42dbe7c06be9194248e53c408a260977a0f2dc4d5", "chunk_index": 0}
{"text": "456\nA Complete Guide to the Futures mArket\ncan be achieved by using acontract ratio that is inversely proportional to the contract value (CV) ratio. \nThis can be expressed as follows (see footnote 2 for symbol definitions):\nN\nN\nCV\nCV\nUP\nUP\ntt\n2\n1\n1\n2\n11 0\n22 0\n== =\n=\n,\n,\nor, NN CV\nCV21\n1\n2\n= \n\n\n\n\n\nFor example, if New York coffee is trading at $1.41/lb and London coffee at $.80/lb, the equal-dollar-\nvalue spread would indicate acontract ratio of 1 New York coffee/3 London coffee:\nNN CV\nCV N UP\nUP\ntt\n21\n1\n2\n1\n11 0\n22 0\n= \n\n\n\n\n =\n\n\n\n\n\n\n=\n=\n,\n,\nIf New York coffee contractN1 1= ,\nN2 =× ×=37 5001 41/22 0430 80 3 London contracts,$ ., $.\nThus, in an equal-dollar-value spread position, 3 New York coffee contracts would be balanced by 9 \n(not 5) London contracts.\nIt may help clarify matters to compare the just-defined equal-dollar-value approach to the \nequal-unit approach for the case of the New York coffee/London coffee spread. Although the equal-\nunit spread is indifferent to equal absolute price changes, it will be affected by equal-percentage \nprice changes (unless, of course, the price levels in both markets are equal, in which case the two \napproaches are equivalent). For example, given initiation price levels of New York coffee = $1.41/lb \nand London coffee = $.80/lb, consider the effect of a 25 percent price decline on along 3 New York/\nshort 5 London coffee (equal unit) spread:\nProfit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,3525 39 656=−\nProfit/loss in short London coffee position 52 20 43 0=× ×−,( $. 220 +2 20 43)$ ,=\nProfit/loss in sprea d1 7 613=− $,\nThe equal-dollar-value spread, however, would be approximately unchanged:\nProfit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,3525 39 656=−\nProfit/loss in short London coffee position 92 20 43 0=× ×+,( $. 220 +3 96 77)$ ,=\n Profit/loss in sprea d+ 21= $\nReturning to our original example, if the trader anticipating price weakness in London coffee rela-\ntive to New York coffee had used the equal-dollar-value approach (assuming a 3-contract position for \nNew York coffee), the results would have been as follows:\nProfit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,10 11 250=−\nProfit/loss in short London coffee position 92 20 43 +0=× ×,( $. 115 29 758) $,=+\nProfit/loss in sprea d+ 18 508= $,", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:474", "doc_id": "ba233bae423f594470f9b21ba07a0b1ff76cfce0d681ee086d0490bd04e81b1c", "chunk_index": 0}
{"text": "457\nINTERCOMMODITY SPREADS: DETERMINING CONTRACT RATIOS\n Thus, while the naive placement of an equal contract spread actually results in a $2,218 loss \ndespite the validity of the trade concept, the more appropriate equal-dollar-value approach results in \na $18,508 gain. This example emphasizes the critical importance of determining appropriate contract \nratios in intercommodity and intermarket spreads. \n An essential point to note is that if intercommodity and intermarket spreads are traded using an \nequal-dollar-value approach—as they should be—the price diff erence between the markets is no \nlonger the relevant subject of analysis. Rather, such an approach is most closely related to the price \nratio between the two markets. This fact means that chart analysis and the defi nition of historical \nranges should be based on the price ratio, not the price diff erence. Figures 31.1 , 31.2 , and 31.3 illus-\ntrate this point. Figure 31.1 depicts the September 2013 wheat/September 2013 corn spread in the \nstandard form as aprice diff erence. Figure 31.2 illustrates the price ratio of September 2013 wheat \nto September 2013 corn during the same period. Finally, Figure 31.3 plots the equity fl uctuations of \nthe approximate equal-dollar-value spread: 3 wheat versus 4 corn. Note how much more closely the \nequal dollar position is paralleled by the ratio than by the price diff erence. \n3 \n 3 The equal-dollar-value spread would be precisely related to the price ratio only if the contract ratios in the \nspread were continuously adjusted to refl ect changes in the price ratio. (An analogous complication does not \nexist in equal-unit spreads, since the contract weightings are determined independent of price levels.) However, \nunless price levels change drastically during the holding period of the spread, the absence of theoretical readjust-\nments in contract ratios will make little practical diff erence. In other words, equity fl uctuations in the equal-\ndollar-value spread will normally closely track the movements of the price ratio.\n FIGURE /uni00A031.1 September 2013 Wheat Minus September 2013 Corn\nChart created using TradeStation. ©TradeStation Technologies, Inc. All rights reserved.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:475", "doc_id": "22fd1a16f1c338177f39fc9854baa406c96833bf92c683966b273ea4624dbd21", "chunk_index": 0}
{"text": "459\nINTERCOMMODITY SPREADS: DETERMINING CONTRACT RATIOS\n In the preceding example, because wheat is alarger contract than corn (in dollar-value terms), \nalong 1 wheat/short 1 corn spread would be biased in the direction of the general price trend of \ngrains. For example, during November 2012–August 2013, aperiod of declining grain prices (see \nFigure 31.4 ), the equal contract spread seems to suggest that wheat prices weakened signifi cantly \nrelative to corn prices (see Figure 31.1 ). In reality, as indicated by Figures 31.2 and 31.3 , the \nwheat/corn relationship during this period was best characterized by atrading range. Toillustrate \nthe trading implications of the spread ratio, consider along wheat/short corn spread initiated at the \nlate-November 2012 relative high and liquidated at the August 2013 peak. This trade would have \nresulted in anear breakeven trade if the spread were implemented on an equal-dollar-value basis \n(see Figure 31.2 or 31.3 ), but asignifi cant loss if an equal contract criterion were used instead (see \nFigure 31.1 ). \n It should now be clear why the standard assumption of an equal contract position is usually valid \nfor intramarket spreads. In these spreads, contract sizes are identical, while price levels are normally \nclose. Thus, the equal-dollar-value approach suggests acontract ratio very close to 1:1. \n If, however, two contracts in an intramarket spread are trading at signifi cantly diff erent price \n levels, the argument for using the equal-dollar-value approach (as opposed to equal contract positions) \nwould be analogous to the intercommodity and intermarket case. Wide price diff erences between \ncontracts in an intramarket spread can occur in extreme bull markets that place alarge premium on \n FIGURE /uni00A031.4 September 2013 Wheat and September 2013 Corn", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:477", "doc_id": "df07419da62292014fda165f74a160ee27433684e2c153be46d34a2a15eb72d0", "chunk_index": 0}
{"text": "461\nThe stock market is but amirror which . . . provides an image of the underlying or \nfundamental economic situation.\n—John Kenneth Galbraith\n ■ Intramarket Stock Index Spreads\nSpreads in carrying charge markets, such as gold, provide agood starting point for developing atheo-\nretical behavioral model for spreads in stock index futures. As is the case for gold, there can never \nbe any near-term shortage in stock indexes, which means spreads will be entirely determined by \ncarrying charges. As was explained in Chapter 30, gold spreads are largely determined by short-term \ninterest rates. For example, since atrader could accept delivery of gold on an expiring contract and \nredeliver it against asubsequent contract, the price spread between the two months would primarily \nreflect financing costs and, hence, short-term rates. If the premium of the forward contract were sig-\nnificantly above the level implied by short-term rates, the arbitrageur could lock in arisk-free profit \nby performing acash-and-carry operation. And if the premium were significantly lower, an arbitra-\ngeur could lock in arisk-free profit by implementing ashort nearby/long forward spread, borrowing \ngold to deliver against the nearby contract and accepting delivery at the expiration of the forward \ncontract. These arbitrage forces will tend to keep the intramarket spreads within areasonably well-\ndefined band for any given combination of short-term interest rates and gold prices.\nThe same arguments could be duplicated substituting astock index for gold. In abroad sense this \nis true, but there is one critical difference between stock index spreads and gold spreads: Stocks pay \nSpread Trading in \nStock Index Futures\nChapter 32", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:479", "doc_id": "422490856fc13cf26760808951f859267df6681747cb29e00cb75db166f2689f", "chunk_index": 0}
{"text": "462\nA Complete Guide to the Futures mArket\ndividends. Thus, the interest rate cost of holding astock position is offset (partially, or more than \ntotally) by dividend income. The presence of dividends is easily incorporated into the framework of \ncalculating atheoretical spread level. The spread would be in equilibrium if, based on current prices, \ninterest rates, and dividends, there would be no difference between holding the actual equities in \nthe index for the interim between the two spread months versus buying the forward index futures \ncontract. Holding equities would incur an interest rate cost that does not exist in holding futures, but \nwould also accrue the dividend yield the holder of futures does not receive. The theoretical spread \nlevel (P\n2 − P1) at the expiration of P 1 at which these two alternative means of holding along equity \nposition—equity and stock index futures—would imply an equivalent outcome can be expressed \nsymbolically as follows:\nPP Ptid21 1 360−= \n \n −()\nwhere P1 = price of nearby (expiring) futures contract\n P2 = price of forward futures contract\n t = number of days between expiration of nearby contract and expiration of forward contract\n i = short-term interest rate level at time of P1 expiration\n d = annualized dividend yield (%)\nAs is evident from this equation, if short-term interest rates exceed dividend yields, forward \nfutures will trade at apremium to nearby contracts. Conversely, if the dividend yield exceeds short-\nterm interest rates, forward futures will trade at adiscount.\nSince the dividend yield is not subject to sharp changes in the short run, for any given index \n(price) level, intramarket stock index spreads would primarily reflect expected future short-term \nrates (similar to gold spreads). If short-term interest rates exhibit low volatility, as characterized by \nthe near-zero interest rate environment that prevailed in the years following the 2008 financial crisis, \nstock index spreads will tend to trade in relatively narrow range—aconsequence of both major \ndrivers of stock index spreads (interest rates and dividend yield) being stable.\n ■ Intermarket Stock Index Spreads\nAs is the case with intercommodity and intermarket spreads trading at disparate price levels, stock \nindex spreads should be traded as ratios rather than differences—an approach that will make the \nspread position indifferent to equal percentage price changes in both markets (indexes). As areminder, \nto trade aratio, the trader should implement each leg of the spread in approximately equal contract \nvalue positions, which, as was shown in Chapter 31, can be achieved by using acontract ratio that is \ninversely proportional to the contract value ratio.\nFor example, if the E-mini Nasdaq 100 futures contract, which has acontract value of 20 times the \nindex, is trading at 4,300 (acontract value of $86,000), and the Russell 2000 Mini futures contract,", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:480", "doc_id": "6e47559460dd010af5725d7fab8e468db954e987270d593ed3f1987b613e2639", "chunk_index": 0}
{"text": "463\nSPREAd TRAdING IN SToCK INdEx FuTuRES\nwhich has acontract value of 100 times the index, is trading at 1,150 (acontract value of $115,000), \nthe contract value ratio (CVR) of Nasdaq to Russell futures would be equal to:\nCVR2 04 ,300 /1 00 1,150 07 478=× ×=() () .\nTherefore, the contract ratio would be equal to the inverse of the contract value ratio: \n1/0.7478 = 1.337. Thus, for example, aspread with 3 long (short) Russell contracts would be bal-\nanced by 4 Nasdaq short (long) contracts: 3 × 1.337 = 4.01.\nBecause some stock indexes are inherently more volatile than other indexes—for example, smaller-\ncap indexes tend to be more volatile than larger-cap indexes—some traders may wish to make an \nadditional adjustment to the contract ratio to neutralize volatility differences. If this were done, the \ncontract ratio defined by the inverse of the contract value ratio would be further adjusted by multiply-\ning by the inverse of some volatility measure ratio. \none good candidate for such avolatility measure is \nthe average true range (ATR), which was defined in Chapter 17. As an illustration, if in the aforemen-\ntioned example of the Nasdaq 100/Russell 2000 ratio, the prevailing ATR of the Nasdaq 100 is 0.8 \ntimes the ATR of the Russell 2000, then the Nasdaq/Russell 2000 contract ratio of 1.337 would be \nfurther adjusted by multiplying by the inverse of the ATR ratio (1 / 0.8 = 1.25), yielding acontract \nratio of 1.671 instead of 1.337. If this additional adjustment is made, then aspread with 3 long (short) \nRussell contracts would be balanced by 5 short (long) Nasdaq contracts: 3 × 1.671= 5.01.\nIt is up traders to decide whether they wish to further adjust the contract ratio for volatility. For the \nremainder of this chapter, we assume the more straightforward case of contract ratios being adjusted \nonly for contract value differences (i.e., without any additional adjustment for volatility differences).\nThe four most actively traded stock index futures contracts are the E-mini S&P 500, E-mini \nNasdaq 100, E-mini \ndow , and the Russell 2000 Mini. There are six possible spread pairs for these \nfour markets:\n ■ E-mini S&P 500 / E-mini dow\n ■ E-mini S&P 500 / E-mini Nasdaq 100\n ■ E-mini S&P 500 / Russell 2000 Mini\n ■ E-mini Nasdaq 100 / E-mini dow\n ■ E-mini Nasdaq 100 / Russell 2000 Mini\n ■ E-mini dow / Russell 2000 Mini\nTraders who believe acertain group of stocks will perform better or worse than another group \ncan express this view through stock index spreads. For example, atrader who expected large-cap \nstocks to outperform small-cap stocks could initiate long E-mini S&P 500/short Russell 2000 Mini \nspreads or long E-mini \ndow/short Russell 2000 Mini spreads. Atrader expecting relative outperfor-\nmance by small-cap spreads would place the reverse spreads. As another example, atrader expecting \nrelative outperformance by technology stocks might consider spreads that are long the tech-heavy \nNasdaq 100 index and short another index, such as long E-mini Nasdaq 100/short E-mini S&P 500", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:481", "doc_id": "ed220857a9066ee2ce05293142f2eb73f1100bcb7a19cbd3a43029e140755662", "chunk_index": 0}
{"text": "464A CoMPLETE GuIdE To THE FuTuRES MARKET\nspreads. Again, to trade these types of spreads as price ratios, the spreads would be implemented so \nthe contract values of each side are approximately equal, acondition that will be achieved when the \ncontract ratio between the indexes is equal to the inverse of the contract value ratio. \n Figures 32.1 through 32.6 illustrate the contract value ratios for these six spread pairs during \n2002–2015. In some cases, such as the S&P 500/dow spread, the contract value ratio does not vary \nmuch. As can be seen in Figure 32.1 , the contract value ratio for this pair ranged by afactor of only \nabout 1.2 from low to high over the entire period. For other index pairs, however, the contract value \nratio ranged widely. For example, Figure 32.4 shows that during the same period, the high Nasdaq/\ndow contract value ratio was nearly 2.5 times the low ratio. Since the contract ratio required to keep \nthe trade neutral to equal percentage price changes in both markets is equal to the inverse of the \nprevailing contract value ratio, the appropriate contract ratio for these spreads can range widely over \ntime. For example, for the aforementioned Nasdaq 100/dow ratio, athree-contract dow position \nwould have been balanced by aseven-contract Nasdaq position when the contract value ratio was at \nits low versus only athree-contract position (rounding up) when the ratio was at its high. \n Figures 32.7 through 32.12 illustrate the price ratios for the six stock index pairs during the same \nperiod, along with an overlay of one of the indexes to facilitate visually checking of the relationships \nbetween the index price ratio and the overall stock market direction. Note that the price ratios \nin Figures 32.7 through 32.12 are identical in pattern to the contract value ratios in Figures 32.1 \nthrough 32.6 , which is aconsequence of the contract value ratio being equal to the price ratio times \naconstant—the constant being equal to the ratio of the multipliers for the indexes. \n FIGURE  32.1 Contract Value Ratio: S&P 500/dow E-Mini Futures", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:482", "doc_id": "a8c7c64e0a929fa0a06138b18b4d0dad66150ee2d9dc3cb630f430a5d1209ea9", "chunk_index": 0}
{"text": "471\nSpread Trading in \nCurrency Futures\nLenin was certainly right. There is no subtler, no surer means of overturning the existing basis of \nsociety than to debauch the currency. The process engages all the hidden forces of economic law on \nthe side of destruction, and does it in amanner which not one man in amillion is able to diagnose.\n—John Maynard Keynes\n ■ Intercurrency Spreads\nConceptually, intercurrency spreads are identical to outright currency trades. After all, anet long or short \ncurrency futures position is also aspread in that it implies an opposite position in the dollar. For example, \nanet long Japanese yen (JY) position means that one is long the JY versus the U.S. dollar (USD). If the JY \nstrengthens against the USD, the long JY position will gain. If the JY strengthens against the Swiss franc \n(SF) and euro but remains unchanged against the USD, the long JY position will also remain unchanged.\nIn an intercurrency spread, the implied counterposing short in the USD is replaced by another \ncurrency. For example, in along JY/short euro spread, the position will gain when the JY strengthens \nrelative to the euro, but will be unaffected by fluctuations of the JY relative to the dollar. The long \nJY/short euro spread is merely the combination of along JY/short USD and along USD short euro \nposition, in which the opposite USD positions offset each other. (Tobe precise, the implied USD posi-\ntions will only be completely offset if the dollar values of the JY and euro positions are exactly equal.)\nThere are two possible reasons for implementing an intercurrency spread:\n 1. The trader believes currency 1 will gain against the USD, while currency 2 will lose against the USD. In \nthis case, along currency 1/short currency 2 spread is best thought of as two separate outright trades.\n 2. The trader believes that one foreign currency will gain on another, but has no strong opinion \nregarding the movement of either currency against the USD. In this case, the intercurrency spread \nis analogous to an outright currency trade, with the implied short or long in the USD replaced by \nanother currency. If, however, the two currencies are far more closely related to each other than to \nthe USD, the connotation normally attributed to aspread might be at least partially appropriate.\nChapter 33", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:489", "doc_id": "c6741c5a7539a7cd9ce80ce329ccffcb9e4e6ada6b8127c8ce6542f741cb2e99", "chunk_index": 0}
{"text": "472\nA Complete Guide to the Futures mArket\nIf an intercurrency spread is motivated by the second of these factors, the position should be \n balanced in terms of equal dollar values. (This may not always be possible for the small trader.) \nOtherwise, equity losses can occur, even if the exchange rate between the two currencies remains \nunchanged.\nFor example, consider along 4 December SF/short 4 December euro spread position imple-\nmented when the December SF = $1.000 and the December euro = $1.250. At the trade initiation, \nthe exchange rate between the SF and euro is 1 euro = 1.25 SF. If the SF rises to $1.100 and the \neuro climbs to $1.375, the exchange rate between the SF and euro is unchanged: 1 euro = 1.25 SF. \nHowever, the spread position will have lost $12,500:\nEquity change numbe ro fc ontrac ts number of unitsp er contra ct ga=× × iin/loss peru nit\nEquity change in long SF 41 25 000 01 0= 50 000=× ×,$ .$ ,\nEquity change in short euro 4 125 000 01 25 62 500=× ×− =−,$ .$ ,\nNetp rofit/loss 12 500=− $,\nThe reason the spread loses money even though the SF/euro exchange rate remains unchanged \nis that the original position was unweighted. At the initiation prices, the spread represented along \nSF position of $500,000 but ashort euro position of $625,000. Thus, the spread position was biased \ntoward gaining if the dollar weakened against both currencies and losing if the dollar strengthened. If, \nhowever, the spread were balanced in terms of equal dollar values, the equity of the position would \nhave been unchanged. For example, if the initial spread position were long 5 December SF/short 4 \nDecember euro (aposition in which the dollar value of each side = $625,000), the aforementioned \nprice shift would not have resulted in an equity change:\nEquity change in long SF 51 25 000 01 06 25 00=× ×=,$ .$ ,\nEquity change in short euro 4 125 000 01 25 62 500=× ×− =−,( $. )$ ,\nNetprofit/loss 0=\nThe general formula for determining the equal-dollar-value spread ratio (number of contracts of \ncurrency 1 per contract of currency 2) is:\nEqual-dollar-spread rati onumbe ro funits per\ncontra ct of currenc= yy2\npriceo fcurrenc y2\nnumbe ro funits per\ncontra ct of currenc y1\n() ()\n(() ()\npriceo fcurrenc y1\nFor example, if currency 1, the British pound (BP) = $1.50, and currency 2, the euro = $1.20, \nand the BP futures contract consists of 62,500 units, while the euro futures contract consists of \n125,000 units, the implied spread ratio would be:\n(, )($ .)\n(, )($ .) .125 0001 20\n62 5001 50 16=", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:490", "doc_id": "a504a6f17a904016697306bc5e5a9a416e2f2d3f843f4b2367bc3ab657112e27", "chunk_index": 0}
{"text": "473\nSPreAD TrADINg IN CUrreNCY FUTUreS\nThus, the equal dollar value spread would consist of 1.6 BP contracts per euro contract, or 8 BP to \n5 euro.\nequity fluctuations in an equal-dollar-value intercurrency spread position will mirror the price \nratio (or exchange rate) between currencies. It should be emphasized that price ratios (as opposed to \nprice spreads) are the only meaningful means of representing intercurrency spreads. For example, if \nthe BP = $1.50 and SF = $1.00, an increase of $0.50 in both the currencies will leave the price spread \nbetween the BP and SF unchanged, even though it would drastically alter the relative values of the two \ncurrencies: adecline of the BP vis-à-vis the SF from 1.5 SF to 1.33 SF.\n ■ Intracurrency Spreads\nAn intracurrency spread—the price difference between two futures contracts for the same currency—\ndirectly reflects the implied forward interest rate differential between dollar-denominated accounts \nand accounts denominated in the given currency. For example, the June/December euro spread \nindicates the expected relationship between six-month eurodollar and euro rates in June.\n1\nTodemonstrate the connection between intracurrency spreads and interest rate differentials, we \ncompare the alternatives of investing in dollar-denominated versus euro-denominated accounts:\nS = spot exchange rate ($/euro)\nF = current forward exchange rate for date at end of investment period ($/euro)\nr\n1 = simple rate of return on dollar-denominated account for investment period (nonannualized)\nr2 = simple rate of return on euro-denominated account for investment period (nonannualized)\nalternative a:\nInvest in Dollar-Denominated account\nalternative B:\nInvest in euro-Denominated account\n1. Invest $1 in dollar-denominated account. 1. Convert $1 to euro at spot.\n2. Funds at end of period = $1 (1 + r1) exchange rate is S, which yields 1/Seuro. (By definition, if Sequals dollars \nper euro, 1/S = euro per dollar.)\n2. Invest 1/Seuro in euro-denominated account at r\n2.\n3. Lock in forward exchange rate by selling the anticipated euro proceeds \nat end of investment period at current forward rate F.2\n4. Funds at end of period = 1/S (1 + r2) euro.\n5. Converted to dollars at rate F, funds at end of period = $F/S (1 + r2) \n(since F = dollars per euro).\n1 The eurocurrency rates are interest rates on time deposits for funds outside the country of issue and hence free \nof government controls. For example, interest rates on dollar-denominated deposits in London are eurodollar \nrates, while rates on sterling-denominated deposits in Frankfurt are eurosterling rates. The quoted eurocurrency \nrates represent the rates on transactions between major international banks.\n2 Ashort forward position can be established in one of two ways: (1) selling futures that are available for forward \ndates at three-month intervals; and (2) initiating along spot/short forward position in the foreign exchange (FX) \nswap market and simultaneously selling spot.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:491", "doc_id": "837637f11a9e8746daf861a436c77f2c16f90e288f73e1c0c768fab42edc61a0", "chunk_index": 0}
{"text": "475\nSPreAD TrADINg IN CUrreNCY FUTUreS\nOf course, the market forces just described would come into play well before the forward/spot \nratio increased to 0.82/0.80 = 1.025. The intervention of arbitrageurs will assure the six-month \nforward/spot ratio would not rise significantly above 1 + r 1/1 + r2 = 1.0099. Asimilar argument \ncould be used to demonstrate that arbitrage intervention would keep the forward/spot ratio from \ndeclining significantly below 1.0099. In short, arbitrage activity will assure that the forward/spot \nratio will be approximately defined by the above equation. This relationship is commonly referred to \nas the interest rate parity theorem.\nSince currency futures must converge with spot exchange rates at expiration, the price spread \nbetween aforward futures contract and anearby expiring contract must reflect the prevailing interest \nrate ratio (between the eurodollar rate and the given eurocurrency rate).\n4 Hence, aspread between \ntwo forward futures contracts can be interpreted as reflecting the market’sexpectation for the inter-\nest rate ratio at the time of the nearby contract expiration. Specifically, if P\n1 = price of the more \nnearby futures expiring at t1 and P2 = price of the forward futures contract expiring at time t 2, then \nP2/P1 will equal the expected interest rate ratio (expressed as 1+r1/1+r2) for term rates of duration \nt2 − t1 at time t1. It should be stressed that the forward interest rate ratio implied by spreads in futures \nwill usually differ from the prevailing interest rate ratio.\nIf the market expects the eurodollar rate to be greater than the foreign eurocurrency rate, forward \nfutures for that currency will trade at apremium to more nearby futures—the wider the expected \ndifferential, the wider the spread. Conversely, if the foreign eurocurrency rate is expected to be \ngreater than the eurodollar rate, forward futures will trade at adiscount to nearby futures.\nThe above relationships suggest that intracurrency spreads can be used to trade expectations \nregarding future interest rate differentials between different currencies. If atrader expected eurodol-\nlar rates to gain (move up more or down less) on aforeign eurocurrency rate (relative to the expected \ninterest rate ratio implied by the intracurrency futures spread), this expectation could be expressed \nas along forward/short nearby spread in that currency. Conversely, if the trader expected the foreign \neurocurrency rate to gain on the eurodollar rate, the implied trade would be along nearby/short \nforward intracurrency spread.\nAs atechnical point, a 1:1 spread ratio would fluctuate even if the implied forward interest rate \nratio were unchanged. For example, if P\n2 = $0.81/euro and P1 = $0.80/euro, a 10-percent increase \nin both rates would result in a 810-point price gain in the forward contract and only a 800-point gain \nin the nearby contract, even though the implied forward interest rate ratio would be unchanged (since \nan equal percentage change in each month would leave F/Sunchanged). In order for the spread posi-\ntion to be unaffected by equal percentage price changes in both contracts, adevelopment that would \nnot affect the implied forward interest rate ratio, the spread would have to be implemented so that the \ndollar value of the long and short positions were equal. This parity will be achieved when the contract \nratio is equal to the inverse of the price ratio. For example, given the above case of P\n2 = $0.81 and \n4 All references to interest rate ratios in this section should be understood to mean (1 + r1)/(l + r2) where r1 \nand r2 are the nonannualized rates of return for the time interim between Sand F. Thus, in the above example, \nthe interest rate ratio for the six-month period given annualized rates of 4.04 percent and 2.01 percent is equal \nto 1.02/1.01 = 1.0099. The reader should be careful not to misconstrue the intended definition of interest rate \nratio with aliteral interpretation, which in the above example would suggest afigure of 0.02/0.01 = 2.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:493", "doc_id": "7175b962df2287aada666875e267a6ce2620e3e43a1591807ae6b904d1366f60", "chunk_index": 0}
{"text": "476\nA Complete Guide to the Futures mArket\nP1 = $0.80, an 80-contract forward/81-contract nearby spread would not be affected by equal price \nchanges (e.g., a 10-percent price increase would cause atotal 64,800-point change in both legs of the \nspread). As can be seen in this example, abalanced spread will only be possible for extremely large \npositions. This fact, however, does not present aproblem, since the distortion is sufficiently small so \nthat a 1:1 contract ratio spread serves as areasonable approximation.\nIntracurrency spreads can also be combined to trade expectations regarding two foreign euro-\ncurrency rates. In this case, the trader would implement along nearby/short forward spread in the \ncurrency with the expected relative rate gain, and along forward/short nearby spread in the other \ncurrency. For example, assume that in February the June/December euro spread implies that the \nJune six-month eurodollar rate will be 1 percent above the euro rate, while the June/December JY \nspread implies that the June eurodollar rate will be 2 percent above the euroyen rate. In combina-\ntion, these spreads imply that the June euro rate will be higher than the June euroyen rate. If atrader \nexpected euroyen rates to be higher than euro rates in June, the following combined spread positions \nwould be implied: long June JY/short December JY plus long December euro/short June euro.\nTosummarize, intracurrency spreads can be used to trade interest rate differentials in the follow-\ning manner:\nexpectation Indicated trade\neurodollar rate will gain on given eurocurrency rate \n(relative to rate ratio implied by spread).\nLong forward/short nearby\nspread in given currency\neurodollar rate will lose on given eurocurrency rate \n(relative to rate ratio implied by spread).\nLong nearby/short forward\nspread in given currency\neurocurrency rate 1 will gain on eurocurrency rate 2 \n(relative to rate ratio implied by spreads in both markets).\nLong nearby/short forward spread in market 1 and long \nforward/short nearby spread in market 2", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:494", "doc_id": "3adf15f42b33e5c5b62125ca6f4f95b69048578b919975009d0eac78fe395323", "chunk_index": 0}
{"text": "477\nAput might more properly be called astick. For the whole point of aput—its purpose, if you \nwill—is that it gives its owner the right to force 100 shares of some godforsaken stock onto \nsomeone else at aprice at which he would very likely rather not take it. So what you are really \ndoing is sticking it to him.\n—Andrew Tobias\nGetting By on $100,000 a Year (and Other Sad Tales)\n ■ Preliminaries\nThere are two basic types of options: calls and puts. The purchase of acall option on futures1 provides \nthe buyer with the right, but not the obligation, to purchase the underlying futures contract at aspeci-\nfied price, called the strike or exercise price, at any time up to and including the expiration date. 2 Aput \noption provides the buyer with the right, but not the obligation, to sell the underlying futures contract \nat the strike price at any time prior to expiration. (Note, therefore, that buying aput is abearish trade, \nwhile selling aput is abullish trade.) The price of an option is called the premium, and is quoted in \nAn Introduction to \nOptions on Futures\nChapter 34\n1 Chapters 34 and 35 deal specifically with options on futures contracts. However, generally speaking, analogous \nconcepts would apply to options on cash (physical) goods or instruments (e.g., bullion versus gold futures). \nSome of the advantages of basing an option contract on futures as opposed to the cash asset are discussed in the \nnext section.\n2 For some markets, the expiration date on the option and the underlying futures contract will be the same; for other \nmarkets, the expiration date on the option will be aspecified date prior to the expiration of the futures contract.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:495", "doc_id": "2e78894731da405fad492b8585712d61b3a1a15a19f48906f12c745481b55678", "chunk_index": 0}
{"text": "478\nA Complete Guide to the Futures mArket either dollars (or cents) per unit or points. Table 34.1 illustrates how to calculate the dollar value of \napremium. As aspecific example, atrader who buys a $1,000 August gold call at apremium of $50 \npays $50/oz ($5,000 per contract) for the right to buy an August gold futures contract at $1,000 \n(regardless of how high its price may rise) at any time up to the expiration date of the August option.\nBecause options are traded for both puts and calls and anumber of strike prices for each futures \ncontract, the total number of different options traded in amarket will far exceed the number of \nfutures contracts—often by afactor of 10 to 1 or more. This broad variety of listed options provides \nthe trader with myriad alternative trading strategies.\nLike their underlying futures contracts, options are exchange-traded, standardized contracts. \nConsequently, option positions can be offset prior to expiration simply by entering an order opposite \nto the position held. For example, the holder of acall could liquidate his position by entering an order \nto sell acall with the same expiration date and strike price.\nThe buyer of acall seeks to profit from an anticipated price rise by locking in aspecific purchase \nprice. His maximum possible loss will be equal to the dollar amount of the premium paid for the \noption. This maximum loss would occur on an option held until expiration if the strike price were \nabove the prevailing futures price. For example, if August gold futures were trading at $990 upon the \nexpiration of the August option, a $1,000 call would be worthless because futures could be purchased \nmore cheaply at the existing market price.\n3 If the futures were trading above the strike price at expira-\ntion, then the option would have some value and hence would be exercised. However, if the difference \ntable 34.1 Determining the Dollar Value of Option premiums\nContracts Quoted on an Index\nOption premium (in points) × $ value per point = $ value of the option premium\nExamples:\nE-mini S&P 500 options\n8.50 (option premium) × $50 per point = $425 (option premium $ value)\nU.S. dollar index options\n2.30 (option premium) × $1,000 per point = $2,300 (option premium $ value)\nContracts Quoted in Dollars\nOption premium (in dollars or \ncents per unit)\n× No. of units in futures contract = $ value of the option premium\nExamples:\nGold options\n$42 (option premium) × 100 (ounces in futures contract) = $4,200 (option premium $ value)\nWTI crude oil options\n$1.24 (option premium) × 1,000 (barrels in futures contract) = $1,240 (option premium $ value)\n3 However, it should be noted that even in this case, the call buyer could have recouped part of the premium if \nhe had sold the option prior to expiration. This is true since the option will maintain some value (i.e., premium \ngreater than zero) as long as there is some possibility of the futures price rising above the strike price prior to \nthe expiration of the option.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:496", "doc_id": "e1337cf17355918f46f5d8164f7fbd19069cf9f89d1646e8fb4339149eaab706", "chunk_index": 0}
{"text": "479\nAN INTrOduCTION TO OPTIONS ON FuTureS\nbetween the futures price and the strike price were less than the premium paid for the option, the \nnet result of the trade would still be aloss. In order for the call buyer to realize anet profit, the dif-\nference between the futures price and the strike price would have to exceed the premium at the time \nthe call was purchased (after adjusting for commission cost). The higher the futures price, the greater \nthe resulting profit. Of course, if the futures reach the desired objective, or the call buyer changes his \nmarket opinion, he could sell his call prior to expiration.\n4\nThe buyer of aput seeks to profit from an anticipated price decline by locking in asales price. \nSimilar to the call buyer, his maximum possible loss is limited to the dollar amount of the premium \npaid for the option. In the case of aput held until expiration, the trade would show anet profit if the \nstrike price exceeded the futures price by an amount greater than the premium of the put at purchase \n(after adjusting for commission cost).\nWhile the buyer of acall or put has limited risk and unlimited potential gain,\n5 the reverse is true \nfor the seller. The option seller (“writer”) receives the dollar value of the premium in return for \nundertaking the obligation to assume an opposite position at the strike price if an option is exercised. \nFor example, if acall is exercised, the seller must assume ashort position in futures at the strike \nprice (since by exercising the call, the buyer assumes along position at that price). \nupon exercise, \nthe exchange’sclearinghouse will establish these opposite futures positions at the strike price. After \nexercise, the call buyer and seller can either maintain or liquidate their respective futures positions.\nThe seller of acall seeks to profit from an anticipated sideways to modestly declining market. In \nsuch asituation, the premium earned by selling acall will provide the most attractive trading oppor-\ntunity. However, if the trader expected alarge price decline, he would usually be better off going \nshort futures or buying aput—trades with open-ended profit potential. In asimilar fashion, the seller \nof aput seeks to profit from an anticipated sideways to modestly rising market.\nSome novices have trouble understanding why atrader would not always prefer the buy side of an \noption (call or put, depending on his market opinion), since such atrade has unlimited potential and \nlimited risk. Such confusion reflects the failure to take probability into account. Although the option \nseller’stheoretical risk is unlimited, the price levels that have the greatest probability of occurring \n(i.e., prices in the vicinity of the market price at the time the option trade occurs) would result in anet \ngain to the option seller. \nroughly speaking, the option buyer accepts alarge probability of asmall loss \nin return for asmall probability of alarge gain, whereas the option seller accepts asmall probability \nof alarge loss in exchange for alarge probability of asmall gain. In an efficient market, neither the \nconsistent option buyer nor the consistent option seller should have any advantage over the long run.\n6\n4 even if the call is held until the expiration date, it will usually still be easier to offset the position in the options \nmarket rather than exercising the call.\n5 Technically speaking, the gains on aput would be limited, since prices cannot fall below zero; but for practical \npurposes, it is entirely reasonable to speak of the maximum possible gain on along put position as being unlimited.\n6 Tobe precise, this statement is not intended to imply that the consistent option buyer and consistent option seller \nwould both have the same expected outcome (zero excluding transactions costs). Theoretically, on average, it is rea-\nsonable to expect the market to price options so there is some advantage to the seller to compensate option sellers for \nproviding price insurance—that is, assuming the highly undesirable exposure to alarge, open-ended loss. So, in effect, \noption sellers would have amore attractive return profile and aless attractive risk profile than option buyers, and it \nis in this sense that the market will, on average, price options so that there is no net advantage to the buyer or seller.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:497", "doc_id": "1cc74f942175447826ece1a23e80744a789baf7ec07731897059f912239e4914", "chunk_index": 0}
{"text": "480\nA Complete Guide to the Futures mArket\n ■ Factors That Determine Option Premiums\nAn option’spremium consists of two components:\nPremiu mi ntri nsic valuet imev alue=+\nThe intrinsic value of acall option is the amount by which the current futures price is above the strike \nprice. The intrinsic value of aput option is the amount by which the current futures price is below the \nstrike price. In effect, the intrinsic value is that part of the premium that could be realized if the option were \nexercised and the futures contract offset at the current market price. For example, if July crude oil futures \nwere trading at $74.60, acall option with astrike price of $70 would have an intrinsic value of $4.60. The \nintrinsic value serves as afloor price for an option. Why? Because if the premium were less than the intrinsic \nvalue, atrader could buy and exercise the option, and immediately offset the resulting futures position, \nthereby realizing anet gain (assuming this profit would at least cover the transaction costs).\nOptions that have intrinsic value (i.e., calls with strike prices below the current futures price and \nputs with strike prices above the current futures price) are said to be in-the-money. Options with no \nintrinsic value are called out-of-the-money options. An option whose strike price equals the futures \nprice is called an at-the-money option. The term at-the-money is also often used less restrictively to refer \nto the specific option whose strike price is closest to the futures price.\nAn out-of-the-money option, which by definition has an intrinsic value of zero, nonetheless retains \nsome value because of the possibility the futures price will move beyond the strike price prior to the expi-\nration date. An in-the-money option will have avalue greater than the intrinsic value because aposition in \nthe option will be preferred to aposition in the underlying futures contract. \nreason: Both the option and \nthe futures contract will gain equally in the event of favorable price movement, but the option’smaximum \nloss is limited. The portion of the premium that exceeds the intrinsic value is called the time value.\nIt should be emphasized that because the time value is almost always greater than zero, one should \navoid exercising an option before the expiration date. Almost invariably, the trader who wants to \noffset his option position will realize abetter return by selling the option, atransaction that will yield \nthe intrinsic value plus some time value, as opposed to exercising the option, an action that will yield \nonly the intrinsic value.\nThe time value depends on four quantifiable factors\n7:\n 1. the relationship between the strike price and the current futures price. As illus-\ntrated in Figure 34.1, the time value will decline as an option moves more deeply in-the-money \nor out-of-the-money. \ndeeply out-of-the-money options will have little time value, since it is \nunlikely the futures will move to (or beyond) the strike price prior to expiration. deeply in-\nthe-money options have little time value because these options offer very similar positions to \nthe underlying futures contracts—both will gain and lose equivalent amounts for all but an \nextreme adverse price move. In other words, for adeeply in-the-money option, the fact that the \n7 Theoretically, the time value will also be influenced by price expectations, which are anon-quantifiable factor.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:498", "doc_id": "3e5e9f549be714bf78935234a31bbb22b16703a24bb80a92a030bd6460665284", "chunk_index": 0}
{"text": "481\nAN INTrOduCTION TO OPTIONS ON FuTureS\nrisk is limited is not worth very much, because the strike price is so far away from the prevailing \nfutures price. As Figure 34.1 shows, the time value will be at amaximum at the strike price. \n 2. time remaining until expiration. The more time remaining until expiration, the greater \nthe time value of the option. This is true because alonger life span increases the probability \nof the intrinsic value increasing by any specifi ed amount prior to expiration. In other words, \nthe more time until expiration, the greater the probable price range of futures. Figure 34.2 \nillustrates the standard theoretical assumption regarding the relationship between time value \nand time remaining until expiration for an at-the-money option. Specifi cally, the time value is \n FIGURE  34.1 Theoretical Option Premium Curve \n Source: Chicago Board of Trade, Marketing department. \nCall Option\nStrike price\nIntrinsic value\nT -bond futures price130\n132\n134\n136\n138\n140\nTime value premium\n8\n6\n4\n2 Option premium\nStrike price\nIntrinsic\nvalue\nT-bond futures price\n124\n126\n128\n130\n8\n6\n4\n2 Option premium\nPut Option\nTime value premium\n FIGURE  34.2 Time Value decay \n Source: Options on Comex Gold Futures, published by Commodity \nexchange, Inc. (COMeX), 1982. \nTime value decay\n94 10\nTime remaining until expiration (months)\nTime value premium", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:499", "doc_id": "edb5157197dea8294ae3d671d88ad3580be319309c872d9e9339192fc926f0c5", "chunk_index": 0}
{"text": "482\nA Complete Guide to the Futures mArket\ntable 34.2 Option prices as a Function of Volatility in \ne-Mini S&p 500 Futures pricesa\nannualized Volatility put or Call premium\n10 22.88 ($1,144)\n20 45.75 ($2,288)\n30 68.62 ($3,431)\n40 91.46 ($4,573)\n50 114.29 ($5,715)\na At-the-money options at astrike price of 2000 with 30 days to expiration.\n8 James Bowe, Option Strategies Trading Handbook (New York, NY: Coffee, Sugar, and Cocoa exchange, 1983).\nassumed to be afunction of the square root of time. (This relationship is aconsequence of the \ntypical assumption regarding the shape of the probability curve for prices of the underlying \nfutures contract.) Thus, an option with nine months until expiration would have 1.5 times the \ntime value of afour-month option with the same strike price \n(; ;. )93 42 32 15== ÷= \nand three times the time value of aone-month option (; ;)93 11 31 3== ÷= .\n 3. Volatility. Time value will vary directly with the estimated volatility of the underlying futures \ncontract for the remaining lifespan of the option. This relationship is the result of the fact that \ngreater volatility raises the probability the intrinsic value will increase by any specified amount \nprior to expiration. In other words, the greater the volatility, the larger the probable range of \nfutures prices. As Table 34.2 shows, volatility has astrong impact on theoretical option pre-\nmium values.\nAlthough volatility is an extremely important factor in determining option premium values, \nit should be stressed that the future volatility of the underlying futures contract is never pre-\ncisely known until after the fact. (In contrast, the time remaining until expiration and the rela -\ntionship between the current price of futures and the strike price can be exactly specified at any \njuncture.) Thus, volatility must always be estimated on the basis of historical volatility data. As \nwill be explained, this factor is crucial in explaining the deviation between theoretical and actual \npremium values.\n 4. Interest rates. The effect of interest rates on option premiums is considerably smaller than \nany of the above three factors. The specific nature of the relationship between interest rates and \npremiums was succinctly summarized by James Bowe\n8:\nThe effect of interest rates is complicated because changes in rates affect not only the \nunderlying value of the option, but the futures price as well. Taking it in steps, abuyer \nof any given option must pay the premium up front, and of course the seller receives \nthe money. If interest rates go up and everything else stays constant, the opportunity \ncost to the option buyer of giving up the use of his money increases, and so he is will-\ning to bid less. Conversely, the seller of options can make more on the premiums by", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:500", "doc_id": "f1983a0528a3fba20fb5b7ddcc603c4902542195642f53978ec5a05bd85489a1", "chunk_index": 0}
{"text": "483\nAN INTrOduCTION TO OPTIONS ON FuTureS\ninvesting the cash received and so is willing to accept less; the value of the options fall. \nHowever, in futures markets, part of the value of distant contracts in acarry market \nreflects the interest costs associated with owning the commodity. An increase in the \ninterest rate might cause the futures price to increase, leading to the value of existing \ncalls going up. The net effect on calls is ambiguous, but puts should decline in value \nwith increasing interest rates, as the effects are reinforcing.\n ■ Theoretical versus Actual Option Premiums\nThere is avariety of mathematical models available that will indicate the theoretical “fair value” for an \noption, given specific information regarding the four factors detailed in the previous section. Theoret-\nical values will approximate, but by no means coincide with, actual premiums. \ndoes the existence of \nsuch adiscrepancy necessarily imply that the option is mispriced? definitely not. The model-implied \npremium will differ from the actual premium for two reasons:\n 1. The model’sassumption regarding the mathematical relationship between option prices (premi-\nums) and the factors that affect option prices may not accurately describe market behavior. This \nis always true because, to some extent, even the best option-pricing models are only theoretical \napproximations of true market behavior.\n 2. The volatility figure used by an option-pricing model will normally differ somewhat from the \nmarket’sexpectation of future volatility. This is acritical point that requires further elaboration.\nrecall that although volatility is acrucial input in any option pricing formula, its value can \nonly be estimated. The theoretical “fair value” of an option will depend on the specific choice of avolatility figure. Some of the factors that will influence the value of the volatility estimate are the \nlength of the prior period used to estimate volatility, the time interval in which volatility is mea-\nsured, the weighting scheme (if any) used on the historical volatility data, and adjustments (if any) \nto reflect relevant influences (e.g., the recent trend in volatility). It should be clear that any specific \nvolatility estimate will implicitly reflect anumber of unavoidably arbitrary decisions. \ndifferent \nassumptions regarding the best procedure for estimating future volatility from past volatility will \nyield different theoretical premium values. Thus, there is no such thing as asingle, well-defined fair \nvalue for an option.\nAll that any option pricing model can tell you is what the value of the option should be given \nthe specific assumptions regarding expected volatility and the form of the mathematical relationship \nbetween option prices and the key factors affecting them. If agiven mathematical model provides aclose approximation of market behavior, adiscrepancy between the theoretical value and the actual \npremium means the market expectation for volatility, called the implied volatility, differs from the \nhistorically based volatility estimate used in the model. The question of whether the volatility assump-\ntions of aspecific pricing model provide more accurate estimates of actual volatility than the implied \nvolatility figures (i.e., the future volatility suggested by actual premiums) can only be answered \nempirically. Abias toward buying “underpriced” options (relative to the theoretical model fair value)", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:501", "doc_id": "7e13841473b97b47e88467c16f8d4d02a433ec5706710b9425d39fd7e40a0941", "chunk_index": 0}
{"text": "484\nA Complete Guide to the Futures mArket\nand selling “overpriced” options would be justified only if empirical evidence supported the conten-\ntion that, on balance, the model’svolatility assumptions proved to be better than implied volatility in \npredicting actual volatility levels.\nIf amodel’svolatility estimates were demonstrated to be superior to implied volatility estimates, \nit would suggest, from astrict probability standpoint, abullish trader would be better off selling puts \nthan buying calls if options were overpriced (based on the fair value figures indicated by the model), \nand buying calls rather than selling puts if options were underpriced. Similarly, abearish trader would \nbe better off selling calls than buying puts if options were overpriced, and buying puts rather than \nselling calls if options were underpriced. The best strategy for any individual trader, however, would \ndepend on the specific profile of his price expectations (i.e., the probabilities the trader assigns to \nvarious price outcomes).\n ■ Delta (the Neutral Hedge Ratio)\nDelta, also called the neutral hedge ratio, is the expected change in the option price given aone-unit \nchange in the price of the underlying futures contract. For example, if the delta of an August gold \ncall option is 0.25, it means that a $1 change in the price of August futures can be expected to result \nin a $0.25 change in the option premium. Thus, the delta value for agiven option can be used to \ndetermine the number of options that would be equivalent in risk to asingle futures contract for small \nchanges in price. It should be stressed that delta will change rapidly as prices change. Thus, the delta \nvalue cannot be used to compare the relative risk of options versus futures for large price changes.\nTable 34.3 illustrates the estimated delta values for out-of-the-money, at-the-money, and in-the-\nmoney call options for arange of times to expiration. Where did these values come from? They are \nderived from the same mathematical models used to determine atheoretical value for an option pre-\nmium given the relationship between the strike price and the current price of futures, time remaining \ntable 34.3 Change in the premium of an e-Mini S&p 500 Call Option for 20.00 ($1000) Move in the \nUnderlying Futures Contracta\nIncrease in the 2000 call option premium if the futures price rises:\nFrom 1900 to 1920 From 2000 to 2020 From 2100 to 2120\nTime to expiration $ Delta $ Delta $ Delta\n1 week $10 0.01 $500 0.5 $1,000 1\n1 month $120 0.12 $510 0.51 $870 0.87\n3 months $260 0.26 $510 0.51 $750 0.75\n6 months $330 0.33 $520 0.52 $690 0.69\n12 months $390 0.39 $520 0.52 $650 0.65\naAssumed volatility: 15 percent; assumed interest rate: 2 percent per year.\nSource: CMe Group (www .cmegroup.com).", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:502", "doc_id": "ae7471bc8c1455b4acca2463673113e569ce1c358bce2a0672e4831ccf5d35fc", "chunk_index": 0}
{"text": "485\nAN INTrOduCTION TO OPTIONS ON FuTureS\nuntil expiration, estimated volatility, and interest rates. For any given set of values for these factors, \ndelta will equal the absolute difference between the option premium indicated by the model and the \nmodel-indicated premium if the futures price changes by one point. Table 34.3 illustrates anumber \nof important observations regarding theoretical delta values:\n 1. Delta values for out-of-the-money options are low. This relationship is aresult of the \nfact that there is ahigh probability that any given price increase\n9 will not make any actual differ-\nence to the value of the option at expiration (i.e., the option will probably expire worthless).\n 2. Delta values for in-the-money options are relatively high, but less than one. In-\nthe-money options have high deltas because there is ahigh probability that aone-point change \nin the futures price will mean aone-point change in the option value at expiration. However, \nsince this probability must always be equal to less than one, the delta value will also always be \nequal to less than one.\n 3. Delta values for at-the-money options will be near 0.50. Since there is a 50/50 chance \nthat an at-the-money option will expire in-the-money, there will be an approximately 50/50 \nchance that aone-point increase in the price of futures will result in aone-point increase in the \noption value at expiration.\n 4. Delta values for out-of-the-money options will increase as time to expiration \nincreases. Alonger time to expiration will increase the probability that aprice increase in \nfutures will make adifference in the option value at expiration, since there is more time for \nfutures to reach the strike price.\n 5. Delta values for in-the-money options will decrease as time to expiration \nincreases. Alonger time to expiration will increase the probability that achange in the futures \nprice will not make any difference to the option value at expiration since there is more time for \nfutures to fall back to the strike price by the time the option expires.\n 6. Delta values for at-the-money options are not substantially affected by time to \nmaturity until near expiration. This behavioral pattern is true because the probability that \nan at-the-money option will expire in-the-money remains close to 50/50 until the option is \nnear expiration.\n9 This section implicitly assumes that the option is acall. If the option is aput, read “price decrease” for all refer-\nences to “price increase.”", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:503", "doc_id": "89813e43c68519ea9383e2b33edea250f56c1958179fb1864770d6aa469ea502", "chunk_index": 0}
{"text": "487\nBrokers are fond of pointing out to possible buyers of options that they are asplendid thing to \nbuy, and pointing out to sellers that they are asplendid thing to sell. They believe implicitly in \nthis paradox. Thus the buyer does well, the seller does well, and it is not necessary to stress the \npoint that the broker does well enough. Many examples can be cited showing all three of them \nemerging from their adventures with aprofit. One wonders why the problem of unemployment \ncannot be solved by having the unemployed buy and sell each other options, instead of mooning \naround on those park benches.\n—Fred Schwed\nWhere Are the Customers’ Yachts?\n ■ Comparing Trading Strategies\nThe existence of options greatly expands the range of possible trading strategies. For example, in the \nabsence of an option market, atrader who is bullish can either go long or initiate abull spread (in those \nmarkets in which spread movements correspond to price direction). However, if option-related trad-\ning approaches are included, the bullish trader can consider numerous alternative strategies including: \nlong out-of-the-money calls, long in-the-money calls, long at-the-money calls, short out-of-the-money \nputs, short in-the-money puts, short at-the-money puts, “synthetic” long positions, combined positions \nin futures and options, and avariety of bullish option spreads. Frequently, one of these option-related \nstrategies will offer significantly better profit potential for agiven level of risk than an outright futures \nposition. Thus, the trader who considers both option-based strategies and outright positions should \nhave adecided advantage over the trader who restricts his trades to only futures.\nOption Trading \nStrategies\nChapter 35", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:505", "doc_id": "328cf362e788dacce90f87ee81e9cd8be5c460b7bb411f05ce1ebe0ea480618c", "chunk_index": 0}
{"text": "488\nA Complete Guide to the Futures mArket\nThere is no single best trading approach. The optimal trading strategy in any given situation will \ndepend on the prevailing option premium levels and the specific nature of the expected price sce-\nnario. How does one decide on the best strategy? This chapter will attempt to answer this critical \nquestion in two steps. First, we will examine the general profit/loss characteristics (profiles) of awide range of alternative trading strategies. Second, we will consider how price expectations can be \ncombined with these profit/loss profiles to determine the best trading approach.\nThe profit/loss profile is adiagram indicating the profit or loss implied by aposition (vertical axis) \nfor arange of market prices (horizontal axis). The profit/loss profile provides an ideal means of \nunderstanding and comparing different trading strategies. The following points should be noted \nregarding the profit/loss profiles detailed in the next section:\n 1. All illustrations are based on asingle option series, for asingle market, on asingle date: the \nAugust 2015 gold options on April 13, 2015. This common denominator makes it easy to com-\npare the implications of different trading strategies. The choice of April 13, 2015, was not arbi-\ntrary. On that date, the closing price of August futures (1,200.20) was almost exactly equal to \none of the option strike prices ($1,200/oz), thereby providing anearly precise at-the-money \noption—afactor that greatly facilitates the illustration of theoretical differences among out-of-\nthe-money, in-the-money, and at-the-money options. The specific closing values for the option \npremiums on that date were as follows ($/oz):\nStrike price august Calls august puts\n1,050 155.2 5.1\n1,100 110.1 10.1\n1,150 70.1 19.9\n1,200 38.8 38.7\n1,250 19.2 68.7\n1,300 9.1 108.7\n1,350 4.5 154.1\nOption pricing data in this chapter courtesy of OptionVue (www .optionvue.com).\nThe reader should refer to these quotes when examining each of the profit/loss profiles in \nthe next section.\n 2. In order to avoid unnecessarily cluttering the illustrations, the profit/loss profiles do not include \ntransaction costs and interest income effects, both of which are very minor. (Note the assump-\ntion that transaction costs equal zero imply that commission costs equal zero and that positions \ncan be implemented at the quoted levels—in this case, the market close.)\n 3. The profit/loss profiles reflect the situation at the time of the option expiration. This assumption \nsimplifies the exposition, since the value of an option can be precisely determined at that point \nin time. At prior times, the value of the option will depend on the various factors discussed in \nthe previous chapter (e.g., time until expiration, volatility, etc.). Allowing for an evaluation of \neach option strategy at interim time stages would introduce alevel of complexity that would \nplace the discussion beyond the scope of this book. However, the key point to keep in mind", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:506", "doc_id": "6340d32c9140fcf4cda1300992c4bc3d72b32e16fb51f26b43a390d90d0b3bfe", "chunk_index": 0}
{"text": "489\nOPTION TrAdINg STrATegIeS\nis that the profit/loss profile for strategies that include anet long options position will shift \nupward as the time reference point is further removed from the expiration date. The reason is \nthat at expiration, options have only intrinsic value; at points prior to expiration, options also \nhave time value. Thus, prior to expiration, the holder of an option could liquidate his position at \naprice above its intrinsic value—the liquidation value assumed in the profit/loss profile. Simi-\nlarly, the profit/loss profile would be shifted downward for the option writer (seller) at points \nin time prior to expiration. This is true since at such earlier junctures, the option writer would \nhave to pay not only the intrinsic value but also the time value if he wanted to cover his position.\n 4. It is important to keep in mind that asingle option is equivalent to asmaller position size than asingle futures contract (see section entitled “\ndelta—the Neutral Hedge ratio” in the previous \nchapter). Similarly, an out-of-the-money option is equivalent to asmaller position size than an \nin-the-money option. Thus, the trader should also consider the profit/loss profiles consisting \nof various multiples of each strategy. In any case, the preference of one strategy over another \nshould be based entirely on the relationship between reward and risk rather than on the absolute \nprofit (loss) levels. In other words, strategy preferences should be totally independent of posi-\ntion size.\n 5. Trading strategies are evaluated strictly from the perspective of the speculator. Hedging applica-\ntions of option trading are discussed separately at the end of this chapter.\n ■ Profit/Loss Profiles for Key Trading Strategies\nStrategy 1: Long Futures\nexAMPle. Buy August gold futures at $1,200. (See Table 35.1 and Figure 35.1.)\nComment. The simple long position in futures does not require much explanation and is included \nprimarily for purposes of comparison to other less familiar trading strategies. As every trader knows, \nthe long futures position is appropriate when one expects asignificant price advance. However, as will \ntabLe 35.1 profit/Loss Calculations: Long Futures\nFutures price at expiration ($/oz) Futures price Change ($/oz) profit/Loss on position\n1,000 –200 –$20,000\n1,050 –150 –$15,000\n1,100 –100 –$10,000\n1,150 –50 –$5,000\n1,200 0 $0\n1,250 50 $5,000\n1,300 100 $10,000\n1,350 150 $15,000\n1,400 200 $20,000", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:507", "doc_id": "7fe1b87a4320a9e6db431cb9f0cab93f38362dbb143556f2fa10daecc0f177ac", "chunk_index": 0}
{"text": "491\nOPTION TrAdINg STrATegIeS\nComment. Once again, this strategy requires little explanation and is included primarily for com-\nparison to other strategies. As any trader knows, the short futures position is appropriate when one \nis expecting asignifi cant price decline. However, as will be seen later in this chapter, for any given \nexpected price scenario, some option-based strategy will often off er amore attractive trading oppor-\ntunity in terms of reward/risk characteristics. \n Strategy 3a: Long Call (at-the-Money) \nexAMPle . Buy August $1,200 gold futures call at apremium of $38.80/oz ($3,880), with August gold \nfutures trading at $1,200/oz. (See Table 35.3 aand Figure 35.3 a.) \nComment. The long call is abullish strategy in which maximum risk is limited to the premium paid \nfor the option, while maximum gain is theoretically unlimited. However, the probability of aloss is \ngreater than the probability of again, since the futures price must rise by an amount exceeding the \noption premium (as of the option expiration) in order for the call buyer to realize aprofi t. Two spe-\ncifi ccharacteristics of the at-the-money option are the following: \n 1. The maximum loss will only be realized if futures are trading at or below their current level at \nthe time of the option expiration. \n 2. For small price changes, each $1 change in the futures price will result in approximately a $0.50 \nchange in the option price. (At-the-money options near expiration, which will change by agreater amount, are an exception.) Thus, for small price changes, anet long futures position is \nequivalent to approximately two call options in terms of risk. \n FIGURE  35.2 Profi t/loss Profi le: Short Futures \nPrice of August gold futures at option expiration ($/oz)\n1,000 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nProfit/loss at expiration ($)\n20,000\n15,000\n10,000\n5,000\n−5,000\n−10,000\n−15,000\n−20,000\n0", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:509", "doc_id": "df810b95c015a1dd6f868dfac7d35cedc4a21373c184fefa39dbff3e4f75648f", "chunk_index": 0}
{"text": "492A COMPleTe gUIde TO THe FUTUreS MArKeT\n tabLe 35.3a profit/Loss Calculations: Long Call (at-the-Money) \n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august \n$1,200 Call at \nInitiation ($/oz)\n$ amount of \npremium paid\nCall Value at \nexpiration\nprofit/Loss of \nposition [(4) – (3)]\n1,000 38.8 $3,880 $0 –$3,880\n1,050 38.8 $3,880 $0 –$3,880\n1,100 38.8 $3,880 $0 –$3,880\n1,150 38.8 $3,880 $0 –$3,880\n1,200 38.8 $3,880 $0 –$3,880\n1,250 38.8 $3,880 $5,000 $1,120\n1,300 38.8 $3,880 $10,000 $6,120\n1,350 38.8 $3,880 $15,000 $11,120\n1,400 38.8 $3,880 $20,000 $16,120\n FIGURE  35.3a Profi t/loss Profi le: long Call (At-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures at time of position\ninitiation and strike price\nBreakeven price = $1,238.80\nProfit/loss at expiration ($)\n1,000\n15,000\n17,500\n12,500\n10,000\n7 ,500\n2,500\n0\n−2,500\n−5,000\n5,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:510", "doc_id": "923cdf30aa2dc4106d976d2e555cd76e15f9a0f8e2121520f3f0f6b37d783b37", "chunk_index": 0}
{"text": "493\nOPTION TrAdINg STrATegIeS\nStrategy 3b: Long Call (Out-of-the-Money)\nexAMPle. Buy August $1,300 gold futures call at apremium of $9.10/oz ($910), with August gold \nfutures trading at $1,200/oz. (See Table 35.3b and Figure 35.3b.)\nComment. The buyer of an out-of-the-money call reduces his maximum risk in exchange for accept-\ning asmaller probability that the trade will realize aprofit. By definition, the strike price of an out-of-\nthe-money call is above the current level of futures. In order for the out-of-the-money call position \nto realize aprofit, the futures price (as of the time of the option expiration) must exceed the strike \nprice by an amount greater than the premium ($9.10/oz in this example). Note that in the out-of-\nthe-money call position, price increases that leave futures below the option strike price will still result \nin amaximum loss on the option. The long out-of-the-money call might be aparticularly appropriate \nposition for the trader expecting alarge price advance, but also concerned about the possibility of alarge price decline.\nIt should be emphasized that the futures price need not necessarily reach the strike price in order \nfor the out-of-the-money call to be profitable. If the market rises quickly, the call will increase in \nvalue and hence can be resold at aprofit. (However, this characteristic will not necessarily hold true \nfor slow price advances, since the depressant effect of the passage of time on the option premium \ncould more than offset the supportive effect of the increased price level of futures.)\nFor small price changes, the out-of-the-money call will change by less than afactor of one-half for \neach dollar change in the futures price. Thus, for small price changes, each long futures position will \nbe equivalent to several long out-of-the-money calls in terms of risk.\ntabLe 35.3b profit/Loss Calculations: Long Call (Out-of-the-Money)\n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august \n$1,300 Call at \nInitiation ($/oz)\n$ amount of \npremium paid\nCall Value at \nexpiration\nprofit/Loss on \nposition [(4) – (3)]\n1,000 9.1 $910 $0 –$910\n1,050 9.1 $910 $0 –$910\n1,100 9.1 $910 $0 –$910\n1,150 9.1 $910 $0 –$910\n1,200 9.1 $910 $0 –$910\n1,250 9.1 $910 $0 –$910\n1,300 9.1 $910 $0 –$910\n1,350 9.1 $910 $5,000 $4,090\n1,400 9.1 $910 $10,000 $9,090", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:511", "doc_id": "cf611cbdd6128eb8e9725ae5d314f3ce894ab126c45e8305ead6b3e037610b56", "chunk_index": 0}
{"text": "494A COMPleTe gUIde TO THe FUTUreS MArKeT\n FIGURE  35.3b Profi t/loss Profi le: long Call (Out-of-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation Strike price\nBreakeven price\n= $1,309.10\nProfit/loss at expiration ($)\n1,000\n10,000\n5,000\n7 ,500\n2,500\n−2,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n Strategy 3c: Long Call (In-the-Money) \nexample . Buy August $1,100 gold futures call at apremium of $110.10 /oz ($11,010), with August \ngold futures trading at $1,200/oz. (See Table 35.3 cand Figure 35.3 c.) \nComment. In many respects, along in-the-money call position is very similar to along futures posi-\ntion. The three main diff erences between these two trading strategies are: \n 1. The long futures position will gain slightly more in the event of aprice rise—an amount equal \nto the time value portion of the premium paid for the option ($1,010 in the above example). \n 2. For moderate price declines, the long futures position will lose slightly less. (Once again, the \ndiff erence will be equal to the time value portion of the premium paid for the option.) \n 3. In the event of alarge price decline, the loss on the in-the-money long call position would be lim-\nited to the total option premium paid, while the loss on the long futures position will be unlimited. \n In asense, the long in-the-money call position can be thought of as along futures position with abuilt-in stop. This characteristic is an especially important consideration for speculators who typically \nemploy protective stop-loss orders on their positions—aprudent trading approach. Atrader using aprotective sell stop on along position faces the frustrating possibility of the market declining suffi ciently \nto activate his stop and subsequently rebounding. The long in-the-money call position off ers the spec-\nulator an alternative method of limiting risk that does not present this danger. Of course, this benefi tdoes not come without acost; as mentioned above, the buyer of an in-the-money call will gain slightly \nless than the outright futures trader if the market advances, and will lose slightly more if the market \ndeclines moderately. However, if the trader is anticipating volatile market conditions, he might very", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:512", "doc_id": "c544a728be1e251263854c9a7cf65153794c415ffd714aab553d0d80cc2987c7", "chunk_index": 0}
{"text": "495\nOPTION TrAdINg STrATegIeS\nwell prefer along in-the-money call position to along futures position combined with aprotective \nsell stop order. In any case, the key point is that the trader who routinely compares the strategies \nof buying an in-the-money call versus going long futures with aprotective sell stop should enjoy an \nadvantage over those traders who never consider the option-based alternative. \n FIGURE  35.3c Profi t/loss Profi le: long Call (In-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at\ntime of position\ninitiationStrike price\nBreakeven price = $1210.10\nProfit/loss at expiration ($)\n1,000\n10,000\n−10,000\n−15,000\n5,000\n−5,000\n0\n15,000\n20,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n tabLe 35.3c profit/Loss Calculations: Long Call (In-the-Money) \n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august $1,100 \nCall at Initiation ($/oz)\n$ amount of \npremium paid\nCall Value at \nexpiration\nprofit/Loss on \nposition [(4) – (3)]\n1,000 110.1 $11,010 $0 –$11,010\n1,050 110.1 $11,010 $0 –$11,010\n1,100 110.1 $11,010 $0 –$11,010\n1,150 110.1 $11,010 $5,000 –$6,010\n1,200 110.1 $11,010 $10,000 –$1,010\n1,250 110.1 $11,010 $15,000 $3,990\n1,300 110.1 $11,010 $20,000 $8,990\n1,350 110.1 $11,010 $25,000 $13,990\n1,400 110.1 $11,010 $30,000 $18,990", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:513", "doc_id": "cf0671e29463db41e6f69b6e57838f2faa55fb3de7730eced591d248f4b84d13", "chunk_index": 0}
{"text": "496\nA Complete Guide to the Futures mArket\nTable 35.3d summarizes the profit/loss implications of various long call positions for arange of \nprice assumptions. Note that as calls move deeper in-the-money, their profit and loss characteristics \nincreasingly resemble along futures position. The very deep in-the-money $1,050 call provides \nan interesting apparent paradox: The profit/loss characteristics of this option are nearly the same \nas those of along futures position for all prices above $1,050, but the option has the advantage of \nlimited risk for lower prices. How can this be? Why wouldn’tall traders prefer the long $1,050 \ncall to the long futures position and, therefore, bid up its price so that its premium also reflected \nmore time value? (The indicated premium of $15,520 for the $1,050 call consists almost entirely \nof intrinsic value.)\nThere are two plausible explanations to this apparent paradox. First, the option price reflects \nthe market’sassessment that there is avery low probability of gold prices moving to this deep in-\nthe-money strike price, and therefore the market places alow value on the time premium. In other \nwords, the market places alow value on the loss protection provided by an option with astrike price \nso far below the market. Second, the $1,050 call represents afairly illiquid option position, and the \nquoted price does not reflect the bid/ask spread. No doubt, apotential buyer of the call would have \nhad to pay ahigher price than the quoted premium in order to assure an execution.\ntabLe 35.3d profit/Loss Matrix for Long Calls with Different Strike prices\nDollar amount of premiums paid\n$1,050 $1,100 $1,150 $1,200 $1,250 $1,300 $1,350\nCall Call a Call Call a Call Call a Call\n$15,520 $11,010 $7,010 $3,880 $1,920 $910 $450\nposition profit/Loss at expiration\nFutures price at \nexpiration ($/oz)\nLong \nFutures \nat $1,200\nIn-the-Money at-the-Money Out-of-the-Money\n$1,050\nCall\n$1,100\nCalla\n$1,150\nCall\n$1,200\nCalla\n$1,250\nCall\n$1,300\nCalla\n$1,350\nCall\n1,000 –$20,000 –$15,520 –$11,010 –$7,010 –$3,880 –$1,920 –$910 –$450\n1,050 –$15,000 –$15,520 –$11,010 –$7,010 –$3,880 –$1,920 –$910 –$450\n1,100 –$10,000 –$10,520 –$11,010 –$7,010 –$3,880 –$1,920 –$910 –$450\n1,150 –$5,000 –$5,520 –$6,010 –$7,010 –$3,880 –$1,920 –$910 –$450\n1,200 $0 –$520 –$1,010 –$2,010 –$3,880 –$1,920 –$910 –$450\n1,250 $5,000 $4,480 $3,990 $2,990 $1,120 –$1,920 –$910 –$450\n1,300 $10,000 $9,480 $8,990 $7,990 $6,120 $3,080 –$910 –$450\n1,350 $15,000 $14,480 $13,990 $12,990 $11,120 $8,080 $4,090 –$450\n1,400 $20,000 $19,480 $18,990 $17,990 $16,120 $13,080 $9,090 $4,550\naThese calls are compared in Figure 35.3d.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:514", "doc_id": "08b0b5e979846d5740e91a7f828dd5c8b398f00000a878560e646397cd14fdff", "chunk_index": 0}
{"text": "497\nOPTION TrAdINg STrATegIeS\n Figure 35.3 dcompares the three types of long call positions to along futures position. It should be \nnoted that in terms of absolute price changes, the long futures position represents the largest position \nsize, while the out-of-the-money call represents the smallest position size. Figure 35.3 dsuggests the \nfollowing important observations: \n 1. As previously mentioned, the in-the-money call is very similar to an outright long futures \nposition. \n 2. The out-of-the-money call will lose the least in adeclining market, but will also gain the least in \narising market. \n 3. The at-the-money call will lose the most in asteady market and will be the middle-of-the-road \nperformer (relative to the other two types of calls) in advancing and declining markets. \n Again, it should be emphasized that these comparisons are based upon single-unit positions that \nmay diff er substantially in terms of their implied position size (as suggested by their respective delta \nvalues). Acomparison that involved equivalent position size levels for each strategy (i.e., equal delta \nvalues for each position) would yield diff erent observations. This point is discussed in greater detail in \nthe section entitled “Multiunit Strategies.” \n FIGURE  35.3d Profi t/loss Profi le: long Futures and long Call Comparisons (In-the-Money, \nAt-the-Money, and Out-of-the-Money)\nChart created using TradeStation. ©TradeStation Technologies, Inc. All rights reserved. \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time of position initiation\nLong futures\nAt-the-money call\n(strike price = $1,200)\nOut-of-the-money\ncall (strike price = $1,300)\nIn-the-money call\n(strike price = $1,100)\nProfit/loss at expiration ($)\n1,000\n10,000\n−10,000\n−15,000\n5,000\n−5,000\n0\n15,000\n20,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:515", "doc_id": "18b925de3eeaad34975bf403cd49ab407ac0a8db703989ec1521791a09af81a5", "chunk_index": 0}
{"text": "498A COMPleTe gUIde TO THe FUTUreS MArKeT\n Strategy 4a: Short Call (at-the-Money) \nexample . Sell August $1,200 gold futures call at apremium of $38.80 /oz ($3,880), with August gold \nfutures trading at $1,200/oz. (See Table 35.4 aand Figure 35.4 a.) \n tabLe 35.4a profit/Loss Calculations-Short Call (at-the-Money) \n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august \n$1,200 Call at \nInitiation ($/oz)\n$ amount of \npremium received\nCall Value at \nexpiration\nprofit/Loss on \nposition [(3) – (4)]\n1,000 38.8 $3,880 $0 $3,880\n1,050 38.8 $3,880 $0 $3,880\n1,100 38.8 $3,880 $0 $3,880\n1,150 38.8 $3,880 $0 $3,880\n1,200 38.8 $3,880 $0 $3,880\n1,250 38.8 $3,880 $5,000 –$1,120\n1,300 38.8 $3,880 $10,000 –$6,120\n1,350 38.8 $3,880 $15,000 –$11,120\n1,400 38.8 $3,880 $20,000 –$16,120\n FIGURE  35.4a Profi t/loss Profi le: Short Call (At-the-Money)\nChart created using TradeStation. ©TradeStation Technologies, Inc. All rights reserved. \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nand strike price Breakeven price\n= $1,238.80\nProfit/loss at expiration ($)\n1,000\n5,000\n2,500\n−5,000\n−2,500\n0\n−10,000\n−7,500\n−17,500\n−15,000\n−12,500\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:516", "doc_id": "c589ddc2d2ff5566e671b0cffc628bee4bf3e06b5c5b22f91f0f004933f12a47", "chunk_index": 0}
{"text": "499\nOPTION TrAdINg STrATegIeS\nComment. The short call is abearish position with amaximum potential gain equal to the premium \nreceived for selling the call and unlimited risk. However, in return for assuming this unattractive \nmaximum reward/maximum risk relationship, the seller of acall enjoys agreater probability of \nrealizing aprofit than aloss. Note the short at-the-money call position will result in again as long as \nthe futures price at the time of the option expiration does not exceed the futures price at the time \nof the option initiation by an amount greater than the premium level ($38.80/oz in our example). \nHowever, the maximum possible profit (i.e., the premium received on the option) will only be real-\nized if the futures price at the time of the option expiration is below the prevailing market price at the \ntime the option was sold (i.e., the strike price). The short call position is appropriate if the trader is \nmodestly bearish and views the probability of alarge price rise as being very low . If, however, the trader \nanticipated alarge price decline, he would probably be better off buying aput or going short futures.\nStrategy 4b: Short Call (Out-of-the-Money)\nexample. Sell August $1,300 gold futures call at apremium of $9.10/oz ($910), with August gold \nfutures trading at $1,200/oz. (See Table 35.4b and Figure 35.4b.)\nComment. The seller of an out-of-the-money call is willing to accept asmaller maximum gain (i.e., \npremium) in exchange for increasing the probability of again on the trade. The seller of an out-of-\nthe-money call will retain the full premium received as long as the futures price does not rise by an \namount greater than the difference between the strike price and the futures price at the time of the \noption sale. The trade will be profitable as long as the futures price at the time of the option expiration \nis not above the strike price by more than the option premium ($9.10/oz in this example). The short \nout-of-the-money call represents aless bearish posture than the short at-the-money call position. \nWhereas the short at-the-money call position reflects an expectation that prices will either decline \nor increase only slightly, the short out-of-the-money call merely reflects an expectation that prices \nwill not rise sharply.\ntabLe 35.4b profit/Loss Calculations: Short Call (Out-of-the-Money)\n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august $1,300 \nCall at Initiation ($/oz)\n$ amount of \npremium received\nValue of Call \nat expiration\nprofit/Loss on \nposition [(3) – (4)]\n1,000 9.1 $910 $0 $910\n1,050 9.1 $910 $0 $910\n1,100 9.1 $910 $0 $910\n1,150 9.1 $910 $0 $910\n1,200 9.1 $910 $0 $910\n1,250 9.1 $910 $0 $910\n1,300 9.1 $910 $0 $910\n1,350 9.1 $910 $5,000 –$4,090\n1,400 9.1 $910 $10,000 –$9,090", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:517", "doc_id": "cc073a1d0a8274424d422c75a3ccaaa643bb5a5c533484fdede1c1e81894513c", "chunk_index": 0}
{"text": "501\nOPTION TrAdINg STrATegIeS\nComment. For most of the probable price range, the profi t/loss characteristics of the short in-the-\nmoney call are fairly similar to those of the outright short futures position. There are three basic dif-\nferences between these two positions: \n 1. The short in-the-money call will lose modestly less than the short futures position in \nan advancing market because the loss will be partially off set by the premium received for \nthe call. \n 2. The short in-the-money call will gain modestly more than the short futures position in amod-\nerately declining market. \n 3. In avery sharply declining market, the profi tpotential on ashort futures position is open-ended, \nwhereas the maximum gain in the short in-the-money call position is limited to the total pre-\nmium received for the call. \n In eff ect, the seller of an in-the-money call chooses to lock in modestly better results for the prob-\nable price range in exchange for surrendering the opportunity for windfall profi ts in the event of aprice collapse. generally speaking, atrader should only choose ashort in-the-money call over ashort \nfutures position if he believes that the probability of asharp price decline is extremely small. \n Table 35.4 dsummarizes the profi t/loss results for various short call positions for arange of \nprice assumptions. As can be seen, as calls move more deeply in-the-money, they begin to resemble \n FIGURE  35.4c Profi t/loss Profi le: Short Call (In-the-Money)\nChart created using TradeStation. ©TradeStation Technologies, Inc. All rights reserved. \nPrice of August gold futures at option expiration ($/oz)\nFutures price at\ntime of position\ninitiation\nStrike price\nBreakeven price\n= $1210.10\nProfit/loss at expiration ($)\n1,000\n10,000\n15,000\n−10,000\n5,000\n−5,000\n0\n−20,000\n−15,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:519", "doc_id": "a7234ff9f9ed383a319b21ddd91e90ebf29f22cfe59dbd465de22c5210682ef3", "chunk_index": 0}
{"text": "502\nA Complete Guide to the Futures mArket\nashort futures position more closely. (Sellers of deep in-the-money calls should be aware that longs \nmay choose to exercise such options well before expiration. early exercise can occur if the poten-\ntial interest income on the premium is greater than the theoretical time value of the option for azero interest rate assumption.) Short positions in deep out-of-the-money calls will prove profitable \nfor the vast range of prices, but the maximum gain is small and the theoretical maximum loss is \nunlimited.\nFigure 35.4d compares each type of short call to ashort futures position. The short at-the-money \ncall position will be the most profitable strategy under stable market conditions and the middle-of-\nthe-road strategy (relative to the other two types of calls) in rising and declining markets. The short \nout-of-the-money call will lose the least in arising market, but it will also be the least profitable \nstrategy if prices decline. The short in-the-money call is the type of call that has the greatest potential \nand risk and, as mentioned above, there is astrong resemblance between this strategy and an outright \nshort position in futures.\nIt should be emphasized that the comparisons in Figure 35.4d are based upon single-unit positions. \nHowever, as previously explained, these alternative strategies do not represent equivalent position \nsizes. Comparisons based on positions weighted equally in terms of some risk measure (e.g., equal \ndelta values) would yield different empirical conclusions.\ntabLe 35.4d profit/Loss Matrix for Short Calls with Different Strike prices\nDollar amount of premium received\n$1,050 $1,100 $1,150 $1,200 $1,250 $1,300 $1,350\nCall Call Call Call Call Call Call\n$15,520 $11,010 $7,010 $3,880 $1,920 $910 $450\nposition profit/Loss at expiration\nFutures price at \nexpiration ($/oz)\nShort Futures \nat $1,200\nIn-the-Money \nat-the-\nMoney Out-of-the Money\n$1,050 Call $1,100 Call a $1,150 Call $1,200 Call a $1,250 Call $1,300 Call a $500 Call\n1,000 $20,000 $15,520 $11,010 $7,010 $3,880 $1,920 $910 $450\n1,050 $15,000 $15,520 $11,010 $7,010 $3,880 $1,920 $910 $450\n1,100 $10,000 $10,520 $11,010 $7,010 $3,880 $1,920 $910 $450\n1,150 $5,000 $5,520 $6,010 $7,010 $3,880 $1,920 $910 $450\n1,200 $0 $520 $1,010 $2,010 $3,880 $1,920 $910 $450\n1,250 –$5,000 –$4,480 –$3,990 –$2,990 –$1,120 $1,920 $910 $450\n1,300 –$10,000 –$9,480 –$8,990 –$7,990 –$6,120 –$3,080 $910 $450\n1,350 –$15,000 –$14,480 –$13,990 –$12,990 –$11,120 –$8,080 –$4,090 $450\n1,400 –$20,000 –$19,480 –$18,990 –$17,990 –$16,120 –$13,080 –$9,090 –$4,550\naThese calls are compared in Figure 35.4d.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:520", "doc_id": "7725fbe88259acedb7acc534c67bc3190e433f547e223e41afa51be44fc3f4d1", "chunk_index": 0}
{"text": "503\nOPTION TrAdINg STrATegIeS\n Strategy 5a: Long put (at-the-Money) \nexample . Buy August $1,200 gold futures put at apremium of $38.70/oz ($3,870), with August gold \nfutures trading at $1,200/oz. (See Table 35.5 aand Figure 35.5 a.) \n FIGURE  35.4d Profi t/loss Profi le: Short Futures and Short Call Comparisons (In-the-Money, \nAt-the-Money, and Out-of-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nShort futures\nAt-the-money call\n(strike price = $1,200)\nOut-of-the-money call\n(strike price = $1,300)\nIn-the-money call\n(strike price = $1,100)\nProfit/loss at expiration ($)\n1,000\n10,000\n15,000\n−10,000\n5,000\n−5,000\n0\n−15,000\n−20,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n tabLe 35.5a profit/Loss Calculations: Long put (at-the-Money) \n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august $1,200 \nput at Initiation ($/oz)\n$ amount of \npremium paid\nput Value at \nexpiration\nprofit/Loss on \nposition [(4) – (3)]\n1,000 38.7 $3,870 $20,000 $16,130\n1,050 38.7 $3,870 $15,000 $11,130\n1,100 38.7 $3,870 $10,000 $6,130\n1,150 38.7 $3,870 $5,000 $1,130\n1,200 38.7 $3,870 $0 –$3,870\n1,250 38.7 $3,870 $0 –$3,870\n1,300 38.7 $3,870 $0 –$3,870\n1,350 38.7 $3,870 $0 –$3,870\n1,400 38.7 $3,870 $0 –$3,870", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:521", "doc_id": "2252c6791ff34134a203207044ac1e85cc717a674eaab3bc466c4cee75794fc4", "chunk_index": 0}
{"text": "504A COMPleTe gUIde TO THe FUTUreS MArKeT\nComment. The long put is abearish strategy in which maximum risk is limited to the premium paid \nfor the option, while maximum gain is theoretically unlimited. However, the probability of aloss is \ngreater than the probability of again, since the futures price must decline by an amount exceeding \nthe option premium (as of the option expiration) in order for the put buyer to realize aprofi t. Two \nspecifi ccharacteristics of the at-the-money option are: \n 1. The maximum loss will be realized only if futures are trading at or above their current level at \nthe time of the option expiration. \n 2. For small price changes, each $1 change in the futures price will result in approximately a $0.50 \nchange in the option price (except for options near expiration). Thus, for small price changes, anet short futures position is equivalent to approximately 2 put options in terms of risk. \n Strategy 5 b: Long put (Out-of-the-Money) \nexample . Buy August $1,100 gold futures put at apremium of $10.10 /oz ($1,010). (The current \nprice of August gold futures is $1,200/oz.) (See Table 35.5 band Figure 35.5 b.) \nComment. The buyer of an out-of-the-money put reduces his maximum risk in exchange for accept-\ning asmaller probability that the trade will realize aprofi t. By defi nition, the strike price of an out-of-\nthe-money put is below the current level of futures. In order for the out-of-the-money put position \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nand strike price\nBreakeven price = $1,161.30\nProfit/loss at expiration ($)\n1,000\n10,000\n7,500\n−5,000\n5,000\n−2,500\n2,500\n0\n17,500\n15,000\n12,500\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n FIGURE  35.5a Profi t/loss Profi le: long Put (At-the-Money)", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:522", "doc_id": "904b45f9f9a0f0168820d22575b6a289842010a7931f61d0fda750bbdab34aff", "chunk_index": 0}
{"text": "505\nOPTION TrAdINg STrATegIeS\nto realize aprofi t, the futures price (as of the time of the option expiration) must penetrate the strike \nprice by an amount greater than the premium ($10.10/oz in the above example). Note that in the \nout-of-the-money put position, price decreases that leave futures above the option strike price will \nstill result in amaximum loss on the option. The long out-of-the-money put might be aparticularly \nappropriate position for the trader expecting alarge price decline, but also concerned about the pos-\nsibility of alarge price rise. \n tabLe 35.5b profit/Loss Calculations: Long put (Out-of-the-Money) \n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august $1,100 \nput at Initiation ($/oz)\n$ amount of \npremium paid\nValue of put \nat expiration\nprofit/Loss on \nposition [(4) – (3)]\n1,000 10.1 $1,010 $10,000 $8,990\n1,050 10.1 $1,010 $5,000 $3,990\n1,100 10.1 $1,010 $0 –$1,010\n1,150 10.1 $1,010 $0 –$1,010\n1,200 10.1 $1,010 $0 –$1,010\n1,250 10.1 $1,010 $0 –$1,010\n1,300 10.1 $1,010 $0 –$1,010\n1,350 10.1 $1,010 $0 –$1,010\n1,400 10.1 $1,010 $0 –$1,010\nPrice of August gold futures at option expiration\nFutures price at time\nof position initiation\nBreakeven\nprice\n= $1,089.90\nProfit/loss at expiration ($)\n1,000\n7,500\n10,000\n5,000\n−2,500\n2,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nStrike price\n FIGURE  35.5b Profi t/loss Profi le: long Put (Out-of-the-Money)", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:523", "doc_id": "cbb6bc8784c55919bf1ad48dc4b6f5cd3448a8ef045b705c92d10647693e935b", "chunk_index": 0}
{"text": "506\nA Complete Guide to the Futures mArket\nIt should be emphasized that the futures price need not necessarily reach the strike price in order \nfor the out-of-the-money put to be profitable. If the market declines quickly, the put will increase in \nvalue, and hence can be resold at aprofit. (However, this behavior will not necessarily hold for slow \nprice declines, since the depressant effect of the passage of time on the option premium could well \nmore than offset the supportive effect of the decreased price level of futures.)\nFor small price changes, the out-of-the-money put will change by less than afactor of one-half for \neach dollar change in the futures price. Thus, for small price changes, each short futures position will \nbe equivalent to several short out-of-the-money puts in terms of risk.\nStrategy 5c: Long put (In-the-Money)\nexample. Buy August $1,300 gold futures put at apremium of $108.70/oz ($10,870), with August \ngold futures trading at $1,200/oz. (See Table 35.5c and Figure 35.5c.)\nComment. In many respects, along in-the-money put option is very similar to ashort futures posi-\ntion. The three main differences between these two trading strategies are:\n 1. The short futures position will gain slightly more in the event of aprice decline—an amount \nequal to the time value portion of the premium paid for the option ($870 in this example).\n 2. For moderate price advances, the short futures position will lose slightly less. (Once again, the \ndifference will be equal to the time value portion of the premium paid for the option.)\n 3. In the event of alarge price advance, the loss on the in-the-money long put position would be \nlimited to the total option premium paid, while the loss on the short futures position would be \nunlimited.\ntabLe 35.5c profit/Loss Calculations: Long put (In-the-Money)\n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august $1,300 \nput at Initiation ($/oz)\nDollar amount \nof premium paid\nValue of put \nat expiration\nprofit/Loss on \nposition [(3) – (4)]\n1,000 108.7 $10,870 $30,000 $19,130\n1,050 108.7 $10,870 $25,000 $14,130\n1,100 108.7 $10,870 $20,000 $9,130\n1,150 108.7 $10,870 $15,000 $4,130\n1,200 108.7 $10,870 $10,000 –$870\n1,250 108.7 $10,870 $5,000 –$5,870\n1,300 108.7 $10,870 $0 –$10,870\n1,350 108.7 $10,870 $0 –$10,870\n1,400 108.7 $10,870 $0 –$10,870", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:524", "doc_id": "1a857b4a32033c58997ca9dc393ffe42e4e31baff9f43335a1f119157bb1973b", "chunk_index": 0}
{"text": "507\nOPTION TrAdINg STrATegIeS\n In asense, the long in-the-money put position can be thought of as ashort futures position with \nabuilt-in stop. This characteristic is an especially important consideration for speculators who \ntypically employ protective stop loss orders on their positions—aprudent trading approach. Atrader using aprotective buy stop on ashort position faces the frustrating possibility of the market \nadvancing suffi ciently to activate his stop and subsequently breaking. The long in-the-money put \nposition off ers the speculator an alternative method of limiting risk that does not present this \ndanger. Of course, this benefi tdoes not come without acost: as mentioned earlier, the buyer of an \nin-the-money put will gain slightly less than the outright short futures trader if the market declines \nand lose slightly more if the market advances moderately. However, if the trader is anticipating \nvolatile market conditions, he might very well prefer along in-the-money put position to ashort \nfutures position combined with aprotective buy stop order. In any case, the key point is that the \ntrader who routinely compares the strategies of buying an in-the-money put versus going short \nfutures with aprotective buy stop should enjoy an advantage over those traders who never consider \nthe option-based alternative. \n Table 35.5 dsummarizes the profi t/loss implications of various long put positions for arange of \nprice assumptions. Note that as puts move deeper in-the-money, their profi tand loss characteristics \nincreasingly resemble ashort futures position. \n FIGURE  35.5c Profi t/loss Profi le: long Put (In-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures\nprice at time\nof position\ninitiation\nStrike price\nBreakeven price\n= $1,191.30\nProfit/loss at expiration ($)\n1,000\n10,000\n−10,000\n−15,000\n5,000\n−5,000\n0\n15,000\n20,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:525", "doc_id": "3f21aad084259bf714249781a35d0ab1f0bf712f3eb5c871f464df7ad7d1c1f2", "chunk_index": 0}
{"text": "508\nA Complete Guide to the Futures mArket\ntabLe 35.5d profit/Loss Matrix for Long puts with Different Strike prices\nDollar amount of premium paid\n$1,350 \nput\n$1,300 \nput\n$1,250 \nput\n$1,200 \nput\n$1,150 \nput\n$1,100 \nput\n$1,050 \nput\n$15,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510\nposition profit/Loss at expiration\nFutures price at \nexpiration ($/oz)\nShort Futures \nat $1,200\nIn-the-Money at-the-Money Out-of-the-Money\n$1,350 \nput\n$1,300 \nputa\n$1,250 \nput\n$1,200 \nputa\n$1,150 \nput\n$1,100 \nputa\n$1,050 \nput\n1,000 $20,000 $19,590 $19,130 $18,130 $16,130 $13,010 $8,990 $4,490\n1,050 $15,000 $14,590 $14,130 $13,130 $11,130 $8,010 $3,990 –$510\n1,100 $10,000 $9,590 $9,130 $8,130 $6,130 $3,010 –$1,010 –$510\n1,150 $5,000 $4,590 $4,130 $3,130 $1,130 –$1,990 –$1,010 –$510\n1,200 $0 –$410 –$870 –$1,870 –$3,870 –$1,990 –$1,010 –$510\n1,250 –$5,000 –$5,410 –$5,870 –$6,870 –$3,870 –$1,990 –$1,010 –$510\n1,300 –$10,000 –$10,410 –$10,870 –$6,870 –$3,870 –$1,990 –$1,010 –$510\n1,350 –$15,000 –$15,410 –$10,870 –$6,870 –$3,870 –$1,990 –$1,010 –$510\n1,400 –$20,000 –$15,410 –$10,870 –$6,870 –$3,870 –$1,990 –$1,010 –$510\naThese puts are compared in Figure 35.5d.\nFigure 35.5d compares the three types of long put positions to ashort futures position. It should \nbe noted that in terms of absolute price changes, the short futures position represents the largest \nposition size, while the out-of-the-money put represents the smallest position size. Figure 35.5d sug-\ngests the following important observations:\n 1. As previously mentioned, the in-the-money put is very similar to an outright short futures \nposition.\n 2. The out-of-the-money put will lose the least in arising market, but will also gain the least in adeclining market.\n 3. The at-the-money put will lose the most in asteady market and will be the middle-of-\nthe-road performer (relative to the other two types of puts) in declining and advancing \nmarkets.\nAgain, it should be emphasized that these comparisons are based on single-unit positions that \nmay differ substantially in terms of their implied position size (as suggested by their respective delta \nvalues). Acomparison that involved equivalent position size levels for each strategy (i.e., equal delta \nvalues for each position) would yield different observations.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:526", "doc_id": "097a19e90b8ca14370bfc4efa2d62ef40e372c6303d5833c1fe9704ec5dd19fb", "chunk_index": 0}
{"text": "509\nOPTION TrAdINg STrATegIeS\nexample . Sell August $1,200 gold futures put at apremium of $38.70/oz ($3,870), with August gold \nfutures trading at $1,200/oz. (See Table 35.6 aand Figure 35.6 a.) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nShort futures\nAt-the-money put\n(strike price = $1,200)\nOut-of-the-money put\n(strike price = $1,100)\nIn-the-money\nput (strike price = $1,300)\nPrice/loss at expiration ($)\n1,000\n10,000\n−10,000\n−15,000\n5,000\n−5,000\n0\n15,000\n20,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n FIGURE  35.5d Profi t/loss Profi le: Short Futures and long Put Comparisons (In-the-Money, \nAt-the-Money, and Out-of-the-Money) \n tabLe 35.6a profit/Loss Calculations: Short put (at-the-Money) \n(1) (2) (3) (4) (5)\n Futures price at \nexpiration ($/oz) \n premium of august $1,200 \nput at Initiation ($/oz) \n $ amount of \npremium received \n put Value at \nexpiration \n profit/Loss on \nposition [(3) – (4)] \n1,000 38.7 $3,870 $20,000 –$16,130\n1,050 38.7 $3,870 $15,000 –$11,130\n1,100 38.7 $3,870 $10,000 –$6,130\n1,150 38.7 $3,870 $5,000 –$1,130\n1,200 38.7 $3,870 $0 $3,870\n1,250 38.7 $3,870 $0 $3,870\n1,300 38.7 $3,870 $0 $3,870\n1,350 38.7 $3,870 $0 $3,870\n1,400 38.7 $3,870 $0 $3,870", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:527", "doc_id": "d82b72d89893654195acf2202492c78b40b5a944ab0b9e4140a3e96be3e3e021", "chunk_index": 0}
{"text": "510A COMPleTe gUIde TO THe FUTUreS MArKeT\nComment. The short put is abullish position with amaximum potential gain equal to the premium \nreceived for selling the put and unlimited risk. However, in return for assuming this unattractive \nmaximum reward/maximum risk relationship, the seller of aput enjoys agreater probability of real-\nizing aprofi tthan aloss. Note that the short at-the-money put position will result in again as long as \nthe futures price at the time of the option expiration is not below the futures price at the time of the \noption initiation by an amount greater than the premium level ($38.70/oz in our example). However, \nthe maximum possible profi t (i.e., the premium received on the option) will only be realized if the \nfutures price at the time of the option expiration is above the prevailing market price at the time the \noption was sold (i.e., the strike price). The short put position is appropriate if the trader is modestly\nbullish and views the probability of alarge price decline as being very low . If, however, the trader \nanticipated alarge price advance, he would probably be better off buying acall or going long futures. \n Strategy 6b: Short put (Out-of-the-Money) \nexample . Sell August $1,100 gold futures put at apremium of $10.10 /oz ($1,010), with August gold \nfutures trading at $1,200/oz. (See Table 35.6 band Figure 35.6 b .) \nComment. The seller of an out-of-the-money put is willing to accept asmaller maximum gain (i.e., \npremium) in exchange for increasing the probability of gain on the trade. The seller of an out-of-the-\nmoney put will retain the full premium received as long as the futures price does not decline by an \n FIGURE  35.6a Profi t/loss Profi le: Short Put (At-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nand strike price\nBreakeven price\n= $1,161.30\nProfit/loss at expiration ($)\n1,000\n−10,000\n−12,500\n5,000\n2,500\n−2,500\n−5,000\n−7,500\n0\n−15,000\n−17,500\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:528", "doc_id": "83866dc297f84743897b67f6c544506daadbda431b80477948c2e0083002ba1d", "chunk_index": 0}
{"text": "511\nOPTION TrAdINg STrATegIeS\namount greater than the diff erence between the futures price at the time of the option sale and the \nstrike price. The trade will be profi table as long as the futures price at the time of the option expira-\ntion is not below the strike price by more than the option premium ($10.10/oz in this example). \nThe short out-of-the-money put represents aless bullish posture than the short at-the-money put \n tabLe 35.6b profit/Loss Calculations: Short put (Out-of-the-Money) \n(1) (2) (3) (4) (5)\n Futures price at \nexpiration ($/oz) \n premium of august $1,100 \nput at Initiation ($/oz) \n Dollar amount of \npremium received \n Value of put \nat expiration \n profit/Loss on \nposition [(3) – (4)] \n1,000 10.1 $1,010 $10,000 –$8,990\n1,050 10.1 $1,010 $5,000 –$3,990\n1,100 10.1 $1,010 $0 $1,010\n1,150 10.1 $1,010 $0 $1,010\n1,200 10.1 $1,010 $0 $1,010\n1,250 10.1 $1,010 $0 $1,010\n1,300 10.1 $1,010 $0 $1,010\n1,350 10.1 $1,010 $0 $1,010\n1,400 10.1 $1,010 $0 $1,010\nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nBreakeven price\n= $1,089.90\nProfit/loss at expiration ($)\n1,000\n−10,000\n2,500\n−2,500\n−5,000\n−7,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nStrike price\n FIGURE  35.6b Profi t/loss Profi le: Short Put (Out-of-the-Money)", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:529", "doc_id": "7a14e608941281fddef9a2fed216f104dd6ef4e19d80361ab852844a0d6450bf", "chunk_index": 0}
{"text": "512\nA Complete Guide to the Futures mArket\nposition. Whereas the short at-the-money put position reflects an expectation that prices will either \nrise or decline only slightly, the short out-of-the-money put merely reflects an expectation that prices \nwill not decline sharply.\nStrategy 6c: Short put (In-the-Money)\nexample. Sell August $1,300 gold futures put at apremium of $108.70/oz ($10,870), with August \ngold futures trading at $1,200/oz. (See Table 35.6c and Figure 35.6c.)\nComment. For most of the probable price range, the profit/loss characteristics of the short in-the-\nmoney put are fairly similar to those of the outright long futures position. There are three basic dif-\nferences between these two positions:\n 1. The short in-the-money put will lose modestly less than the long futures position in adeclining market because the loss will be partially offset by the premium received for \nthe put.\n 2. The short in-the-money put will gain modestly more than the long futures position in amoder-\nately advancing market.\n 3. In avery sharply advancing market, the profit potential on along futures position is open-ended, \nwhereas the maximum gain in the short in-the-money put position is limited to the total pre-\nmium received for the put.\nIn effect, the seller of an in-the-money put chooses to lock in modestly better results for the \nprobable price range in exchange for surrendering the opportunity for windfall profits in the \nevent of aprice explosion. \ngenerally speaking, atrader should only choose ashort in-the-money \nput over along futures position if he believes that the probability of asharp price advance is \nextremely small.\ntabLe 35.6c profit/Loss Calculations: Short put (In-the-Money)\n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august $1,300 \nput at Initiation ($/oz)\nDollar amount of \npremium received\nput Value at \nexpiration\nprofit/Loss on \nposition [(3) – (4)]\n1,000 108.7 $10,870 $30,000 –$19,130\n1,050 108.7 $10,870 $25,000 –$14,130\n1,100 108.7 $10,870 $20,000 –$9,130\n1,150 108.7 $10,870 $15,000 –$4,130\n1,200 108.7 $10,870 $10,000 $870\n1,250 108.7 $10,870 $5,000 $5,870\n1,300 108.7 $10,870 $0 $10,870\n1,350 108.7 $10,870 $0 $10,870\n1,400 108.7 $10,870 $0 $10,870", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:530", "doc_id": "913e168377e481043ebb01c845a804e2dc3136c5323560584ad52589f1fbc341", "chunk_index": 0}
{"text": "513\nOPTION TrAdINg STrATegIeS\n Table 35.6 dsummarizes the profi t/loss results for various short put positions for arange of price \nassumptions. As can be seen, as puts move more deeply in the money, they begin to more closely \nresemble along futures position. (As previously explained in the case of calls, sellers of deep in-the-\nmoney options should be cognizant of the real possibility of early exercise.) Short positions in deep \nout-of-the-money puts will prove profi table for the vast range of prices, but the maximum gain is \nsmall and the theoretical maximum loss is unlimited. \n Figure 35.6 dcompares each type of short put to along futures position. The short at-the-money \nput position will be the most profi table strategy under stable market conditions and the middle-of-\nthe-road strategy (relative to the other two types of puts) in declining and rising markets. The short \nout-of-the-money put will lose the least in adeclining market, but it will also be the least profi table \nstrategy if prices advance. The short in-the-money put is the type of put that has the greatest potential \nand risk and, as mentioned above, there is astrong resemblance between this strategy and an outright \nlong position in futures. \n It should be emphasized that the comparisons in Figure 35.6 dare based upon single-unit positions. \nHowever, as previously explained, these alternative strategies do not represent equivalent position \nsizes. Comparisons based on positions weighted equally in terms of some risk measure (e.g., equal \ndelta values) would yield diff erent empirical conclusions. \n FIGURE  35.6c Profi t/loss Profi le: Short Put (In-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures price\nat time of\nposition initiation\nBreakeven price\n=$1,191.30\nProfit/loss at expiration ($)\n1,000\n10,000\n15,000\n−10,000\n5,000\n−5,000\n−15,000\n−20,000\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nStrike price", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:531", "doc_id": "9ff502d7d3fc9252b8c54d60551785bd9823b1bab555272aaf0051b98572e47f", "chunk_index": 0}
{"text": "514A COMPleTe gUIde TO THe FUTUreS MArKeT\n tabLe 35.6d profit/Loss Matrix for Short puts with Different Strike prices \nDollar amount of premium received\n$1,350\nput\n$1,300\nput\n$1,250\nput\n$1,200\nput\n$1,150\nput\n$1,100\nput\n$1,050\nput\n$15,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510\nposition profit/Loss at expiration\nFutures price at \nexpiration ($/oz)\nLong \nFutures \nat $1,200\nIn-the-\nMoney\nat-the-\nMoney\nOut-of-\nthe-Money\n$1,350\nput\n$1,300\nput a \n$1,250\nput\n$1,200\nput a \n$1,150\nput\n$1,100\nput a \n$1,050\nput\n1,000 –$20,000 –$19,590 –$19,130 –$18,130 –$16,130 –$13,010 –$8,990 –$4,490\n1,050 –$15,000 –$14,590 –$14,130 –$13,130 –$11,130 –$8,010 –$3,990 $510\n1,100 –$10,000 –$9,590 –$9,130 –$8,130 –$6,130 –$3,010 $1,010 $510\n1,150 –$5,000 –$4,590 –$4,130 –$3,130 –$1,130 $1,990 $1,010 $510\n1,200 $0 $410 $870 $1,870 $3,870 $1,990 $1,010 $510\n1,250 $5,000 $5,410 $5,870 $6,870 $3,870 $1,990 $1,010 $510\n1,300 $10,000 $10,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510\n1,350 $15,000 $15,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510\n1,400 $20,000 $15,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510\n a These puts are compared in Figure 35.6 d. \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nLong futures\nAt-the-money put\n(strike price = $1,200) \nOut-of-the money\nput (strike price\n= $1,100)\nIn-the-money put\n(strike price = $1,300)\nProfit/loss at expiration ($)\n1,000\n10,000\n15,000\n−10,000\n5,000\n−5,000\n0\n−15,000\n−20,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n FIGURE  35.6d Profi t/loss Profi le: long Futures and Short Put Comparisons (In-the-Money, \nAt-the-Money, and Out-of-the-Money)", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:532", "doc_id": "ea3424a8f285fa113a886b39823bdc35ab2dbfdc276b98fc788c44e750a9d026", "chunk_index": 0}
{"text": "515\nOPTION TrAdINg STrATegIeS\nStrategy 7: Long Straddle (Long Call + Long put)\nexample. Buy August $1,200 gold futures call at apremium of $38.80/oz ($3,880) and simultane-\nously buy an August $1,200 gold futures put at apremium of $38.70/oz ($3,870). (See Table 35.7 \nand Figure 35.7.)\nComment. The long straddle position is avolatility bet. The buyer of astraddle does not have \nany opinion regarding the probable price direction; he merely believes that option premiums \nare underpriced relative to the potential market volatility. Andrew Tobias once offered asome -\nwhat more cynical perspective of this type of trade\n1: “Indeed, if you haven’tany idea of which \nway the [market] is headed but feel it is headed someplace, you can buy both aput and acall \non it. That’scalled astraddle and involves enough commissions to keep your broker smiling \nall week.”\nAs can be seen in Figure 35.7, the long straddle position will be unprofitable for awide price \nrange centered at the current price. Since this region represents the range of the most probable price \noutcomes, the long straddle position has alarge probability of loss. In return for accepting alarge \nprobability of loss, the buyer of astraddle enjoys unlimited profit potential in the event of either alarge price rise or alarge price decline. The maximum loss on along straddle position is equal to the \ntotal premium paid for both the long call and long put and will only be experienced if the expiration \nprice is equal to the futures price at the time the options were purchased. (Implicit assumption: both \nthe call and put are at-the-money options.)\ntabLe 35.7 profit/Loss Calculations: Long Straddle (Long Call + Long put)\n(1) (2) (3) (4) (5) (6) (7)\nFutures price \nat expiration \n($/oz)\npremium of august \n$1,200 Call at \nInitiation ($/oz)\npremium of august \n$1,200 put at \nInitiation ($/oz)\n$ amount of \ntotal premium \npaid\nCall Value at \nexpiration\nput Value at \nexpiration\nprofit/Loss on \nposition \n[(5) + (6) – (4)]\n1,000 38.8 38.7 $7,750 $0 $20,000 $12,250\n1,050 38.8 38.7 $7,750 $0 $15,000 $7,250\n1,100 38.8 38.7 $7,750 $0 $10,000 $2,250\n1,150 38.8 38.7 $7,750 $0 $5,000 –$2,750\n1,200 38.8 38.7 $7,750 $0 $0 –$7,750\n1,250 38.8 38.7 $7,750 $5,000 $0 –$2,750\n1,300 38.8 38.7 $7,750 $10,000 $0 $2,250\n1,350 38.8 38.7 $7,750 $15,000 $0 $7,250\n1,400 38.8 38.7 $7,750 $20,000 $0 $12,250\n1 Andrew Tobias, Getting By on $100,000 a Year (and Other Sad Tales) (New York, NY: Simon & Schuster, 1980).", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:533", "doc_id": "ab035137623d7ae6964bdaa424b74e16f3ab7f44f32f6d9ebf02e86bfa6551e6", "chunk_index": 0}
{"text": "516A COMPleTe gUIde TO THe FUTUreS MArKeT\n Strategy 8: Short Straddle (Short Call + Short put) \nexample . Sell August $1,200 gold futures call at apremium of $38.80/oz ($3,880 ) and simultane-\nously sell an August $1,200 put at apremium of $38.70/oz ($3,870). (See Table 35.8 and Figure 35.8 .) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nand call and put\nstrike prices\nBreakeven price\n= $1,122.50\nBreakeven price\n= 1,277.50\nProfit/loss at expiration ($)\n1,000\n5,000\n10,000\n15,000\n–10,000\n–5,000\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n FIGURE  35.7 Profi t/loss Profi le: long Straddle (long Call + long Put) \n tabLe 35.8 profit/Loss Calculations: Short Straddle (Short Call + Short put) \n(1) (2) (3) (4) (5) (6) (7)\nFutures price \nat expiration \n($/oz)\npremium of august \n$1,200 Call at \nInitiation ($/oz)\npremium of august \n$1,200 put at \nInitiation ($/oz)\n$ amount of \ntotal premium \nreceived\nCall Value at \nexpiration\nput Value at \nexpiration\nprofit/Loss on \nposition \n[(4) – (5) – (6)]\n1,000 38.8 38.7 $7,750 $0 $20,000 –$12,250\n1,050 38.8 38.7 $7,750 $0 $15,000 –$7,250\n1,100 38.8 38.7 $7,750 $0 $10,000 –$2,250\n1,150 38.8 38.7 $7,750 $0 $5,000 $2,750\n1,200 38.8 38.7 $7,750 $0 $0 $7,750\n1,250 38.8 38.7 $7,750 $5,000 $0 $2,750\n1,300 38.8 38.7 $7,750 $10,000 $0 –$2,250\n1,350 38.8 38.7 $7,750 $15,000 $0 –$7,250\n1,400 38.8 38.7 $7,750 $20,000 $0 –$12,250", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:534", "doc_id": "ec90d4e814cb5576fb4e33f1fc3a3640d80c80d8cc30523503500b6eefc2ccc7", "chunk_index": 0}
{"text": "517\nOPTION TrAdINg STrATegIeSComment. The short straddle position will be profi table over awide range of prices. The best outcome \nfor aseller of astraddle is atotally unchanged market. In this circumstance, the seller will realize his \nmaximum profi t, which is equal to the total premium received for the sale of the call and put. The short \nstraddle position will remain profi table as long as prices do not rise or decline by more than the combined \ntotal premium of the two options. The seller of the straddle enjoys alarge probability of aprofi table trade, \nin exchange for accepting unlimited risk in the event of either avery sharp price advance or decline. \n This strategy is appropriate if the speculator expects prices to trade within amoderate range, but \nhas no opinion regarding the probable market direction. Atrader anticipating nonvolatile market con-\nditions, but also having aprice-directional bias, would be better off selling either calls or puts rather \nthan astraddle. For example, atrader expecting low volatility and modestly declining prices should \nsell 2 calls instead of selling astraddle. \n Strategy 9: bullish “texas Option hedge” (Long Futures + Long Call) 2\nexample . Buy August gold futures at $1,200 and simultaneously buy an August $1,200 gold futures \ncall at apremium of $38.80 /oz ($3,880). (See Table 35.9 and Figure 35.9 .) \n FIGURE  35.8 Profi t/loss Profi le: Short Straddle (Short Call + Short Put) \n Profi t/loss Profi le: Short Straddle (Short Call + Short Put) \nPrice of August gold futures at option expiration ($/oz)\nBreakeven price\n= $1,122.50\nBreakeven price\n= 1,277.50\nProfit/loss at expiration ($)\n1,000\n5,000\n10,000\n–10,000\n–15,000\n–5,000\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nFutures price at time\nof position initiation\nand call and put\nstrike prices\n 2 By defi nition, ahedge implies afutures position opposite to an existing or anticipated actual position. In com-\nmodity trading, Texas hedge is afacetious reference to so-called “hedgers” who implement afutures position in the \nsame direction as their cash position. The classic example of a Texas hedge would be acattle feeder who goes long \ncattle futures. Whereas normal hedging reduces risk, the Texas hedge increases risk. There are many option strate-\ngies that combine off setting positions in options and futures. This strategy is unusual in that it combines reinforcing \npositions in futures and options. Consequently, the term Texas option hedge seems to provide an appropriate label.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:535", "doc_id": "e353ec2707792464ca9823b57f95c5afd51618702925cc8cf23cb6f9aeb4829f", "chunk_index": 0}
{"text": "518A COMPleTe gUIde TO THe FUTUreS MArKeT\n tabLe 35.9 profit/Loss Calculations: bullish “texas Option hedge” (Long Futures + Long Call) \n(1) (2) (3) (4) (5) (6)\nFutures price at \nexpiration ($/oz)\npremium of august \n$1,200 Call at \nInitiation ($/oz)\n$ amount of \npremium paid\nprofit/Loss on Long \nFutures position\nCall Value at \nexpiration\nprofit/Loss on \nposition [(4)+(5)–(3)]\n1,000 38.8 $3,880 –$20,000 $0 –$23,880\n1,050 38.8 $3,880 –$15,000 $0 –$18,880\n1,100 38.8 $3,880 –$10,000 $0 –$13,880\n1,150 38.8 $3,880 –$5,000 $0 –$8,880\n1,200 38.8 $3,880 $0 $0 –$3,880\n1,250 38.8 $3,880 $5,000 $5,000 $6,120\n1,300 38.8 $3,880 $10,000 $10,000 $16,120\n1,350 38.8 $3,880 $15,000 $15,000 $26,120\n1,400 38.8 $3,880 $20,000 $20,000 $36,120\n FIGURE  35.9 Profi t/loss Profi le: Bullish “Texas Option Hedge” (long Futures + long Call) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time of position\ninitiation and strike price\nBreakeven price = $1,219.40\nProfit/loss at expiration ($)\n1,000\n37,500\n50,000\n25,000\n−25,000\n−37,500\n12,500\n−12,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nLong 2 futures\nLong futures + long call", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:536", "doc_id": "359f66d3a944892689138e19d6afd0c8c3ae9e147b0c646c62be28b98bf23662", "chunk_index": 0}
{"text": "519\nOPTION TrAdINg STrATegIeS\nComment. This strategy provides an interesting alternative method of pyramiding—that is, increas-\ning the size of awinning position. For example, atrader who is already long afutures contract at aprofit and believes the market is heading higher may wish to increase his position without doubling \nhis risk in the event of aprice reaction—as would be the case if he bought asecond futures contract. \nSuch aspeculator could choose instead to supplement his long position with the purchase of acall, \nthereby limiting the magnitude of his loss in the event of aprice retracement, in exchange for real-\nizing amoderately lower profit if prices continued to rise.\nFigure 35.9 compares the alternative strategies of buying two futures versus buying afutures con-\ntract and acall. (For simplicity of exposition, the diagram assumes that both the futures contract and \nthe call are purchased at the same time.) As can be seen, the long two futures position will always do \nmoderately better in arising market (by an amount equal to the premium paid for the call), but will \nlose more in the event of asignificant price decline. The difference in losses between the two strate-\ngies will widen as larger price declines are considered.\nStrategy 10: bearish “texas Option hedge” (Short Futures + \nLong put)\nexample. Sell August gold futures at $1,200 and simultaneously buy an August $1,200 gold put at apremium of $38.70/oz ($3,870). (See Table 35.10 and Figure 35.10.)\nComment. This strategy is perhaps most useful as an alternative means of increasing ashort position. \nAs illustrated in Figure 35.10, the combination of ashort futures contract and along put will gain \nmoderately less than 2 short futures contracts in adeclining market, but will lose amore limited \namount in arising market.\ntabLe 35.10 profit/Loss Calculations: bearish “texas Option hedge” (Short Futures + Long put)\n(1) (2) (3) (4) (5) (6)\nFutures price at \nexpiration ($/oz)\npremium of august $1200 \nput at Initiation ($/oz)\n$ amount of \npremium paid\nprofit/Loss on Short \nFutures position\nput Value at \nexpiration\nprofit/Loss on position \n[(4) + (5) – (3)]\n1,000 38.7 $3,870 $20,000 $20,000 $36,130\n1,050 38.7 $3,870 $15,000 $15,000 $26,130\n1,100 38.7 $3,870 $10,000 $10,000 $16,130\n1,150 38.7 $3,870 $5,000 $5,000 $6,130\n1,200 38.7 $3,870 $0 $0 –$3,870\n1,250 38.7 $3,870 –$5,000 $0 –$8,870\n1,300 38.7 $3,870 –$10,000 $0 –$13,870\n1,350 38.7 $3,870 –$15,000 $0 –$18,870\n1,400 38.7 $3,870 –$20,000 $0 –$23,870", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:537", "doc_id": "63db0a14ccb6fc2c445295ac861a37d27cda431d4ea6a4003a393bc29bd312ff", "chunk_index": 0}
{"text": "520A COMPleTe gUIde TO THe FUTUreS MArKeT\n Strategy 11a: Option-protected Long Futures (Long Futures + Long \nat-the-Money put) \nexample . Buy August gold futures at $1,200/oz and simultaneously buy an August $1200 gold put at \napremium of $38.70/oz ($3,870). (See Table 35.11 aand Figure 35.11 a.) \nComment. Afrequently recommended strategy is that the trader implementing (or holding) along \nfutures position can consider buying aput to protect his downside risk. The basic idea is that if the \nmarket declines, the losses in the long futures position will be off set dollar for dollar by the long put \nposition. Although this premise is true, it should be stressed that such acombined position represents \nnothing more than aproxy for along call. The reader can verify the virtually identical nature of these \ntwo alternative strategies by comparing Figure 35.11 ato Figure 35.3 a. If prices increase, the long \nfutures position will gain, while the option will expire worthless. On the other hand, if prices decline, \nthe loss in the combined position will equal the premium paid for the put. In fact, if the call and put \npremiums are equal, along futures plus long put position will be precisely equivalent to along call. \n In most cases, the trader who fi nds the profi t/loss profi le of this strategy attractive would be better \noff buying acall, because the transaction costs are likely to be lower. However, if the trader already \nholds along futures position, buying aput may be areasonable alternative to liquidating this position \nand buying acall. \nPrice of August gold futures at option expiration ($/oz)\nFutures price at\ntime of position\ninitiation and\nstrike price\nBreakeven price = $1,180.65\nProfit/loss at expiration ($)\n1,000\n37,500\n50,000\n25,000\n−25,000\n−37,500\n12,500\n−12,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nShort 2 futures\nShort futures + long put\n FIGURE  35.10 Profi t/loss Profi le: Bearish “Texas Option Hedge” (Short Futures + long Put)", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:538", "doc_id": "9b1af08add58564c4005ec51c91c5f050383863b3206dca1ce77520da4998499", "chunk_index": 0}
{"text": "521\nOPTION TrAdINg STrATegIeS\n tabLe 35.11a profit/Loss Calculations: Option-protected Long Futures—Long Futures + Long at-the-\nMoney put (Similar to Long at-the-Money Call) \n(1) (2) (3) (4) (5) (6)\nFutures price at \nexpiration ($/oz)\npremium of august $1,200 \nput at Initiation ($/oz)\n$ amount of \npremium paid\nprofit/Loss on Long \nFutures position\nput Value at \nexpiration\nprofit/Loss on position \n[(4) + (5) – (3)]\n1,000 38.7 $3,870 –$20,000 $20,000 –$3,870\n1,050 38.7 $3,870 –$15,000 $15,000 –$3,870\n1,100 38.7 $3,870 –$10,000 $10,000 –$3,870\n1,150 38.7 $3,870 –$5,000 $5,000 –$3,870\n1,200 38.7 $3,870 $0 $0 –$3,870\n1,250 38.7 $3,870 $5,000 $0 $1,130\n1,300 38.7 $3,870 $10,000 $0 $6,130\n1,350 38.7 $3,870 $15,000 $0 $11,130\n1,400 38.7 $3,870 $20,000 $0 $16,130\n FIGURE  35.11a Profi t/loss Profi le: Option-Protected long Futures—long Futures + long \nat-the-Money Put (Similar to long At-the-Money Call) \nPrice of August gold futures at option expiration ($/oz)\nFutures at time of\nposition initiation\nand strike price\nBreakeven price = $1,238.70\nProfit/loss at expiration ($)\n1,000\n10,000\n7,500\n12,500\n15,000\n17,500\n5,000\n−5,000\n−2,500\n2,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:539", "doc_id": "bce2e81a117de9c993ab4f39463baec9bc0e2f32db242af225c87331e5360efb", "chunk_index": 0}
{"text": "522A COMPleTe gUIde TO THe FUTUreS MArKeT\n Strategy 11b: Option-protected Long Futures (Long Futures + Long \nOut-of-the-Money put) \nexample . Buy August gold futures at $1,200/oz and simultaneously buy an August $1,100 gold \nfutures put at apremium of $10.10/oz ($1,010). (See Table 35.11 band Figure 35.11 b.) \n tabLe 35.11b profit/Loss Calculations: Option-protected Long Futures—Long Futures + Long Out-of-\nthe-Money put (Similar to Long In-the-Money Call) \n(1) (2) (3) (4) (5) (6)\nFutures price at \nexpiration ($/oz)\npremium of august $1,100 \nput at Initiation ($/oz)\n$ amount of \npremium paid\nprofit/Loss on Long \nFutures position\nput Value at \nexpiration\nprofit/Loss on position \n[(4) + (5) – (3)]\n1,000 10.1 $1,010 –$20,000 $10,000 –$11,010\n1,050 10.1 $1,010 –$15,000 $5,000 –$11,010\n1,100 10.1 $1,010 –$10,000 $0 –$11,010\n1,150 10.1 $1,010 –$5,000 $0 –$6,010\n1,200 10.1 $1,010 $0 $0 –$1,010\n1,250 10.1 $1,010 $5,000 $0 $3,990\n1,300 10.1 $1,010 $10,000 $0 $8,990\n1,350 10.1 $1,010 $15,000 $0 $13,990\n1,400 10.1 $1,010 $20,000 $0 $18,990\n FIGURE  35.11b Profi t/loss Profi le: Option-Protected long Futures—long Futures + long \nOut-of-the-Money Put (Similar to long In-the-Money Call) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nBreakeven price = $1,210.10\nProfit/loss at expiration ($)\n1,000\n10,000\n15,000\n20,000\n5,000\n−5,000\n−10,000\n−15,000\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nStrike price", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:540", "doc_id": "bf66fd8a2e93ad965c5433f706e080f85c27f1c968b7e03607563ff9aa76d74e", "chunk_index": 0}
{"text": "523\nOPTION TrAdINg STrATegIeS\nComment. As can be verified by comparing Figure 35.11b to Figure 35.3c, this strategy is virtually \nequivalent to buying an in-the-money call. Supplementing along futures position with the purchase \nof an out-of-the-money put will result in slightly poorer results if the market advances, or declines \nmoderately, but will limit the magnitude of losses in the event of asharp price decline. Thus, much \nlike the long in-the-money call position, this strategy can be viewed as along position with abuilt-\nin stop.\nIn most cases, it will make more sense for the trader to simply buy an in-the-money call since \nthe transaction cost will be lower. However, if aspeculator is already long futures, the purchase of \nan out-of-the-money put might present aviable alternative to liquidating this position and buying an \nin-the-money call.\nStrategy 12a: Option-protected Short Futures (Short Futures + Long \nat-the-Money Call)\nexample. Sell August gold futures at $1,200/oz and simultaneously buy an August $1,200 gold call \nat apremium of $38.80/oz ($3,880). (See Table 35.12a and Figure 35.12a.)\nComment. Afrequently recommended strategy is that the trader implementing (or holding) ashort \nfutures position can consider buying acall to protect his upside risk. The basic idea is that if the mar-\nket advances, the losses in the short futures position will be offset dollar for dollar by the long call \nposition. Although this premise is true, it should be stressed that such acombined position represents \nnothing more than aproxy for along put. The reader can verify the virtually identical nature of these \ntwo alternative strategies by comparing Figure 35.12a to Figure 35.5a. If prices decline, the short \nfutures position will gain, while the option will expire worthless. And if prices advance, the loss in the \ncombined position will equal the premium paid for the call. In fact, if the put and call premiums are \nequal, ashort futures plus long call position will be precisely equivalent to along put.\ntabLe 35.12a profit/Loss Calculations: Option-protected Short Futures—Short Futures + Long at-the-\nMoney Call (Similar to Long at-the-Money put)\n(1) (2) (3) (4) (5) (6)\nFutures price at \nexpiration ($/oz)\npremium of august $1,200 \nCall at Initiation ($/oz)\n$ amount of \npremium paid\nprofit/Loss on Short \nFutures position\nCall Value at \nexpiration\nprofit/Loss on position \n[(4)+ (5) – (3)]\n1,000 38.8 $3,880 $20,000 $0 $16,120\n1,050 38.8 $3,880 $15,000 $0 $11,120\n1,100 38.8 $3,880 $10,000 $0 $6,120\n1,150 38.8 $3,880 $5,000 $0 $1,120\n1,200 38.8 $3,880 $0 $0 –$3,880\n1,250 38.8 $3,880 –$5,000 $5,000 –$3,880\n1,300 38.8 $3,880 –$10,000 $10,000 –$3,880\n1,350 38.8 $3,880 –$15,000 $15,000 –$3,880\n1,400 38.8 $3,880 –$20,000 $20,000 –$3,880", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:541", "doc_id": "26050cdcacc1a70de7dcf46b589d0badfd703c08b0cfb61dae4577c3a487c9e1", "chunk_index": 0}
{"text": "524A COMPleTe gUIde TO THe FUTUreS MArKeT\n In most cases, the trader who fi nds the profi t/loss profi le of this strategy attractive would be better \noff buying aput, because the transaction costs are likely to be lower. However, if the trader already \nholds ashort futures position, buying acall may be areasonable alternative to liquidating this position \nand buying aput. \n Strategy 12b: Option-protected Short Futures (Short Futures + Long \nOut-of-the-Money Call) \nexample . Sell August gold futures at $1,200/oz and simultaneously buy an August $1,300 gold \nfutures call at apremium of $9.10/oz ($910). (See Table 35.12 band Figure 35.12 b.) \nComment. As can be verifi ed by comparing Figure 35.12 bto Figure 35.5 c, this strategy is virtually \nequivalent to buying an in-the-money put. Supplementing ashort futures position with the purchase \nof an out-of-the-money call will result in slightly poorer results if the market declines or advances \nmoderately, but will limit the magnitude of losses in the event of asharp price advance. Thus, much \nas with the long in-the-money put position, this strategy can be viewed as ashort position with abuilt-in stop. \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nand strike priceBreakeven price = $1,161.20\nProfit/loss at expiration ($)\n1,000\n10,000\n17,500\n15,000\n12,500\n7,500\n5,000\n2,500\n−5,000\n−2,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n FIGURE  35.12a Profi t/loss Profi le: Option-Protected Short Futures—Short Futures + long \nAt-the-Money Call (Similar to long At-the-Money Put)", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:542", "doc_id": "f8c67c3aa7a045ea1360604f78a97f3676ef521bb096dd480d8dcd67ddc7269e", "chunk_index": 0}
{"text": "525\nOPTION TrAdINg STrATegIeS\n In most cases, it will make more sense for the trader simply to buy an in-the-money put since the \ntransaction costs will be lower. However, if aspeculator is already short futures, the purchase of an \nout-of-the-money call might present aviable alternative to liquidating this position and buying an \nin-the-money put. \n tabLe 35.12b profit/Loss Calculations: Option-protected Short Futures—Short Futures + Long Out-\nof-the-Money Call (Similar to Long In-the-Money put) \n(1) (2) (3) (4) (5) (6)\nFutures price at \nexpiration ($/oz)\npremium of august $1,300 \nCall at Initiation ($/oz)\n$ amount of \npremium paid\nprofit/Loss on Short \nFutures position\nCall Value at \nexpiration\nprofit/Loss on position \n[(4) + (5) – (3)]\n1,000 9.1 $910 $20,000 $0 $19,090\n1,050 9.1 $910 $15,000 $0 $14,090\n1,100 9.1 $910 $10,000 $0 $9,090\n1,150 9.1 $910 $5,000 $0 $4,090\n1,200 9.1 $910 $0 $0 –$910\n1,250 9.1 $910 –$5,000 $0 –$5,910\n1,300 9.1 $910 –$10,000 $0 –$10,910\n1,350 9.1 $910 –$15,000 $5,000 –$10,910\n1,400 9.1 $910 –$20,000 $10,000 –$10,910\n FIGURE  35.12b Profi t/loss Profi le: Option-Protected Short Futures—Short Futures + long \nOut-of-the-Money Call (Similar to long In-the-Money Put) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nBreakeven price = $1,190.90\nProfit/loss at expiration ($)\n1,000\n10,000\n15,000\n20,000\n5,000\n−5,000\n−10,000\n−15,000\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nStrike price", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:543", "doc_id": "7d199764550e1a5f682011c514e838915a306d82b6ab1ba8b9326dbc5a4c1212", "chunk_index": 0}
{"text": "526\nA Complete Guide to the Futures mArket\nStrategy 13: Covered Call Write (Long Futures + Short Call)\nexample. Buy August gold futures at $1,200/oz and simultaneously sell an August $1,200 gold \nfutures call at apremium of $38.80/oz ($3,880). (See Table 35.13 and Figure 35.13.)\nComment. There has been alot of nonsense written about covered call writing. In fact, even \nthe term is misleading. The implication is that covered call writing—the sale of calls against long \npositions—is somehow amore conservative strategy than naked call writing—the sale of calls without \nany offsetting long futures position. This assumption is absolutely false. Although naked call writing \nimplies unlimited risk, the same statement applies to covered call writing. As can be seen in Figure \n35.13, the covered call writer merely exchanges unlimited risk in the event of amarket advance (as is \nthe case for the naked call writer) for unlimited risk in the event of amarket decline. In fact, the reader \ncan verify that this strategy is virtually equivalent to a “naked” short put position (see Strategy 35.6a).\nOne frequently mentioned motivation for covered call writing is that it allows the holder of along \nposition to realize abetter sales price. For example, if the market is trading at $1,200 and the holder \nof along futures contract sells an at-the-money call at apremium of $38.80/oz instead of liquidating \nhis position, he can realize an effective sales price of $1,238.80 if prices move higher (the $1,200 \nstrike price plus the premium received for the sale of the call). And, if prices move down by no more \nthan $38.80/oz by option expiration, he will realize an effective sales price of at least $1,200. Pre-\nsented in this light, this strategy appears to be a “heads you win, tails you win” proposition. However, \nthere is no free lunch. The catch is that if prices decline by more than $38.80, the trader will realize alower sales price than if he had simply liquidated the futures position. And, if prices rise substantially \nhigher, the trader will fail to participate fully in the move as he would have if he had maintained his \nlong position.\nThe essential point is that although many motivations are suggested for covered call writing, the \ntrader should keep in mind that this strategy is entirely equivalent to selling puts.\ntabLe 35.13 profit/Loss Calculations: Covered Call Write—Long Futures + Short Call (Similar to \nShort put)\n(1) (2) (3) (4) (5) (6)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,200 Call \nat Initiation ($/oz)\n$ amount of \npremium received\nprofit/Loss on Long \nFutures position\nCall Value at \nexpiration\nprofit/Loss on position \n[(3) + (4) – (5)]\n1,000 38.8 $3,880 –$20,000 $0 –$16,120\n1,050 38.8 $3,880 –$15,000 $0 –$11,120\n1,100 38.8 $3,880 –$10,000 $0 –$6,120\n1,150 38.8 $3,880 –$5,000 $0 –$1,120\n1,200 38.8 $3,880 $0 $0 $3,880\n1,250 38.8 $3,880 $5,000 $5,000 $3,880\n1,300 38.8 $3,880 $10,000 $10,000 $3,880\n1,350 38.8 $3,880 $15,000 $15,000 $3,880\n1,400 38.8 $3,880 $20,000 $20,000 $3,880", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:544", "doc_id": "e1a70ac1a89542c914ecf7b311cbb751903606c819f694db0bf00238e10d4a83", "chunk_index": 0}
{"text": "527\nOPTION TrAdINg STrATegIeS\n Strategy 14: Covered put Write (Short Futures + Short put) \nexample . Sell August futures at $1,200 and simultaneously sell an August $1,200 gold futures put at \napremium of $38.70/oz ($3,870). (See Table 35.14 and Figure 35.14 .) \n FIGURE  35.13 Profi t/loss Profi le: Covered Call Write—long Futures + Short Call (Similar to \nShort Put) \n Profi t/loss Profi le: Covered Call Write—long Futures + Short Call (Similar to \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n5,000\n2,500\n0\n−2,500\n−7 ,500\n−10,000\n−12,500\n−15,000\n−5,000\n1,050 1,100 1,150 1,200 1,250\nFutures price at time\nof position initiation\nand strike price\n Breakeven price\n= $1,161 .20\n1,300 1,350 1,400\n−17 ,500\n tabLe 35.14 profit/Loss Calculations: Covered put Write—Short Futures + Short put (Similar to \nShort Call) \n(1) (2) (3) (4) (5) (6)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,200 put \nat Initiation ($/oz)\n$ amount of \npremium received\nprofit/Loss on Short \nFutures position\nput Value at \nexpiration\nprofit/Loss on position \n[(3) + (4) – (5)]\n1,000 38.7 $3,870 $20,000 $20,000 $3,870\n1,050 38.7 $3,870 $15,000 $15,000 $3,870\n1,100 38.7 $3,870 $10,000 $10,000 $3,870\n1,150 38.7 $3,870 $5,000 $5,000 $3,870\n1,200 38.7 $3,870 $0 $0 $3,870\n1,250 38.7 $3,870 –$5,000 $0 –$1,130\n1,300 38.7 $3,870 –$10,000 $0 –$6,130\n1,350 38.7 $3,870 –$15,000 $0 –$11,130\n1,400 38.7 $3,870 –$20,000 $0 –$16,130", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:545", "doc_id": "8a9fb2dd1bbe453d2396db3f2a30159f51f0b2f4db187820694e391101a863b1", "chunk_index": 0}
{"text": "528A COMPleTe gUIde TO THe FUTUreS MArKeT\nComment. Comments analogous to those made for Strategy 13 would apply here. The sale of aput \nagainst ashort futures position is equivalent to the sale of acall. The reader can verify this by compar-\ning Figure 35.14 to Figure 35.4 a. The two strategies would be precisely equivalent (ignoring transac-\ntion cost diff erences) if the put and call premiums were equal. \n Strategy 15: Synthetic Long Futures (Long Call + Short put) \nexample . Buy an August $1,150 gold futures call at apremium of $70.10/oz ($7,010) and simultane-\nously sell an August $1,150 gold futures put at apremium of $19.90/oz ($1,990). (See Table 35.15 \nand Figure 35.15 .) \nComment. Asynthetic long futures position can be created by combining along call and ashort put \nfor the same expiration date and the same strike price. For example, as illustrated in Table 35.15 and Figure \n 35.15 , the combined position of along August $1,150 call and ashort August $1,150 put is virtually \nidentical to along August futures position. The reason for this equivalence is tied to the fact that the \ndiff erence between the premium paid for the call and the premium received for the put is approxi-\nmately equal to the intrinsic value of the call. each $1 increase in price will raise the intrinsic value of \nthe call by an equivalent amount and each $1 decrease in price will reduce the intrinsic value of the \n FIGURE  35.14 Profi t/loss Profi le: Covered Put Write—Short Futures + Short Put (Similar \nto Short Call) \nPrice of August gold futures at option expiration ($/oz)\n1,000 1,050 1,100 1,150 1,200 1,250\nFutures price at time\nof position initiation\nand strike price Breakeven price\n= $1,238.70\n1,300 1,350 1,400\nProfit/loss at expiration ($)\n5,000\n2,500\n0\n−2,500\n−7 ,500\n−10,000\n−12,500\n−17 ,500\n−15,000\n−5,000", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:546", "doc_id": "4c3ea3cbb1fd8fa4727debd8dafb749ed5ef367254e3e27f77dda708aaee65b7", "chunk_index": 0}
{"text": "529\nOPTION TrAdINg STrATegIeS\n tabLe 35.15 profit/Loss Calculations: Synthetic Long Futures (Long Call + Short put) \n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,150 \nCall at Initiation \n($/oz)\n$ amount \nof premium \npaid\npremium of \naugust $1,150 \nput at Initiation \n($/oz)\n$ amount \nof premium \nreceived\nCall Value \nat \nexpiration\nput Value \nat \nexpiration\nprofit/Loss on \nposition \n[(5) − (3) + (6) − (7)]\n1,000 70.1 $7,010 19.9 $1,990 $0 $15,000 −$20,020\n1,050 70.1 $7,010 19.9 $1,990 $0 $10,000 −$15,020\n1,100 70.1 $7,010 19.9 $1,990 $0 $5,000 −$10,020\n1,150 70.1 $7,010 19.9 $1,990 $0 $0 −$5,020\n1,200 70.1 $7,010 19.9 $1,990 $5,000 $0 −$20\n1,250 70.1 $7,010 19.9 $1,990 $10,000 $0 $4,980\n1,300 70.1 $7,010 19.9 $1,990 $15,000 $0 $9,980\n1,350 70.1 $7,010 19.9 $1,990 $20,000 $0 $14,980\n1,400 70.1 $7,010 19.9 $1,990 $25,000 $0 $19,980\n FIGURE  35.15 Profi t/loss Profi le: Synthetic long Futures (long Call + Short Put) \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n20,000\n15,000\n10,000\n5,000\n−5,000\n−10,000\n−15,000\n−20,000\n0\n1,050 1,100 1,150 1,200 1,250\nFutures price at time\nof position initiation\nBreakeven price\n= $1,200.20\n1,300 1,350 1,400", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:547", "doc_id": "3b9c43829b67bd734cd50490e3b0f1a08badfd3d3aa713c9605f9435139b2982", "chunk_index": 0}
{"text": "530\nA Complete Guide to the Futures mArket\ncall (or if prices decline below $1,150, increase the value of the put) by an equivalent amount. Thus, \nas long as the expiration date and strike price of the two options are identical, along call/short put \nposition acts just like along futures contract.\nThe futures equivalent price implied by asynthetic position is given by the following formula:\nSynthetic futures pos itio nprices trike pricec all prem ium=+ − −put premi um\nIt should be noted there will be one synthetic futures position price corresponding to each strike \nprice for which options are traded for the given futures contract.\nIn this example, the synthetic long position is the same price as along futures contract. (Synthetic \nfutures position price = $1,150 + $70.10 − $19.90 = $1,200.20.) Thus, ignoring transaction costs \nand interest income effects, buying the August $1,150 call and simultaneously selling the August \n$1,150 put would be equivalent to buying an August futures contract. Of course, the trader consider-\ning this strategy as an alternative to an outright long futures position must incorporate transaction \ncosts and interest income effects into the calculation. In this example, the true cost of the synthetic \nfutures position would be raised vis-à-vis along futures contract as aresult of the following three \nfactors:\n 1. Because the synthetic futures position involves two trades, in aless liquid market, it is reason-\nable to assume the execution costs will also be greater. In other words, the option-based strategy \nwill require the trader to give up more points (relative to quoted levels) in order to execute the \ntrade.\n 2. The synthetic futures position will involve greater commission costs.\n 3. The dollar premium paid for the call ($7,010) exceeds the dollar premium received for the put \n($1,990). Thus, the synthetic futures position will involve an interest income loss on the differ-\nence between these two premium payments ($5,020). This factor, however, would be offset by \nthe margin requirements on along futures position.\nOnce the above differences are accounted for, the apparent relative advantage asynthetic futures \nposition will sometimes seemingly offer will largely, if not totally, disappear. Nonetheless, insofar as \nsome market inefficiencies may exist, the synthetic long futures position will sometimes offer aslight \nadvantage over the direct purchase of afutures contract. In fact, the existence of such discrepancies \nwould raise the possibility of pure arbitrage trades.\n3 For example, if the price implied by the synthetic \nlong futures position was less than the futures price, even after accounting for transaction costs and \ninterest income effects, the arbitrageur could lock in aprofit by buying the call, selling the put, and \nselling futures. Such atrade is called areverse conversion. Alternately, if after adjusting for transaction \ncosts and interest income effects, the implied price of the synthetic long futures position were greater \nthan the futures price, the arbitrageur could lock in aprofit by buying futures, selling the call, and \nbuying the put. Such atrade is called aconversion.\n3 Pure arbitrage implies arisk-free trade in which the arbitrageur is able to lock in asmall profit by exploiting \ntemporary price distortions between two related markets.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:548", "doc_id": "bde7ade9e6b6d59ef7f31cdfda0be4cfb721861dc2dc5a945d32ec7d0e1d95e4", "chunk_index": 0}
{"text": "531\nOPTION TrAdINg STrATegIeS\nIt should be obvious that such risk-free profit opportunities will be limited in terms of \nboth duration and magnitude. generally speaking, conversion and reverse conversion arbitrage \nwill normally only be feasible for professional arbitrageurs who enjoy much lower transac-\ntion costs (commissions plus execution costs) than the general public. The activity of these \narbitrageurs will tend to keep synthetic futures position prices about in line with actual futures \nprices.\nStrategy 16: Synthetic Short Futures (Long put + Short Call)\nexample. Buy an August $1,300 gold futures put at apremium of $108.70/oz ($10,870) and simul-\ntaneously sell an August $1,300 gold futures call at apremium of $9.10/oz ($910). (See Table 35.16 \nand Figure 35.16.)\nComment. As follows directly from the discussion of the previous strategy, asynthetic short futures \nposition can be created by combining along put and ashort call with the same expiration date and the same \nstrike price. In this example, the synthetic futures position based upon the $1,300 strike price options \nis $0.40 higher priced than the underlying futures contract. (Synthetic futures position = $1,300 \n+ $9.10 − $108.70 = $1,200.40.) However, for reasons similar to those discussed in the previous \nstrategy, much of the advantage of an implied synthetic futures position price versus the actual futures \nprice typically disappears once transaction costs and interest income effects are incorporated into the \nevaluation. An arbitrage employing the synthetic short futures position is called aconversion and was \ndetailed in the previous strategy.\ntabLe 35.16 profit/Loss Calculations: Synthetic Short Futures (Long put + Short Call)\n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures \nprice at \nexpiration \n($/oz)\npremium of \naugust $1,300 \nCall at Initiation \n($/oz)\nDollar \namount of \npremium \nreceived\npremium of \naugust $1,300 \nput at Initiation \n($/oz)\nDollar \namount of \npremium \npaid\nValue of \nCall at \nexpiration\nValue of \nput at \nexpiration\nprofit/Loss on \nposition \n[(3) − (5) + (7) − (6)]\n1,000 9.1 $910 108.7 $10,870 $0 $30,000 $20,040\n1,050 9.1 $910 108.7 $10,870 $0 $25,000 $15,040\n1,100 9.1 $910 108.7 $10,870 $0 $20,000 $10,040\n1,150 9.1 $910 108.7 $10,870 $0 $15,000 $5,040\n1,200 9.1 $910 108.7 $10,870 $0 $10,000 $40\n1,250 9.1 $910 108.7 $10,870 $0 $5,000 –$4,960\n1,300 9.1 $910 108.7 $10,870 $0 $0 –$9,960\n1,350 9.1 $910 108.7 $10,870 $5,000 $0 –$14,960\n1,400 9.1 $910 108.7 $10,870 $10,000 $0 –$19,960", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:549", "doc_id": "653179a27b1d5f0d2a005584467bf9b508668a4951b411845e03875497d90ae7", "chunk_index": 0}
{"text": "532A COMPleTe gUIde TO THe FUTUreS MArKeT\n Strategy 17: the ratio Call Write (Long Futures + Short 2 Calls) \nexample . Buy August gold futures at $1,200 and simultaneously sell two August $1,200 gold futures \ncalls at apremium of $38.80/ oz. ($7,760). (See Table 35.17 and Figure 35.17 .) \n FIGURE  35.16 Profi t/loss Profi le: Synthetic Short Futures (long Put + Short Call). \nFutures price at time\nof position initiation\nBreakeven price\n= $1,210.40\nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n20,000\n15,000\n10,000\n5,000\n−5,000\n−10,000\n−15,000\n−20,000\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n tabLe 35.17 profit/Loss Calculations: ratio Call Write—Long Futures + Short 2 Calls (Similar to \nShort Straddle) \n(1) (2) (3) (4) (5) (6)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,200 Call \nat Initiation ($/oz)\n$ amount of \ntotal premium \nreceived\nprofit/Loss on \nLong Futures \nposition\nValue of 2 Calls \nat expiration\nprofit/Loss on position \n[(3) + (4) − (5)]\n1,000 38.8 $7,760 –$20,000 $0 –$12,240\n1,050 38.8 $7,760 –$15,000 $0 –$7,240\n1,100 38.8 $7,760 –$10,000 $0 –$2,240\n1,150 38.8 $7,760 –$5,000 $0 $2,760\n1,200 38.8 $7,760 $0 $0 $7,760\n1,250 38.8 $7,760 $5,000 $10,000 $2,760\n1,300 38.8 $7,760 $10,000 $20,000 –$2,240\n1,350 38.8 $7,760 $15,000 $30,000 –$7,240\n1,400 38.8 $7,760 $20,000 $40,000 –$12,240", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:550", "doc_id": "fbf4a17f60b50a823e4ce6af4cd3b3754d20260f54c51bc97554a01c1a95cf4c", "chunk_index": 0}
{"text": "533\nOPTION TrAdINg STrATegIeS\nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n10,000\n5,000\n−5,000\n−10,000\n0\n1,050 1,100 1,150 1,200 1,250\nBreakeven price\n= $1,122.40\nBreakeven price\n= $1,277 .60\n1,300 1,350 1,400\n−15,000\nFutures price at time\nof position initiation\n FIGURE  35.17 Profi t/loss Profi le: ratio Call Write—long Futures + Short 2 Calls (Similar to \nShort Straddle) \nComment. The combination of 1 long futures contract and 2 short at-the-money calls is abalanced \nposition in terms of delta values. In other words, at any given point in time, the gain or loss in the \nlong futures contract due to small price changes (i.e., price changes in the vicinity of the strike price) \nwill be approximately off set by an opposite change in the call position. (Over time, however, amar-\nket characterized by small price changes will result in the long futures position gaining on the short \ncall position due to the evaporation of the time value of the options.) The maximum profi tin this \nstrategy will be equal to the premium received for the 2 calls and will occur when prices are exactly \nunchanged. This strategy will show anet profi tfor awide range of prices centered at the prevailing \nprice level at the time the position was initiated. However, the position will imply unlimited risk in \nthe event of very sharp price increases or declines. \n The profi t/loss profi le for this strategy should look familiar—it is virtually identical to the short \nstraddle position (see Strategy 35.8). The virtual equivalence of this strategy to the short straddle \nposition follows directly from the previously discussed structure of asynthetic futures position:\nRatio call wr itel ong futures short calls\n=+ 2\n However, from the synthetic futures position relationship, we know that:\n Long futures long call short put ≈+", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:551", "doc_id": "e28abdd7c9aec87a3b427cdbeac1e535ee0eadbf0586d75741a5cd0c48cb12f6", "chunk_index": 0}
{"text": "534\nA Complete Guide to the Futures mArket\nThus:\nRatio call writ el ong call short put short calls or\nRati\n ≈+ + 2,\noo call wr ite short put short call≈+\nThe right-hand term of this last equation is, in fact, the definition of ashort straddle. In similar \nfashion, it can be demonstrated that ashort put write (short futures + short 2 puts) would also yield \naprofit/loss profile nearly identical to the short straddle position.\nStrategy 18: bull Call Money Spread (Long Call with Lower Strike \nprice/Short Call with higher Strike price)\nexample. Buy an August $1,250 gold futures call at apremium of $19.20/oz ($1,920) and \nsimultaneously sell an August $1,300 call at apremium of $9.10 ($910). (See Table 35.18 and \nFigure 35.18.)\nComment. This type of spread position is also called adebit spread because the amount of premium \npaid for the long call is greater than the amount of the premium received for the short call. The maxi-\nmum risk in this type of trade is equal to the difference between these two premiums. The maximum \npossible gain in this spread will be equal to the difference between the two strike prices minus the \nnet difference between the two premiums. The maximum loss will occur if prices fail to rise at least \nbeyond the lowest strike price. The maximum gain will be realized if prices rise above the higher \nstrike price. Note that although the maximum profit exceeds the maximum risk by afactor of nearly \n4 to 1, the probability of aloss is significantly greater than the probability of again. This condition is \ntrue since prices must rise $60.10/oz before the strategy proves profitable.\ntabLe 35.18 profit/Loss Calculations: bull Call Money Spread (Long Call with Lower Strike price/\nShort Call with higher Strike price)\n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,250 \nCall ($/oz)\n$ amount \nof premium \npaid\npremium of \naugust $1,300 \nCall ($/oz)\nDollar amount \nof premium \nreceived\n$1,250 Call \nValue at \nexpiration\n$1,300 Call \nValue at \nexpiration\nprofit/Loss on \nposition \n[(5) − (3) + (6) − (7)]\n1,000 19.2 $1,920 9.1 $910 $0 $0 -$1,010\n1,050 19.2 $1,920 9.1 $910 $0 $0 -$1,010\n1,100 19.2 $1,920 9.1 $910 $0 $0 -$1,010\n1,150 19.2 $1,920 9.1 $910 $0 $0 -$1,010\n1,200 19.2 $1,920 9.1 $910 $0 $0 -$1,010\n1,250 19.2 $1,920 9.1 $910 $0 $0 -$1,010\n1,300 19.2 $1,920 9.1 $910 $5,000 $0 $3,990\n1,350 19.2 $1,920 9.1 $910 $10,000 $5,000 $3,990\n1,400 19.2 $1,920 9.1 $910 $15,000 $10,000 $3,990", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:552", "doc_id": "1c3c033b5b8b63fb42838ee88e1853f5323d19722831024c50def2ef109975c3", "chunk_index": 0}
{"text": "535\nOPTION TrAdINg STrATegIeS\n This strategy can perhaps be best understood by comparing it to the long call position (e.g., long \nAugust $1,250 gold futures call). In eff ect, the spread trader reduces the premium cost for the long \ncall position by the amount of premium received for the sale of the more deeply out-of-the-money \ncall. This reduction in the net premium cost of the trade comes at the expense of sacrifi cing the pos-\nsibility of unlimited gain in the event of alarge price rise. As can be seen in Figure 35.18 , in contrast \nto the outright long call position, price gains beyond the higher strike price will cease to aff ect the \nprofi tability of the trade. \n Strategy 19a: bear Call Money Spread (Short Call with Lower Strike \nprice/Long Call with higher Strike price)—Case 1 \nexample . Buy August $1,150 gold futures call at apremium of $70.10/oz ($7,010) and simultane-\nously sell an August $1,100 gold futures call at apremium of $110.10/oz ($11,010), with August \ngold futures trading at $1,200/oz. (See Table 35.19 aand Figure 35.19 a.) \nComment. This type of spread is called acredit spread, since the amount of premium received for \nthe short call position exceeds the premium paid for the long call position. The maximum possible \ngain on the trade is equal to the net diff erence between the two premiums. The maximum possible \nloss is equal to the diff erence between the two strike prices minus the diff erence between the two \npremiums. The maximum gain would be realized if prices declined to the lower strike price. The \nmaximum loss would occur if prices failed to decline to at least the higher strike price. Although \n FIGURE  35.18 Profi t/loss Profi le: Bull Call Money Spread (long Call with lower Strike Price/\nShort Call with Higher Strike Price) \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n3,750\n5,000\n2,500\n0\n−1,250\n1,250\n1,050 1,100 1,150 1,200 1,250\nBreakeven price\n= $1,260.10\n1,300 1,350 1,400\n−2,500\nFutures price at time\nof position initiation", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:553", "doc_id": "bc4da05d0e02d92fc969e39690edeede794a7097bc20611f27af1db09d0d4fe1", "chunk_index": 0}
{"text": "536A COMPleTe gUIde TO THe FUTUreS MArKeT\n tabLe 35.19a profit/Loss Calculations: bear Call Money Spread (Short Call with Lower Strike price/\nLong Call with higher Strike price); Case 1—both Calls In-the-Money \n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,150 \nCall ($/oz)\n$ amount \nof premium \npaid\npremium of \naugust $1,100 \nCall ($/oz)\n$ amount \nof premium \nreceived\n$1,150 Call \nValue at \nexpiration\n$1,100 Call \nValue at \nexpiration\n profit/Loss on \nposition \n [(5) − (3) + (6) − (7)] \n1,000 70.1 $7,010 110.1 $11,010 $0 $0 $4,000\n1,050 70.1 $7,010 110.1 $11,010 $0 $0 $4,000\n1,100 70.1 $7,010 110.1 $11,010 $0 $0 $4,000\n1,150 70.1 $7,010 110.1 $11,010 $0 $5,000 –$1,000\n1,200 70.1 $7,010 110.1 $11,010 $5,000 $10,000 –$1,000\n1,250 70.1 $7,010 110.1 $11,010 $10,000 $15,000 –$1,000\n1,300 70.1 $7,010 110.1 $11,010 $15,000 $20,000 –$1,000\n1,350 70.1 $7,010 110.1 $11,010 $20,000 $25,000 –$1,000\n1,400 70.1 $7,010 110.1 $11,010 $25,000 $30,000 –$1,000\nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n3,750\n5,000\n2,500\n0\n−1,250\n1,250\n1,050 1,100 1,150 1,200 1,250\nBreakeven price = $1,140\n1,300 1,350 1,400\nFutures price at time\nof position initiation\n FIGURE  35.19a Profi t/loss Profi le: Bear Call Money Spread (Short Call with lower Strike \nPrice/long Call with Higher Strike Price); Case 1—Both Calls In-the-Money", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:554", "doc_id": "b82ddeb800023b94c16b5d2506691d6fd134f04ce44a2fdce545954252e019b2", "chunk_index": 0}
{"text": "537\nOPTION TrAdINg STrATegIeS\nin the above example the maximum gain exceeds the maximum risk by afactor of 4 to 1, there is \nagreater probability of anet loss on the trade, since prices must decline by $60/oz before aprofit \nis realized.\nIn this type of spread, the trader achieves abearish position at afairly low premium cost at the \nexpense of sacrificing the potential for unlimited gains in the event of avery sharp price decline. This \nstrategy might be appropriate for the trader expecting aprice decline but viewing the possibility of avery large price slide as being very low .\nStrategy 19b: bear Call Money Spread (Short Call with Lower Strike \nprice/Long Call with higher Strike price)—Case 2\nexample. Buy an August $1,300 gold futures call at apremium of $9.10/oz ($9.10) and simultane-\nously sell an August $1,200 gold futures call at apremium of $38.80/oz ($3,880), with August gold \nfutures trading at $1,200/oz. (See Table 35.19b and Figure 35.19b.)\nComment. In contrast to the previous strategy, which involved two in-the-money calls, this illustra-\ntion is based on aspread consisting of ashort at-the-money call and along out-of-the-money call. \nIn asense, this type of trade can be thought of as ashort at-the-money call position with built-in \nstop-loss protection. (The long out-of-the-money call will serve to limit the risk in the short at-the-\nmoney call position.) This risk limitation is achieved at the expense of areduction in the net premium \nreceived by the seller of the at-the-money call (by an amount equal to the premium paid for the out-\nof-the-money call). This trade-off between risk exposure and the amount of net premium received \nis illustrated in Figure 35.19b, which compares the outright short at-the-money call position to the \nabove spread strategy.\ntabLe 35.19b profit/Loss Calculations: bear Call Money Spread (Short Call with Lower Strike price/Long \nCall with higher Strike price); Case 2—Short at-the-Money Call/Long Out-of-the-Money \nCall\n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,300 \nCall ($/oz)\n$ amount \nof premium \npaid\npremium of \naugust $1,200 \nCall ($/oz)\n$ amount \nof premium \nreceived\nValue of \n$1,300 Call at \nexpiration\nValue of \n$1,200 Call at \nexpiration\nprofit/Loss on \nposition \n[(5) − (3) + (6) − (7)]\n1,000 9.1 $910 38.8 $3,880 $0 $0 $2,970\n1,050 9.1 $910 38.8 $3,880 $0 $0 $2,970\n1,100 9.1 $910 38.8 $3,880 $0 $0 $2,970\n1,150 9.1 $910 38.8 $3,880 $0 $0 $2,970\n1,200 9.1 $910 38.8 $3,880 $0 $0 $2,970\n1,250 9.1 $910 38.8 $3,880 $0 $5,000 –$2,030\n1,300 9.1 $910 38.8 $3,880 $0 $10,000 –$7,030\n1,350 9.1 $910 38.8 $3,880 $5,000 $15,000 –$7,030\n1,400 9.1 $910 38.8 $3,880 $10,000 $20,000 –$7,030", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:555", "doc_id": "a5d6aab5fa59ffe929a58064a9a4b319acd5dd309545f56f32b4e85a790b7730", "chunk_index": 0}
{"text": "538A COMPleTe gUIde TO THe FUTUreS MArKeT\n Strategy 20a: bull put Money Spread (Long put with Lower Strike \nprice/Short put with higher Strike price)—Case 1 \nexample . Buy an August $1,250 gold futures put at apremium of $68.70/oz ($6,870) and simulta-\nneously sell an August $1,300 put at apremium of $108.70/oz ($10,870), with August gold futures \ntrading at $1,200/oz. (See Table 35.20 aand Figure 35.20 a.) \nComment. This is anet credit bull spread that uses puts instead of calls. The maximum gain in this \nstrategy is equal to the diff erence between the premium received for the short put and the premium \npaid for the long put. The maximum loss is equal to the diff erence between the strike prices minus \nthe diff erence between the premiums. The maximum gain will be achieved if prices rise to the higher \nstrike price, while the maximum loss will occur if prices fail to rise at least to the lower strike price. \nThe profi t/loss profi le of this trade is very similar to the profi le of the net debit bull call money \nspread illustrated in Figure 35.18 . \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n5,000\n2,500\n0\n−2,500\n−5,000\n−7 ,500\n−10,000\n−12,500\n−17 ,500\n1,050 1,100 1,150 1,200 1,250\nBear call money spread\nShort at-the-money\ncall\nBreakeven price on\nspread = $1,229.70\nBreakeven price on\nshort call = $1,238.80\n1,300 1,350 1,400\n−15,000\nFutures price at time\nof position initiation\n FIGURE  35.19b Profi t/loss Profi le: Bear Call Money Spread (Short Call with lower Strike \nPrice/long Call with Higher Strike Price); Case 2—Short At-the-Money Call/long Out-of-the-\nMoney Call with Comparison to Short At-the-Money Call", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:556", "doc_id": "8c5911d751eaf19a30684d07aec6919bbc2d5169655f92068339b692106677c2", "chunk_index": 0}
{"text": "539\nOPTION TrAdINg STrATegIeS\n tabLe 35.20a profit/Loss Calculations: bull put Money Spread (Long put with Lower Strike price/\nShort put with higher Strike price); Case 1—both puts In-the-Money \n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,250 \nput ($/oz)\n$ amount \nof premium \npaid\npremium of \naugust $1,300 \nput ($/oz)\n$ amount \nof premium \nreceived\n$1,250 put \nValue at \nexpiration\n$1,300 put \nValue at \nexpiration\nprofit/Loss on \nposition\n[(5) − (3) + (6) −(7)]\n1,000 68.7 $6,870 108.7 $10,870 $25,000 $30,000 –$1,000\n1,050 68.7 $6,870 108.7 $10,870 $20,000 $25,000 –$1,000\n1,100 68.7 $6,870 108.7 $10,870 $15,000 $20,000 –$1,000\n1,150 68.7 $6,870 108.7 $10,870 $10,000 $15,000 –$1,000\n1,200 68.7 $6,870 108.7 $10,870 $5,000 $10,000 –$1,000\n1,250 68.7 $6,870 108.7 $10,870 $0 $5,000 –$1,000\n1,300 68.7 $6,870 108.7 $10,870 $0 $0 $4,000\n1,350 68.7 $6,870 108.7 $10,870 $0 $0 $4,000\n1,400 68.7 $6,870 108.7 $10,870 $0 $0 $4,000\n FIGURE  35.20a \n Profi t/loss Profi le: Bull Put Money Spread (long Put with lower Strike Price/\nShort Put with Higher Strike Price); Case 1—Both Puts In-the-Money \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n3,750\n5,000\n2,500\n0\n1,250\n1,050 1,100 1,150 1,200 1,250\nBreakeven price\n= $1,260\n1,300 1,350 1,400\n−1,250\nFutures price at time\nof position initiation", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:557", "doc_id": "927ed6bf26faed4465297f66a0b1a5d5d1f50a56e79620aea242ab6db17a3279", "chunk_index": 0}
{"text": "540\nA Complete Guide to the Futures mArket\nStrategy 20b: bull put Money Spread (Long put with Lower Strike \nprice/Short put with higher Strike price)—Case 2\nexample. Buy an August $1,100 gold futures put at apremium of $10.10/oz ($1,010) and simul-\ntaneously sell an August $1,200 put at apremium of $38.70/oz ($3,870), with August gold futures \ntrading at $1,200/oz. (See Table 35.20b and Figure 35.20b.)\nComment. In contrast to Case 1, which involved two in-the-money puts, this strategy is based on \nalong out-of-the-money put versus ashort at-the-money put spread. In asense, this strategy can \nbe viewed as ashort at-the-money put position with abuilt-in stop. (The purchase of the out-of-\nthe-money put serves to limit the maximum possible loss in the event of alarge price decline.) This \nrisk limitation is achieved at the expense of areduction in the net premium received. This trade-off \nbetween risk exposure and the amount of premium received is illustrated in Figure 35.20b, which \ncompares the outright short at-the-money put position to this spread strategy.\nStrategy 21: bear put Money Spread (Short put with Lower Strike \nprice/Long put with higher Strike price)\nexample. Sell an August $1,100 gold futures put at apremium of $10.10/oz ($1,010) and simul-\ntaneously buy an August $1,150 put at apremium of $19.90/oz ($1,990), with August gold futures \ntrading at $1,200/oz. (See Table 35.21 and Figure 35.21.)\nComment. This is adebit bear spread using puts instead of calls. The maximum risk is equal to the \ndifference between the premium paid for the long put and the premium received for the short put. The \nmaximum gain equals the difference between the two strike prices minus the difference between \nthe premiums. The maximum loss will occur if prices fail to decline to at least the higher strike price. \nThe maximum gain will be achieved if prices decline to the lower strike price. The profit/loss profile of \nthis spread is approximately equivalent to the profile of the bear call money spread (see Figure 35.19a).\ntabLe 35.20b profit/Loss Calculations: bull put Money Spread (Long put with Lower Strike price/Short put \nwith higher Strike price); Case 2—Long Out-of-the-Money put/Short at-the-Money put\n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,100 \nput ($/oz)\nDollar \namount of \npremium paid\npremium of \naugust $1,200 \nput ($/oz)\nDollar amount \nof premium \nreceived\nValue of \n$1,100 put at \nexpiration\nValue of \n$1,200 put at \nexpiration\nprofit/Loss on \nposition \n[(5) − (3) + (6) − (7)]\n1,000 10.1 $1,010 38.7 $3,870 $10,000 $20,000 –$7,140\n1,050 10.1 $1,010 38.7 $3,870 $5,000 $15,000 –$7,140\n1,100 10.1 $1,010 38.7 $3,870 $0 $10,000 –$7,140\n1,150 10.1 $1,010 38.7 $3,870 $0 $5,000 –$2,140\n1,200 10.1 $1,010 38.7 $3,870 $0 $0 $2,860\n1,250 10.1 $1,010 38.7 $3,870 $0 $0 $2,860\n1,300 10.1 $1,010 38.7 $3,870 $0 $0 $2,860\n1,350 10.1 $1,010 38.7 $3,870 $0 $0 $2,860\n1,400 10.1 $1,010 38.7 $3,870 $0 $0 $2,860", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:558", "doc_id": "4f2a34c18556675811d076a213f5d4f54a66b6b235aa02fec1f0ea4b7acd38e6", "chunk_index": 0}
{"text": "541\nOPTION TrAdINg STrATegIeS FIGURE  35.20b Profi t/loss Profi le: Bull Put Money Spread (long Put with lower Strike Price/\nShort Put with Higher Strike Price); Case 2—long Out-of-the-Money Put/Short At-the-Money \nPut with Comparison to Short At-the-Money Put \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n5,000\n2,500\n0\n−2,500\n−5,000\n−7 ,500\n−10,000\n−12,500\n−15,000\n1,050 1,100 1,150 1,200 1,250\nBull put money spread\nShort at-the-money\nput\nBreakeven price on spread = $1,171.40\nBreakeven price on short put $1,161.30\n1,300 1,350 1,400\n−17 ,500\nFutures price at time\nof position initiation\n tabLe 35.21 profit/Loss Calculations: bear put Money Spread (Short put with Lower Strike price/Long \nput with higher Strike price) \n(1) (2) (3) (4) (5) (6) (7)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,150 \nput ($/oz)\n$ amount \nof premium \npaid\npremium of \naugust $1,100 \nput ($/oz)\n$ amount \nof premium \nreceived\nValue of \n$1,150 \nput\nValue of \n$1,100 \nput\nprofit/Loss on position \n[(5) − (3) + (6) − (7)]\n1,000 19.9 $1,990 10.1 $1,010 $15,000 $10,000 $4,020\n1,050 19.9 $1,990 10.1 $1,010 $10,000 $5,000 $4,020\n1,100 19.9 $1,990 10.1 $1,010 $5,000 $0 $4,020\n1,150 19.9 $1,990 10.1 $1,010 $0 $0 –$980\n1,200 19.9 $1,990 10.1 $1,010 $0 $0 –$980\n1,250 19.9 $1,990 10.1 $1,010 $0 $0 –$980\n1,300 19.9 $1,990 10.1 $1,010 $0 $0 –$980\n1,350 19.9 $1,990 10.1 $1,010 $0 $0 –$980\n1,400 19.9 $1,990 10.1 $1,010 $0 $0 –$980", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:559", "doc_id": "efd22702fe8f5f3472becb22b0298b2e45b278613f2101aaf96845b6a75da800", "chunk_index": 0}
{"text": "542A COMPleTe gUIde TO THe FUTUreS MArKeT\n Other Spread Strategies \n Money spreads represent only one class of option spreads. Acomplete discussion of option spread \nstrategies would require asubstantial extension of this section—adegree of detail beyond the scope \nof this presentation. The following are examples of some other types of spreads. \ntime spread. Atime spread is aspread between two calls or two puts with the same strike price, \nbut adiff erent expiration date. An example of atime spread would be: long 1 August $1,300 \ngold futures call/short 1 december $1,300 gold futures call. Time spreads are more complex \nthan the other strategies discussed in this section, because the profi t/loss profi le at the time \nof expiration cannot be precisely predetermined, but rather must be estimated on the basis of \ntheoretical valuation models. \nDiagonal spread. This is aspread between two calls or two puts that diff er in terms of both the \nstrike price and the expiration date. An example of adiagonal spread would be: long 1 August \n$1,200 gold futures call/short 1 december $1,250 gold futures call. In eff ect, this type of \nspread combines the money spread and the time spread into one trade. \nbutterfl yspread. This is athree-legged spread in which the options have the same expiration \ndate but diff er in strike prices. Abutterfl yspread using calls consists of two short calls at agiven \nstrike price, one long call at ahigher strike price, and one long call at alower strike price. \n The list of types of option spreads can be significantly extended, but the above examples \nshould be sufficient to give the reader some idea of the potential range of complexity of spread \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n3,750\n5,000\n2,500\n0\n−1,250\n−2,500\n1,250\n1,050 1,100 1,150 1,200 1,250\nBreakeven price\n= $1,140.20\n1,300 1,350 1,400\nFutures price at time\nof position initiation\n FIGURE  35.21 Profi t/loss Profi le; Bear Put Money Spread (Short Put with lower Strike Price/\nlong Put with Higher Strike Price)", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:560", "doc_id": "a309141e4b9924b5ea8c255a9cbccf5c99ecab562cf01517faa1b48ade4f4de1", "chunk_index": 0}
{"text": "543\nOPTION TrAdINg STrATegIeS\nstrategies. One critical point that must be emphasized regarding option spreads is that these \nstrategies are normally subject to amajor disadvantage: the transaction costs (commissions plus \ncumulative bid/asked spreads) for these trades are relatively large compared to the profit poten-\ntial. This consideration means that the option spread trader must be right alarge percentage of \nthe time if he is to come out ahead of the game. The importance of this point cannot be overem -\nphasized. In short, as ageneralization, other option strategies will usually offer better trading \nopportunities.\nMultiunit Strategies\nThe profit/loss profile can also be used to analyze multiple-unit option strategies. In fact, multiple-\nunit option positions may often provide the more appropriate strategy for purposes of comparison. \nFor example, as previously detailed, along futures position is more volatile than along or short call \nposition. In fact, for small price changes, each $1 change in afutures price will only result in approxi-\nmately a $0.50 change in the call price (the delta value for an at-the-money call is approximately \nequal to 0.5). As aresult, in considering the alternatives of buying futures and buying calls, it probably \nmakes more sense to compare the long futures position to two long calls (see Table 35.22) as opposed \nto one long call.\nFigure 35.22 compares the strategies of long futures versus long two calls, which at the time of \ninitiation are approximately equivalent in terms of delta values. Note this comparison indicates that \nthe long futures position is preferable if prices change only moderately, but that the long two-call \nposition will gain more if prices rise sharply, and lose less if prices decline sharply. In contrast, the \ncomparison between long futures and along one-call position would indicate that futures provide \nthe better strategy in the event of aprice advance of any magnitude (see Figure 35.3d). For most \npurposes, the comparison employing two long calls will be more meaningful because it comes much \ncloser to matching the risk level implicit in the long futures position.\ntabLe 35.22 profit/Loss Calculations: Long two at-the-Money Calls\n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august \n$1,200 Call ($/oz)\n$ amount of total \npremium paid\nValue of 2 Calls \nat expiration\nprofit/Loss on \nposition [(4) − (3)]\n1,000 38.8 $7,760 $0 –$7,760\n1,050 38.8 $7,760 $0 –$7,760\n1,100 38.8 $7,760 $0 –$7,760\n1,150 38.8 $7,760 $0 –$7,760\n1,200 38.8 $7,760 $0 –$7,760\n1,250 38.8 $7,760 $10,000 $2,240\n1,300 38.8 $7,760 $20,000 $12,240\n1,350 38.8 $7,760 $30,000 $22,240\n1,400 38.8 $7,760 $40,000 $32,240", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:561", "doc_id": "2fc4bc0fe28ca47e206f21f38000896a886983b99ecf4981ff84e245bb940dc4", "chunk_index": 0}
{"text": "544A COMPleTe gUIde TO THe FUTUreS MArKeT\n Choosing an Optimal Strategy \n It the previous sections we examined awide range of alternative trading strategies. Now what? How \ndoes atrader decide which of these alternatives provides the best trading opportunity? This ques-\ntion can be answered only if probability is incorporated into the analysis. The selection of an optimal \noption strategy will depend entirely on the trader’sprice and volatility expectations. Insofar as these \nexpectations will diff er from trader to trader, the optimal option strategy will also vary, and the \nsuccess of the selected option strategy will depend on the accuracy of the trader’sexpectations. In \norder to select an optimal option strategy, the trader needs to translate his price expectations into \nprobabilities. \n The basic approach requires the trader to assign estimated probability levels for the entire range \nof feasible price intervals. Figure 35.23 illustrates six diff erent types of probability distributions for \nAugust gold futures. These distributions can be thought of as representing six diff erent hypothetical \nexpectations. (The charts in Figure 35.23 implicitly assume that the current price of August gold \nfutures is $1,200.) Several important points should be made regarding these probability distributions: \n 1. The indicated probability distributions only represent approximations of traders’ price expec-\ntations. In reality, any reasonable probability distribution would be represented by asmooth \ncurve. The stair-step charts in Figure 35.23 are only intended as crude models that greatly sim-\nplify calculations. (The use of smooth probability distributions would require integral calculus \nin the evaluation process.) \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n25,000\n12,500\n−12,500\n−25,000\n0\n1,050 1,100 1,150 1,200 1,250\nBreakeven price on long\n2 calls = $1,238.80\nLong futures\nLong 2 calls\n1,300 1,350 1,400\n37 ,500\n+37 ,500\nFutures price at time\nof position initiation\n FIGURE  35.22 Profi t/loss Profi le: Two long Calls vs. long Futures", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:562", "doc_id": "f52e80fb47609274d2a36f6a5b8b9169a2b33962cc9291fddbe1ca1dc5c38ae1", "chunk_index": 0}
{"text": "546\nA Complete Guide to the Futures mArket\n 5. The probability distributions in Figure 35.23 represent sample hypothetical illustrations \nof personal price expectations. The indicated optimal strategy in any given situation will \ndepend upon the specific shape of the expected price distribution, an input that will differ from \ntrader to trader.\nThe general nature of the price expectations implied by each of the distributions in Figure 35.23 \ncan be summarized as follows:\nExpected Probability Distribution 1. Higher prices and low volatility. This interpretation follows from \nthe fact that there is agreater probability of higher prices and that the probabilities are heavily \nweighted toward intervals close to the current price level.\nExpected Probability Distribution 2. Higher prices and high volatility. This distribution reflects the \nsame 60/40 probability bias toward higher prices as was the case for \ndistribution 1, but the \nassumed probability of asubstantially higher or lower price is much greater.\nExpected Probability Distribution 3. lower prices and low volatility. This distribution is the bearish \ncounterpart of distribution 1.\nExpected Probability Distribution 4. lower prices and high volatility. This distribution is the bearish \ncounterpart of distribution 2.\nExpected Probability Distribution 5. Neutral price assumptions and low volatility. This distribution is \nsymmetrical in terms of higher and lower prices, and probability levels are heavily weighted \ntoward prices near the current level.\nExpected Probability Distribution 6. Neutral price assumptions and high volatility. This distribution is \nalso symmetrical in terms of high and low prices, but substantially higher and lower prices have \namuch greater probability of occurrence than in \ndistribution 5.\nFigure 35.24 combines expected Probability distribution 1 with three alternative bullish strat-\negies. (Since it is assumed that there is agreater probability of higher prices, there is no need to \nconsider bearish or neutral trading strategies.) Insofar as the assumed probability distribution is \nvery heavily weighted toward prices near the current level, the short put position appears to offer \nthe best strategy. Figure 35.25 combines the same three alternative bullish strategies with the bull -\nish/volatile price scenario suggested by \nexpected Probability distribution 2. In this case, the long \ncall position appears to be the optimal strategy, since it is by far the best performer for large price \nadvances and declines—price outcomes that account for asignificant portion of the overall prob -\nability distribution.\nIn analogous fashion, Figure 35.26 suggests the preferability of the short call position given \nthe bearish/nonvolatile price scenario assumption, while Figure 35.27 suggests that the long put \nposition is the optimal strategy given the bearish/volatile price scenario. Finally, two alternative \nneutral strategies are compared in Figures 35.28 and 35.29 for two neutral price distributions \nthat differ in terms of assumed volatility. The short straddle appears to offer the better strategy in \nthe low volatility distribution assumption, while the reverse conclusion is suggested in the volatile \nprice case.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:564", "doc_id": "3e59c75722ca13e20e303728359a304fe805c1fa7f71dcb642ef1554fc549b69", "chunk_index": 0}
{"text": "548A COMPleTe gUIde TO THe FUTUreS MArKeT\n FIGURE  35.26 “Bearish/Nonvolatile” expected Probability distribution and Profi t/loss \nProfi les for Three Alternative Bearish Strategies \n “Bearish/Nonvolatile” expected Probability distribution and Profi t/loss \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n25,000\n12,500\n−12,500\n−25,000\n0\n1,050 1,100 1,150 1,200 1,250\nShort futures\nShort 2 calls\nLong 2 puts\n.20\n.18\n.16\n.14\n.12\n.10\nProbability\n.08\n.06\n.04\n.02\n1,300 1,350 1,400\n FIGURE  35.27 “Bearish/Volatile” expected Probability distribution and Profi t/loss Profi les \nfor Three Alternative Bearish Strategies \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n25,000\n12,500\n−12,500\n−25,000\n0\n1,050 1,100 1,150 1,200 1,250\n.20\n.18\n.16\n.14\n.12\n.10\nProbability\n.08\n.06\n.04\n.02\n1,300 1,350 1,400\nShort futures\nShort 2 calls\nLong 2 puts", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:566", "doc_id": "7484994cb5de64e8f60b45c2e1e19ab762aab211894dadaa40ad795c8ac46b6f", "chunk_index": 0}
{"text": "553\nOPTION TrAdINg STrATegIeS\ntabLe 35.26 probability-Weighted profit/Loss ratio Comparisons for “bearish/Volatile” expected \nprobability Distribution\nShort Futures Short Call Long put\nprice range \n($/oz)\naverage \nprice \n($/oz)\nassumed \nprobability\nGain/Loss \nat average \nprice ($)\nprobability-\nWeighted \nGain/Loss ($)\nGain/Loss \nat average \nprice ($)\nprobability-\nWeighted \nGain/Loss ($)\nGain/Loss \nat \naverage \nprice ($)\nprobability-\nWeighted \nGain/Loss ($)\n950–999.9 975 0.06 22,500 1,350 3,880 233 18,630 1,117.8\n1,000–1,049.9 1,025 0.1 17,500 1,750 3,880 388 13,630 1,363\n1,050–1,099.9 1,075 0.12 12,500 1,500 3,880 466 8,630 1,035.6\n1,100–1,149.9 1,125 0.14 7,500 1,050 3,880 543 3,630 508.2\n1,150–1,199.9 1,175 0.18 2,500 450 3,880 698 –1,370 –246.6\n1,200–1,249.9 1,225 0.12 –2,500 –300 1,380 166 –3,870 –464.4\n1,250–1,299.9 1,275 0.1 –7,500 –750 –3,620 –362 –3,870 –387\n1,300–1,349.9 1,325 0.08 –12,500 –1,000 –8,620 –690 –3,870 –309.6\n1,350–1,399.9 1,375 0.06 –17,500 –1,050 –13,620 –817 –3,870 –232.2\n1,400–1,449.9 1,425 0.04 –22,500 –900 –18,620 –745 –3,870 –154.8\nProbability-weighted profit/loss ratio: 6,100/4,000 = 1.53 2,494/2,614 = 0.95 4,025/1,795 = 2.24\ntabLe 35.27 probability-Weighted profit/Loss ratio Comparisons for “Neutral/Nonvolatile” expected \nprobability Distribution\nLong Straddle Short Straddle\nprice range \n($/oz)\naverage \nprice ($/oz)\nassumed \nprobability\nGain/Loss at \naverage price ($)\nprobability- \nWeighted \nGain/Loss ($)\nGain/Loss at \naverage price ($)\nprobability- \nWeighted \nGain/Loss ($)\n1,000–1,049.9 1,025 0.05 9750 488 –9,750 –488\n1,050–1,099.9 1,075 0.1 4,750 475 –4,750 –475\n1,100–1,149.9 1,125 0.15 –250 –38 250 38\n1,150–1,199.9 1,175 0.2 –5,250 –1,050 5,250 1,050\n1,200–1,249.9 1,225 0.2 –5,250 –1,050 5,250 1,050\n1,250–1,299.9 1,275 0.15 –250 –38 250 38\n1,300–1,349.9 1,325 0.1 4,750 475 –4,750 –475\n1,350–1,399.9 1,375 0.05 9,750 488 –9,750 –488\nProbability-weighted profit/loss ratio: 1,925/2,175 = 0.89 2,175/1,925 = 1.13", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:571", "doc_id": "99415fa82dca0611ed57e997402ec9ce3ca6d6747112e397c43fdc32369d6598", "chunk_index": 0}
{"text": "554\nA Complete Guide to the Futures mArket\nhedging applications\nThe entire discussion in this chapter has been approached from the vantage point of the speculator. \nHowever, option-based strategies can also be employed by the hedger. Toillustrate how options can be \nused by the hedger, we compare five basic alternative strategies for the gold jeweler who anticipates arequirement for 100 ounces of gold in August. The assumed date in this illustration is April 13, 2015, \naday on which the relevant price quotes were as follows: spot gold = $1,198.90, August gold futures \n= $1,200, August $1,200 gold call premium = $38.80, August $1,200 gold put premium = $38.70. \nThe five purchasing alternatives are:\n5\n 1. Wait until time of requirement. In this approach, the jeweler simply waits until August \nbefore purchasing the gold. In effect, the jeweler gambles on the interim price movement of \ngold. If gold prices decline, he will be better off. However, if gold prices rise, his purchase price \nwill increase. If the jeweler has forward-contracted for his products, he may need to lock in his \nraw material purchase costs in order to guarantee asatisfactory profit margin. Consequently, the \nprice risk inherent in this approach may be unacceptable.\ntabLe 35.28 probability-Weighted profit/Loss ratio Comparisons for “Neutral/Volatile” expected \nprobability Distribution\nLong Straddle Short Straddle\nprice range \n($/oz)\naverage \nprice ($/oz)\nassumed \nprobability\nGain/Loss at \naverage price ($)\nprobability- \nWeighted \nGain/Loss ($)\nGain/Loss at \naverage price ($)\nprobability- \nWeighted \nGain/Loss ($)\n950–999.9 975 0.05 14,750 738 –14,750 –738\n1,000–1,049.9 1,025 0.08 9,750 780 –9,750 –780\n1,050–1,099.9 1,075 0.1 4,750 475 –4,750 –475\n1,100–1,149.9 1,125 0.12 –250 –30 250 30\n1,150–1,199.9 1,175 0.15 –5,250 –788 5,250 788\n1,200–1,249.9 1,225 0.15 –5,250 –788 5,250 788\n1,250–1,299.9 1,275 0.12 –250 –30 250 30\n1,300–1,349.9 1,325 0.1 4,750 475 –4,750 –475\n1,350–1,399.9 1,375 0.08 9,750 780 –9,750 –780\n1,400–1,449.9 1,425 0.05 14,750 738 –14,750 –738\nProbability-weighted profit/loss ratio: 3,985/1,635 = 2.44 1,635/3,985 = 0.41\n5 There is no intention to imply that the following list of alternative hedging strategies is all-inclusive. Many other \noption-based strategies are also possible. For example, the jeweler could buy acall and sell aput at the same \nstrike price—astrategy similar to buying afutures contract (see Strategy 15).", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:572", "doc_id": "9edc0fabdaab68a6eb4658c83c0c8facb69a1b340ada7bb5bcc8d6fd16844d94", "chunk_index": 0}
{"text": "555\nOPTION TrAdINg STrATegIeS\n 2. buy spot gold. The jeweler can buy spot gold and store it until August. In this case, he locks \nin apurchase price of $1,198.90/oz plus carrying costs (interest, storage, and insurance). This \napproach eliminates price risk, but also removes the potential of benefiting from any possible \nprice decline.\n 3. buy gold futures. The jeweler can purchase one contract of August gold futures, thereby \nlocking in aprice of $1,200/oz. The higher price of gold futures vis-à-vis spot gold reflects the \nfact that futures embed carrying costs. Insofar as the price spread between futures and spot gold \nwill be closely related to the magnitude of carrying costs, the advantages and disadvantages of \nthis approach will be very similar to those discussed in the above strategy.\n 4. buy an at-the-money call. Instead of purchasing spot gold or gold futures, the jeweler could \ninstead buy an August $1,200 gold futures call at apremium of $38.80/oz. The disadvantage of \nthis approach is that if prices advance the jeweler locks in ahigher purchase price: $1,238.80/\noz. However, by purchasing the call, the jeweler retains the potential for asubstantially lower \npurchase price in the event of asharp interim price decline. Thus, if, for example, spot prices \ndeclined to $1,050/oz by the time of the option expiration, the jeweler’spurchase price would \nbe reduced to $1,088.80/oz (the spot gold price plus the option premium).\n6 In effect, the pur-\nchase of the call can be viewed as aform of price risk insurance, with the cost of this insurance \nequal to the “premium.”\n7\n 5. buy an out-of-the-money call. As an example, the jeweler could purchase an August \n$1,300 gold futures call at apremium of $9.10/oz. In this case, the jeweler forgoes protection \nagainst moderate price advances in exchange for reducing the premium costs. Thus, the jeweler \nassures he will have to pay no more than $1,309.10/oz. The cost of this price protection is $910 \nas opposed to the $3,880 premium for the at-the-money call. In asense, the purchase of the \nout-of-the-money call can be thought of as aprice risk insurance policy with a “deductible.” As \nin the case of purchasing an at-the-money call, the jeweler would retain the potential of benefit-\ning from any interim price decline.\nAs should be clear from the above discussion, options meaningfully expand the range of choices \nopen to the hedger. As was the case for speculative applications, the choice of an optimal strategy will \ndepend on the trader’s (hedger’s) individual expectations and preferences. It should be stressed that \nthis section is only intended as an introduction to the concept of using options for hedging. Acompre-\nhensive review of hedging strategies would require afar more extensive discussion.\n6 Technically speaking, since gold futures options expire before the start of the contract month, the effective \npurchase price would be raised by the amount of carrying costs for the remaining weeks until August.\n7 The use of futures for hedging is also often described as “insurance.” However, in this context, the term is \nmisapplied. In standard application, the term insurance implies protection against acatastrophic event for acost \nthat is small relative to the potential loss that is being insured. In using futures for hedging, the potential cost is \nequivalent to the loss protection. For example, if the jeweler buys gold futures, he will protect himself against \na $10,000 increase in purchase cost if prices increase by $100/oz, but he will also realize a $10,000 loss on \nhis hedge if prices decline by $100/oz. In this sense, the use of the call for hedging comes much closer to the \nstandard concept of insurance: the magnitude of the potential loss being insured is much greater than the cost \nof the insurance.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:573", "doc_id": "79ecde0e4cf3de6647177995d7fc26c0d83e43e5a2e228c1d99db1415f87a848", "chunk_index": 0}
{"text": "685\nAchievement, elements of, 586–587\nAcreage figures, 355\nAction, taking, 583\nActual contract series, 279–280\nAdjusted R\n2, 642\nAdjusted rate mortgages (ARMs), 423, 424\nAdvice, seeking, 580\nAgricultural markets. See also U.S. Department of \nAgriculture (USDA)\nacreage figures, 355\ncattle (see Cattle)\ncorn (see Corn)\ncotton (see Cotton)\ngrain prices and, 351\nhogs (see Hog production)\nproduction costs and, 351\nseasonal considerations and, 356\nwheat (see Wheat market)\nAMR. See Average maximum retracement (AMR)\nAnalogous season method, 374\nAnalysis of regression equation:\nautocorrelation and (see Autocorrelation)\ndummy variables and, 659–663\nDurbin-Watson statistic, as measure of \nautocorrelation, 652–654\nheteroscedasticity and, 672–673\nmissing variables, time trend and, 655–658\nmulticollinearity and, 663–666\noutliers and, 649–673\nresidual plot, 650–651\ntopics, advanced, 666–671\napriori restriction, 660\nArbitrage, pure, 530\nARMs. See Adjusted rate mortgages (ARMs)\nAt-of-the-money call, buying, 555\nAt-of-the-money options\ndefinition of, 480\ndelta values and, 485\nATR. See Average true range (ATR)\nAutocorrelation:\ndefinition of, 651\nDurbin-Watson statistic as measure of, 652–654\nimplications of, 654–655\ntransformations to remove, 670–671\nAvailability of substitutes, 361\nAverage maximum retracement (AMR), 331\nAverage parameter set performance, 311\nAverage percentage method, seasonal index, \n391–394\nAverage return, 323, 326\nAverage true range (ATR), 262, 463\nBackward elimination, stepwise regression, 682\nBad luck insurance, 257\nBalanced spread, 455\nBalance table, 373–374\nBar charts, 35–39\nBear call money spread, 535–538\ncase 1: short call with lower strike price/long call \nwith higher strike price, 535–536\ncase 2: short call with lower strike price/long call \nwith higher strike price, 537–538\nIndex", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:703", "doc_id": "cd7691b4737bb3df49c619a3118a6fb7dc64aa00426dc0d14073f569a0b04ea6", "chunk_index": 0}
{"text": "686\nIndex\nBullishness:\nbullish put trade, 477\nfundamentals and, 349\nmarket response analysis and, 404, 405\nBullish Texas option hedge, 517–519\nBull market:\nflags, pennants and, 131–132\nintramarket spreads and, 460\nrun days in, 118\nspread trades and, 443\nthrust days and, 116, 117\nBull put money spread:\ncase 1: long put with lower strike price/short put \nwith higher strike price, 538–539\ncase 2: long put with lower strike price/short put \nwith higher strike \nprice, 540\n“Bull trap”:\nabout, 205–211\nconfirmation conditions, 208, 209\nButterfly spread, 542\nBuy and sell signals, trend-following systems and, \n252\nBuy hedge, cotton mill, 12–13\nCall options, 477\nCalmar ratio, 331\nCalmness, 585\nCancel if close order. See CIC (cancel if close) order.\nCandlestick charts, 43–44\n“real body,” 43, 44\n“shadows,” 43\nCarrying-charge markets, 282\nCarrying charges, limited-risk spread and, 446, \n447–448\nCarryover stocks, 355, 432–433\nCase-Shiller Home Price Index, 423, 424\nCash settlement process, 4\nCash versus futures price seasonality, 389–390\nCattle:\ncattle-on-feed numbers, 352–354\nfutures, 348, 385\ninflation and, 385\nproduction loss, 351\nspread trades and, 444–445\nCentral limit theorem, 609–612\nChange of market opinion, 204\nBearishness:\nbearish put trade, 477\nfundamentals and, 349\nmarket response analysis and, 404, 406\nBearish Texas option hedge, 519–520\nBear market:\nof 1980-1982, 366–367\nflags, pennants and, 133–134\nrun days in, 118, 119\nspread trades and, 443\nthrust days and, 116\n“Bear trap”:\nabout, 205–211\nconfirmation conditions, 208, 210\nBeat the Dealer, 587\nBell-shaped curve, 601\nBenchmark, 327\nBernanke, Ben, 431–432\nBest fit, regression analysis and, 591–593\ndeviations, 591–592\nleast-squares approach, 592–593, 594\n“Best linear unbiased estimators” (BLUE), 621\nBet size, variation in, 581\n“Black box” system, 576\nBlind simulation approach, system optimization, 311\nBLASH approach, 27–28\nBLUE. See “Best linear unbiased estimators” (BLUE)\nBottom formations. See Top and bottom formations\nBowe, James, 482–483\nBox size, 42\nBreakout(s), 86–89\nconfirmation of, 86\ncontinuation patterns and, 180–181\ncounter-to-anticipated, flag or pennant, 219–222\ndefinition of, 33\ndownside, 87, 88\nfalse signals for, 151, 153\nfalse trend-line, 211–213\nflags, pennants and, 128\nopposite direction breakout of flag or pennant \nfollowing normal, 222–225\nupside, 87, 89\nwinning signals for, 152, 153\nBreakout systems, 243–244\nBritish pound (BP), intercurrency spreads and, \n472–473\nBull call money spread, 534–535", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:704", "doc_id": "b236d44a772a595af3dc4f6e9e0e0663e69172ea7fa055f1da49679943a95212", "chunk_index": 0}
{"text": "687\nIndex\nComfortable choices, trading principles \nand, 584\nComfort zone, trading within, 577\nCommissions, 19\nCommodities:\nbearing little or no relationship to general rule, \n444–445\nconforming to inverse of general rule, 444\ndemand curves and, 361\ngeneral spread trade rule and, 443–444\nintercommodity spread and, 441–442\nnonstorable, 351, 360, 444\nperishable, 360, 364\nCommodities, 357\nCommodity Traders Consumers Report, 434\nCommodity trading advisors (CTAs), 23, 578\nComparing indicators, 157–165\ndifference indicators, 158, 159\nindicator correlations, 161–162, 163\npopular comparisons, 164\nComparisons:\nnominal price levels, 355\none-year, 350\ntwo managers, 320–322\nCompounded return, 323\nComputer testing of trading systems. See Testing/\noptimizing trading systems\nConfidence, 579–580\nConfidence interval(s), 612–614\nfor an individual forecast, 627–629\nmultiple regression model and, 642\nConfirmation conditions, 247–250\nbull or bear trap, 208\npattern, 249, 250\npenetration as, 248\ntime delay and, 248–249\nConfirmation myth, 170\nCongestion phases. See Continuation patterns\nConsistency, 582\nConstant-forward (“perpetual”) series, 281–282\nConsumer price index (CPI), 383\nConsumption:\ndefinition of, 363\ndemand and, 357, 363–366\nprice and, 364\nas proxy for inelastic demand, 370\nContingent order, 18\nChart(s):\nBLASH approach, 27–28\nequity, 566\nlinked-contract (see Linked-contract charts)\nRandom Walkers and, 29–34\ntypes of (see Chart types)\nChart analysis, 149–154\nconfirmation conditions and, 150\nfalse breakout signals, 151, 153\nlong-term chart, 152, 154\nmost important rules in, 205–231\nspread trades and, 449\ntrading range and, 150\nwinning breakout signals, 152, 153\nChart-based objectives, 189\nChart patterns, 109–147\ncontinuation patterns, 123–134\nflags and pennants (see Flags and pennants)\nhead and shoulders, 138–141\none-day patterns (see One-day patterns)\nreversal days, 113–116, 147\nrounding tops and bottoms, 141–143\nrun days, 116, 118–119\nspikes (see Spikes)\nthrust days, 116, 117\nTop and bottom formations (see Top and bottom \nformations)\nTriangles (see Triangles)\nwedge, 146–147\nwide-ranging days (see Wide-ranging days)\nChart types, 35–44\nbar charts, 35–39\ncandlestick charts, 43–44\nclose-only (“line”) charts, 40–42\nlinked contract series: nearest futures versus \ncontinuous futures, 39–40\npoint-and-figure charts, 42–43\nCIC (cancel if close) order, 188\nClose-only (“line”) charts, 40–42\nCME/COMEX contract, 459\nCochrane-Orcutt procedure, 671\nCode parameter, 293\nCoefficient of determination (r\n2), 630–633\nCoffee:\nintercommodity spreads and, 453–454, 456\nseasonal index and, 400\nspread trade example, 445–446", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:705", "doc_id": "11b5a1b50b4c2935515a981ded7d5dec1616286b130033f9ddbe016dfccd2dde", "chunk_index": 0}
{"text": "688\nIndex\nCountertrend systems, 254–256\ncontrary opinion, 256\ndefinition of, 236\nfading minimum move, 255\nfading minimum move with confirmation delay, 255\ngeneral considerations, 254–255\noscillators, 255\ntypes of, 255–256\nCountertrend trade entry signals, 182\nCovered call write, 526–527\nCovered put write, 527–528\nCPI. See Consumer price index (CPI)\nCR\n2 (corrected R2), 642–643\nCRB Commodity Yearbook, 414\nCredit spread, 535\nCrop reports, 434\nCrop years, intercrop spread and, 441\nCrossover points, moving averages and, 182\nCrude oil market. See also WTI crude oil\nmoney stop and, 185\npoor timing and, 425\nseasonal index and, 399\nCTAs. See Commodity trading advisors (CTAs)\nCurrency futures, 471–476\nintercurrency spreads, 471–473\nintracurrency spreads, 473–476\nCurvature, breaking of, 229, 230\nDaily price limit, 8–9\nData errors, 679\nData insufficiency, conclusions and, 357\nData vendors, futures price series selection and, 287\nDay versus good-till-canceled (GTC) order, 16\nDegrees of freedom (df), 615, 640, 644\nDeliverable grade, 9\nDelivery, 4\nDelta (neutral hedge ratio), 484–485\nDemand:\nconsumption and, 357, 363–366\ndefinition of, 359–362, 363\nelasticity of, 361–362\nhighly inelastic, 370–371\nincorporation of (see Incorporation of demand)\nincrease in, 364\ninflation and, 355\nprice and, 362–363\nquantifying, 362–363\nstable, 368\nContinuation patterns, 123–134\nflags and pennants (see Flags and pennants)\ntrading range breakouts and, 180–181\ntriangles (see Triangles)\nContinuous (spread-adjusted) price series, \n282–285\nContinuous distribution, 600–601\nContinuous futures. See also Nearest vs. continuous \nfutures\nprice gaps and, 282\nrule of seven and, 194–196\nContinuous futures charts:\ncreation of, 47\nmeasured moves and, 190–193\nnearest futures vs., 39–40\nContinuous parameter, 292–293\nContract months, 5, 8\nContract rollovers. See Rollover dates\nContract size, 5\nContract specifications:\nabout, 5–9\nsample, 6–7\nContrary opinion, 203–204, 256\nConversion, 530\nCopper:\ninflation and, 385\nprice-forecasting model, 366–367\nprice moves and, 428, 429\nCorn:\nethanol production and, 680\nintercommodity spreads and, 457–459\nmajor resistance area and, 427\nprice movements and, 430\nproduction, 348\nseasonal index and, 401\nunexpected developments and, 419, \n420, 421\nCorrected R\n2 (CR2), 642–643\nCorrelation coefficient (r), independent variables \nand, 665–666\nCorrelation matrix, 666\nCosts. See also Carrying charges\nproduction, price declines and, 351–352\ntransaction, 295–296, 313\nCotton:\ncarryover and, 432–433\nunexpected developments and, 418\nyields, 355", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:706", "doc_id": "9f791138d59d35cfba27076bddb84dcfdbcba71c3bfc3278e6a5e25a1d201bd6", "chunk_index": 0}
{"text": "689\nIndex\nDummy variables, 659–663\nDurbin-Watson statistic, as measure of \nautocorrelation, 652–654\nEckardt, Bill, 578, 584\nEdge, having an, 576\nEfficient market hypothesis, 428, 431\nElasticity of demand, 361–362\nElementary statistics, 597–618\ncentral limit theorem, 609–612\nconfidence intervals, 612–614\nmeasures of dispersion, 597–599\nnormal curve (Z) table, reading, 604–606\npopulation mean, 607\npopulations and samples, 606\nprobability distributions, 599–604\nsampling distribution, 608–609\nstandard deviation, 599, 607\nt-test, 614–618\nE-Mini Dow:\ndescending triangle, 127\nfutures, uptrend line, 60\nintermarket stock index spreads, 461–470\nE-Mini Nasdaq 100:\ndouble bottom, 135, 137\ndowntrend lines and, 67\nflags and pennants, 130\nintermarket stock index spreads, 461–470\nuptrend lines and, 59, 61\nwide-ranging down bar, 123\nE-Mini S&P 500:\nintermarket stock index spreads, 461–470\nmarket response analysis and, 408, 409\noptions on futures and, 482, 484\nprice envelope bands and, 107, 108\nseasonal index and, 399\ntrend lines and, 74\nupthrust/downthrust days and, 117\nEmployment report:\nstock index futures response to, 408–409\nT -Note futures response to monthly, 404–407\nENPPT . See Expected net profit per trade (ENPPT)\nEqual-dollar-spread ratio, 472\nEqual-dollar-value spread, 455–460\nEqually weighted term, 453\nEquilibrium, 363, 365\nEquity change, intercurrency spreads and, 472–473\nEquity chart, 566\nDemand curve, 359, 361\nDemand-influencing variables, 368–370\nDeMark, Thomas, 66, 69, 199\nDeMark sequential, 199–203\nDependent variable, determining, 675–676\nDetrended seasonal index, 394\nDeviation:\ndefinition of, 623\ntotal, 630–631\nDiagonal spread, 542\nDiary, maintaining trader’s, 565\nDifference indicators:\nClose – Close vs. Close – MA, 158\nratio versions, 159\nDiscipline, 578\nDiscrete parameter, 293\nDiscrete variable, 600\nDiscretionary traders, losing period adjustments, \n562–563\nDisloyalty/loyalty, 583–584\nDispersion, measures of, 597–599\nDisturbance, definition of, 623\nDiversification:\nplanned trading approach and, 560, 561–562\ntrend-following systems and, \n256–258\nDividends, 462\nDollar:\nequal-dollar-value spread, 455–460\nintercurrency spreads and, 471\nprice, 383\nDollar value, option premiums and, \n477–478\nDouble top, penetration of, 227–229\ncurvature, breaking of, 229\nDouble tops and bottoms:\ndouble bottom, 137–138\ndouble top, 136\ntriple top, 129\nDown run day, 118, 268\nDownthrust day, 116\nDowntrend channels, 62, 63\nDowntrend lines:\ndefinition of, 57\nexamples of, 59, 61, 65\nfalse breakout signals, 211, 213\nDriehaus, Richard, 578, 585\nDruckenmiller, Stanley, 581, 584", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:707", "doc_id": "1ba5a46d846abbf659af38d0d5d1b647b7f9ef005423ace9164322174765cd19", "chunk_index": 0}
{"text": "691\nIndex\nGeneric trading systems:\nbreakouts (see Breakout systems)\nmoving averages and, 237–243\nGold:\nfundamental analysis and, 347, 371\nfutures (see Gold futures)\nintramarket stock index spreads and, 461\nmarket response analysis and, 410\nprices, 284\nseasonal index and, 400\nspot, buying, 555\nGold futures:\nbuying, 555\nvolume shift in, 10\nGold/silver spread, 454\nGood-till-canceled (GTC) orders. See GTC orders\nGovernment regulations, potential impact \nof, 415\nGovernment reports, unexpected developments \nand, 420\nGPR (gain-to-pain ratio), 328–329\nGrain prices, 351\nGreat Recession, 423\nGresham’slaw of money, 312\nGrinder, John, 586\nGross domestic product (GDP):\ndeflator, 383\nindependent variables and, 677\nGTC orders:\nabout, 16\norder placement and, 568\nstop-loss points and, 183, 188\ntrade exit and, 569\nHard work, skill versus, 576–577\nHead and shoulders:\nabout, 138–141\nfailed top pattern, 227–229\nHeating oil:\nalternative approach, 396–397\naverage percentage method, 391, 392–394, \n398\nlink relative method, 394–396, 398\nHedge, definition of, 517\nHedge ratio, neutral (delta), 484–485\nHedging, 11–13\napplications, 554–555\nbuy hedge, 12–13\nFundamental analysis:\nabout, 16\nanalogous season method, 374\nbalance table, 373–374\ndanger in using, 417\ndiscounting and, 428–430\nexpectations, role of, 379–381\nfallacies. see Fallacies\nforecasting model, building, 413–415\ngold market and, 371\nindex models, 376–377\ninflation, incorporation of, 383–388\nlong-term implications versus short-term \nresponse, 432–435\nmarket response analysis (see Market response \nanalysis)\nmoney management and, 426–427\n“old hand” approach, 373\npitfalls in, 418–426\nreasons to use, 427–428\nregression analysis, 374–375\nseasonal analysis and, 389–401\nspread trades and, 449\nsupply-demand analysis, 359–371\ntechnical analysis and, 21–24, 417–418, 426–427\ntrading and, 417–435\ntypes of, 373–377\nFundSeeder.com, 343\nFutures markets, nature of, 3–4\nFutures price series selection, 279–288\nactual contract series, 279–280\ncomparing the series, 285–287\nconstant-forward (“perpetual”) series, 281–282\ncontinuous (spread-adjusted) price series, 282–285\nnearest futures, 280\nGain(s):\nexpected, 550, 551\nmaximization of, 583\nGain-to-pain ratio (GPR), 328–329\nGardner, John, 314\nGDP . See Gross domestic product (GDP)\nGeneral rule, spreads, 443–445\nabout, 443\napplicability and nonapplicability, 443–444\ncommodities bearing little or no relationship to, \n444–445\ncommodities conforming to inverse of, 444", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:709", "doc_id": "286b828b0b6862ebd29ac0f0c92fe8a858ebb17f1e9614e18e2d612137949272", "chunk_index": 0}
{"text": "692\nIndex\nIntercurrency spreads, 471–473\nequity change and, 472–473\nreasons for implementing, 471–472\nInterest rate differentials, intracurrency spreads and, \n473, 476\nInterest rate parity theorem, 475\nInterest rate ratios, intracurrency spreads \nand, 475\nInterest rates:\noption premiums and, 482–483\nrecession and, 367\nIntermarket spreads, 442, 453, 462–470\nInternal trend lines, 73–78\nalternate, 75\nversus conventional, 74, 76–77\nsupport and resistance and, 106\nInternational Cocoa Agreement, 356\nInternational Sugar Agreement, 356\nIn-the-money options:\ndefinition of, 480\ndelta values and, 485\nIntracurrency spreads, 473–476\ninterest rate differentials and, 473, 476\ninterest rate ratios and, 475\nIntramarket (or interdelivery) spread, 441\nIntramarket stock index spreads, 461–462\nIntrinsic value, of options, 489\nIntuition, 586\nInvestment insights, 343\nJapanese stock market, 22\nJapanese yen (JY), intercurrency spreads and, 471\nJobs report. See Employment report\nKitchen sink approach, 312\nKuwait, 1990 invasion of, 420\nLast notice day, 9\nLast trading day, 9\nLeading Indicator myth, 171–172\nLeast-squares approach, 592–593, 594\nLefèvre, Edwin, 178, 570, 580–581\nLessons, trader’sdiary and, 565\nLeverage:\nnegative, 320\nrisk and, 320\nthrough borrowing. see Notional funding\nLimit days, automatic trading systems and, 296\nfinancial markets and, 13–14\ngeneral observations on, 13–15\nsell hedge, 11–12\nHeteroscedasticity, 672–673\nHidden risk, 320\nHildreth-Lu procedure, 671\nHite, Larry, 585\nHog production:\nfundamentals and, 348, 350, 356\nregression analysis and, 374, 589–591\nregression equation and, 633\nsupply-demand analysis and, 360, 365\nHope, as four-letter word, 584\nHousing market:\nCase-Shiller Home Price Index, 423\nhousing bubble, 2003-2006, 423, 425\nImplied volatility, 483–484\nIncorporation of demand:\ndemand change, growth pattern in, 368\ndemand-influencing variables, identification of, \n368–370\nhighly inelastic demand (and supply elastic \nrelative to demand), 370–371\nmethods for, 367–371\nneed for, 366–367\nstable demand, 368\nIndependence, 579\nIndependent variables:\nforecasting model, building, 415\nmulticollinearity and, 665\nregression analysis and, 677, 679\nIndex models, 376–377\nIndividual contract series, 279–280\nInflation:\nadjustments, 355\nprice data for, 414\nprice-forecasting models and, 383–388\nInflationary boom, 422\nInflation indexes, 383\nInformation, viewing old as new , 349–350\nIntelligence, 582–583\nIntercommodity spreads, 441–442. See also Limited-\nrisk spread\nabout, 441–442\ncontract ratios and, 453–460\nIntercrop spreads, 441, 460\nHedging (continued)", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:710", "doc_id": "9dfc18401c957be85bf186f67268b0cf8039a95ffb8e8ca68f0a95ea4985b9ff", "chunk_index": 0}
{"text": "693\nIndex\nMarket(s):\nagricultural, 351\nbear (see Bear market)\nbull (see Bull market)\ncorrelated, leverage reduction and, 562\nexcitement and, 585\nexiting position and, 584–585\nfree, 357\nhousing (see Housing market)\nnonrandom prices and, 587\nplanned trading approach and, 560\ntrading results and, 317\nMarket characteristic adjustments, trend-following \nsystems and, 251–252\nMarket direction, 449\nMarket hysteria, 585\nMarket-if-touched (MIT) order, 18\nMarket observations. See Rules, trading\nMarket opinion:\nappearances and, 582–583\nchange of, 204\nMarket order, 16\nMarket patterns, trading rules and, 572–573\nMarket Profile trading technique, 585\nMarket psychology, shift in, 429\nMarket response analysis, 403–411\nisolated events and, 409–410\nlimitations of, 410–411\nrepetitive events and, 403–410\nstock index futures response to employment \nreports, 408–409\nT -Note futures response to monthly U.S. \nemployment report, 404–407\nMarket Sense and Nonsense: How the Markets Really Work, \n319\nMarket statistics, balance table and, 373–374\nMarket wizard lessons, 575–587\nMarket Wizards books, 575, 579, 580, 581, 585, 586\nMAR ratio, 330, 335\nMBSs. See Mortgage-backed securities (MBSs)\nMcKay, Randy, 576, 581, 583\nMeasured moves (MM), 190–193\nMeasures of dispersion, 597–599\nMechanical systems. See Technical trading systems\nMetals. See Copper; Gold market\nMethod:\ndetermination of, 576\ndevelopment of, 576\nLimited-risk spread, 446–448\nLimit order, 17\n“Line” (close-only) charts, 40–42\nLinearity, transformations to achieve, 666–669\nLinearly weighted moving average (LWMA), \n239–240\nLinked-contract charts, 45–56\ncomparing the series, 48\ncontinuous (spread-adjusted) price series, 47\ncreation of, methods for, 46–48\nnearest futures, 46–47\nnearest vs. continuous futures, 39–40, 48–51, \n52–56\nnecessity of, 45–46\nLinked contract series: nearest futures versus \ncontinuous futures, 39–40\nLink relative method, seasonal index, 394–396\nLiquidation information, 564\nLive cattle. See Cattle\nLivestock markets, 287. See also Cattle; Hog \nproduction\nLong call (at-the-money) trading strategy, 491–492\nLong call (out-of-the-money) trading strategy, \n493–494\nLong futures trading strategy, 489–490\nLong put (at-the-money), 503–504\nLong put (in-the-money), 506–508\nLong put (out-of-the-money), 504–506\nLong straddle, 515–516\nLong-term implications versus short-term response, \n432–435\nLong-term moving average, reaction to, 181–182\nLook-back period, 173\nLosing period adjustments, planned trading \napproach and, 562–563\nLosing trades, overlooking, 313\nLosses:\npartial, taking, 583\ntemporary large, 245\nLoyalty/disloyalty, 583–584\nLumber, inflation and, 384\n“Magic number” myth, 170\nManagers:\ncomparison of two, 320–322\nnegative Sharpe ratios and, 325\nMAR. See Minimum acceptable return (MAR)\nMargins, 19", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:711", "doc_id": "0de21b8d92199039c001288ea2dd82fa1f47a280083399ad45b2fc5a30677c29", "chunk_index": 0}
{"text": "695\nIndex\nOption trading strategies, 487–555\ncomparing, 487–489\nhedging applications and, 554–555\nmultiunit strategies, 543–544\noptimal, choosing, 544–554\nprofit/loss profiles (see Profit/loss profile)\nspread strategies, other, 542–543\nOrders, types of, 16–19\nOrdinary least squares (OLS), 654\nOrganization of the Petroleum Exporting Countries \n(OPEC), 356, 425\nOriginal trading systems, 261–278\nrun-day breakout system, 268–273\nrun-day consecutive count system, 273–278\nwide-ranging-day system (see Wide-ranging-day \nsystem)\nOscillators, 167–170, 255\nOut-of-the-money call, buying, 555\nOut-of-the-money options:\ndefinition of, 480\ndelta values and, 485\nOutright positions, spread tables and, 440, 441\nOverbought/oversold indicators, 198–199\nParabolic price moves, 585\nParameter(s):\ndefinition of, 291, 606\ntypes of, 292–293\nParameter set:\naverage performance, 311\ndefinition of, 291\nParameter shift, trend-following systems \nand, 247\nParameter stability, optimizing systems \nand, 297\nPast performance, evaluation, 319–341\ninvestment insights, 343\nreturn alone, 319–322\nrisk-adjusted return measures, 323–335\nvisual (see Visual performance evaluation)\nPatience, virtue of, 580–581\nPattern(s). See also Chart patterns; Continuation \npatterns; One-day patterns\nmarket, 572–573\nseasonal, 415\nPattern recognition systems, definition of, 237\nPenetration of top and bottom formations, 225–229\nObservations, market. See Rules, trading\nOCO (one-cancels-other) order, 18\nOil. See Crude oil market; Heating oil; WTI \ncrude oil\n“Old hand” approach, 373\nOLS (Ordinary least squares), 654\nOne-cancels-other (OCO) order, 18\nOne-day patterns:\nabout, 109–123\nspikes, 109–113\nOne-tailed test, 614, 617\nOne-year comparisons, 350\nOPEC. See Organization of the Petroleum Exporting \nCountries’ (OPEC)\nOpen interest, volume and, 9–10\nOpen-mindedness, 585\nOptimization:\ndefinition of, 297\npast performance and, 313\nOptimization myth, 298–310\nOptimizing systems, 297–298\nOption(s):\nfair value of, theoretical, 483\nqualities of, 489\nOption premium curve, theoretical, 481\nOption premiums, 480–483\ncomponents of, 480\ninterest rates and, 482–483\nintrinsic value and, 480\nstrike price and current futures price, 480–481\ntheoretical versus actual, 483–484\ntime remaining until expiration, \n481–482\ntime value and, 480–483\nvolatility and, 482\nOption-protected long futures:\nlong futures + long at-the-money put, 520–521\nlong futures + long out-of-the-money put, \n522–523\nOption-protected short futures:\nshort futures + long at-the-money call, 523–524\nshort futures + long out-of-the-money call, \n524–525\nOptions on futures, 477–485\nabout, 477–479\ndelta and (neutral hedge ratio), 484–485\noption premiums and (see Option premiums)", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:713", "doc_id": "856cbb8e15d11b80e6b4735f8eeb4a0ab49f37e8ef6dd46ed26a37fa13e7ae3d", "chunk_index": 0}
{"text": "696\nIndex\nPreforecast period (PFP) price, 677–678\nPremium(s):\ndefinition of, 477\ndollar value of option, 477–478\nPrice(s):\nconsumption and, 364\ndollar price, 383\ngrain, 351\nnonrandom, 587\npreforecast period (PFP) price, 677–678\nstrike or exercise, 477\nsupply, demand and\nswings (see Price swings)\ntarget levels and, 356–357\nPrice changes, price series and, 285\nPrice envelope bands, 107–108\nPrice-forecasting models:\nadding expectations as variable in, 380\ndemand and, 366–367\ninflation and, 383\nPrice-indicator divergences, 171–172\nPrice levels:\nnearest futures and, 91, 101\nnearest futures price series and, 48\nnominal, comparing, 355\nprice series and, 285\nPrice movements:\ndramatic, 428\nfitting news to, 431–432\nlinked series and, 286\nparabolic, 585\ntrend-following systems and, 245, 246\nPrice oscillator, 163\nPrice quoted in, 5\nPrice reversals, 229\nPrice seasonality, cash versus futures, 389–390\nPrice-supporting organizations, 356\nPrice swings:\nnearest futures and, 101\nnearest futures price series and, 48\nPrice trigger range (PTR), 262\nProbability:\ndistributions, 599–604\nheads and tails coin tosses, 390\nreal versus, 390–391\nProbability-weighted profit/loss ratio (PWPLR), \n550–551\nProducer price index (PPI), 383\nPennants. See Flags and pennants\nPeople’s Republic of China (PRC), 418\nPercent retracement, reversal of minor reaction, \n179–180\nPercent return, optimizing systems and, 297\nPerformance evaluation, visual. See Visual \nperformance evaluation\nPerishable commodities, 360\n“Perpetual” (constant-forward) series, 281–282\nPersonality, trading method and, 576\nPersonal trading, analysis of, 565–566\nPerspective:\nkeeping, 587\nlack of, 351\nPetroleum. See Crude oil market; Heating oil; \nOrganization of the Petroleum Exporting \nCountries’ (OPEC); WTI crude oil\nPhilosophy, trading, 559, 578\nPivotal events, 422\nPlanned trading approach, 559–566\nmarkets to be traded, 560\npersonal trading, analysis of, 565–566\nplanning time routine and, 563\nrisk control plan (see Risk control plan)\ntrader’sdiary, maintaining, 565\ntrader’sspreadsheet, maintaining, 563–564\ntrading philosophy and, 559\nPoint-and-figure charts, 42–43\nPopulation, definition of, 598\nPopulation mean, estimation of, 607\nPopulation regression line, 619–620\nPopulations and samples, 606\nPosition, trading around, 581–582\nPosition exit criteria, 189–204\nchange of market opinion, 204\nchart-based objectives, 189\ncontrary opinion, 203–204\nDeMark sequential, 199–203\nmeasured moves, 190–193\noverbought/oversold indicators, 198–199\nrule of seven, 194–196\nsupport and resistance levels, 196–197\ntrailing stops, 204\nPPI. See Producer price index (PPI)\nPRC. See People’s Republic of China (PRC)\nPrecious metals market. See also Gold market\ncarrying charges and, 446\ndemand and, 362", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:714", "doc_id": "28acefd797a8e63f1ecb174cd582fd8ef5165c8113bbb3488ee6f107fac4607d", "chunk_index": 0}
{"text": "697\nIndex\nPrudence, 583\nPTR. See Price trigger range (PTR)\nPure arbitrage, 530\nPWPLR. See Probability-weighted profit/loss ratio \n(PWPLR)\nPyramiding:\nmidtrend entry and, 182\nrejected signals and, 251\ntrend-following systems and, 252–253\nQuantum Fund, 22\nRandom error, 628, 679\nRandom sample, definition of, 608\nRandom variable, 599\nRandom Walkers, 29–34\nRate of change, 163\nRatio call write, 532–534\nReaction count, 179–180\nRecession, severe, 367. See also Great Recession\nRegression analysis, 589–595, 675–683\nabout, 374–375, 589–591\nassumptions of, basic, 620\nbest fit, meaning of, 591–593\ndependent variable, determining, 675–676\nexample, practical, 593\nforecast error and, 679–680\nindependent variables, selecting, 677\nleast-squares approach, 592–593, 594\npractical considerations in applying, 675–683\npreforecast period (PFP) price and, 677–678\nregression forecast, reliability of, 593–595\nsimulation, 680–681\nstep-by-step procedure, sample, 682–683\nstepwise regression, 681–682\nsurvey period length and, 678–679\nRegression coefficients:\ncomputing t-value for, 626\nmulticollinearity and, 665\nsampling distribution of, 621\ntesting significance of, 620–626\nRegression equation, 619–635\nanalyzing (see Analysis of regression equation)\ncoefficient of determination R\n2, 630–633\nconfidence interval for an individual forecast, \n627–629\nextrapolation, 630\nmisspecification and, 679\nProduction costs, price declines and, 351–352\nProfit(s):\npartial, pulling out, 584\nslow systems and, 245, 246\nwinning trades and, 570–571\nProfit/loss matrix, short puts with different strike \nprices, 514\nProfit/loss profile:\nalternative bearish strategies, three, 548\nalternative bullish strategies, three, 547\nalternative neutral strategies, two, 549\nbear call money spread, 536, 538\nbearish “Texas option hedge,” 520\nbear put money spread, 539, 542\nbull call money spread, 535\nbullish “Texas option hedge,” 518\nbull put money spread, 541\ncovered call write, 527\ncovered put write, 528\ndefinition of, 488\nkey option trading strategies and, 489–542\nkey trading strategies and, 489–542\nlong call (at-the-money), 492, 495\nlong call (out-of-the-money), 494\nlong futures, 490\nlong futures and long call comparisons, 497\nlong futures and short put comparisons, 514\nlong put (at-the-money), 504\nlong put (in-the-money), 507\nlong put (out-of-the-money), 505\nlong straddle, 516\noption-protected long futures, 521, 522\noption-protected short futures, 524, 525\nratio call write, 533\nshort call (at-the-money), 498\nshort call (in-the-money), 501\nshort call (out-of-the-money), 500\nshort futures, 491\nshort futures and long put comparisons, 509\nshort futures and short call comparisons, 503\nshort put (at-the-money), 510\nshort put (in-the-money), 513\nshort put (out-of-the-money), 511\nshort straddle, 517\nsynthetic long futures, 529\nsynthetic short futures, 532\ntrading strategies and, 488–489\ntwo long calls vs. long futures, 544", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:715", "doc_id": "4f85edd20f9db8d1e708aafd67ed44d96c3fc79db9834312c30727798c00eec1", "chunk_index": 0}
{"text": "699\nIndex\ndetrended, 394\nlink relative method, 394–396, 398\nSeasonal patterns, forecasting model, 415\nSecuritizations, 423\nSEE. See Standard error of the estimate (SEE)\nSegmented trades, analysis of, 565–566\nSell hedge, cotton producer, 11–12\nSell signals, trend-following systems and, 252\nSER. See Standard error of the regression (SER)\nSeries selection. See Futures price series selection\nSettlement type, 9\nSharpe ratio, 323–325, 334, 343. See also Symmetric \ndownside-risk (SDR) Sharpe ratio\nShort call (at-the-money) trading strategy, \n498–499\nShort call (in-the-money) trading strategy, 500–502\nShort call (out-of-the-money) trading strategy, \n499–500\nShort futures trading strategy, 490–491\nShort put (at-the-money), 509–510\nShort put (in-the-money), 512–513\nShort put (out-of-the-money), 510–512\nShort straddle, 516–517\nShort-term response versus long-term implications, \n432–435\nSideways market, moving averages and, 79, 81\nSignal price, limit days and, 296\nSignals, failed, 205, 206\nSimple moving average (SMA), 165–167\nSimple regression, 625\nSimulated results, 312–313\nfabrication, 313\nkitchen sink approach, 312\nlosing trades, overlooking, 313\noptimization and, 317\nrisk, ignoring, 312–313\nterminology and, 311\ntransaction costs, 313\nwell-chosen example, 312\nSimulation, blind, 311\nSingle market system variation (SMSV), 256–257\nSkill, hard work versus, 576–577\nSklarew , Arthur, 194\nSlippage:\nautomatic trading systems and, 295\nsampling distribution and, 608\ntransaction costs and, 291\ntrend-following systems and, 247\nRules, trading, 567–574\nanalysis and review of, 573–574\nmarket patterns and, 572–573\nmiscellaneous, 571–572\nrisk control (money management), 569–570\ntrade entry, 568–569\ntrade exit, 569–570\nwinning trades, holding/exiting, 570–571\nRun-day breakout system, 268–273\nbasic concept, 268\ndaily checklist, 269\nillustrated example, 270–273\nparameters, 269\nparameter set list, 270\ntrading signals, 269\nRun-day consecutive count system, 273–278\nbasic concept, 273\ndaily checklist, 274\ndefinitions, 273\nillustrated example, 275–278\nparameters, 274\nparameter set list, 274\ntrading signals, 273–274\nRun days, 116, 118–119, 268\nRussell 2000 Mini, intermarket stock index spreads, \n461–470\nSamples, populations and, 598, 606\nSampling distribution, 608–609\nSands, Russell, 434\nSaucers. See Rounding tops and bottoms\nSaudi Arabia, 425\nScale order, 18\nSchwager, Jack, 319\nSchwartz, Marty, 22, 585\nSDR Sharpe ratio, 327–328, 334\nSE. See Standard error (SE)\nSeasonal analysis, 389–401\ncash versus futures price seasonality, \n389–390\nexpectations, role of, 390\nreal or probability, 390–391\nseasonal index (see Seasonal index)\nseasonal trading, 389\nSeasonal considerations, ignoring, 356\nSeasonal index, 391–401\nalternative approach, 396–401\naverage percentage method, 391–394", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:717", "doc_id": "3dc3acee867e70c774be709b1dcec5a453aebfe747184feae8a64ecd0ef2a695", "chunk_index": 0}
{"text": "700\nIndex\nstock index futures and (see Stock index futures)\ntime, 542\ntypes of, 441–442\nSpread seasonality, 449\nSpreadsheet, maintaining traders, ’ 563–564\nStability:\nof return, 338\ntime (see Time stability)\nStandard deviation:\ncalculation of, 323, 599\nestimation of, 607\nStandard error (SE), 612, 627\nStandard error of the estimate (SEE), 627\nStandard error of the mean, 612\nStandard error of the regression (SER):\nabout, 627\nmultiple regression model and, 641–642\nsimulation and, 681\nStandardized residuals, regression run analysis and, \n647\nStatistic, definition of, 606\nStatistics:\nelementary (see Elementary statistics)\nforecasting model, building, 414\ninfluence of expectations on actual, 381\nusing prior-year estimates rather than revised, \n379–380\nSteidlmayer, Peter, 585\nStepwise regression, 681–682\nStochastic indicator, 199\nStock index futures:\ndividends and, 462\nintermarket stock index spreads, 462–470\nintramarket stock index spreads, 461–462\nmost actively traded contracts, 463\nresponse to employment reports, 408–409\nspread pairs, 463\nspread trading in, 461–470\nStock market collapse, 425\nStop, trailing. See Trailing stop\nStop close only, 18\nStop-limit order, 17\nStop-loss points, 183–188\nflags and pennants and, 184–185\nmoney stop and, 185, 187\nrelative highs and relative lows, 185, 186\nrelative lows and, 185, 186\nselecting, 183–188\nSMSV . See Single market system variation (SMSV)\nSoros, George, 22\nSource/product spread, 442\nSoybeans, inflation and, 384\nSpike(s), 109–113\ndefinition of, 112–113\nreversal days and, 147\n“spike days,” 237\nSpike days. See Spike(s)\nSpike extremes, return to, 213–216\nSpike highs:\npenetration of, 214–215\nqualifying conditions and, 110–111\nsignificance of, 109\nspike extremes and, 213–216\nSpike lows:\npenetration of, 215\nprice declines, 109\nsignificance of, 110\nSpike penetration signals negated, 216\nSpike reversal days, 115–116\nSpot gold, 555\nSpread-adjusted (continuous) price series, 282–285\nSpread order, 15, 19\nSpreads:\nabout, 439–440\nanalysis and approach, 448–449\nbalanced, 455\nbutterfly, 542\nchart analysis and, 449\ncredit, 535\ncurrency futures and (see Currency futures)\ndefinition of, 440\ndiagonal, 542\nequal-dollar-value spread, 455–460\nfundamentals and, 449\ngeneral rule (see General rule, spreads)\nhistorical comparison and, 448\nintercommodity (see Intercommodity spreads)\nintercrop, 441, 460\nintermarket, 442, 453\nintramarket (or interdelivery), 441\nlimited-risk, 446–448\npitfalls and points of caution, 449–451\nrather than outright - example, 445–446\nreason for trading, 440–441\nseasonality and, 449\nsimilar periods, isolation of, 449", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf#page:718", "doc_id": "a8d3dbbf5ec86b013c6b9cbb72ce4a0849707473e65d9d1e8564248ee5db21e5", "chunk_index": 0}
{"text": "Introduction\nCongratulations on\ndownloading “\nOptions Trading,”\nand thank you for doing so.\nThe world of options trading is growing increasingly chaotic, and downloading this book is the first step you can take towards actually doing something about it. The first step is also always the easiest. However, the information you find in the following chapters is so important to take to heart as they are not concepts that can be put into action immediately. If you file them away for when they are really needed, then when the time comes that you actually use them, you will be glad you did.\nTo that end, the following chapters will discuss the primary preparedness principals that you will need to consider if you ever hope to really be successful in the investing world. This means you will want to consider the quality of your options—including the potential issues raised by their current value, how they can be best utilized in an emergency case to drive in quick cash, and how to operate with them properly.\nWith stock selection out of the way, you will then learn everything you need to know about trading in awide variety of markets including stocks, forex, and commodities (using the options instrument in each market). Rounding out the three primary requirements for successful options trading, you will then learn about crucial risk management principles and what they will mean for you. Finally, you will learn how investing is the quickest way to reach financial freedom.\nThere are plenty of books on this subject on the market, thanks again for choosing this one! Every effort was made to ensure it is full of as much useful information as possible, so please enjoy!", "source": "eBooks\\Branden Turner - Options Trading (azw3 epub mobi)\\Branden Turner - Options Trading.epub#section:c003.xhtml", "doc_id": "10f90ce542961ba571a5af5b763fd1d9e528ba5845ed7d8c9c602736df724f22", "chunk_index": 0}
{"text": "CFD\nThis is akey point\nthat actually explains why there is much less bureaucracy for forex trading than for buying and selling bank shares. CFDs (Contract for Difference) are contracts for differences that follow the performance of agiven underlying (share, currency, index, etc.) and that can be exchanged, that is, bought or sold. CFDs differ from shares because they are not co-owned by acompany and therefore do not give voting rights to those holding them. However, CFDs offer the same economic benefits as equities, such as profits, dividends, and splits.\nIn even more technical terms, the CFD exchanges the difference in value between the opening price of the certain underlying security (e.g., share) and its closing price. Following this mechanism, the trader who negotiates CFDs:\nGets apositive result if it buys before the underlying goes up\nGets anegative result if it sells before the underlying goes down\nThe mechanism is very simple, and we are sure that it is already clear. We need to buy if we think that astock is close to the upside, we need to sell it if we think that astock is close to the downside. CFDs follow the values of the underlying assets so you can get positive results just like shareholders, but playing at home from the comfort of your home.", "source": "eBooks\\Branden Turner - Options Trading (azw3 epub mobi)\\Branden Turner - Options Trading.epub#section:c016.xhtml", "doc_id": "e0655c938f171af45f74e87d3035366afccff2b0419b24025640926d38acf381", "chunk_index": 0}
{"text": "Chapter 5: Ways to Trade\nThe main method for\ninvesting in the forex market, therefore, remains the classic forex market. When you operate on the forex market, you are actually buying and selling currencies.\nHowever, over the years, other financial instruments have been introduced to invest in forex and currencies indices on the forex exchange. We are talking about CFD (contract for difference) and binary options. The main feature of these two financial instruments is the following: when you use them to invest in forex, you will not actually own the lots you are investing in.\nThat said, for those who do not intend to trade online, it could make little sense. Let'stry to clarify. Both CFDs and binary options are contracts between investors and brokers. It'snot like the classic forex market, where traders buy and sell among themselves. In CFDs and binary options, the asset movement (in this case the buying and selling of currencies) does not take place.\nCFDs and binary options are used to speculate on the performance of the value of equity securities. If the trader'sforecast is correct, the operation will lead to aprofit; vice versa, if the trader'sprediction is wrong, the operation will lead to aloss. So, the mode of operation is similar to the stock market: if Iinvest on the upside, whether Ido it with CFDs or actually buy currencies, Ionly earn money if the value increases.\nAs we explained in the previous paragraphs, CFDs are also derivative instruments, so they are used to speculate on the performance of asset values. This means that when you buy and sell CFDs, you will never own the asset traded (as opposed to classic forex trading).\nMoreover, as with binary options, with CFDs it is possible to trade on:\nEquity securities\nEquity indices\nForex currencies pairs\nCommodities\nETF\nLeverage plays an important role in CFD trading: through leverage, we can literally multiply the value of our investment. Just to give an example, if you use alever of 1: 100 and invest € 100, thanks to this lever you can move well € 10,000 (using only your hundred!). All this is made possible thanks to the leverage, which is asort of \"loan\" (if we can define it) by the broker, thanks to which you can invest more money than you really have.\nBut if we talk about eToro, we can'tavoid talking about Social Trading. For those who do not know, eToro was the first broker to have introduced Social Trading in CFDs. Thanks to Social trading it is possible to invest by copying (automatically) the operations carried out by the other traders registered on the eToro platform. All you need is acouple of clicks to find the traders to follow, choose the amount to invest, and you're done. In this way, even novice traders can exploit the knowledge and experience of professional traders, copying their operations.\nThe online trading strategies are based on the study of mathematical and graphic analysis that can suggest the trader the best moment to buy and sell. As we have seen today, it is possible to invest in the stock market thanks to online trading, choosing between trading binary options and trading with the forex market.\nPrecise right away that there is no suitable trading strategy for all traders, but there are different trading strategies, based on traders and their style of trading. Therefore, it is possible to customize different online trading strategies on the basis of their trading objectives, their intellectual and psychological abilities.\nWe also recommend using 2 proven techniques not to turn winnings into losses:\nstop loss: it establishes amaximum loss that you are willing to suffer;\ntake profit: you place adynamic exit level that rises slowly.", "source": "eBooks\\Branden Turner - Options Trading (azw3 epub mobi)\\Branden Turner - Options Trading.epub#section:c042.xhtml", "doc_id": "7ea5691628ffc5cda2313f236e9f4df4dbe3ddef92f30eb8543ec62438ccaf22", "chunk_index": 0}
{"text": "Chapter 10: Swing Trading Options\nSwing trading with\noptions can be extremely difficult. This is why we decided to create this chapter, in which we go through some of the main ideas and concepts to always keep in mind, to be profitable from the start. Now, it is clear that at the beginning it is not easy to take money out of the market. However, with the right guidelines, it is not that difficult to achieve success in ashort period of time. Anyway, let'sget into some of the key factors to consider when it comes to swing trading with options.\n“\nIf you are undecided, stay still.”\nIt is not necessary to invest continuously. If you do not have precise ideas, it is better to do nothing and wait for clearer signs. Often times, the market is full of indecision: keep calm and stack up money for the future.\n\"Cut losses and let profits run.”\nThis is perhaps the best known and most important rule for those investing in the stock market. An indispensable factor for the application of this rule is the identification, immediately after the purchase, of the stop loss. This is how much you are willing to lose on that investment (consider when determining the average daily excursion of the stock). The cold and systematic application, even if painful, of the stop loss will preserve you from huge losses that would make the sale more and more traumatic, freezing capital that could be invested elsewhere.\n“Learn from your mistakes.”\nErrors are not always negative: if you follow astrategy with amethod, if you apply the stop losses, you will not make particularly serious mistakes. Errors are an integral part of stock trading: you need to analyze why you made them and what you can learn from them. In this way, asmall loss can become agood investment lesson for the future.\n“Take profit and invest them back.”\nIf one of our titles is on the rise, take profit will be applied as the stock grows. Astock cannot grow indefinitely, when the trend is reversed, selling at the top, we will have had aprofit avoiding further descents. If then the title should go up again, it does not matter, it will go better next time. You cannot always sell at the top since you cannot time the market.\n\"Buy on the rumor and sell on the news.\"\nWhen positive news on acertain title officially comes out, pay attention. It may already be too late to invest in that title since the market could already have priced it in.\nDo not believe in “safe investments.”\nIf someone tells you that atitle will certainly reach acertain price, he either does not understand much of the stock market or is only doing his own interests.\n“Never become emotionally attached to astock.”\nSome investors always follow alimited number of companies that they consider more reliable than others. There are no titles better than others, but only favorable situations and unfavorable situations. Often, instead of admitting an error, one perseveres on it with the consequence of being heavily unbalanced on astock. This is really bad, especially if you are overcommitted to astock in which, at that moment, the market does not believe in.\n\"Always maintain certain liquidity available.\"\nCyclically we find ourselves in situations of several days of generalized decline of the whole stock exchange and often, for lack of liquidity, we cannot grasp excellent buying opportunities. Keep some money aside to jump on big opportunities.\n“Choose the right platform\n.”\nOne important rule for investing in the stock market is that the platform makes adifference. Carefully selecting safe, honest and reliable trading platforms is the first step to make money. Those who start investing in the stock market for the first time must be careful to choose platforms that are really simple to use, perhaps with high-quality educational support. Some platforms also offer add-on tools, such as notifications, social trading and free analysis tools to guide less experienced traders.\n“Invest only in what you understand.”\nAs the \"guru\" of finance Warren Buffett said, \"never, never, invest in something that you do not understand, and above all, that you do not know.” The overwhelming majority of investors can achieve their capital growth goals by using the most common financial instruments, which are almost always simple to understand. The complex tools are best left to the great experts in the field.\n“Diversify your portfolio.”\nWhen investing, the word to keep in mind is “diversification.” Never invest in asingle title, because if that sinks, your money will come to the same end. It is always better to have diversified investments to minimize the specific risks of acompany, amarket, an asset class or acurrency. The more you diversify and the lower the probability of having drastic falls.\n“Understand and evaluate the risk.”\nThe risk is an intrinsic component of every investment. If it does not exist, there is no return. Whether they are government bonds, stocks or mutual funds, they all have arisk component, which will obviously be greater if y", "source": "eBooks\\Branden Turner - Options Trading (azw3 epub mobi)\\Branden Turner - Options Trading.epub#section:c079.xhtml", "doc_id": "760118cc9c900a2afe67da89cd1fc747db91028b97605cf44e4ef912a64ebd4a", "chunk_index": 0}
{"text": "once bought, are not to be sold. It is, therefore, better to evaluate the industrial trends in the long term and then buy them, leaving aside the passengers' enthusiasm.\n“\nWhen investing in real estate, know the area you are investing in\n.”\nTo start with, it is good that you put your focus on your area of residence or, if you live in abig city, even on your neighborhood or on one that you know well. If you think to act on afield of action too large, you risk dispersing too much energy towards something that can present totally different solutions. Dedicate yourself only to residential buildings, apartments or houses. The commercial ones, even if they can be very profitable, have other rules and in general greater difficulties. The same for the land: you can do big business, but it is not something suitable for those who start.\n“\nChoose the right leverage and use it to your advantage\n.”\nReal estate investments must be done with leverage. If you want to make an investment only with your money, then the essence of real estate investment is not clear to you. In fact, the concept of financial leverage allows you to invest with money that is not yours but to make money directly for you. Leverage an economic tool that allows you to get where you would not get only with your own strength. You can take out amortgage (if you can afford it) or engage financial partners. It may seem strange to you, but it is not at all: even the richest need partners and remember that afigure that seems almost unimaginable to you, it may be normal to somebody else.\n\"\nVerba volant, scripta manent\n\"\nthe Latins used to say. So never make verbal agreements, even if it is arelative or achildhood friend. Consult alawyer to have the templates of the documents to be used. Like everything, at first it will seem difficult, but after afew times you will become an expert in basic legal practices for the sale of real estate, and you will be able to create documents in avery short time even by yourself.\n“\nConsider shorter positions\n.”\nIn the fixed income universe, ashort duration approach is potentially able to reduce sensitivity to rising interest rates, while optimizing the returns/risk rations\n“\nKnow your risk/reward ratio\n.”\nAhigher return may be tempting, but you must be sure not to take too many risks about the remuneration you would get. In bond markets, this means avoiding lengthening duration in acontext of rising interest rates. Increasing investments in riskier assets may seem appropriate at the moment (when the macroeconomic scenario is quite positive), but it could turn out to be arather risky choice if the situation should change. For example, the yields offered by high yield debt, on average 3% in Europe and 5.5% in the United States, would not be sufficient to compensate investors if insolvencies passed from their current level of 2% to amore normal one of the 5%. Conversely, market areas with agood risk/return profile, with high-rated issuers offering attractive returns, include emerging market debt, subordinated financial bonds, and hybrid corporate bonds. Aiming at long-term quality makes it possible to take on fair risks, helping to limit the impact of any negative macroeconomic event.\n“Take the currency pairing into account.”\nGlobal investments are exposed to currency risks. High yield bonds and emerging market funds, for example, are usually denominated in US dollars, but the underlying bonds they hold may be issued in another currency. Fund managers may choose to include currency risk in the overall portfolio risk as exchange rates fluctuate or decide to contain this risk through currency hedging.\n“\nStay flexible, keep some cash aside\n.”\nIt is important to have the flexibility to underwrite and liquidate investments to seize the best opportunities. However, trades are expensive and can quickly erode earnings. This happens above all in the bond markets, given the relatively low levels of returns. The bid-ask spread is on average 30-40% of the yield, so an excess of trades erodes this margin and obviously reduces the total return. Even holding portfolios with structurally short duration, allowing short-term bonds to come to maturity naturally, can improve returns because you will effectively pay the bid-ask spread once.\n“\nBuild up your portfolio over time\n.”\nIf investing asmall sum such as 5000 Euro, will not allow you to live on that income, it can certainly represent an opportunity, to make money. Also, even if you have good economic availability, the ideal is always \"to make it safe,\" start to invest from small figures and then fuel the investment over time.\n“The past does not equal the future.”\nThe story is not indicative of how an investment will result in the future and investors should always try to weigh the potential risks associated with aparticular investment, as well as its possible returns.\nOnce you have established aprofitable options trading strategy that generates apassive income every single month, you cannot fl", "source": "eBooks\\Branden Turner - Options Trading (azw3 epub mobi)\\Branden Turner - Options Trading.epub#section:c079.xhtml", "doc_id": "760118cc9c900a2afe67da89cd1fc747db91028b97605cf44e4ef912a64ebd4a", "chunk_index": 2}
{"text": "xiii\nIntroduCtIon\nYou have atremendous advantage over algorithmic trading models, \ninvestment bank trading desks, hedge funds, and anyone who appears on or \npays attention to cable business news shows. This book is written to show \nwhere that advantage lies and how to exploit it to make confident and suc-\ncessful investment choices. In doing so, it explains how options work and \nwhat they can tell you about the market’sestimation of the value of stocks. \neven if, after reading it, you decide to stick with straight stock in-\nvesting and never make an option transaction, understanding how options \nwork will give you atremendous advantage as an investor. The reason for \nthis is simple: by understanding options, you can understand what the rest \nof the market is expecting the future price of astock to be. Understanding \nwhat future stock prices are implied by the market is like playing cards with \nan opponent who always leaves his or her hand face up on the table. You \ncan look at the cards you are dealt, compare them with your opponent’s, \nand play the round only when you are sure that you have the winning hand.\nBy incorporating options into your portfolio, you will enjoy an even \ngreater advantage because of apeculiarity about how option prices are \ndetermined. Option prices are set by market participants making trans-\nactions, but those market participants all base their sale and purchase \ndecisions on the same statistical models. These models are like sausage \ngrinders. They contain no intelligence or insight but rather take in afew \nsimple inputs, grind them up in amechanical way, and spit out an option \nprice of aspecific form. \nAn option model does not, for instance, care about the operational \ndetails of acompany. This oversight can lead to situations that seem to be \ntoo good to be true. For instance, Ihave seen acase in which an investor", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:14", "doc_id": "73c8dffd40d7d04c51c9b5c6ef5ed185d0091e48ba4f5fa6d86da0bac8e37d78", "chunk_index": 0}
{"text": "could commit to buy astrong, profitable company for less than the amount \nof cash it held—in effect, allowing the investor to pay $0.90 to receive adollar plus ashare of the company’sfuture profits! Although it is true that \nthese kinds of opportunities do not come along every day, they do indeed \ncome along for patient, insightful investors.\nThis example lies at the heart of intelligent option investing, the es-\nsence of which can be expressed as athree-step process:\n1. Understanding the value of astock\n2. Comparing that intelligently estimated value with the mechani-\ncally derived one implied by the option market\n3. Tilting the risk-reward balance in one’sfavor by investing in the \nbest opportunities using acombination of stocks and options\nThe goal of this book is to provide you with the knowledge you need to be \nan intelligent option investor from the standpoint of these three steps. \nThere is alot of information contained within this book but also alot \nof information left out. This is not meant to be an encyclopedia of option \nequations, ahandbook of colorfully named option strategies, or atreatise on \nfinancial statement analysis. Unlike academic books covering options, such \nas hull’sexcellent book,\n1 not asingle integration symbol or mathematical \nproof is found between this book’scovers. Understanding how options are \npriced is an important step in being an intelligent option investor; doing dif-\nferential partial equations or working out mathematical proofs is not. \nUnlike option books written for professional practitioners, such as \nnatenberg’sbook,2 you will not find explanations about complex strategies \nor graphs about how “the greeks”3 vary under different conditions. Floor \ntraders need to know these things, but intelligent option investors—those \nmaking considered long-term investments in the financial outcomes of \ncompanies—have very different motivations, resources, and time horizons \nfrom floor traders. Intelligent option investors, it turns out, do better not \neven worrying about the great majority of things that floor traders must \nconsider every day.\nUnlike how-to books about day trading options, this book does not \nhave one word to say about chart patterns, market timing, get-rich-quick \nschemes, or any of the many other delusions popular among people who \nxiv  •   Introduction", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:15", "doc_id": "7bf135f8dc2c8345c4bfe0df24eb3d77c9d2f5452e52a51e6cceeb7fb6be44d8", "chunk_index": 0}
{"text": "Introduction    • xv\nwill soon be paupers. Making good decisions is avital part of being an \nintelligent option investor; frenetic, haphazard, and unconsidered trading \nis most certainly not.\nUnlike books about securities analysis, you will not find detailed dis-\ncussions about every line item on afinancial statement. Understanding \nhow acompany creates value for its owners and how to measure that value \nis an important step in being an intelligent option investor; being able to \nrattle off information about arcane accounting conventions is not.\nTo paraphrase Warren Buffett,\n4 this book aims to provide you with \nasound intellectual framework for assessing the value of acompany and \nmaking rational, fact-based decisions about how to invest in them with the \nhelp of the options market.\nThe book is split into three parts:\n• part Iprovides an explanation of what options are, how they are \npriced, and what they can tell you about what the market thinks the \nfuture price of astock will be. This part corresponds to the second \nstep of intelligent option investing listed earlier.\n• part II sets forth amodel for determining the value of acompany \nbased on only ahandful of drivers. It also discusses some of the \nbehavioral and structural pitfalls that can and do affect investors’ \nemotions and how to avoid them to become abetter, more rational \ninvestor. This part corresponds to the first step of intelligent option \ninvesting listed earlier. \n• part III turns theory into practice—showing how to read the nec-\nessary information on an option pricing screen; teaching how \nto measure and manage leverage in aportfolio containing cash, \nstocks, and options; and going into detail about the handful of op-\ntion strategies that an intelligent option investor needs to know to \ngenerate income, boost growth, and protect gains in an equity port-\nfolio. This part corresponds to the final step of intelligent option \ninvesting listed earlier.\nno part of this book assumes any prior knowledge about options or \nstock valuation. That said, it is not some sort of “Options for Beginners” or \n“My First Book of valuation” treatment either.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:16", "doc_id": "aa5cfb4fec9cb346d786259f0ab29a71ae1f141055f44ca0e7773b4e39b22ecd", "chunk_index": 0}
{"text": "Investing beginners will learn all the skills—soup to nuts—they need \nto successfully and confidently invest in the stock and options market. peo-\nple who have some experience in options and who may have used covered \ncalls, protective puts, and the like will find out how to greatly improve their \nresults from these investments and how to use options in other ways as \nwell. professional money managers and analysts will develop athorough \nunderstanding of how to effectively incorporate option investments into \ntheir portfolio strategies and may in fact be encouraged to consider ques-\ntions about valuation and behavioral biases in anew light as well.\nThe approach used here to teach about valuation and options is \nunique, simple without being simpleminded, and extremely effective in \ncommunicating these complex topics in amemorable, vivid way. read-\ners used to seeing option books littered with hockey-stick diagrams and \npartial differential equations may have some unlearning to do, but no mat-\nter your starting point—whether you are anovice investor or aseasoned \nhedge fund manager—by the end of this book, Ibelieve that you will look \nat equity investing in anew light.\nxvi  •   Introduction", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:17", "doc_id": "7c167387a6e5cfd04dd3cce8fcd59eee0a34a06e8ff768369b7df7df2a79d595", "chunk_index": 0}
{"text": "1\nPart I\nOptiOns FOr the \nintelligent invest Or\nDon’tbelieve anything you have heard or read about options.\nIf you listen to media stories, you will learn that options are modern \nfinancial innovations so complex that only someone with an advanced \ndegree in mathematics can properly understand them. \nEvery contention in the preceding sentence is wrong.\nIf you listen to the pundits and traders blabbing on the cable business \nchannels, you will think that you will never be successful using options \nunless you understand what “put backspreads, ” “iron condors, ” and count- \nless other colorfully named option strategies are. You will also learn that \noptions are short-term trading tools and that you’ll have to be arazor-sharp \n“technical analyst” who can “read charts” and jump in and out of positions \nafew times aweek (if not afew times aday) to do well.\nEvery contention in the preceding paragraph is so wrong that believing \nthem is liable to send you to the poor house.\nThe truth is that options are simple, directional instruments that \nwe understand perfectly well from countless encounters with them in \nour daily lives. They are the second-oldest financial instrument known to \nhumanity—in aquite literal sense, modern economic life would not be \npossible without them. Options are instruments that not only can be used \nbut should be used in long-term strategies; they most definitely should be \ntraded in and out of as infrequently as possible.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:18", "doc_id": "d0ca3a594be6d85efe368f3c1394ed72d92a85377401de5a02036979b03bd486", "chunk_index": 0}
{"text": "2  •   The Intelligent Option Investor\nThe first part of this book will give you agood understanding of \nwhat options are, how their prices are determined, and how those prices \nfluctuate based on changes in market conditions.\nThere is agood reason to develop asolid understanding of this \ntheoretical background: the framework the option market uses to determine \nthe price of options is based on provably faulty premises that, while \n“approximately right” in certain circumstances, are laughably wrong in \nother circumstances. The faults can be exploited by intelligent, patient inves-\ntors who understand which circumstances to avoid and which to seek out.\nWithout understanding the framework the market uses to value \noptions and where that framework breaks down, there is no way to exploit \nthe faults. Part Iof this book, in anutshell, is designed to give you an \nunderstanding of the framework the market uses to value options.\nThis book makes extensive use of diagrams to explain option theory, \npricing, and investment strategies. Those readers of the printed copy of this \nbook are encouraged to visit the Intelligent Option Investor website (www \n.IntelligentOptionInvestor.com) to see the full-color versions of the type of \nillustrations listed here. Doing so will allow you to visualize options even \nmore effectively in the distinctive intelligent option investing way.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:19", "doc_id": "c6266ec93c71b5dd33c0e33c3fa56f639621916a40f3660a8045f41af7e84bd9", "chunk_index": 0}
{"text": "3\nChapter 1\nOptiOn Fundamentals\nThis chapter introduces what an option is and how to visualize options in \nan intelligent way while hinting at the great flexibility and power asensible \nuse of options gives an investor. It is split into three sections:\n1. Option Overview: Characteristics, everyday options, and abrief \noption history.\n2. Option Directionality: An investigation of similarities and differ -\nences between stocks and options. This section also contains an \nintroduction to the unique way that this book visualizes options \nand to the inescapable jargon used in the options world and abit \nof intelligent option investor–specific jargon as well.\n3. Option Flexibility: An explanation of why options are much more \ninvestor-friendly than stocks, as well as examples of the handful of \nstrategies an intelligent option investor uses most often.\nEven those of you who know something about options should at the \nvery least read the last section. You will find that the intelligent option \ninvestor makes very close to zero use of the typical hockey-stick diagrams \nshown in other books. Instead, this book uses the concept of arange of \nexposure. The rest of the book—discussing option pricing, corporate \nvaluation, and option strategies—builds on this range-of-exposure concept, \nso skipping it is likely to lead to confusion later.\nThis chapter is an important first step in being an intelligent option \ninvestor. Someone who knows how options work does not qualify as be-\ning an intelligent option investor, but certainly, one cannot become an", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:20", "doc_id": "4af027e8a0e4a59e20343afcc28d293d6f441e4babaa0735e261e309dae7e5c2", "chunk_index": 0}
{"text": "4  •   The Intelligent Option Investor\nintelligent option investor without understanding these basic facts. The \nconcepts discussed here will be covered in greater detail and depth later in \nthis book. For now, it is enough to get asense for what options are, how to \nthink about them, and why they might be useful investment tools.\nCharacteristics and History\nBy the end of this section, you should know the four key characteristics \nof options, be able to name afew options that are common in our daily \nlives, and understand abit about the long history of options as afinancial \nproduct and how modern option markets operate.\nJargon introduced in this section is as follows:\nBlack-Scholes-Merton model (BSM)\nListed look-alike\nCentral counterparty\nCharacteristics of Options\nRather than giving adefinition for options, I’ll list the four most important \ncharacteristics that all options share and provide afew common examples. \nOnce you understand the basic characteristics of options, have seen afew \nexamples, and have spent some time thinking about them, you will start to \nsee elements of optionality in nearly every situation in life.\nAn option\n1. Is acontractual right\n2. Is in force for aspecified time \n3. Allows an investor to profit from the change in value of another \nasset\n4. Has value as long as it is still in force\nThis definition is broad enough that it applies to all sorts of options—\nthose traded on apublic exchange such as the Chicago Board Options \nExchange and those familiar to us in our daily lives.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:21", "doc_id": "e559903c1934f879e2aab74edd645306baa6fd40714885a94e17a468e15b8925", "chunk_index": 0}
{"text": "Option Fundamentals   • 5\nOptions in Daily Life\nThe type of option with which people living in developed economies are \nmost familiar is an insurance contract. Let’ssay that you want to fully insure \nyour $30,000 car. You sign acontract (option characteristic number 1) \nwith your insurance company that covers you for aspecified amount of time \n(option characteristic number 2)—let’ssay one year. If during the coverage \nperiod your car is totaled, your insurance company buys your wreck of acar (worth $0 or close to it) for $30,000—allowing you to buy an identical \ncar. When this happens, you as the car owner (or investor in areal asset) \nrealize aprofit of $30,000 over the market value of your destroyed car \n(option characteristic number 3). Obviously, the insurance company is \nbound to uphold its promise to indemnify you from loss for the entire term \nof the contract; the fact that you have aright to sell aworthless car to your \ninsurance company for the price you paid for it implies that the insurance \nhas value during its entire term (option characteristic number 4). \nAnother type of option, while perhaps not as widely used by everyday \nfolks, is easily recognizable. Imagine that you are astruggling author who \nhas just penned your first novel. The novel was not agreat seller, but one day \nyou get acall from amovie producer offering you $50,000 for the right to \ndraft ascreenplay based on your work. This payment will grant the producer \nexclusive right (option characteristic number 1) to turn the novel into amovie, as well as the right to all proceeds from apotential future movie \nfor aspecific period of time (option characteristic number 2)—let’ssay \n10 years. After that period is up, you as the author are free to renegotiate an-\nother contract. As astruggling artist working in an unfulfilling day job, you \nhappily agree to the deal. Three weeks later, apopular daytime talk show \nhost features your novel on her show, and suddenly, you have a New York \nTimes bestseller on your hands. The value of your literary work has gone \nfrom slight to great in asingle week. Now the movie producer hires the \nCohen brothers to adapt your film to the screen and hires George Clooney, \nMatt Damon, and Julia Roberts to star in the movie. When it is released, \nthe film breaks records at the box office. How much does the producer pay \nto you? Nothing. The producer had acontractual right to profit from the \nscreenplay based on your work. When the producer bought this right, your \nliterary work was not worth much; suddenly, it is worth agreat deal, and", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:22", "doc_id": "26000e09db04c2a92f7bdcf30c4e3ff1790774f90705f11cab3700a5948b0fd1", "chunk_index": 0}
{"text": "6  •   The Intelligent Option Investor\nthe producer owns the upside potential from the increase in value of your \nstory (option characteristic number 3). Again, it is obvious that the right \nto the literary work has value for the entire term of the contract (option \ncharacteristic number 4).\nKeep these characteristics in mind, and we will go on to look at how \nthese defining elements are expressed in financial markets later in this \nchapter. Now that you have an idea of what an option looks like, let’sturn \nbriefly to ashort history of these financial instruments.\nA Brief History of Options\nMany people believe that options are anew financial invention, but in \nfact, they have been in use for more than two millennia—one of the first \nhistorically attested uses of options was by apre-Socratic philosopher \nnamed Miletus, who lived in ancient Greece. Miletus the philosopher was \naccused of being useless by his fellow citizens because he spent his time \nconsidering philosophical matters (which at the time included astudy of \nnatural phenomena as well) rather than putting his nose to the grindstone \nand weaving fishing nets or some such thing.\nMiletus told them that his knowledge was in fact not useless and that \nhe could apply it to something people cared about, but he simply chose not \nto. As proof of his contention, when his studies related to weather revealed \nto him that the area would enjoy abumper crop of olives in the upcoming \nseason, he went around to the owners of all the olive presses and paid them \nafee to reserve the presses (i.e., he entered into acontractual agreement—\noption characteristic number 1) through harvest time (i.e., the contract \nhad aprespecified life—option characteristic number 2). \nIndeed, Miletus’sprediction was correct, and the following season \nyielded abumper crop of olives. The price of olives must have fallen because \nof the huge surge of supply, and demand for olive presses skyrocketed \n(because turning the olive fruit into oil allowed the produce to be stored \nlonger). Because Miletus had cornered the olive press market, he was able \nto generate huge profits, turning the low-value olives into high-value oil \n(i.e., he profited from the change in value of an underlying asset—option \ncharacteristic number 3). His rights to the olive presses ended after the har-\nvest but not before he had become very wealthy thanks to his philosophical", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:23", "doc_id": "b4be020f80cf7720216c347eb893c7010677e747e0066ba95046a97e408fbbc8", "chunk_index": 0}
{"text": "Option Fundamentals   • 7\nstudies (i.e., his contractual rights had value through expiration—option \ncharacteristic number 4).\nThis is only one example of an ancient option transaction (afew thou-\nsand years before the first primitive common stock came into existence), \nbut as long as there has been insurance, option contracts have been awell-\nunderstood and widely used financial instrument. Can you imagine how \nlittle cross-border trade would occur if sellers and buyers could not shift the \nrisk of transporting goods to athird party such as an insurance company? \nHow many ships would have set out for the Spice Islands during the Age of \nExploration, for instance? Indeed, it is hard to imagine what trade would \nlook like today if buyers and sellers did not have some way to mitigate the \nrisks associated with uncertain investments.\nFor hundreds of years, options existed as private contracts specifying \nrights to an economic exposure of acertain quantity of acertain good over \nagiven time period. Frequently, these contracts were sealed between the \nproducers and sellers of acommodity product and wholesale buyers of \nthat commodity. Both sides had an existing exposure to the commodity \n(the producer wanted to sell the commodity, and the wholesaler wanted to \nbuy it), and both sides wanted to insure themselves against interim price \nmovements in the underlying commodity.\nBut there was aproblem with this system. Let’ssay that you were a \nRenaissance merchant who wanted to insure your shipment of spice from \nIndia to Europe, and so you entered into an agreement with an insurer. The \ninsurer asked you to pay acertain amount of premium up front in return \nfor guaranteeing the value of your cargo. Your shipment leaves Goa but is \nlost off Madagascar, and all your investment capital goes down with the \nship to the bottom of the Indian Ocean. However, when you try to find \nyour option counterparty—your insurer—it seems that he has absconded \nwith your premium money and is living alife of pleasure and song in \nanother country. In the parlance of modern financial markets, your option \ninvestment failed because of counterparty risk. \nPrivate contracts still exist today in commodity markets as well as \nthe stock market (the listed look-alike option market—private contracts \nspecifying the right to upside and downside exposure to single stocks, \nexchange-traded funds, and baskets is one example that institutional \ninvestors use heavily). However, private contracts still bring with them a", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:24", "doc_id": "cd6dc705407177b0aaf4fd6e2a3cfdce51b3dde19363c6796ebeb2e2a362baf8", "chunk_index": 0}
{"text": "8  •   The Intelligent Option Investor\nrisk of default by one’scounterparty, so they are usually only entered into \nafter both parties have fully assessed the creditworthiness of the other. \nObviously, individual investors—who might simply want to speculate on \nthe value of an underlying stock or exchange-traded fund (ETF)—cannot \nspend the time doing acredit check on every counterparty with whom \nthey might do business.\n1 Without away to make sure that both parties are \nfinancially able to keep up their half of the option bargain, public option \nmarkets simply could not exist.\nThe modern solution to this quandary is that of the central counter -\nparty. This is an organization that standardizes the terms of the option con-\ntracts transacted and ensures the financial fulfillment of the participating \ncounterparties. Central counterparties are associated with securities \nexchanges and regulate the parties with which they deal. They set rules \nregarding collateral that must be placed in escrow before atransaction \ncan be made and request additional funds if market price changes cause \nacounterparty’saccount to become undercollateralized. In the United \nStates, the central counterparty for options transactions is the Options \nClearing Corporation (OCC). The OCC is an offshoot of the oldest option \nexchange, the Chicago Board Option Exchange (CBOE).\nIn the early 1970s, the CBOE itself began as an offshoot of alarge \nfutures exchange—the Chicago Mercantile Exchange—and subsequently \nstarted the process of standardizing option contracts (i.e., specifying the \nexact per-contract quantity and quality of the underlying good and the \nexpiration date of the contract) and building the other infrastructure and \nregulatory framework necessary to create and manage apublic market. \nAlthough market infrastructure and mechanics are very important for \nthe brokers and other professional participants in the options market, \nmost aspects are not terribly important from an investor’spoint of view \n(the things that are—such as margin—will be discussed in detail later in \nthis book). The one thing an investor must know is simply that the option \nmarket is transparent, well regulated, and secure. Those of you who have abit of extra time and want to learn more about market mechanics should \ntake alook through the information on the CBOE’sand OCC’swebsites.\nListing of option contracts on the CBOE meant that investors needed \nto have asense for what afair price for an option was. Three academics, \nFischer Black, Myron Scholes, and Robert Merton, were responsible for", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:25", "doc_id": "e241eacecaa69b8c09fe507c62e6a5a3c165476b53b21862e15a73de9af2eccd", "chunk_index": 0}
{"text": "Option Fundamentals   • 9\ndeveloping and refining an option pricing model known as the Black-\nScholes or Black-Scholes-Merton model, which Iwill hereafter abbreviate \nas the BSM.\nThe BSM is atestament to human ingenuity and theoretical elegance, \nand even though new methods and refinements have been developed \nsince its introduction, the underlying assumptions for new option pricing \nmethods are the same as the BSM. In fact, throughout this book, when you \nsee “BSM, ” think “any statistically based algorithm for determining option \nprices .”\nThe point of all this background information is that options are not \nonly not new-fangled financial instruments but in fact have along and \nproud history that is deeply intertwined with the development of modern \neconomies themselves. Those of you interested in amuch more thorough \ncoverage of the history of options would do well to read the book, Against \nthe Gods: The Remarkable History of Risk, by Peter Bernstein (New York: \nWiley, 1998).\nNow that you have agood sense of what options are and how they are \nused in everyday life, let’snow turn to the single most important thing for afundamental investor to appreciate about these financial instruments: their \ninherent ability to exploit directionality.\nDirectionality\nThe key takeaway from this section is evident from the title. In addition to \ndemonstrating the directional power inherent in options, this section also \nintroduces the graphic tools that Iwill use throughout the rest of this book \nto show the risk and reward inherent in any investment—whether it is an \ninvestment in astock or an option.\nFor those of you who are not well versed in options yet, this is the \nsection in which Iexplain most of the jargon that you simply cannot escape \nwhen transacting in options. However, even readers who are familiar with \noptions should at least skim through this explanation. Doing so will likely \nincrease your appreciation for the characteristics of options that make \nthem such powerful investment tools and also will introduce you to this \nnovel way of visualizing them.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:26", "doc_id": "800d3449b3003eb00733f270328c0b2957a598ac3a5d7ced0dc30220f51e254f", "chunk_index": 0}
{"text": "10  •   The Intelligent Option Investor\nJargon introduced in this section is as follows:\nCall option Moneyness\nPut option In the money (ITM)\nRange of exposure At the money (ATM)\nStrike price Out of the money (OTM)\nGain exposure Premium\nAccept exposure American style\nCanceling exposure European style\nExercise (an option)\nVisual Representation of a Stock\nVisually, agood stock investment looks like this: \n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nFuture Stock Price\nLast Stock Price\nYou can make alot of mistakes when investing, but as long as you are right \nabout the ultimate direction astock will take and act accordingly, all those \nmistakes will be dwarfed by the success of your position.\nGood investing, then, is essentially aprocess of recognizing and \nexploiting the directionality of mispriced stocks. Usually, investors get \nexposure to astock’sdirectionality by buying, or going long, that stock. This \nis what the investor’srisk and reward profile looks like when he or she buys \nthe stock:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:27", "doc_id": "d5f9b023a8b6659ff82d98dee26a593aae20781fa35eaa2ed3f42f5df5427330", "chunk_index": 0}
{"text": "Option Fundamentals   • 11\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nGREEN\nRED\nAs soon as the “Buy” button is pushed, the investor gains expo-\nsure to the upside potential of the stock—this is the shaded region la-\nbeled “green” in the figure. However, at the same time, the investor \nalso must accept exposure to downside risk—this is the shaded region \nlabeled “red. ”\nAnyone who has invested in stocks has avisceral understanding of \nstock directionality. We all know the joy of being right as our investment \nsoars into the green and we’ve all felt the sting as an investment we own \nfalls into the red. We also know that to the extent that we want to gain \nexposure to the upside potential of astock, we must necessarily simultane-\nously accept its downside risk.\nOptions, like stocks, are directional instruments that come in two \ntypes. These two types can be defined in directional terms:\nCall option Asecurity that allows an investor exposure to astock’supside potential (remember, “Call up”)\nPut option Asecurity that allows an investor exposure to astock’sdownside potential (remember, “Put down”)\nThe fact that options split the directionality of stocks in half—up and \ndown—is agreat advantage to an investor that we will investigate more in \namoment. \nRight now, let’stake alook at each of these directional instruments—\ncall options and put options—one by one.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:28", "doc_id": "43c9c4f2997704d7ad816741c7c8222b333314ecdd3b3e76fd87f1dfffc92bb0", "chunk_index": 0}
{"text": "12  •   The Intelligent Option Investor\nVisual Representation of Call Options\nIn asimilar way that we created adiagram of the risk-reward profile of owner-\nship in acommon stock, anice way of understanding how options work is to \nlook at avisual representation. The following diagram represents acall option.\nThere are afew things to note about this representation:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nGREEN\n1. The shaded area (green) represents the price and time range over \nwhich the investor has economic exposure—Iterm this the range \nof exposure. Because we are talking about call options, and because \ncall options deal with the upside potential of astock, you see that \nthe range of exposure lies higher than the present stock price \n(remember, “Call up”). \n2. True to one of the defining characteristics of an option mentioned \nearlier, our range of exposure is limited by time; the option pictured \nin the preceding figure expires 500 days in the future, after which \nwe have no economic exposure to the stock’supside potential. \n3. The present stock price is $50 per share, but our upside exposure only \nbegins at $60 per share. The price at which economic exposure begins \nis called the strike price of an option. In this case, the strike price is \n$60 per share, but we could have picked astrike price at the market price \nof the stock, further above the market price of the stock (e.g., astrike \nprice of $75), or even below the market price of the stock. We will inves-\ntigate optimal strike prices for certain option strategies later in this book.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:29", "doc_id": "6115d0bd7599f042d850dbbbc95a9436a6c56d2906fe4b957b9034f40f25d0d4", "chunk_index": 0}
{"text": "Option Fundamentals   • 13\n4. The arrow at the top of the shaded region in the figure indicates \nthat our exposure extends infinitely upward. If, for some reason, \nthis stock suddenly jumped not from $50 to $60 per share but \nfrom $50 to $1,234 per share, we would have profitable exposure \nto all that upside.\n5. Clearly, the diagram showing apurchased call option looks agreat deal \nlike the top of the diagram for apurchased stock. Look back at the top \nof the stock purchase figure and compare it with the preceding figure: \nthe inherent directionality of options should be completely obvious.\nAny time you see agreen region on diagrams like this, you should \ntake it to mean that an investor has the potential to realize again on the \ninvestment and that the investor has gained exposure. Any time an option \ninvestor gains exposure, he or she must pay up front for that potential gain. \nThe money one pays up front for an option is called premium (just like the \nfee you pay for insurance coverage).\nIn the preceding diagram, then, we have gained exposure to arange \nof the stock’supside potential by buying acall option (also known as along \ncall). If the stock moves into this range before or at option expiration, we \nhave the right to buy the stock at our $60 strike price (this is termed exer -\ncising an option) or simply sell the option in the option market. It is almost \nalways the wrong thing to exercise an option for reasons we discuss shortly.\n2\nIf, instead, the stock is trading below our strike price at expiration, the \noption is obviously worthless—we owned the right to an upside scenario \nthat did not materialize, so our ownership right is worth nothing.\nIt turns out that there is special jargon that is used to describe the \nrelationship between the stock price and the range of option exposure:\nJargon Situation\nIn the money (ITM) Stock price is within the option’srange of exposure\nOut of the money (OTM) Stock price is outside the option’srange of exposure\nAt the money (ATM) Stock price is just at the border of the option’srange of \nexposure\nEach of these situations is said to describe the moneyness of the option. \nGraphically, moneyness can be represented by the following diagram:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:30", "doc_id": "116b24d5ab7175f6ffccc936be8200c170b3b4639f13492fcd650d96519737fc", "chunk_index": 0}
{"text": "14  •   The Intelligent Option Investor\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nITM\nATM\nOTM\nDate/Day Count\nStock Price\n749 999\nGREEN\nAs we will discuss in greater detail later, not only can an investor use \noptions to gain exposure to astock, but the investor also can choose to accept \nexposure to it. Accepting exposure means running the risk of afinancial loss if \nthe stock moves into an option’srange of exposure. If we were to accept expo-\nsure to the stock’supside potential, we would graphically represent it like this:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nRED\nAny time you see ashaded region labeled “red” on diagrams like this, you \nshould take it to mean that the investor has accepted the risk of realizing aloss \non the investment and should say that the investor has accepted exposure. Any \ntime an option investor accepts exposure, he or she gets to receive premium \nup front in return for accepting the risk. In the preceding example, the investor \nhas accepted upside exposure by selling acall option (a.k.a. ashort call).", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:31", "doc_id": "161469a5cf3f6f50a1099e4873844521dadd29247256131eccbe83f9a74d6e1a", "chunk_index": 0}
{"text": "Option Fundamentals   • 15\nIn this sold call example, we again see the shaded area representing \nthe exposure range. We also see that the exposure is limited to 500 days \nand that it starts at the $60 strike price. The big difference we see between \nthis diagram and the one before it is that when we gained upside exposure \nby buying acall, we had potentially profitable exposure infinitely upward; \nin the case of ashort call, we are accepting the possibility of an infinite \nloss. Needless to say, the decision to accept such risk should not be taken \nlightly. We will discuss in what circumstances an investor might want to \naccept this type of risk and what techniques might be used to manage that \nrisk later in this book. For right now, think of this diagram as part of an \nexplanation of how options work, not why someone might want to use this \nparticular strategy.\nLet’sgo back to the example of along call because it’seasier for \nmost people to think of call options this way. Recall that you must pay apremium if you want to gain exposure to astock’sdirectional potential. In \nthe diagrams, you will mark the amount of premium you have to pay as astraight line, as can be seen here:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249\nBreakeven Line: $62.50\n499\nDate/Day Count\nStock Price\n749 999\nGREEN\nIhave labeled the straight line the “Breakeven line” for now and have as-\nsumed that the option’spremium totals $2.50. \nYou can think of the breakeven line as ahurdle the stock must cross \nby expiration time. If, at expiration, the stock is trading for $61, you have \nthe right to purchase the shares for $60. You make a $1 profit on this trans-\naction, which partially offsets the original $2.50 cost of the option.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:32", "doc_id": "aa8784ace085c36311fcf57dd5f37ac7d7ad0f5032b4cb608310116d15cf7bb9", "chunk_index": 0}
{"text": "16  •   The Intelligent Option Investor\nIt is important to note that astock does not have to cross this line for \nyour option investment to be profitable. We will discuss this dynamic in \nChapter 2 when we learn more about the time value of options.\nVisual Representation of Put Options\nNow that you understand the conventions we use for our diagrams, let’sthink about how we might represent the other type of option, dealing with \ndownside exposure—the put. First, let’sassume that we want to gain expo-\nsure to the downside potential of astock. Graphically, we would represent \nthis in the following way:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nGREEN\nFirst, notice that, in contrast to the diagram of the call option, the \ndirectional exposure of aput option is bounded on the downside by $0, \nso we do not draw an arrow indicating infinite exposure. This is the same \ndownside exposure of astock because astock cannot fall below zero dollars \nper share.\nIn this diagram, the time range for the put option is the same 500 days \nas for our call option, but the price range at which we have exposure starts \nat astrike price of $50—the current market price of the stock—making this \nan at-the-money (ATM) put. If you think about moneyness in terms of arange of exposure, the difference between out of the money (OTM) and in \nthe money (ITM) becomes easy and sensible. Here are examples of differ-\nent moneyness cases for put options:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:33", "doc_id": "5a4d812fc095915da0c80f688c25c3a608f53dd7ce4e5462387e222e6dc87118", "chunk_index": 0}
{"text": "18  •   The Intelligent Option Investor\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nBreakeven Line: $45.00\nRED\nIn this diagram, we are receiving a $5 premium payment in return for \naccepting exposure to the stock’sdownside. As such, as long as the stock \nexpires above $45, we will realize aprofit on this investment.\nVisual Representation of Options Canceling Exposure\nLet’stake alook again at our visual representation of the risk and reward \nof astock:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nGREEN\nRED\nWe bought this stock at $50 per share and will experience an unreal-\nized gain if the stock goes up and an unrealized loss if it goes down. What \nmight happen if we were to simultaneously buy aput, expiring in 365 days \nand struck at $50, on the same stock?\nBecause we are purchasing aput, we know that we are gaining expo-\nsure to the downside. Any time we gain exposure, we shade the exposure", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:35", "doc_id": "968b0674380a38cfa96163b2ff6c5a8ef81744e6f8ab83b7c90fe2413c0c387e", "chunk_index": 0}
{"text": "20  •   The Intelligent Option Investor\nAny time again of exposure overlaps another gain of exposure, \nthe potential gain from an investment if the stock price moves into that \nregion rises. We will not represent this in the diagrams of this book, \nbut you can think of overlapping gains as deeper and deeper shades of \ngreen (when gaining exposure) and deeper and deeper shades of red \n(when accepting it).\nNow that you understand how to graphically represent gaining and \naccepting exposure to both upside and downside directionality and how to \nrepresent situations when opposing exposures overlap, we can move onto \nthe next section, which introduces the great flexibility options grant to an \ninvestor and discusses how that flexibility can be used as aforce of either \ngood or evil.\nFlexibility\nAgain, the main takeaway of this section should be obvious from the title. \nHere we will see the only two choices stock investors have with regard to \nrisk and return, and we will contrast that with the great flexibility an option \ninvestor has. We will also discuss the concept of an effective buy price and \nan effective sell price—two bits of intelligent option investor jargon. Last, \nwe will look at atypical option strategy that might be recommended by \nan option “guru” and note that these types of strategies actually are at \ncross-purposes with the directional nature of options that makes them so \npowerful in the first place.\nJargon introduced in this chapter is as follows:\nEffective buy price (EBP) Covered call\nEffective sell price (ESP) Long strangle\nLeg\nStocks Give Investors Few Choices\nAstock investor only has two choices when it comes to investing: going \nlong or going short. Using our visualization technique, those two choices \nlook like this:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:37", "doc_id": "dbee1c97a20bab5d6d819da65d4a9e649abf29e3509cc3a2e5c9c32a7f7ab034", "chunk_index": 0}
{"text": "Option Fundamentals   • 21\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\nGREEN\nGREEN\nRED\nRED\nGoing long astock (i.e., buying \nastock).\n Going short astock (i.e., short \nselling astock).\nIf you want to gain exposure to astock’supside potential by going \nlong (left-hand diagram), you also must simultaneously accept exposure to \nthe stock’sdownside risk. Similarly, if you want to gain exposure to astock’sdownside potential by going short (right-hand diagram), you also must ac-\ncept exposure to the stock’supside risk. \nIn contrast, option investors are completely unrestrained in their \nability to choose what directionality to accept or gain. An option investor \ncould, for example, very easily decide to establish exposure to the direc-\ntionality of astock in the following way:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nGREEN\nGREEN\nGRAY\nGRAY\nGREEN\nRED\nRED\nRED\nWhy an investor would want to do something like this is completely beyond \nme, but the point is that options are flexible enough to allow this type of acrazy structure to be built.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:38", "doc_id": "572497f265998399278b667463e65d802b94860046d532121840fcfef2056137", "chunk_index": 0}
{"text": "22  •   The Intelligent Option Investor\nThe beautiful thing about this flexibility is that an intelligent option in-\nvestor can pick and choose what exposure he or she wants to gain or accept in \norder to tailor his or her risk-return profile to an underlying stock. By tailoring \nyour risk-return profile, you can increase growth, boost income, and insure \nyour portfolio from downside shocks. Let’stake alook at afew examples.\nOptions Give Investors Many Choices\nBuying a Call for Growth\n-\n50\n100\n150\n200\nBE = $55\nGREEN\nAbove an investor is bullish on the prospects of the stock and is using acall op-\ntion to gain exposure to astock’supside potential above $50 per share. Rather \nthan accepting exposure to the stock’sentire downside potential (maximum \nof a $50 loss) as he or she would have by buying the stock outright, the call-\noption investor would pay an upfront premium of, in this case, $5.\nSelling a Put for Income\n50\n100\n150\n200\n-\nBE = $45\nRED", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:39", "doc_id": "cd32c1233693ed898b17c1dfe30a85e16bac824890128db2bdda16d679ce3868", "chunk_index": 0}
{"text": "Option Fundamentals   • 23\nHere an investor is bullish on the prospects of the stock, so he or she doesn’tmind accepting exposure to the stock’sdownside risk below $50. In return for \naccepting this risk, the option investor receives apremium—let’ssay $5. This \n$5 is income to the investor—kind of like ado-it-yourself dividend payment.\nBy the way, as you will discover later in this book, this is also the risk-\nreturn profile of acovered call.\nBuying a Put for Protection\n50\n100\n150\n200\n-\nGREEN\nREDGRAY\nAbove an investor wants to enjoy exposure to the stock’supside potential \nwhile limiting his or her losses in case of amarket fall. By buying aput \noption struck afew dollars under the market price of the stock, the investor \ncancels out the downside exposure he or she accepted when buying the \nstock. With this protective put overlay in place, any loss on the stock will be \ncompensated for through again on the put contract. The investor can use \nthese gains to buy more of the stock at alower price or to buy another put \ncontract as protection when the first contract expires.\nTailoring Exposure with Puts and Calls\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\nBE = $60.50\nGREEN\nRED", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:40", "doc_id": "beaa939e32a31993a21b6396249b0756cc674dc373b907a451f50a3dab2fc2f6", "chunk_index": 0}
{"text": "24  •   The Intelligent Option Investor\nHere an investor is bullish on the prospects of the stock and is tailor -\ning where to gain and accept exposure by selling ashort-term put and \nsimultaneously buying alonger-term call. By doing this, the investor \nbasically subsidizes the purchase of the call option with the sale of the \nput option, thereby reducing the level the stock needs to exceed on the \nupside before one breaks even. In this case, we’re assuming that the call \noption costs $1.50 and the put option trades for $1.00. The cash inflow \nfrom the put option partially offsets the cash outflow from the call op-\ntion, so the total breakeven amount is just the call’s $60 strike price plus \nthe net of $0.50.\nEffective Buy Price/Effective Sell Price\nOne thing that Ihope you realized while looking at each of the preceding \ndiagrams is how similar each of them looks to aparticular part of our long \nand short stock diagrams:\nBuying astock.\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\nRED\nGREEN\nGREEN\nRED\nShort selling astock.\nFor example, doesn’tthe diagram labeled “Buying acall for growth” \nin the preceding section look just like the top part of the buying stock \ndiagram?", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:41", "doc_id": "dbef75470454bbe5b99cd87a6a96e8a2bb3bf9f16b63ced410a64e8aac287153", "chunk_index": 0}
{"text": "Option Fundamentals   • 25\nIn fact, many of the option strategies Iwill introduce in this book \nsimply represent acarving up of the risk-reward profile of along or short \nstock position and isolating one piece of it. To make it more clear and easy \nto remember the rules for breaking even on different strategies, Iwill actu-\nally use adifferent nomenclature from breakeven.\nIf adiagram has one or both of the elements of the risk-return profile \nof buying astock, Iwill call the breakeven line the effective buy price and \nabbreviate it EBP. For example, if we sell aput option, we accept downside \nrisk in the same way that we do when we buy astock: \n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nEBP = $45\nRED\nBasically, what we are saying when we accept downside risk is that \nwe are willing to buy the stock if it goes below the strike price. In return \nfor accepting this risk, we are paid $5 in premium, and this cash inflow \neffectively lowers the buying price at which we own the stock. If, when the \noption expires, the stock is trading at $47, we can think of the situation \nnot as “being $3 less than the strike price” but rather as “being $2 over the \nbuyprice .”\nConversely, if adiagram has one or both of the elements of the risk-\nreturn profile of short selling astock, Iwill call the breakeven line the \neffective sell price and abbreviate it ESP. For example, if we buy aput option \nanticipating afall in the stock, we would represent it graphically like this:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:42", "doc_id": "bc92e1787bf1c679f87dd1a38dad000468013b06a776ea1d54342cce736b94ae", "chunk_index": 0}
{"text": "26  •   The Intelligent Option Investor\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nESP = $45\nGREEN\nWhen ashort seller sells astock, he or she gets immediate profit exposure \nto the stock’sdownside potential. The seller is selling at $50 and hopes to make \naprofit by buying the shares back later at alower price—let’ssay $35. When we \nget profit exposure to astock’sdownside potential using options, we are getting \nthe same exposure as if we sold the stock at $50, except that we do not have to \nworry about losing our shirts if the stock moves up instead of down. In order to \nget this peace of mind, though, we must spend $5 in premium. This means that \nif we hold the position to expiration, we will only realize anet profit if the stock \nis trading at the $50 mark less the money we have already paid to buy that ex-\nposure—$5 in this case. As such, we are effectively selling the stock short at $45.\nThere are some option strategies that end up not looking like one of \nthe two stock positions—the flexibility of options allows an investor to do \nthings astock investor cannot. For example, here is the graphic representa-\ntion of astrategy commonly called along strangle:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nBE 1 = $80.75\nBE 2 = $19.25\nGREEN\nGREEN", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:43", "doc_id": "3d4eab28fd46cd5f8ebcf066c5ab5625dff83f6ccfc406d899fe6900f20a8267", "chunk_index": 0}
{"text": "Option Fundamentals   • 27\nHere we have astock trading at $50 per share, and we have bought \none put option and one call option. The put option is struck at $20 and \nis trading for $0.35. The call option is struck at $80 and is trading for \n$0.40. Note that the top part of the diagram looks like the top part of the \nlong-stock diagram and that the bottom part looks like the bottom part \nof the short-stock diagram. Because astock investor cannot be simulta-\nneously long and short the same stock, we cannot use such terminology \nas effective buy or effective sell price. In this case, we use breakeven and \nabbreviate it BE.\nThis option strategy illustrates one way in which options are much \nmore flexible than stocks because it allows us to profit if the stock moves \nup (into the call’srange of exposure) or down (into the put’srange of \nexposure). If the stock moves up quickly, the call option will be in the \nmoney, but the put option will be far, far, far out of the money . Thus, if \nwe are ITM on the call, the premium paid on the puts probably will end \nup atotal loss, and vice versa. For this reason, we calculate both break-\neven prices as the sum of both legs of our option structure (where aleg \nis defined as asingle option in amultioption strategy). As long as the leg \nthat winds up ITM is ITM enough to cover the cost of the other leg, we \nwill make aprofit on this investment. The only way we can fail to make aprofit is if the stock does not move one way or another enough before the \noptions expire.\nFlexibility without Directionality Is a Sucker’s Game\nDespite this great flexibility in determining what directional invest-\nments one wishes to make, as Imentioned earlier, option market mak-\ners and floor traders generally attempt to mostly (in the case of floor \ntraders) or wholly (in the case of market makers) insulate themselves \nagainst large moves in the underlying stock or figure out how to lim-\nit the cost of the exposure they are gaining and do so to such an ex-\ntent that they severely curtail their ability to profit from large moves. \nIdo not want to belabor the point, but Ido want to leave you with one \ngraphic illustration of a “typical” complex option strategy sometimes \ncalled acondor :", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:44", "doc_id": "d35eef746e875c54c57d94937b2a4ea944072bfcb49f69ae3fa112ac11519b33", "chunk_index": 0}
{"text": "28  •   The Intelligent Option Investor\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nBE 1\nBE 2\nRED\nRED\nThere are afew important things to notice. First, notice how much shorter \nthe time frame is—we have moved from a 500-day time exposure to atwo-week \nexposure. In general, afloor trader has no idea of what the long-term value of astock should be, so he or she tries to protect himself or herself from large moves \nby limiting his or her time exposure as much as possible. Second, look at how \nlittle price exposure the trader is accepting! He or she is attempting to control his \nor her price risk by making several simultaneous option trades (which, by the \nway, puts the trader in aworse position in terms of breakeven points) that end up \ncanceling out most of his or her risk exposure to underlying moves of the stock.\nWith this position, the trader is speculating that over the next short \ntime period, this stock’smarket price will remain close to $50 per share; \nwhat basis the trader has for this belief is beyond me. In my mind, winning \nthis sort of bet is no better than going to Atlantic City and betting that the \nmarble on the roulette wheel will land on red—completely random and \nwith only about a 50 percent chance of success.\n3\nIt is amazing to me that, after reading books, subscribing to newslet-\nters, and listening to TV pundits advocating positions such as this, inves-\ntors continue to have any interest in option investing whatsoever!\nWith the preceding explanation, you have agood foundation in the \nconcept of options, their inherent directionality, and their peerless flex-\nibility. We will revisit these themes again in Part III of this book when we \ninvestigate the specifics of how to set up specific option investments.\nHowever, before we do that, any option investor must have agood \nsense of how options are priced in the open market. We cover the topic of \noption pricing in Chapter 2.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:45", "doc_id": "8dcc31fb7e4d9b2811b7cd780ac7ace9ec2387b00e4516602e75a081c7eb2b3d", "chunk_index": 0}
{"text": "29\nChapter 2\nThe black-scholes-\nmerTon model\nAs you can tell from Chapter 1, options are in fact simple financial instru-\nments that allow investors to split the financial exposure to astock into upside \nand downside ranges and then allow investors to gain or accept that expo-\nsure with great flexibility. Although the concept of an option is simple, trying \nto figure out what afair price is for an option’srange of exposure is trickier. The \nfirst part of this chapter details how options are priced according to the Black-\nScholes-Merton model (BSM)—the mathematical option pricing model \nmentioned in Chapter 1—and how these prices predict future stock prices.\nMany facets of the BSM have been identified by the market at large \nas incorrect, and you will see in Part III of this book that when the rubber \nof theory meets the road of practice, it is the rubber of theory that gets \ndeformed. The second half of this chapter gives astep-by-step refutation \nto the principles underlying the BSM. Intelligent investors should be very, \nvery happy that the BSM is such apoor tool for pricing options and pre-\ndicting future stock prices. It is the BSM’sshortcomings and the general \nmarket’sunwillingness or inability to spot its structural deficiencies that \nallow us the opportunity to increase our wealth.\nMost books that discuss option pricing models require the reader to have \nahigh level of mathematical sophistication. Ihave interviewed candidates with \nmaster’sdegrees in financial engineering who indeed had avery high level \nof mathematical competence and sophistication yet could not translate that \nsophistication into the simple images that you will see over the next few pages.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:46", "doc_id": "26edf9bf70e51aed4ca639fb1c7d9ae596f122e673dbb2f1cf1688fdfc23bea6", "chunk_index": 0}
{"text": "30  •   The Intelligent Option Investor\nThis chapter is vital to someone aspiring to be an intelligent options \ninvestor. Contrary to what you might imagine, option pricing is in itself \nsomething that intelligent option investors seldom worry about. Much \nmore important to an intelligent option investor is what option prices im-\nply about the future price of astock and in what circumstances option \nprices are likely to imply the wrong stock prices. In terms of our intelligent \noption investing process, we need two pieces of information:\n1. Arange of future prices determined mechanically by the option \nmarket according to the BSM\n2. Arationally determined valuation range generated through an \ninsightful valuation analysis\nThis chapter gives the theoretical background necessary to derive the \nformer.\nThe BSM’s Main Job is to Predict Stock Prices\nBy the end of this section, you should have abig-picture sense of how the \nBSM prices options that is put in terms of an everyday example. You will also \nunderstand the assumptions underlying the BSM and how, when combined, \nthese assumptions provide aprediction of the likely future value of astock.\nJargon introduced in this section includes the following:\nStock price efficiency Forward price (stock)\nLognormal distribution Efficient market hypothesis (EMH)\nNormal distribution BSM cone\nDrift\nThe Big Picture\nBefore we delve into the theory of option pricing, let me give you ageneral \nidea of the theory of option prices. Imagine that you and your spouse or \nsignificant other have reservations at anice restaurant. The reservation time \nis coming up quickly, and you are still at home. The restaurant is extremely \nhard to get reservations for, and if you are not there at your reservation time,", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:47", "doc_id": "aa2013e9bcd329f9ec59a2f550797f2e5310a4a02b6c997dd71ad35812733e63", "chunk_index": 0}
{"text": "32  •   The Intelligent Option Investor\nThis example illustrates precisely the process on which the BSM and \nall other statistically based option pricing formulas work. The BSM has afixed number of inputs regarding the underlying asset and the contract itself. \nInputting these variables into the BSM generates arange of likely future values \nfor the price of the underlying security and for the statistical probability of the \nsecurity reaching each price. The statistical probability of the security reach-\ning acertain price (that certain price being astrike price at which we are inter-\nested in buying or selling an option) is directly tied to the value of the option.\nNow that you have afeel for the BSM on aconceptual dining-\nreservation level, let’sdig into aspecific stock-related example.\nStep-by-Step Method for Predicting Future Stock \nPrice Ranges—BSM-Style\nIn order to understand the process by which the BSM generates stock price \npredictions, we should first look at the assumptions underlying the model. \nWe will investigate the assumptions, their tested veracity, and their impli-\ncations in Chapter 3, but first let us just accept at face value what Messrs. \nBlack, Scholes, and Merton take as axiomatic.\nAccording to the BSM,\n• Securities markets are “efficient” in that market prices perfectly \nreflect all publicly available information about the securities. This \nimplies that the current market price of astock represents its fair \nvalue. New information regarding the securities is equally likely to \nbe positive as negative; as such, asset prices are as likely to move up \nas they are to move down.\n• Stock prices drift upward over time. This drift cannot exceed the \nrisk-free rate of return or arbitrage opportunities will be available.\n• Asset price movements are random and their percentage returns \nfollow anormal (Gaussian) distribution.\n• There are no restrictions on short selling, and all hedgers can bor -\nrow at the risk-free rate. There are no transaction costs or taxes. \nTrading never closes (24/7), and stock prices are mathematically \ncontinuous (i.e., they never gap up or down), arbitrage opportuni-\nties cannot persist, and you can trade infinitely small increments of \nshares at infinitely small increments of prices.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:49", "doc_id": "436bb934a1018829ae3f7658bacd23db1d0022f2d450ca438de978de325c3262", "chunk_index": 0}
{"text": "49\nChapter 3\nThe InTellIgenT \nInvesTor’sguIde To \nopTIon prIcIng\nBy the end of this chapter, you should understand how changes in the follow-\ning Black-Scholes-Merton model (BSM) drivers affect the price of an option:\n1. Moneyness\n2. Forward volatility\n3. Time to expiration\n4. Interest rates and dividend yields\nYou will also learn about the three measures of volatility—forward, im-\nplied, and statistical. You will also understand what drivers affect option \nprices the most and how simultaneous changes to more than one variable \nmay work for or against an option investment position.\nIn this chapter and throughout this book in general, we will not try to \nfigure out aprecise value for any options but just learn to realize when an op-\ntion is clearly too expensive or too cheap vis-à-vis our rational expectations \nfor afair value of the underlying stock. As such, we will discuss pricing in \ngeneral terms; for example, “This option will be much more expensive than \nthat one. ” This generality frees us from the computational difficulties that \ncome about when one tries to calculate too precise aprice for agiven op-\ntion. The BSM is designed to give aprecise answer, but for investing, simply \nknowing that the price of some security is significantly different from what \nit should be is enough to give one an investing edge.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:66", "doc_id": "a74bbaa3a00e7349c6d3e96e607a8675451a826ab6da004075594275c5a97004", "chunk_index": 0}
{"text": "50  •   The Intelligent Option Investor\nIn terms of how this chapter fits in with the goal of being an \nintelligent option investor, it is in this chapter that we start overlaying \nthe range of exposure introduced in Chapter 1 with the implied stock \nprice range given by the BSM cone that was introduced in Chapter 2. \nThis perspective will allow us to get asense of how expensive it will \nbe to gain exposure to agiven range or, conversely, to see how much \nwe are likely to be able to generate in revenue by accepting exposure \nto that range. Understanding the value of agiven range of exposure as \nperceived by the marketplace will allow us to determine what option \nstrategy will be best to use after we determine our own intelligent \nvaluation range for astock.\nJargon introduced in this chapter is as follows:\nStrike–stock price ratio Volatility (Vol) \nTime value Forward volatility\nIntrinsic value Implied volatility\nTenor Statistical volatility\nTime decay Historical volatility\nHow Option Prices are Determined\nIn Chapter 1, we saw what options looked like from the perspective of \nranges of exposure. One of the takeaways of that chapter was how flexible \noptions are in comparison with stocks. Thinking about it amoment, it is \nclear that the flexibility of options must be avaluable thing. What would \nit be worth to you to only gain upside to astock without having to worry \nabout losing capital as aresult of astock price decline? \nThe BSM, the principles of which we discussed in detail in Chapter 2, \nwas intended to answer this question precisely—“What is the fair value of \nan option?” Let us think about option prices in the same sort of probabilis-\ntic sense that we now know the BSM is using.\nFirst, let’sassume that we want to gain exposure to the upside poten-\ntial of a $50 stock by buying acall option with astrike price of $70 and atime to expiration of 365 days. Here is the risk-return profile of this option \nposition merged with the image of the BSM cone:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:67", "doc_id": "7de2ded1fe8980681af5c7be24c14c1db8fef3c1ed626cc8942f927d37cc73e3", "chunk_index": 0}
{"text": "The Intelligent Investor’s Guide to Option Pricing  •  51\n5/18/2012\n20\n30\n40\n50\n60\n70\n80\n90\n100\n5/20/2013 249 499 999749\nAdvanced Building Corp. (ABC)\nDate/Day Count\nStock Price\nGREEN\nNotice that because this call option is struck at $70, the upside po-\ntential we have gained lies completely outside the cone of values the BSM \nsees as reasonably likely. This option, according to the BSM, is something \nlike the bet that aseven-year-old might make with another seven-year-\nold: “If you can [insert practically impossible action here], I’ll pay you azillion dollars. ” The action is so risky or impossible that in order to entice \nhis or her classmate to take the bet, the darer must offer aphenomenal \nreturn.\nOff the playground and into the world of high finance, the way to \noffer someone aphenomenal return is to set the price of arisky asset very \nlow. Following this logic, we can guess that the price for this option should \nbe very low. In fact, we can quantify this “very low” abit more by thinking \nabout the probabilities surrounding this call option investment.\nRemembering back to the contention in Chapter 2 that the lines of \nthe BSM cone represent around a 16 percent probability of occurrence, \nwe can see that the range of exposure lies outside this, so the chance of \nthe stock making it into this range is lower than 16 percent. Let’ssay that \nthe range of exposure sits at just the 5 percent probability level. What this \nmeans is that if you can find 20 identical investments like this and invest in \nall of them, only one will pay off (1/20 = 5 percent).", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:68", "doc_id": "13145d4883f035bacf35648cff12dfb16c669d79dee28a510ca18e034295d64e", "chunk_index": 0}
{"text": "52  •   The Intelligent Option Investor\nThus, if you thought that you would win $1 for each successful invest-\nment you made, you might only be willing to pay $0.04 to play the game. In \nthis case, you would be wagering $0.04 twenty times in the hope of making \n$1 once—paying $0.80 total to net $0.20 for a (probabilistic) 25 percent \nreturn.\nNow how much would you be willing to bet if the perceived chance \nof success was not 1 in 20 but rather 1 in 5? With options, we can increase \nthe chance of success simply by altering the range of exposure. Let’stry this \nnow by moving the strike price down to $60:\n5/18/2012 5/20/2013 249 499 749\n20\n30\n40\n50\n60\n70\n80\n90\n100\n999\nAdvanced Building Corp. (ABC)\nDate/Day Count\nStock Price\nGREEN\nAfter moving the strike price down, one corner of the range of \nexposure we have gained falls within the BSM probability cone. This option \nwill be significantly more expensive than the $70 strike option because the \nperceived probability of the stock moving into this range is material.\nIf we say that the chance of this call option paying its owner $1 is \n1 in 5 rather than 1 in 20 (the range of exposure is within the 16 percent \nline, so we’re estimating it as a 20 percent chance—1 in 5, in other words), \nwe should be willing to pay more to make this investment. If we expected \nto win $1 for every five tries, we should be willing to spend $0.16 per bet. \nHere we would again expect to pay $0.80 in total to net $0.20, and again \nour expected percentage return would be 25 percent.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:69", "doc_id": "c2a7080c871d4c6b883bdb83194c83ea59658e41a78b0a69c46b5b6d2859bac8", "chunk_index": 0}
{"text": "The Intelligent Investor’s Guide to Option Pricing  •  53\nNotice that by moving the strike down from an expected 5 percent chance \nof success to an expected 20 percent chance of success, we have agreed that we \nwould pay four times the amount to play. What would happen if we lowered the \nstrike to $50 so that the exposure range started at the present price of the stock? \nObviously, this at-the-money (ATM) option would be more expensive still:\n5/18/2012\n30\n20\n40\n50\n60\n70\n80\n90\n100\n5/20/2013 249 499 749 999\nAdvanced Building Corp. (ABC)\nDate/Day Count\nStock Price\nGREEN\nThe range of upside exposure we have gained with this option is not only \nwell within the BSM probability cone, but in fact it lies across the dotted line in-\ndicating the “most likely” future stock value as predicted by the BSM. In other \nwords, this option has abit better than a 50 percent chance of paying off, so it \nshould be proportionally more expensive than either of our previous options.\nThe payouts and probabilities Iprovided earlier are completely made \nup in order to show the principles underlying the probabilistic pricing of \noption contracts. However, by looking at an option pricing screen, it is very \neasy to extrapolate annualized prices associated with each of the probabil-\nity levels Imentioned—5, 20, and 50 percent.\nThe following table lists the relative market prices of call options cor-\nresponding to each of the preceding diagrams.\n1 The table also shows the \ncalculation of the call price as apercentage of the present price of the stock \n($50) as well as the strike–stock price ratio , which shows how far above or \nbelow the present stock price agiven strike price is.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:70", "doc_id": "1578758ae512c09dab4d202ec88034cd096ada46c52aec1feed713027f134941", "chunk_index": 0}
{"text": "54  •   The Intelligent Option Investor\nStrike Price Strike–Stock Price Ratio Call Price\nCall Price as a Percent \nof Stock Price\n70 140% $0.25 0.5\n60 120% $1.15 2.3\n50 100% $4.15 8.3\nNotice that each time we lowered the strike price in successive \nexamples, we lowered the ratio of the strike price to the stock price. This \nrelationship (sometimes abbreviated as K/S, where Kstands for strike price \nand Sstands for stock price) and the change in option prices associated \nwith it are easy for stock investors to understand because of the obvious tie \nto directionality. This is precisely the reason why we have used changes in \nthe strike–stock price ratio as avehicle to explain option pricing. There are \nother variables that can cause option prices to change, and we will discuss \nthese in alater section.\nIwill not make such along-winded explanation, but, of course, \nput options are priced in just the same way. In other words, this put \noption,\n5/18/2012\n-\n10\n20\n30\n40\n50\n60\n70\n80\n90\n100\n5/20/2013 249 499 749 999\nAdvanced Building Corp. (ABC)\nDate/Day Count\nStock Price\nGREEN", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:71", "doc_id": "83236b62849fed24b140769a92ae6f59ed462305c926eff775d3c4d32e2c33b4", "chunk_index": 0}
{"text": "56  •   The Intelligent Option Investor\nThis is so because the area of the range of exposure for the option on \nthe left that is bounded by the BSM probability cone is much smaller than \nthe range of exposure for the option on the right that is bounded by the \nsame BSM probability cone.\nTime Value versus Intrinsic Value\nOne thing that Ihope you will have noticed is that so far we have talked \nabout options that are either out of the money (OTM) or at the money \n(ATM). In-the-money (ITM) options—options whose range of exposure \nalready contains the present stock price—may be bought and sold in just \nthe same way as ATM and OTM options, and the pricing principle is ex-\nactly the same. That is, an ITM option is priced in proportion to how much \nof its range of exposure is contained within the BSM probability cone.\nHowever, if we think about the case of an OTM call option, we realize \nthat the price we are paying to gain access to the stock’supside potential \nis based completely on potentiality. Contrast this case with the case of an \nITM call option, where an investor is paying not only for potential upside \nexposure but also for actual upside as well. \nIt makes sense that when we think about pricing for an ITM call option, \nwe divide the total option price into one portion that represents the poten-\ntial for future upside and another portion that represents the actual upside. \nThese two portions are known by the terms time value and intrinsic value, \nrespectively. It is easier to understand this concept if we look at aspecific \nexample, so let’sconsider the case of purchasing acall option struck at $40 \nand having it expire in one year for astock presently trading at $50 per share. \nWe know that acall option deals with the upside potential of astock \nand that buying acall option allows an investor to gain exposure to that up-\nside potential. As such, if we buy acall option struck at $40, we have access \nto all the upside potential over that $40 mark. Because the stock is trading \nat $50 right now, we are buying two bits of upside: the actual bit and the \npotential bit. The actual upside we are buying is $10 worth (= $50 − $40) \nand is termed the intrinsic value of the option. \nAsimple way to think of intrinsic value that is valid for both call options \nand put options is the amount by which an option is ITM. However, the option’scost will be greater than only the intrinsic value as long as there is still time", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:73", "doc_id": "ea395bb03252cbf3c95d078f9985475e143a35458c5f18053e7478cb2e94dbd6", "chunk_index": 0}
{"text": "The Intelligent Investor’s Guide to Option Pricing  •  57\nbefore the option expires. The reason for this is that although the intrinsic value \nrepresents the actual upside of the stock’sprice over the option strike price, \nthere is still the possibility that the stock price will move further upward in the \nfuture. This possibility for the stock to move further upward is the potential bit \nmentioned earlier. Formally, this is called the time value of an option.\nLet us say that our one-year call option struck at $40 on a $50 stock \ncosts $11.20. Here is the breakdown of this example’soption price into in-\ntrinsic and time value:\n $10.00 Intrinsic value: the amount by which the option is ITM\n+ $1.20 Time value: represents the future upside potential of the stock\n= $11.20 Overall option price\nRecall that earlier in this book Imentioned that it is almost always amis-\ntake to exercise acall option when it is ITM. The reason that it is almost always \namistake is the existence of time value. If we exercised the preceding option, \nwe would generate again of exactly the amount of intrinsic value—$10. How-\never, if instead we sold the preceding option, we would generate again totaling \nboth the intrinsic value and the time value—$11.20 in this example—and then \nwe could use that gain to purchase the stock in the open market if we wanted.\nOur way of representing the purchase of an ITM call option from arisk-reward perspective is as follows:\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749\nEBP = $51.25\n999\n100\n90\n80\n70\n60\n50\n40\n30\n20\nDate/Day Count\nStock Price\nGREEN\nORANGE", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:74", "doc_id": "1024928876a062c6ef94994d69eb1e213ceaa2ae10f020eec3086d6249bdd154", "chunk_index": 0}
{"text": "58  •   The Intelligent Option Investor\nUsually, our convention is to shade again of exposure in green, but \nin the case of an ITM option, we will represent the range of exposure with \nintrinsic value in orange. This will remind us that if the stock falls from its \npresent price of $50, we stand to lose the intrinsic value for which we have \nalready paid. \nNotice also that our (two-tone) range of exposure completely over -\nlaps with the BSM probability cone. Recalling that each upper and lower \nline of the cone represents about a 16 percent chance of going higher or \nlower, respectively, we can tell that according to the option market, this \nstock has alittle better than an 84 percent chance of trading for $40 or \nabove in one year’stime.\n2 \nAgain, the pricing used in this example is made up, but if we take alook at option prices in the market today and redo our earlier table to in-\nclude this ITM option, we will get the following:\nStrike Price ($)\nStrike–Stock \nPrice Ratio (%) Call Price ($)\nCall Price as a Percent \nof Stock Price\n70 140 $0.25 0.5\n60 120 $1.15 2.3\n50 100 $4.15 8.3\n40 80 10.85 21.7\nAgain, it might seem confounding that anyone would want to use the \nITM strategy as part of their investment plan. After all, you end up paying \nmuch more and being exposed to losses if the stock price drops. Iask you \nto suspend your disbelief until we go into more detail regarding option \ninvestment strategies in Part III of this book. For now, the important points \nare (1) to understand the difference between time and intrinsic value, \n(2) to see how ITM options are priced, and (3) to understand our convention \nfor diagramming ITM options.\nFrom these diagrams and examples it is clear that moving the range \nof exposure further and further into the BSM probability cone will increase \nthe price of the option. However, this is not the only case in which options \nwill change price. Every moment that time passes, changes can occur to", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:75", "doc_id": "6cd3df2fcab2191ae8e20d20c0a316313e732710b061c21a2ec316dbdb7b617c", "chunk_index": 0}
{"text": "The Intelligent Investor’s Guide to Option Pricing  •  59\nthe size of the BSM’sprobability cone itself. When the cone changes size, \nthe range-of-exposure area within the cone also changes. Let’sexplore this \nconcept more.\nHow Changing Market Conditions \nAffect Option Prices\nAt the beginning of Chapter 2, Istarted with an intuitive example related \nto afriendly bet on whether acouple would make it to arestaurant in time \nfor adinner reservation. Let’sgo back to that example now and see how the \ninputs translate into the case of stock options.\nDinner Reservation Example Stock Option Equivalent\nHow long before seating time Tenor 3 of the option\nDistance between home and restaurant Difference between strike price and \npresent market price (i.e., strike–stock \nprice ratio)\nAmount of traffic/likelihood of getting caught \nat astoplight\nHow much the stock returns are \nthought likely to vary up and down \nAverage traveling speed Stock market drift\nGas expenditure Dividend payout\nLooking at these inputs, it is clear that the only input that is not known \nwith certainty when we start for the restaurant is the amount of traffic/\nnumber of stoplights measure.\nSimilarly, when the BSM is figuring arange of future stock prices, \nthe one input factor that is unknowable and that must be estimated is \nhow much the stock will vary over the time of the option contract. It is \nno surprise, then, that expectations regarding this variable become the \nsingle most important factor for determining the price of an option and \nthe factor that people talk most about when they talk about options—\nvolatility (vol). \nThis factor is properly known as forward volatility and is formally \ndefined as the expected one-standard-deviation fluctuation up and \ndown around the forward stock price. If this definition sounds familiar,", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:76", "doc_id": "5ba87f4962f326d6663bbda6c45f294b6b0f3ae5c7a5163e2179b8a8520b5ddb", "chunk_index": 0}
{"text": "60  •   The Intelligent Option Investor\nit is because it is also the definition of the BSM cone. To the extent that \nexpectations are not directly observable, forward volatility can only be \nguessed at.\nThe option market’sbest guess for the forward volatility, as expressed \nthrough the option prices themselves, is known as implied volatility. We \nwill discuss implied volatility in more detail in the next section and will \nsee how to build a BSM cone using option market prices and the forward \nvolatility they imply in Part III.\nThe one other measure of volatility that is sometimes mentioned is sta-\ntistical volatility (a.k.a. historical volatility). This is apurely descriptive statis-\ntic that measures the amount the stock price actually fluctuated in the past. \nBecause it is simply abackward-looking statistic, it does not directly affect \noption pricing. Although the effect of statistical volatility on option prices \nis not direct, it can have an indirect effect, thanks to abehavioral bias called \nanchoring. Volatility is ahard concept to understand, let alone aquantity to \nattempt to predict. Rather than attempt to predict what forward volatility \nshould be, most market participants simply look at the recent past statistical \nvolatility and tack on some cushion to come to what they think is areason-\nable value for implied volatility. In other words, they mentally anchor on the \nstatistical volatility and use that anchor as an aid to decide what forward vola-\ntility should be. The amount of cushion people use to pad statistical volatility \ndiffers for different types of stocks, but usually we can figure that the market’simplied volatility will be about 10 percentage points higher than statistical \nvolatility. It is important to realize that this is acompletely boneheaded way \nof figuring what forward volatility will be (so don’temulate it yourself), but \npeople do boneheaded things in the financial markets all the time.\nHowever people come to an idea of what forward volatility is rea-\nsonable for agiven option, it is certain that changing perceptions about \nvolatility are one of the main drivers of option prices in the market. To \nunderstand how this works, let’stake alook at what happens to the BSM \ncone as our view of forward volatility changes. \nChanging Volatility Assumptions\nLet’ssay that we are analyzing an option that expires in two years, with astrike price of $70. Further assume that the market is expecting aforward", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:77", "doc_id": "a0cc4dd38033ce51862a3366c5f0ba1ccc3f4ba94b771eff8ddeee08abca3811", "chunk_index": 0}
{"text": "The Intelligent Investor’s Guide to Option Pricing  •  61\nvolatility of 20 percent per year for this stock. Visually, our assumptions \nyield the following:\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749 999\n100\n90\n80\n70\n60\n50\n40\n30\n20\nDate/Day Count\nStock Price\nGREEN\nAforward volatility of 20 percent per year suggests that after \nthree years, the most likely range for the stock’sprice according to the \nBSM will be around $41 on the low side to around $82 on the high \nside. Furthermore, we can tell from our investigations in Chapter 2 that \nthis option will be worth something, but probably not much—about the \nsame as or maybe alittle more than the one-year, $60 strike call option \nwe saw in Chapter 2.\n4\nNow let’sincrease our assumption for volatility over the life of the \ncontract to 40 percent per year. Increasing the volatility means that the \nBSM probability cone becomes wider at each point. In simple terms, what \nwe are saying is that it is likely for there to be many more large swings in \nprice over the term of the option, so the range of the possible outcomes \nis wider.\nHere is what the graph looks like if we double our assumptions \nregarding implied volatility from 20 to 40 percent:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:78", "doc_id": "e617fb58cdf37e03cf73702175f6c198ed8a5ef6448238ab050516b839a1396d", "chunk_index": 0}
{"text": "The Intelligent Investor’s Guide to Option Pricing  •  63\nWith this change in assumptions, we can see that the most likely \nrange for the stock’sprice three years in the future is between about $50 and \nabout $70. As such, the chance of the stock price hitting $70 in two years \nmoves from somewhat likely (20 percent volatility in the first example) to \nvery likely (40 percent volatility in the second example) to very unlikely \n(10 percent volatility in the third example) in the eyes of the BSM. This \ncharacterization of “very unlikely” is seen clearly by the fact that the BSM \nprobability cone contains not one whit of the call option’sexposure range.\nIn each of these cases, we have drawn the graphs by first picking an \nassumed volatility rate and then checking the worth of an option at acer -\ntain strike price. In actuality, option market participants operate in reverse \norder to this. In other words, they observe the price of an option being \ntransacted in the marketplace and then use that price and the BSM model \nto mathematically back out the percentage volatility implied by the option \nprice. This is what is meant by the term implied volatility and is the process \nby which option prices themselves display the best guesses of the option \nmarket’sparticipants regarding forward volatility. \nIndeed, many short-term option speculators are not interested in the \nrange of stock prices implied by the BSM at all but rather the dramatic change in \nprice of the option that comes about with achange in the width of the volatility \ncone. For example, atrader who saw the diagram representing 10 percent annu-\nalized forward volatility earlier might assume that the company should be trad-\ning at 20 percent volatility and would buy options hoping that the price of the \noptions will increase as the implied volatility on the contracts return to normal.\nThis type of market participant talks about buying and selling volatility as if \nimplied volatility were acommodity in its own right. In this style of option trad-\ning, investors assume that option contracts for aspecific stock or index should \nalways trade at roughly the same levels of implied volatility.\n5 When implied vola-\ntilities change from the normal range—either by increasing or decreasing—an \noption investor in this vein sells or buys options, respectively. Notice that this \nstyle of option transaction completely ignores not only the ultimate value of the \nunderlying company but also the very price of the underlying stock. \nIt is precisely this type of strategy that gives rise to the complex short-\nterm option trading strategies we mentioned in Chapter 1—the ones that are \nset up in such away as to shield the investor transacting options from any of \nthe directionality inherent in options. Our take on this kind of trading is that", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:80", "doc_id": "85ce76cef49ee946c251ed52f9f2500e3241ca154bd4011953547dd26f8d1bd1", "chunk_index": 0}
{"text": "64  •   The Intelligent Option Investor\nalthough it is indeed possible to make money using these types of strategies, \nbecause multiple options must be transacted at one time (in order to control \ndirectional risk), and because in the course of one year many similar trades \nwill need to be made, after you pay the transaction costs and assuming that \nyou will not be able to consistently win these bets, the returns you stand to \nmake using these strategies are low when one accounts for the risk undertaken.\nOf course, because this style of option trading benefits brokers by \nallowing them to profit from the bid-ask spread and from afee on each \ntransaction, they tend to encourage clients to trade in this way. What is \ngood for the goose is most definitely not good for the gander in the case of \nbrokers and investors, so, in general, strategies that will benefit the investor \nrelatively more than they benefit the investor’sbroker—like the intelligent \noption investing we will discuss in Part III—are greatly preferable.\nThe two drivers that have the most profound day-to-day impact \non option prices are the ones we have already discussed: achange in the \nstrike–stock price ratio and achange in forward volatility expectations. \nHowever, over the life of acontract, the most consistent driver of option \nvalue change is time to expiration. We discuss this factor next.\nChanging Time-to-Expiration Assumptions\nTo see why time to expiration is important to option pricing, let us leave \nour volatility assumptions fixed at 20 percent per year and assume that we \nare buying acall option struck at $60 and expiring in two years. First, let’slook at our base diagram—two years to expiration:\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749 999\n100\n90\n80\n70\n60\n50\n40\n30\n20\nDate/Day Count\nStock Price\nGREEN", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:81", "doc_id": "f31f786e50a09ab403ce4147200224de8dffac826adb2808eafb369cfe66d961", "chunk_index": 0}
{"text": "The Intelligent Investor’s Guide to Option Pricing  •  65\nIt is clear from the large area of the exposure range bordered by the \nBSM probability cone that this option will be fairly expensive.\nLet’snow look at an option struck at the same price on the same un-\nderlying equity but with only one year until expiration:\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749 999\n100\n90\n80\n70\n60\n50\n40\n30\n20\nDate/Day Count\nStock Price\nGREEN\nConsistent with our expectations, shortening the time to expiration \nto 365 days from 730 days does indeed change the likelihood as calculated \nby the BSM of acall option going above $60 from quite likely to just barely \nlikely. Again, this can be confirmed visually by noting the much smaller \narea of the exposure range bounded by the BSM probability cone in the \ncase of the one-year option versus the two-year one.\nIndeed, even without drawing two diagrams, we can see that the \nchance of this stock rising above $60 decreases the fewer days until expira-\ntion simply because the outline of the BSM probability cone cuts diagonal-\nly through the exposure range. As the cone’soutline gets closer to the edge \nof the exposure range and finally falls below it, the perceived chance falls \nto 16 percent and then lower. We would expect, just by virtue of the cone’sshape, that options would lose value with the passage of time.\nThis effect has aspecial name in the options world—time decay. Time \ndecay means that even if neither astock’sprice nor its volatility change very \nmuch over the duration of an option contract, the value of that option will", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:82", "doc_id": "ea4a92e3bdd0f6c0b13976463f44d25c3c6fab041fcda6557a92bda043134331", "chunk_index": 0}
{"text": "66  •   The Intelligent Option Investor\nstill fall slowly. Time decay is governed by the shape of the BSM cone and \nthe degree to which an option’srange of exposure is contained within the \nBSM cone. The two basic rules to remember are:\n1. Time decay is slowest when more than three months are left \nbefore expiration and becomes faster the closer one moves toward \nexpiration.\n2. Time decay is slowest for ITM options and becomes faster the \ncloser to OTM the option is.\nVisually, we can understand the first rule—that time decay increases \nas the option nears expiration—by observing the following:\nSlope is shallow here...\nBut steep here...\nThe steepness of the slope of the curve at the two different points \nshows the relative speed of time decay. Because the slope is steeper the less \ntime there is on the contract, time decay is faster at this point as well.\nVisually, we can understand the second rule—that OTM options lose \nvalue faster than ITM ones—by observing the following:\nTime BT ime A Time BT ime A\nGREEN\nGREEN\nORANGE\nOTM option ITM option", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:83", "doc_id": "05cc38f8c73e31373be24d7a3ae819868e466a1746ac7a6e343f109240380a14", "chunk_index": 0}
{"text": "The Intelligent Investor’s Guide to Option Pricing  •  67\nAt time Afor the OTM option, we see that there is abit of the range of \nexposure contained within the cone; however, after some time has passed \nand we are at time B, none of the range of exposure is contained within \nthe BSM cone. In contrast, at times Aand Bfor the ITM option, the entire \nrange of exposure is contained within the BSM cone. Granted, the area of \nthe range of exposure is not as great at time Bas it was at time A, but still, \nwhat there is of the area is completely contained within the cone.\nTheoretically, time decay is aconstant thing, but sometimes actual \nmarket pricing does not conform well to theory, especially for thinly traded \noptions. For example, you might not see any change in the price of an option \nfor afew days and then see the quoted price suddenly fall by anickel even \nthough the stock price has not changed much. This is afunction of the way \nprices are quoted—often moving in 5-cent increments rather than in 1-cent \nincrements—and lack of “interest” in the option as measured by liquidity.\nChanging Other Assumptions\nThe other input assumptions for the BSM (stock market drift and dividend \nyield) have very small effects on the range of predicted future outcomes in \nwhat Iwould call “normal” economic circumstances. The reason for this is \nthat these assumptions do not change the width of the BSM cone but rather \nchange the tilt of the forward stock price line.\nRemember that the effect of raising interest rates by afew points is \nsimply to tilt the forward stock price line up by afew degrees; increasing \nyour dividend assumptions has the opposite effect. As long as interest rates \nand dividend yields stay within typical limits, you hardly see adifference in \npredicted ranges (or option prices) on the basis of achange in these variables. \nSimultaneous Changes in Variables\nIn all the preceding examples, we have held all variables but one constant \nand seen how the option price changes with achange in the one “free” \nvariable. The thing that takes some time to get used to when one is first \ndealing with options is that, in fact, the variables don’tall hold still when \nanother variable changes. The two biggest determinants of option price \nare, as we’ve seen, the strike–stock price ratio and the forward volatility", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:84", "doc_id": "a61ba819d4dfffdeeb9a5accef9cf745d11a78c585c8a76b106cec866564d1f4", "chunk_index": 0}
{"text": "68  •   The Intelligent Option Investor\nassumption. Because these are the two biggest determinants, let’stake alook at some common examples in which achange in one offsets or exac-\nerbates achange in the other. \nFollowing are afew examples of how interactions between the variables \nsometimes appear. For each of these examples, Iam assuming ashorter \ninvestment time horizon than Iusually do because most people who get hurt \nby some adverse combination of variables exacerbate their pain by trading \nshort-term contracts, where the effect of time value is particularly severe.\nFalling Volatility Offsets Accurate Directional Prediction\nLet’ssay that we are expecting Advanced Building Corp. to announce that it \nwill release anew product and that we believe that this product announcement \nwill generate asignificant short-term boost in the stock price. We think that \nthe $50 stock price could pop up to $55, so we buy some short-dated calls \nstruck at $55, figuring that if the price does pop, we can sell the calls struck at \n$55 for ahandsome profit. Here’sadiagram of what we are doing:\n20\n25\n30\n35\n40Stock Price\n45\n50\n55\n60\nAdvanced Building Corp. (ABC)\n65\nGREEN\nAs you should be able to tell by this diagram, this call option should \nbe pretty cheap—there is alittle corner of the call option’srange of expo-\nsure within the BSM cone, but not much.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:85", "doc_id": "18b370811d210c29052b84c2c186056cd92f92419b55c572fa4b915debbbd8c3", "chunk_index": 0}
{"text": "The Intelligent Investor’s Guide to Option Pricing  •  69\nNow let’ssay that our analysis is absolutely right. Just after we buy the \ncall options, the company makes its announcement, and the shares pop up \nby 5 percent. This changes the strike–stock price ratio from 1.05 to 1.00. \nAll things being held equal, this should increase the price of the option \nbecause there would be alarger portion of the range of exposure contained \nwithin the BSM cone.\nHowever, as the stock price moves up, let’sassume that not everything \nremains constant but that, instead, implied volatility falls. This does hap-\npen all the time in actuality; the option market is full of bright, insightful \npeople, and as they recognize that the uncertainty surrounding aproduct \nannouncement or whatever is growing, they bid up the price of the options \nto try to profit in case of aswift stock price move.\nIn the preceding diagram, we’ve assumed an implied volatility of 35 \npercent per year. Let’ssay that the volatility falls dramatically to 15 percent \nper year and see what happens to our diagram:\n20\n25\n30\n35\n40Stock Price\n45\n50\n55\n60\nAdvanced Building Corp. (ABC)\n65\nStock price jumps\nImplied volatility drops\nGREEN\nThe stock price moves up rapidly, but as you can see, the BSM cone shrinks \nas the market reassesses the uncertainty of the stock’sprice range in the \nshort term. The tightening of the BSM cone is so drastic that it more than \noffsets the rapid price change of the underlying stock, so now the option is \nactually worth less!", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:86", "doc_id": "5c730be0effd28ec4ef2400c086d5cd75873c0142164b126d586b36d113b59c8", "chunk_index": 0}
{"text": "70  •   The Intelligent Option Investor\nWe, of course, know that it is worth less because after the announce-\nment, there is only the smallest sliver of the call’srange of exposure con-\ntained within the BSM cone. \nVolatility Rise Fails to Offset Inaccurate Directional Prediction\nLet’ssay that we are bullish on the Antelope Bicycle Co. (ABC) and, noting \nthat the volatility looks “cheap, ” buy call options on the shares. In this case, \nan investor would be expecting to make money on both the stock price and \nthe implied volatility increasing—asituation that would indeed create an \namplification of investor profits.\nWe buy a 10 percent OTM call on ABC that expires in 60 days when \nthe stock is trading for $50.\n20\n25\n30\n35\n40Stock Price 45\n50\n55\nAntelope Bicycle Corp. (ABC)\n60\nGREEN\nThe next morning, while checking our e-mail and stock alerts, we find \nthat ABC has been using ametal alloy in its crankshafts that spontaneously \ncombusts after acertain number of cranks. This process has led to severe \nburn injuries to some of ABC’sriders, and the possibility of aclass-action \nlawsuit is high. The market opens, and ABC’sshares crash by 10 percent. At \nthe same time, the volatility on the options skyrocket from 15 to 35 percent", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:87", "doc_id": "e312ea218c8045f6316b5e7ef608742698bf27063e7bb288cde961e955db2aa5", "chunk_index": 0}
{"text": "The Intelligent Investor’s Guide to Option Pricing  •  71\nbecause of the added uncertainty surrounding product liability claims. \nHere is what the situation looks like now:\n20\n25\n30\n35\n40Stock Price 45\n50\n55\nAntelope Bicycle Corp. (ABC)\n60\nGREEN\nThis time we were right that ABC’simplied volatility looked too cheap, but \nbecause we were directionally wrong, our correct volatility prediction does us \nno good financially. The stock has fallen heavily, and even with alarge increase \nin the implied volatility, our option is likely worth less than it was when we \nbought it. Also, because the option is now further OTM than it originally was, \ntime decay is more pronounced. Thus, to the extent that the stock price stays at \nthe new $45 level, our option’svalue will slip away quickly with each passing day.\nRise in Volatility Amplifies Accurate Directional Prediction\nThese examples have shown cases in which changes in option pricing \nvariables work to the investor’sdisadvantage, but it turns out that changes \ncan indeed work to an investor’sadvantage as well. For instance, let’ssay \nthat we find acompany—Agricultural Boron Co. (ABC)—that we think, \nbecause of its patented method of producing agricultural boron com-\npounds, is relatively undervalued. We decide to buy 10 percent OTM calls \non it. Implied volatility is sitting at around 25 percent, but our option is far \nenough OTM that it is not very expensive.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:88", "doc_id": "ba77deb2e4fb732dbd7c29cc7cd79d3d41834e17b1c805f0965c2f92916d2e82", "chunk_index": 0}
{"text": "The Intelligent Investor’s Guide to Option Pricing  •  73\nWith this happy news story, our call options went from nearly \nworthless to worth quite abit—the increase in volatility amplified the \nrising stock price and allowed us to profit from changes to two drivers of \noption pricing.\nThere is an important follow-up to this happy story that is well worth \nkeeping in the back of your mind when you are thinking about investing \nin possible takeover targets using options. That is, our BSM cone widened \nagreat deal when the announcement was made because the market be-\nlieved that there might be ahigher counteroffer or that the deal would fall \nthrough. If instead the announcement from DuPont was that it had made \nafriendly approach to the ABC board of directors and that its offer had \nalready been accepted, uncertainty surrounding the future of ABC would \nfall to zero (i.e., the market would know that barring any antitrust con-\ncerns, DuPont would close on this deal when it said it would). In this case, \nimplied volatility would simply fall away, and the call option’svalue would \nbecome the intrinsic value (in other words, there is no potential or time \nvalue left in the option). The situation would look like this:\n20\n30\n40 Stock Price\n50\n60\n70\nAgricultural Boron Co. (ABC)\n80\nGREEN\nWe would still make $5 worth of intrinsic value on an invested base \nthat must have been very small (let’ssay $0.50 or so), but were the situation \nto remain uncertain, we would make much more.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:90", "doc_id": "61798bb2e3aad2881d004d92a84f9f0c016bb2022064eea788661bc1bab9a32a", "chunk_index": 0}
{"text": "75\nPart II\nAsound intellectuAl \nfrAmework for \nAssessing vAlue\nAfter reading Part I, you should have avery good theoretical grasp on \nhow options work and how option prices predict the future prices of stocks. \nThis takes us partway to the goal of becoming intelligent option investors. \nThe next step is to understand how to make intelligent, rational es-\ntimates of the value of acompany. It makes no sense at all for aperson to \ninvest his or her own capital buying or selling an option if he or she does not \nhave agood understanding of the value of the underlying stock.\nThe problem for most investors—both professional and individual—\nis that they are confused about how to estimate the value of astock. As such, \neven those who understand how the Black-Scholes-Merton model (BSM) \npredicts future stock prices are not confident that they can do any better. \nThere is agood reason for the confusion among both professional and \nprivate investors: they are not taught to pay attention to the right things. \nIndividual investors, by and large, do not receive training in the basic tools \nof valuation analysis—discounted cash flows and how economic transac-\ntions are represented in aset of financial statements. Professional investors \nare exquisitely trained in these tools but too often spend time spinning \ntheir wheels considering immaterial details simply because that is what \nthey have been trained to do and because their compensation usually relies \non short- rather than long-term performance. They have all the tools in the \nworld but are taught to apply them to answering the wrong questions.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:92", "doc_id": "df568094907f21d7b45d24db52851f16e71b06960ed0ac567cad68d73c748a6e", "chunk_index": 0}
{"text": "78  •   The Intelligent Option Investor\nmoney and discount rates, but even being unacquainted with these terms \nright now will not be ahandicap. \nBusiness is essentially acollection of very simple transactions—pro-\nducing, selling, and investing excess profits. In my experience, one of the \nbiggest investing mistakes occurs when people forget to think about busi-\nness in terms of these simple transactions. \nHaving afirm grasp of valuation is an essential part of being an in-\ntelligent option investor. The biggest drawback of the BSM is its initial as-\nsumption that all stock prices represent the true values of the stocks in \nquestion. It follows that the best opportunity for investors comes when astock’spresent price is far from its true intrinsic value. In order to assess \nhow attractive an investment opportunity is, we must have agood under-\nstanding of the source of value for afirm and the factors that contribute to \nit. These are the topics of this chapter and the next. \nIn terms of our intelligent option investing process, we need two \npieces of information:\n1. Arange of future prices determined mechanically by the option \nmarket according to the BSM\n2. Arationally determined valuation range generated through an in-\nsightful valuation analysis\nThis chapter and the next give the theoretical background necessary to de-\nrive the latter. \nJargon to be introduced in this chapter is as follows:\nAsset Structural constraints\nDemand-side constraints Supply-side constraints\nOwners’ cash profit (OCP) Expansionary cash flow\nFree cash flow to owner(s) (FCFO) Working capital\nThe Value of an Asset \nThe meaning of asset , in financial terms, is different from the vernacular \nmeaning of “something I’ dbe upset about if it broke or was stolen. ” In \nfinancial terms, an asset is anything that can be owned that (1) was created", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:95", "doc_id": "6e330bae8959ff0e20cfa18b376ed2cedfc6a24f51d4edc50fff24708af906bb", "chunk_index": 0}
{"text": "102  •   The Intelligent Option Investor\nAnother case in which the normal profit range of acompany may \nchange is through improvements in productivity. And although improve-\nments to productivity can take along time to play out, they can be ex-\ntremely important. The reason for this is that even if acompany is in astage in which revenues do not grow very quickly, if profit margins are in-\ncreasing, profit that can flow to the owner(s) will grow at afaster rate than \nrevenues. You can see this very clearly in the following table:\nYear 0 1 2 3 4 5 6 7 8 9 10\nRevenues \n($)\n1,234 1,271 1,309 1,348 1,389 1,431 1,473 1,518 1,563 1,610 1,658\nRevenue \ngrowth (%)\n— 3 3 3 3 3 3 3 3 3 3\nOCP ($) \n4 432 445 497 485 514 544 560 637 625 708 746\nOCP \nmargin (%)\n35 35 38 36 37 38 38 42 40 44 45\nOCP \ngrowth \nrate (%)\n— 3 12 –2 6 6 3 14 –2 13 5\nEven though revenues grew by aconstant 3 percent per year over this \ntime, OCP margin (owner’scash profit/revenues) increased from 35 to \n45 percent, and the compound annual growth in OCP was nearly twice \nthat of revenue growth—at 6 percent.\nThinking back to the earlier discussion of the life cycle of acompany, \nrecall that the rate at which acompany’scash flows grew was avery important \ndeterminant of the value of the firm. The dynamic of acompany with arela-\ntively slow-growing revenue line and an increasing profit margin is common. \nAtypical scenario is that acompany whose revenues have been increasing \nquickly may be more focused on meeting demand by any means possible rath-\ner than in the most efficient way. As revenue growth slows, attention starts to \nturn to increasing the efficiency of the production processes. As that efficiency \nincreases, so does the profit margin. As the profit margin increases, as long as \nthe revenue line has some positive growth, profit growth will be even faster. \nThis dynamic is worth keeping in mind when analyzing companies \nand in the next section, where Idiscuss the next driver of company value—\ninvestment level and efficacy.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:119", "doc_id": "1e8837af74bdcb5e6ba9db70957e76f3c0e4952ae27b304e08c8b0fa14284090", "chunk_index": 0}
{"text": "The Four Drivers of Value  •  105\nOver this very long period, the nominal GDP growth in the United \nStates averaged just over 6 percent per year. If the investment projects \nof acompany are generally successful, the company will be able to \ndependably grow its profits at arate faster than this 6 percent (or so) \nbenchmark. The length of time it will be able to grow faster than this \nbenchmark will depend on various factors related to the competitive-\nness of the industry, the demand environment, and the investing skill \nof its managers.\nSeeing whether or not investments have been successful over time is \nasimple matter of comparing OCP growth with nominal GDP . Let’slook at \nafew actual examples. Here is agraph of my calculation of Walmart’s OCP \nand OCP margin over the last 13 years:\n2000 2005 2010\n0.00%\n0.50%\n1.00%\n1.50%\n2.00%\n2.50%\n3.00%\n3.50%\n4.00%\n4.50%\n5.00%20,000\n18,000\n16,000\n14,000\n12,000\n10,000\n8,000\n6,000\n4,000\n2,000\n-\nEstimated Owners’ Cash Profit and OCP Margin for Walmart\nTotal Estimated OCP (LH) OCP Margin (RH)\nAs one might expect with such alarge, mature firm, OCP margin \n(shown on the right-hand axis) is very steady—barely breaking from the \n3.5 to 4.5 percent range over the last 10 years. At the same time, its to-\ntal OCP (shown on the left-hand axis) grew nicely as aresult of increases \nin revenues. Over the last seven years, Walmart has spent an average of \naround 2 percent of its revenues on expansionary projects, implying that", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:122", "doc_id": "7e15ce24e4b0925bfc90c0cc735079b38c43226de3f85017e80e0fe30a1e5e20", "chunk_index": 0}
{"text": "141\nPart III \nIntellIgent OptIOn \nInvestIng\nNow that you understand how options work and how to value companies, \nit is time to move from the theoretical to the practical to see how to apply \nthis knowledge to investing in the market. With Part III of this book, we \nmake the transition from theoretical to practical, and by the time you finish \nthis part, you will be an intelligent option investor.\nTo invest in options, you must know how to transact them; this is the \nsubject of Chapter 7. In it, you will see how to interpret an option pricing \nscreen and to break down the information there so that you can under -\nstand what the option market is predicting for the future price of astock. Ialso talk about the only one of the Greeks that an intelligent option investor \nneeds to understand well—delta.\nChapter 8 deals with asubject that is essential for option investors—\nleverage. Not all option strategies are levered ones, but many are. As such, \nwithout understanding what leverage is, how it can be measured and used, \nand how it can be safely and sanely incorporated into aportfolio, you can-\nnot be said to truly understand options.\nChapters 9–11 deal with specific strategies to gain, accept, and mix \nexposure. In these chapters Ioffer specific advice about what strike prices \nare most effective to select and what tenors, what to do when the expected \noutcomes of an investment materially change, and how to incorporate \neach strategy into your portfolio. Chapter 11 also gives guidance on so-\ncalled option overlay strategies, where aposition in astock is overlain by \nan option to modify the stock’srisk-reward profile (e.g., protective puts for \nhedging and covered calls for generating income).", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:158", "doc_id": "31681e60fe62794cf81f9df7915d147982e012b4849ba3080448a030d8111af2", "chunk_index": 0}
{"text": "142  •   The Intelligent Option Investor\nUnlike some books, this book includes only ahandful of strategies, \nand most of those are very simple ones. Ishun complex positions for two \nreasons. First, as you will see, transacting in options can be very expensive. \nThe more complex an option strategy is, the less attractive the potential \nreturns become. Second, the more complex astrategy is, the less the inher-\nent directionality of options can be used to an investor’sadvantage. \nSimple strategies are best. If you understand these simple strategies \nwell, you can start modifying them yourself to meet specific investing sce-\nnarios when and if the need arises. Perhaps by using these simple strategies \nyou will not be able to chat with the local investment club option guru \nabout the “gamma on an iron condor, ” but that will be his or her loss and \nnot yours.\nChapter 12 looks at what it means to invest intelligently while under-\nstanding the two forms of risk you assume by selecting stocks in which to \ninvest: market risk and valuation risk.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:159", "doc_id": "9a03dbd995e52410d024f0ea228d32f4c6b9b0d3f557f0c569f9d5a3659dfb4b", "chunk_index": 0}
{"text": "143\nChapter 7\nFIndIng MIsprIced \nOptIOns\nAll our option-related discussions so far have been theoretical. Now it \nis time to delve into the practical to see how options work in the market. \nAfter finishing this chapter, you should understand\n1. How to read an option chain pricing screen\n2. Option-specific pricing features such as awide bid-ask spread, \nvolatility smile, bid and ask volatility, and limited liquidity/ \navailability\n3. What delta is and why it is important to intelligent option investors\n4. How to compare what the option market implies about future \nstock prices to an intelligently determined range\nIn terms of where this chapter fits into our goal of becoming intelligent \noption investors, obviously, even if you have aperfect understanding of \noption and valuation theory, if you do not understand the practical steps \nyou must take to find actual investment opportunities in the real world, all \nthe theory will do you no good.\nNew jargon introduced in this chapter includes the following:\nClosing price Bid implied volatility\nSettlement price Ask implied volatility\nContract size Volatility smile\nRound-tripping Greeks\nBid-ask spread Delta", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:160", "doc_id": "7f3a75c1efa4ae33e4e7a4649344c27f565743699f61008afb8527b455cc56e3", "chunk_index": 0}
{"text": "144  •   The Intelligent Option Investor\nMaking Sense of Option Quotes\nLet’sstart our practical discussion by taking alook at an actual option \npricing screen. These screens can seem intimidating at first, but by the end \nof this chapter, they will be quite sensible.\nLast\n0.86 -0.23\n-0.14\n-0.04\n-0.17\n-0.14\n-0.06\n-0.13\n-0.12\n-0.07\n-0.09\n-0.14\n-0.06\n-0.20\n-0.26\n-0.10\n+0.01\n0.91 0.94 21.672% 24.733% 0.8387\n0.4313\n0.0631\n0.0000\n0.0000\n0.0000\n0.9580\n0.9598\n0.9620\n0.7053\n0.4743\n0.2461\n0.0357\n0.0392\n0.0482\n21.722%\n22.988%\n62.849%\n72.188%\n81.286%\n201.771%\n192.670%\n175.779%\n20.098%\n18.997%\n18.491%\n25.587%\n29.201%\n35.855%\n55.427%\n123.903%\n64.054%\n23.311%\n22.407%\n21.813%\n21.147%\n22.144%\n23.409%\n54.689%\n66.920%\n35.642%\n23.656%\n23.072%\n22.553%\n21.460%\n21.374%\n21.581%\n32.597%\n24.854%\n23.426%\n20.380%\n19.627%\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\n0.26\n0.04\n0.02\n0.02\n0.02\n13.30\n12.40\n11.35\n1.19\n0.58\n0.22\n0.01\n0.01\n0.02\n11.90\n12.35\n10.10\n1.68\n1.10\n0.67\n0.05\n0.03\n0.02\n0.24\n0.02\n10.35\n9.30\n8.40\n1.17 19.408%\n18.405%\n17.721%\n0.56\n0.20\n11.75\n10.70\n9.50\n1.65\n1.08\n0.65\n0.04\n0.01\n0.01\n11.55 12.30\n12.00\n10.00\n2.48\n1.93\n1.48\n0.41\n0.29\n0.21\n12.20\n3.60\n1.75\n10.05\n9.85\n2.44\n1.91\n1.45\n0.39\n0.27\n0.18\n12.10\n3.50\n1.70\n0.00\n0.23\n0.02\nC0.00\nC0.00\nC0.00\n0.09\n0.45\n1.15\nC4.99\nC5.99\nC6.99\nC4.99\nC5.99\nC6.99\nC12.01\nC11.01\nC10.01\n1.16\n0.54\n0.22\nC0.00\nC0.00\nC0.00\nC0.00\nC0.00\nC0.00\n0.33\n0.76\n1.40\nC5.03\nC6.00\nC6.99\nC0.00\nC0.01\nC0.03\n0.84\n1.23\n1.88\nC12.02\nC11.03\nC10.04\n1.65\n1.06\n0.66\nC0.06\n0.03\n0.02\nC12.05\nC11.07\nC10.10\nC2.58\n1.93\n12.10\n3.40\n1.69\n0.68\n4.25\nC7.27\n1.42\n0.38\nC0.30\nC0.22\nC0.11\nC0.15\nC0.19\n1.80\n2.27\n2.73\nC5.57\nC6.43\nC7.35\nChng Bid AskA skImpl.Impl.Bid Vol. Vol. Delta JUL 26 ´13\n31\n32\n33\n37\n38\n39\n20\n21\n22\n31\n32\n33\n37\n38\n39\nDescription\nCall\nLast Chng Bid AskA skImpl.Impl.Bid Vol. Vol. Delta\nPut\n0.9897\n0.9869\n0.9834\n0.6325\n0.4997\n0.3606\n0.0463\n0.0266\n0.0155\n0.9712\n0.9628\n0.9535\n0.5890\n0.5118\n0.4324\n0.1664\n0.1258\n0.0923\n0.9064\n0.5354\n0.3336\n+0.01\n+0.10\n+0.11\n0.07 0.09 22.812%2 4.853% -0.1613\n-0.5689\n-0.9373\n-1.0000\n-1.0000\n-1.0000\n22.469%\n24.612%\n85.803%\n203.970%\n267.488%\n20.456%\n19.851%\nN/A\nN/A\nN/A\n0.42\n1.20\n5.25\n7.25\n8.90\n0.39\n1.17\n4.90\n4.85\n5.40\n+0.02\n+0.09\n+0.14\n-0.0420\n-0.0402\n-0.0380\n-0.2948\n-0.5261\n-0.7545\n-0.9652\n-0.9616\n-0.9524\n77.739%\n70.681%\n63.514%\n20.303%\n19.170%\n19.011%\n41.423%\n61.602%\n52.378%\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\n0.02\n0.02\n0.02\n0.34\n0.73\n1.38\n5.30\n6.55\n7.30\n0.33\n0.71\n1.35\n4.95\n19.958%\n18.577%\n17.954%\n4.65\n6.70\n22.720%\n22.019%\n21.378%\n20.455%\n19.050%\n21.354%\n0.000%\n23.193%\n22.845%\n22.218%\n21.148%\n20.913%\n20.899%\n+0.07\n+0.05\n+0.16\n+0.09\n+0.12\n+0.04\n50.831%\n48.233%\n46.993%\n23.384%\n22.672%\n22.106%\n36.111%\n30.947%\n44.342%\nN/A\nN/A\nN/A\nN/A\n0.02\n0.03\n0.05\n0.82\n1.25\n1.82\n5.55\n6.30\n7.55\n0.01\n0.80\n1.23\n1.79\n4.95\n6.15\n6.85\n-0.0103\n-0.0131\n-0.0166\n-0.3679\n-0.5008\n-0.6402\n-0.9558\n-0.9757\n-0.9871\n22.989%\n22.284%\n21.453%\n17.134%\n37.572%\n38.919%\n37.587%\n35.246%\n23.914%\n23.485%\n22.925%\n22.967%\n26.265%\n28.715%\n0.11 0.13\n0.17\n0.19\n1.78\n2.25\n2.80\n5.80\n6.85\n7.85\n0.13\n0.17\n1.75\n2.22\n2.76\n5.70\n6.50\n7.40\n-0.0318\n-0.0406\n-0.0503\n-0.4120\n-0.4879\n-0.5665\n-0.8294\n-0.8690\n-0.9025\n34.172%\n23.567%\n23.145%\n22.479%\n21.404%\n19.420%\n18.411%\n37.790%\n35.385%\n30.523%\n24.198%\n23.081%\n0.00\n+0.09\n33.497%\n26.033%\n24.745%\n0.68\n4.25\n7.40\n0.66\n4.15\n7.30\n-0.0906\n-0.4520\n-0.6521\n33.203%\n25.378%\n24.054%\nAUG 16 ´13\n20\n21\n22\n31\n32\n33\n37\n38\n39\nSEP 20 ´13\n20\n21\n22\n31\n32\n33\n37\n38\n39\n20\n32\n37\nJAN 17 ´14\nJAN 16 ´15\nIpulled this screen—showing the prices for options on Oracle (ORCL)—\non the weekend of July 20–21, 2013, when the market was closed. The last \ntrade of Oracle’sstock on Friday, July 19, was at $31.86, down $0.15 from the \nThursday’sclose. Your brokerage screen may look different from this one, but \nyou should be able to pull back all the data columns shown here. Ihave limited \nthe data I’mpulling back on this screen in order to increase its readability. \nMore strikes were available, as well as more expiration dates. The expirations \nshown here are 1 week and 26, 60, 180, and 544 days in the future—the \n544-day expiry being the longest tenor available on the listed market.\nLet’sfirst take alook at how the screen itself is set up without paying \nattention to the numbers listed.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:161", "doc_id": "8867e295c0ff5fd0575a7dda264eedfef1107da08bf70fa75021a656a48cf006", "chunk_index": 0}
{"text": "Finding Mispriced Options    • 145\nCalls are on the left, puts on the right.\nStrike prices\nand expirations\nare listed here.\nYou can tell the stock was down on this day because most of the call\noptions are showing losses and all the put options are showing gains.\nAll the strikes for\neach selected expiry\nare listed grouped\ntogether.\nThis query was set up\nto pull back three\nstrikes at the three\nmoneyness regions\n(20–22, 29–31, 37–39).\nThe 1-week options\nand the LEAPS did\nnot have strikes at\neach of the prices Irequested.\nNow that you can see what the general setup is, let’sdrill down and \nlook at only the calls for one expiration to see what each column means.\nLast\nC12.02 11.75\n10.70\n9.50\n1.65\n1.08\n0.65\n0.04\n0.01\n0.01 0.02\n0.03\n0.05\n0.67\n1.10\n1.68\n10.10\n12.35\n11.90 N/A\nN/A\nN/A\n22.720%\n55.427% 20\nSEP 20 ´13\n21\n22\n31\n32\n33\n37\n38\n39\n0.9869\n0.9834\n0.6325\n0.4997\n0.3606\n0.0463\n0.0266\n0.0155\n123.903%\n64.054%\n23.311%\n22.407%\n21.813%\n21.147%\n22.144%\n23.409%\n22.019%\n21.378%\n20.455%\n19.050%\n21.354%\nC11.03\nC10.04\n1.65\n1.06\n-0.13\n-0.12\n-0.07\n0.00\n+0.01\n0.66\nC0.06\n0.03\n0.02\nChnq Bid AskA skImpl.Impl.Bid Vol. Vol. Delta Description\nCall\n0.9897\nRed\n(loss) Green\n(gain)", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:162", "doc_id": "6505517a4bdd8366e4e96c5ff335b3e11d72f413ca2e7aea89b5e75b6a9603fd", "chunk_index": 0}
{"text": "146  •   The Intelligent Option Investor\nLast\nThis is the last price at which the associated contract traded. Notice that \nthe last price associated with the far in-the-money (ITM) strikes ($20, $21, \n$22) and one of the far out-of-the-money (OTM) strikes ($37) have the \nletter “C” in front of them. This is just my broker’sway of showing that the \ncontract did not trade during that day’strading session and that the last \nprice listed was the closing price of the previous day. Closing prices are not \nnecessarily market prices. At the end of the day, if acontract has not traded, \nthe exchange will give an indicative closing price (or settlement price ) for \nthat day. The Oracle options expiring on August 16, 2013, and struck at \n$20 may not have traded for six months or more, with the exchange simply \n“marking” aclosing price every day.\nOne important fact to understand about option prices is that they \nare quoted in per-share terms but must be transacted in contracts that rep-\nresent control of multiple shares. The number of shares controlled by one \ncontract is called the contract size . In the U.S. market, one standard con-\ntract represents control over 100 shares. Sometimes the number of shares \ncontrolled by asingle contract differs (in the case of acompany that was \nacquired through the exchange of shares), but these are not usually avail-\nable to be traded. In general, one is safe remembering that the contract size \nis 100 shares.\nYou cannot break acontract into smaller pieces or buy just part of acontract—transacting in options means you must do so with indivisible \ncontracts, with each contract controlling 100 shares. Period. As such, every \nprice you see on the preceding screenshot, if you were to transact in one of \nthose options, would cost you 100 times the amount shown. For example, \nthe last price for the $31-strike option was $1.65. The investor who bought \nthat contract paid $165 for it (plus fees, taxes, and commissions, which are \nnot included in the posted price). In the rest of this book, when Imake \ncalculations regarding money spent on acertain transaction, you will al-\nways see me multiply by 100.\nChange\nThis is the change from the previous day’sclosing price. My broker shows \nchange only for contracts that were actively traded that day. It looks like", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:163", "doc_id": "df560c2c3fa7e6260d1bc398ea733fdc9fc7726e61f0e2364d6ce0423b067657", "chunk_index": 0}
{"text": "Finding Mispriced Options    • 147\nthe near at-the-money (ATM) strikes were the most active because of the \ntwo far OTM options that traded; one’sprice didn’tchange at all, and the \nother went up by 1 cent. On aday in which the underlying stock fell, these \ncalls theoretically should have fallen in price as well (because the K/Sratio, \nthe ratio of strike price to stock price, was getting slightly larger). This just \nshows that sometimes there is adisconnect between theory and practice \nwhen it comes to options. \nTo understand what is probably happening, we should understand \nsomething about market makers. Market makers are employees at bro-\nker-dealers who are responsible for ensuring aliquid, orderly securi-\nties market. In return for agreeing to provide aminimum liquidity of \n10 contracts per strike price, market makers get the opportunity to earn \nthe bid-ask spread every time atrade is made (Iwill talk about bid-ask \nspreads later). However, once amarket maker posts agiven price, he or \nshe is guaranteeing atrade at that price. If, in this case (because we’re \ndealing with OTM call options), some unexpected positive news comes \nout that will create ahuge rise in the stock price once it filters into the \nmarket and an observant, quick investor sees it before the market maker \nrealizes it, the investor can get areally good price on those far OTM call \noptions (i.e., the investor could buy afar OTM call option for 1 cent and \nsell it for 50 cents when the market maker realizes what has happened. \nTo provide alittle slack that prevents the market maker from losing too \nmuch money if this happens, market makers usually post prices for far \nOTM options or options on relatively illiquid stocks that are abit unrea-\nsonable—at alevel where asmart investor would not trade with him or \nher at that price. If someone trades at that price, fine—the market maker \nhas committed to provide liquidity, but the agreement does not stipulate \nthat the liquidity must be provided at areasonable price. For this reason, \nfrequently you will see prices on far OTM options that do not follow the \ntheoretical “rules” of options.\nBid-Ask\nFor astock investor, the difference between abid price and an ask price \nis inconsequential. For option investors, though, it is afactor that must \nbe taken into consideration for reasons that Iwill detail in subsequent", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:164", "doc_id": "be918150cf273adbc58319882fc96f3f16d64d56593107ad1f185fdff0304660", "chunk_index": 0}
{"text": "148  •   The Intelligent Option Investor\nparagraphs. The easiest way to think of the bid-ask spread is to think in \nterms of buying anew car. If you buy anew car, you pay, let’ssay, $20,000. \nThis is the ask price. You grab the keys, drive around the block, and \nreturn to the showroom offering to sell the car back to the dealership. The \ndealership buys it for $18,000. This is the bid price. The bid-ask spread is \n$2,000 in this example.\nBid-ask spreads are proportionally much larger for options than \nthey are for stocks. For example, the options I’ve highlighted here are on \navery large, important, and very liquid stock. The bid-ask spread on the \n$32-strike call option (which you will learn in the next section is exactly \nATM) is $0.02 on amidprice of $1.09. This works out to apercentage bid-\nask spread of 1.8 percent. Compare this with the bid-ask spread on Ora-\ncle’sstock itself, which was $0.01 on amidprice of $31.855—apercentage \nspread of 0.03 percent.\nFor smaller, less-liquid stocks, the percentage bid-ask spread is even \nlarger. For instance, here is the option chain for Mueller Water (MW A):\n2.5\n5\n7.5\n10\nLast\nC5.30\nC2.80\n0.55\nC0.00\nChange Bid AskI mpl. Bid Vol. Impl. Ask Vol. Impl. Bid Vol. Impl. Ask Vol.Delta\n2.5\n5\n7.5\n10\n2.5\n5\n7.5\n10\n12.5\nDescriptionCall\nLast Change BidA sk Delta\nPut\nC0.00\nC0.00\nC0.25\nC2.25\nC0.00\nC0.00\nC0.55\nC2.35\nC0.00\nC0.10\nC0.85\nC2.55\nC4.80\n5.20 5.50 N/A 340.099% 0.9978\n0.9978\n0.7330\n0.1316\n0.9347\n0.8524\n0.6103\n0.1516\n0.9933\n0.9190\n0.6070\n0.2566\n0.1024\n142.171%\n46.039%\n76.652%\nN/A\nN/A\n2.95\n0.55\n0.10\n0.20\n0.10 N/A\nN/A\nN/A\n0.10\n0.30\n2.35\n40.733%\nN/A\nN/A\nN/A\nN/A\n36.550%\n38.181%\n35.520%\n35.509%\n35.664%\n2.10\n0.50\n0.05\n0.10\n0.60\n2.402.30\n0.05\n0.15\n0.15\n0.85\n2.60\n4.90\n0.70\n2.45\n4.60\n2.70\n0.500.00\n5.20 5.50\n3.00\n0.90\n0.20\n2.80\n0.80\n0.10\n5.505.10\n3.102.85\n1.151.05\n0.400.30\n0.200.05\n39.708%\nN/A\nN/A\n36.722%\nN/A\n38.754%\n38.318%\n39.127%\n36.347%\n36.336%\n292.169% 0.0000\n-0.0000\n-0.2778\n-0.8663\n-0.0616\n-0.1447\n-0.3886\n-0.8447\n-0.0018\n-0.0787\n-0.3890\n-0.7375\n-0.8913\n128.711%\n53.108%\n88.008%\n117.369%\n60.675%\n42.433%\n44.802%\n110.810%\n50.757%\n42.074%\n43.947%\n49.401%\n163.282%\n75.219%\n42.610%\n45.215%\n122.894%\n64.543%\n42.697%\n44.728%\n50.218%\nC5.30\nC2.80\nC0.85\nC0.10\nC5.30\nC1.10\nC0.35\nC0.10\n3.00 +0.15\nAUG 16 ´13\nNOV 15 ´13\nFEB 21 ´14\nLooking at the closest to ATM call options for the November expiration—\nthe ones struck at $7.50 and circled in the screenshot—you can see that \nthe bid-ask spread is $0.10 on amidprice of $0.85. This works out to 11.8 \npercent.\nBecause the bid-ask spread is so very large on option contracts, \nround-tripping\n1 an option contract creates alarge hurdle that the returns \nof the security must get over before the investor makes any money. In the \ncase of Mueller Water, the options one buys would have to change in price \nby 11.8 percent before the investor starts making any money at all. It is for \nthis reason that Iconsider day trading in options and/or using complex", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:165", "doc_id": "da5bac7a59ad653a0aea32eaeae82fd34b1cd7ded6779070cc0b8fc322b3f2c6", "chunk_index": 0}
{"text": "Finding Mispriced Options    • 149\nstrategies involving the simultaneous purchase and sale of multiple con-\ntracts to be apoor investment strategy.\nImplied Bid Volatility/Implied Ask Volatility\nBecause the price is so different between the bid and the ask, the range of fu-\nture stock prices implied by the option prices can be thought of as different \ndepending on whether you are buying or selling contracts. Employing the \ngraphic conventions we used earlier in this book, this effect is represented \nas follows:\nImplied price range implied\nby ask price volatility of 23.4%\nImplied price range implied\nby bid price volatility of 21.4%\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20131/12/2012\nOracle (ORCL)\nPrice per Share\n60\n50\n40\n30\n20\n10\n-\nBecause Oracle is such abig, liquid company, the difference between \nthe stock prices implied by the different bid-ask implied volatilities is not \nlarge, but it can be substantial for smaller, less liquid companies. Looking \nat the ask implied volatility column, you will notice the huge difference \nbetween the far ITM options’ implied volatilities and those for ATM and \nOTM options. The data in the preceding diagram are incomplete, but \nif you were to graph all the implied volatility data, you would get the \nfollowing:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:166", "doc_id": "1531f5cc55f156f3529cd61f53233b2cdbd9334c0dcbc697becd48400019d63c", "chunk_index": 0}
{"text": "150  •   The Intelligent Option Investor\n18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39\nStrike Price\nOracle (ORCL) Implied Volatility\nImplied Volatility (Percent)\n160\n180\n140\n100\n120\n80\n40\n60\n20\n0\nThinking about what volatility means with regard to future stock \nprices—namely, that it is aprediction of arange of likely values—it does not \nmake sense that options struck at different prices would predict such radi-\ncally different stock price ranges. What the market is saying, in effect, is that it \nexpects different things about the likely future range of stock prices depending \non what option is selected. Clearly, this does not make much sense.\nThis “nonsensical” effect is actually proof that practitioners \nunderstand that the Black-Scholes-Merton model’s (BSM’s) assumptions \nare not correct and specifically that sudden downward jumps in astock \nprice can and do occur more often than would be predicted if returns fol-\nlowed anormal distribution. This effect does occur and even has aname—\nthe volatility smile . Although this effect is extremely noticeable when \ngraphed in this way, it is not particularly important for the intelligent op-\ntion investing strategies about which Iwill speak. Probably the most im-\nportant thing to realize is that the pricing on far OTM and far ITM options \nis alittle more informal and approximate than for ATM options, so if you \nare thinking about transacting in OTM or ITM options, it is worth looking \nfor the best deal available. For example, notice that in the preceding dia-\ngram, the $21-strike implied volatility is actually notably higher than the", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:167", "doc_id": "cb86f4710e5b39486dd5f5d8e9d274fc4b7f1da910ad08893741c627245d54d6", "chunk_index": 0}
{"text": "Finding Mispriced Options    • 151\n$20-strike volatility. If you were interested in buying an ITM call option, \nyou would pay less time value for the $20-strike than for the $21-strike op-\ntions—essentially the same investment. Iwill talk more about the volatility \nsmile in the next section when discussing delta.\nIn asimilar way, sometimes the implied volatility for puts is different \nfrom the implied volatility for calls struck at the same price. Again, this is \none of the market frictions that arises in option markets. This effect also \nhas investing implications that Iwill discuss in the chapters detailing dif-\nferent option investing strategies.\nThe last column in this price display is delta , ameasure that is so \nimportant that it deserves its own section—to which we turn now.\nDelta: The Most Useful of the Greeks\nSomeone attempting to find out something about options will almost \ncertainly hear about how the Greeks are so important. In fact, Ithink that \nthey are so unimportant that Iwill barely discuss them in this book. If you \nunderstand how options are priced—and after reading Part I, you do—the \nGreeks are mostly common sense. \nDelta, though, is important enough for intelligent option investors \nto understand with abit more detail. Delta is the one number that gives \nthe probability of astock being above (for calls) or below (for puts) agiven \nstrike price at aspecific point in time.\nDeltas for calls always carry apositive sign, whereas deltas for puts are \nalways negative, so, for instance, acall option on agiven stock whose delta is \nexactly 0.50 will have aput delta of −0.50. The call delta of 0.50 means that there \nis a 50 percent chance that the stock will expire above that strike, and the put \ndelta of −0.50 means that there is a 50 percent chance that the stock will expire \nbelow that strike. In fact, this strike demonstrates the technical definition of \nATM—it is the most likely future price of the stock according to the BSM.\nThe reason that delta is so important is that it allows you one way \nof creating the BSM probability cones that you will need to find option \ninvestment opportunities. Recall that the straight dotted line in our BSM \ncone diagrams meant the statistically most likely future price for the stock. \nThe statistically most likely future price for astock—assuming that stocks", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:168", "doc_id": "47fd887566e499f14499a8913c62eebf812845edebd217e4a0c3aeb5aaab0729", "chunk_index": 0}
{"text": "152  •   The Intelligent Option Investor\nmove randomly, which the BSM does—is the price level at which there is \nan equal chance of the actual future stock price to be above or below. In \nother words, the 50-delta mark represents the forward price of astock in \nour BSM cones.\nRecall now also that each line demarcating the cone represents roughly a \n16 percent probability of the stock reaching that price at aparticular time in the \nfuture. This means that if we find the call strike prices that have deltas closest to \n0.16 and 0.84 (= 1.00 − 0.16) or the put strike prices that have deltas closest to \n−0.84 and −0.16 for each expiration, we can sketch out the BSM cone at points \nin the future (the data Iused to derive this graph are listed in tabular format at \nthe end of this section).\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012\nDate\nOracle (ORCL)\nPrice per Share\n45\n40\n35\n30\n25\n20\n5\n10\n15\n-\nObviously, the bottom range looks completely distended compared \nwith the nice, smooth BSM cone shown in earlier chapters. This dis-\ntension is simply another way of viewing the volatility smile. Like the \nvolatility smile, the distended BSM cone represents an attempt by partici-\npants in the options market to make the BSM more usable in real situa-\ntions, where stocks really can and do fall heavily even though the efficient \nmarket hypothesis (EMH) says that they should not. The shape is saying,", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:169", "doc_id": "e9dda17baf9c4cf8bf28f62bf971f5a0d3f9ba9c2becb4f0e183b67b20993e33", "chunk_index": 0}
{"text": "Finding Mispriced Options    • 153\n“We think that these prices far below the current price are much more \nlikely than they would be assuming normal percentage returns. ” (Or, in aphrase, “We’re scared!”)\nIf we compare the delta-derived “cone” with atheoretically derived \nBSM cone, here is what we would see:\nOracle (ORCL)\nDate\nPrice per Share\n60\n50\n40\n30\n20\n10\n-\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012\nOf course, we did not need the BSM cone to tell us that the points \nassociated with the downside strikes look too low. But it is interesting to see \nthat the upside and most likely values are fairly close to what the BSM projects. \nNote also that the downside point on the farthest expiration is nearly \nfairly priced according to the BSM, contrary to the shorter-tenor options. \nThis effect could be because no one is trading the far ITM call long-term \nequity anticipation securities (LEAPS), so the market maker has simply \nposted his or her bid and ask prices using the BSM as abase. In the market, \nthis is what usually happens—participants start out with amechanically \ngenerated price (i.e., using the BSM or some other computational option \npricing model) and make adjustments based on what feels right, what \narbitrage opportunities are available, and so on.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:170", "doc_id": "9cf639880bc226199732ec50e773d32a98bd053fc1331e2b305672ac14116f74", "chunk_index": 0}
{"text": "154  •   The Intelligent Option Investor\nOne important thing to note is that although we are using the delta \nfigure to get an idea of the probability that the market is assigning to acertain \nstock price outcome, we are also using deltas for options that nearly no one \never trades. Most option volume is centered around the 50-delta mark and a \n10 to 20 percentage point band around it (i.e., from 30- to 40-delta to 60- to \n70-delta). It is doubtful to me that these thinly traded options contain much \nreal information about market projections of future stock prices.\nAnother problem with using the deltas to get an idea about market \nprojections is that we are limited in the length of time we can project out \nto only the number of strikes available. For this example, Ichose an impor-\ntant tech company with avery liquid stock, so it has plenty of expirations \nand many strikes available so that we can get agranular look at deltas. \nHowever, what if we were looking at Mueller Water’soption chain and try-\ning to figure out what the market is saying?\n2.5\n5\n7.5\n10\nLast\nC5.30\nC2.80\n0.55\nC0.00\nChange Bid Ask Impl. Bid Vol. Impl. Ask Vol. Delta AUG 16 ´13\n2.5\n5\n7.5\n10\nNOV 15 ´13\n2.5\n5\n7.5\n10\n12.5\nFEB 21 ´14\nDescriptionCall\n5.20 5.50 N/A 340.099% 0.9978\n0.9978\n0.7330\n0.1316\n0.9347\n0.8524\n0.6103\n0.1516\n0.9933\n0.9190\n0.6070\n0.2566\n0.1024\n142.171%\n46.039%\n76.652%\nN/A\nN/A\n2.95\n0.55\n0.10\n2.70\n0.500.00\n5.20 5.50\n3.00\n0.90\n0.20\n2.80\n0.80\n0.10\n5.505.10\n3.102.85\n1.151.05\n0.400.30\n0.200.05\n39.708%\nN/A\nN/A\n36.722%\nN/A\n38.754%\n38.318%\n39.127%\n36.347%\n36.336%\n163.282%\n75.219%\n42.610%\n45.215%\n122.894%\n64.543%\n42.697%\n44.728%\n50.218%\nC5.30\nC2.80\nC0.85\nC0.10\nC5.30\nC1.10\nC0.35\nC0.10\n3.00 +0.15\nHere you can see that we only have three expirations: 26, 117, and \n215 days from when these data were taken. In addition, there are hardly \nany strikes that are reasonably close to our crucial 84-delta, 50-delta, and \n16-delta strikes, which means that we have to do alot of extrapolation to \ntry to figure out where the market’sidea of the BSM cone lies.\nTo get abetter picture of what the market is saying, Irecommend \nlooking at options that are the most heavily traded and assuming that the \nimplied volatility on these strikes gives true information about the mar -\nket’sassumptions about the future price range of astock. Using the im-\nplied volatility on heavily traded contracts as the true forward volatility \nexpected by the market allows us to create atheoretical BSM cone that we", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:171", "doc_id": "68fca92319254e0bb253a58f329a6bb774d99431253dbcf7b4e374fba19dd8e9", "chunk_index": 0}
{"text": "Finding Mispriced Options    • 155\ncan extend indefinitely into the future and that is probably alot closer to \nrepresenting actual market expectations for the forward volatility (and, by \nextension, the range of future prices for astock). Once we have this BSM \ncone—with its high-low ranges spelled out for us—we can compare it with \nthe best- and worst-case valuations we derived as part of the company \nanalysis process.\nLet’slook at this process in the next section, where Ispell out, step by \nstep, how to compare an intelligent valuation range with that implied by \nthe option market.\nNote: Data used for Oracle graphing example:\nExpiration Date Lower Middle Upper\n7/25/2013 29.10 31.86 32.75\n8/16/2013 22.00 32.00 33.50\n9/20/2013 19.00 32.00 35.00\n12/20/2013 20.00 32.50 37.00\n1/17/2014 19.00 32.50 37.20\n1/16/2015 23.00 32.30 42.00\nHere Ihave eyeballed (and sometimes done aquick extrapolation) to try \nto get the price that is closest to the 84-delta, 50-delta, and 16-delta marks, \nrespectively. Of course, you could calculate these more carefully and get \nexact numbers, but the point of this is to get ageneral idea of how likely the \nmarket thinks aparticular future stock price is going to be.\nComparing an Intelligent Valuation \nRange with a BSM Range\nThe point of this book is to teach you how to be an intelligent option investor \nand not how to do stochastic calculus or how to program acomputer to \ncalculate the BSM. As such, I’mnot going to explain how to mathematically \nderive the BSM cone. Instead, on my website Ihave an application that will \nallow you to plug in afew numbers and create agraphic representation of a \nBSM cone and carry out the comparison process described in this section. \nThe only thing you need to know is what numbers to plug into this web \napplication!", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:172", "doc_id": "dc1218392753fc17ea1d81fb396296b3bb3926f73e3c920871a3f67f4bf555e0", "chunk_index": 0}
{"text": "156  •   The Intelligent Option Investor\nI’ll break the process into three steps:\n1. Create a BSM cone.\n2. Overlay your rational valuation range on the BSM cone.\n3. Look for discrepancies.\nCreate a BSM Cone\nThe heart of a BSM cone is the forward volatility number. As we have seen, \nas forward volatility increases, the range of future stock prices projected by \nthe BSM (and expected by the market) also increases. However, after hav-\ning looked at the market pricing of options, we also know that amultitude \nof volatility numbers is available. Which one should we look at? Each strike \nprice has its own implied volatility number. What strike price’svolatility \nshould we use? There are also multiple tenors. What tenor options should \nwe look at? Should we look at implied volatility at the bid price? At the ask \nprice? Perhaps we should take the “kitchen sink” approach and just average \nall the implied volatilities listed!\nThe answer is, in fact, easy if you use some simplifying assumptions \nto pick asingle volatility number. Iam not an academic, so Idon’tneces-\nsarily care if these simplifying assumptions are congruent with theory. \nAlso, Iam not an arbitrageur, so Idon’tmuch care about very precise \nnumbers, and this attitude also lends itself well to the use of simplifying \nassumptions. All we have to make sure of is that the simplifying as-\nsumptions don’tdistort our perception to the degree that we make bad \neconomic choices.\nHere are the assumptions that we will make:\n1. The implied volatility on acontract one or two months from expi-\nration that is ATM or at least within the 40- to 60-delta band and \nthat is the most heavily traded will contain the market’sbest idea \nof the true forward volatility of the stock. \n2. If abig announcement is scheduled for the near future, implied \nvolatility numbers may be skewed, so their information might \nnot be reliable. In this case, try to find aheavily traded near ATM \nstrike at an expiry after the announcement will be made. If the \nannouncement will be made in about four months or more, just try", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:173", "doc_id": "c1b82698e7db441ac836cc9b20b3c6d13bae7121e9b3b661ef2c5a6dc5b996bd", "chunk_index": 0}
{"text": "Finding Mispriced Options    • 157\nto eyeball the ATM volatility for the one- and two-month contracts.\n3. If there is alarge bid-ask spread, the relevant forward volatility \nto use is equal to the implied volatility we want to transact. In \nother words, use the ask implied volatility if you are thinking \nabout gaining exposure and the bid implied volatility if you are \nthinking about accepting exposure (the online application shows \ncones for both the bid implied volatility and the ask implied \nvolatility).\nBasically, these rules are just saying, “If you want to know what the \noption market is expecting the future price range of astock to be, find anice, liquid near ATM strike’simplied volatility and use that. ” Most op-\ntion trading is done in atight band around the present ATM mark and for \nexpirations from zero to three months out. By looking at the most heavily \ntraded implied volatility numbers, we are using the market’sprice-discov-\nery function to the fullest. Big announcements sometimes can throw off \nthe true volatility picture, which is why we try to avoid gathering infor -\nmation from options in these cases (e.g., legal decisions, Food and Drug \nAdministration trial decisions, particularly impactful quarterly earnings \nannouncements, and so on). \nIf Iwas looking at Oracle, Iwould probably choose the $32-strike \noptions expiring in September. These are the 50-delta options with \n61 days to expiration, and there is not much of adifference between \ncalls and puts or between the bid and ask. The August expiration op-\ntions look abit suspicious to me considering that their implied volatility \nis acouple of percentage points below that of the others. It probably \ndoesn’tmake abig difference which you use, though. We are trying to \nfind opportunities that are severely mispriced, not trying to split hairs \nof acouple of percentage points. All things considered, Iwould prob-\nably use anumber somewhere around 22 percent for Oracle’sforward \nvolatility.\nC12.02 11.75 N/A 55.427% 0.9897 C0.00 0.02 N/A 50.831%- 0.01032011.90\nC11.03 10.70 N/A 123.903% 0.9869 C0.01 0.03 N/A 48.233%- 0.01312112.35\nC10.04 9.50 N/A 64.054% 0.9834 C0.03 0.05 37.572% 46.993%- 0.01660.012210.10\nC0.06 0.04 20.455% 21.147% 0.0463 C5.03 5.55 N/A 36.111%- 0.95584.95370.05\n1.65 1.65 22.720% 23.311% 0.6325 0.84 +0.07 0.82 22.989% 23.384%- 0.36790.80311.68-0.13\n1.06 1.08 22.019% 22.407% 0.4997 1.23 +0.05 1.25 22.284% 22.672%- 0.50081.23321.10-0.12\n0.66 0.65 21.378% 21.813% 0.3606 1.88 +0.16 1.82 21.453% 22.106%- 0.64021.79330.67-0.07\n0.02 0.01 21.354% 23.409% 0.0155 C6.99 7.55 N/A 44.342%- 0.98716.85390.02+0.01\n0.03 0.01 19.050% 22.144% 0.0266 C6.00 6.30 17.134% 30.947%- 0.97576.15380.030.00\nSEP 20 ´13", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:174", "doc_id": "c626156d5991fddf32fa59f98afed48c712d7f51378acbd1de10a92687dc1219", "chunk_index": 0}
{"text": "158  •   The Intelligent Option Investor\nFor Mueller Water, it’salittle trickier:\n2.5\n5\n7.5\n10\nLast\nC5.30\nC2.80\n0.55\nC0.00\nChange BidA sk Delta AUG 16 ´13\n2.5\n5\n7.5\n10\nNOV 15 ´13\n2.5\n5\n7.5\n10\n12.5\nFEB 21 ´14\nDescriptionCall\nLast Change BidA sk Impl. Bid Vol. Impl. Ask Vol.Impl. Bid Vol. Impl. Ask Vol. Delta\nPut\nC0.00\nC0.00\nC0.25\nC2.25\nC0.00\nC0.00\nC0.55\nC2.35\nC0.00\nC0.10\nC0.85\nC2.55\nC4.80\n5.20 5.50N /A 340.099% 0.9978\n0.9978\n0.7330\n0.1316\n0.9347\n0.8524\n0.6103\n0.1516\n0.9933\n0.9190\n0.6070\n0.2566\n0.1024\n142.171%\n46.039%\n76.652%\nN/A\nN/A\n2.95\n0.55\n0.10\n0.20\n0.10 N/A\nN/A\nN/A\n0.10\n0.30\n2.35\n40.733%\nN/A\nN/A\nN/A\nN/A\n36.550%\n38.181%\n35.520%\n35.509%\n35.664%\n2.10\n0.50\n0.05\n0.10\n0.60\n2.402.30\n0.05\n0.15\n0.15\n0.85\n2.60\n4.90\n2.70\n0.500.00\n5.20 5.50\n3.00\n0.90\n0.20\n2.80\n0.80\n0.10\n5.505.10\n3.102.85\n1.151.05\n0.400.30\n0.200.05\n39.708%\nN/A\nN/A\n36.722%\nN/A\n38.754%\n38.318%\n39.127%\n36.347%\n36.336%\n292.169% 0.0000\n-0.0000\n-0.2778\n-0.8663\n-0.0616\n-0.1447\n-0.3886\n-0.8447\n-0.0018\n-0.0787\n-0.3890\n-0.7375\n-0.8913\n128.711%\n53.108%\n88.008%\n117.369%\n60.675%\n42.433%\n44.802%\n110.810%\n50.757%\n42.074%\n43.947%\n49.401%\n163.282%\n75.219%\n42.610%\n45.215%\n122.894%\n64.543%\n42.697%\n44.728%\n50.218%\nC5.30\nC2.80\nC0.85\nC0.10\nC5.30\nC1.10\nC0.35\nC0.10\n3.00 +0.15\n0.70\n2.45\n4.60\nIn the end, Iwould probably end up picking the implied volatility \nassociated with the options struck at $7.50 and expiring in August 2013 \n(26 days until expiration). Iwas torn between these and the same strike \nexpiring in November, but the August options are at least being actively \ntraded, and the percentage bid-ask spread on the call side is lower for them \nthan for the November options. Note, though, that the August 2013 put \noptions are so far OTM that the bid-ask spread is very wide. In this case, \nIwould probably look closer at the call options’ implied volatilities. In the \nend, Iwould have abid volatility of around 39 percent and an ask volatility \nof around 46 percent. Because the bid-ask spread is large, Iwould probably \nwant to see acone for both the bid and ask.\nPlugging in the 22.0/22.5 for Oracle,\n2 Iwould come up with this cone:\nDate\nOracle (ORCL)\nPrice per Share\n60\n40\n50\n30\n10\n20\n-\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:175", "doc_id": "71ddd48fba5e38de86b304b1870f7fdb6dd1bfe06e79b3c563e8d9787320388c", "chunk_index": 0}
{"text": "Finding Mispriced Options    • 159\nPlugging in the 39/46 for Mueller Water, Iwould get the following:\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012\nDate\nMueller Water (MWA)\nPrice per Share\n25\n20\n15\n5\n10\n-\nYou can see with Mueller Water just how big a 7 percentage point dif-\nference can be for the bid and ask implied volatilities in terms of projected \noutcomes. The 39 percent bid implied volatility generates an upper range \nat just around $15; the 46 percent ask implied volatility generates an upper \nrange that is 20 percent or so higher than that!\nOverlay an Intelligent Valuation Range on the BSM Cone\nThis is simple and exactly the same for abig company or asmall one, \nso I’ll just keep going with the Oracle example. After having done afull \nvaluation as shown in the exam valuation of Oracle on the IOI website, \nyou’ve got abest-case valuation, aworst-case valuation, and probably \nan idea about what alikely valuation is. You simply draw those numbers \nonto achart like this:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:176", "doc_id": "d9906e105d9fed915f750608f6189a35aae00627205ffce35235055ff3fa048a", "chunk_index": 0}
{"text": "Finding Mispriced Options    • 161\nOn the upside, we can see that our likely case valuation is $43 per share, \nwhereas the BSM’smost likely value is abit less than $35—adifference of \nmore than 20 percent. This is the area on the graph labeled “ A. ” The BSM \nprices options based on the likelihood of the stock hitting acertain price \nlevel. The BSM considers the $43 price level to be relatively unlikely, whereas \nIconsider it relatively likely. As such, Ibelieve that options that allow me to \ngain exposure to the upside potential of Oracle—call options—are underval-\nued. In keeping with the age-old rule of investing to buy low, Iwill want to \ngain exposure to Oracle’supside by buying low-priced call options.\nOn the downside, Inotice that there is afairly large discrepancy \nbetween my worst-case valuation ($30) and the lower leg of the BSM cone \n(approximately $24)—this is the region of the graph labeled “B, ” and the \nseparation between the two values is again (just by chance) about 20 percent. \nThe BSM is pricing options granting exposure to the downside—put \noptions—struck at $24 as if they were fairly likely to occur; something that \nis fairly likely to occur will be priced expensively by the BSM. My analysis, \non the other hand, makes me think that the BSM’svaluation outcome is \nvery unlikely. The discrepancy implies that Ibelieve the put options to be \novervalued—the BSM sees a $24 valuation as likely, with expensive options, \nwhereas Isee it as unlikely, with nearly valueless options. In this case, we \nshould consider the other half of the age-old investing maxim and sell high.\nIn agraphic representation, this strategy might look like this:\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012\nDate\nOracle (ORCL)\nPrice per Share\n60\nBest Case\nLikely Case\nWorst Case\n40\n50\n30\n10\n20\nDownside\nUpside\n-\n$52\n$43\n$30\nGREEN\nRED", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:178", "doc_id": "4fa04102902bb1ad4b91d47cbc1cd1cc2d30c56c9b7de3e014298447a79930ff", "chunk_index": 0}
{"text": "164  •   The Intelligent Option Investor\nbecause of their lack of appreciation for the fact that the sword of lever -\nage cuts both ways. Certainly an option investor cannot be considered an \nintelligent investor without having an understanding and adeep sense \nof respect for the simultaneous power and danger that leverage conveys.\nNew jargon introduced in this chapter includes the following:\nLambda\nNotional exposure\nInvestment Leverage\nCommit the following definition to memory:\nInvestment leverage is the boosting of investment returns calcu-\nlated as apercentage by altering the amount of one’sown capital \nat risk in asingle investment.\nInvestment leverage is inextricably linked to borrowing money—this \nis what Imean by the phrase “altering the amount of one’sown capital at \nrisk. ” In this way, it is very similar to financial leverage. In fact, in my mind, \nthe difference between financial and investment leverage is that acompany \nuses financial leverage to fund projects that will produce goods or provide \nservices, whereas in the case of investing leverage, it is used not to produce \ngoods or services but to amplify the effects of aspeculative position.\nFrequently people think of investing leverage as simply borrowing \nmoney to invest. However, as Imentioned earlier, you can invest in options \nfor alifetime and never explicitly borrow money in the process. Ibelieve \nthat the preceding definition is broad enough to handle both the case of \ninvestment leverage generated through explicit borrowing and the case of \nleverage generated by options.\nLet’stake alook at afew example investments—unlevered, levered \nusing debt, and levered using options.\nUnlevered Investment\nLet’ssay that you buy astock for exactly $50 per share, expecting that its intrinsic \nvalue is closer to $85 per share. Over the next year, the stock increases by $5, \nor 10 percent in value. Your unrealized percentage gain on this investment is", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:181", "doc_id": "0cd65880c1dd6114ea15306d6ce51b0944b37625f7a73596d332f769e6431e33", "chunk_index": 0}
{"text": "166  •   The Intelligent Option Investor\nAnd herein lies the painful lesson learned by many asoul in the \nfinancial markets: leverage cuts both ways. The profits happily roll in dur-\ning the good times, but the losses inexorably crash down during bad times.\nLevered Investment Using Options\nDiscussing option-based investing leverage is much easier if we focus on \nthe perspective of gaining exposure. Because most people are more com-\nfortable thinking about the long side of investing, let’slook at an example \nof gaining upside exposure on acompany.\nLet’sassume we see a $50 per share stock that we believe is worth $85 (in \nthis example, Iam assuming that we only have apoint estimate of the intrinsic \nvalue of the company so as to simplify the following diagram—normally, it is \nmuch more helpful to think about fair value ranges, as explained in Part II of \nthis book and demonstrate in the online example). We are willing to buy the \nshare all the way up to aprice of $68 (implying a 25 percent return if bought \nat $68 and sold at $85) and can get call options struck at $65 per share for only \n$1.50. Graphically, this prospective investment looks like this:\nFair Value Estimate\n5/18/2012 5/20/2013 249 499 749 999\n-\n10\n20\n30\n40\n50\n60\n70\n80\n90\nEBP = $66.50\nDate/Day Count\nAdvanced Building Corp. (ABC)\nStock Price\nGREEN", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:183", "doc_id": "60bcaa77cd023c0fa241482dc04913eedbf9504a3e1049e9dc3392e249dcaa01", "chunk_index": 0}
{"text": "Understanding and Managing Leverage    • 167\nIn two years, you are obligated to pay your counterparty $65 if you \nwant to hold the stock, but the decision as to whether to take possession \nof the stock in return for payment is solely at your discretion. In essence, \nthen, you can look at buying acall option as aconditional borrowing of \nfunds sometime in the future. Buying the call option, you are saying, “Imay want to borrow $65 two years from now. Iwill pay you some interest \nup front now, and if Idecide to borrow the $65 in two years, I’ll pay you \nthat principal then. ”\nIn graphic terms, we can think about this transaction like this:\n5/18/2012 5/20/2013 249 499 749 999\n-\n10\n20\n30\n40\n50\n60\n70\n80\n90\n$1.50 “prepaid interest”\nContingent loan, the future repayment\nof principal is made solely at the\ninvestor’sown discretion.\nFair Value Estimate\nAdvanced Building Corp. (ABC)\nDate/Day Count\nStock Price\nGREEN\nIf the stock does indeed hit the $85 mark just at the time our option \nexpires, we will have realized agross profit of $20 (= $85 − $65) on an \ninvestment of $1.50, for apercentage return of 1,233 percent! Obviously, \nthe call option works very much like aloan in terms of altering the \ninvestor’scapital at risk and boosting subsequent investment returns. \nHowever, although the leverage looks very similar, there are two impor -\ntant differences:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:184", "doc_id": "7198be838ef1e09f6fee9fe1fb29e412782b8734d6ce8b729b8f582698821fb8", "chunk_index": 0}
{"text": "168  •   The Intelligent Option Investor\n1. As shown and mentioned earlier, when using an option, payment \non the principal amount of $65 in this case is conditional and com-\npletely discretionary. For an option, the interest payment is made \nup front and is asunk cost.\n2. Because repayment is discretionary in the case of an option, you \ndo not have any financial risk over and above the prepayment of \ninterest in the form of an option premium. Repayment of acon-\nventional loan is mandatory, so you have alarge financial risk if \nyou cannot repay the principal at maturity in this case.\nRegarding the first difference, not only is the loan conditional \nand discretionary, the loan also has value and can be transferred to \nanother for aprofit. What Imean is this: if the stock rises quickly, the \nvalue of that option in the open market will increase, and rather than \nholding the “loan” to maturity, you can simply sell it with your profits \noffsetting the original cost of the prepaid interest plus giving you anice profit. \nRegarding the second difference, consider this: if you are using bor -\nrowed money to invest and your stock drops heavily, the broker will make \namargin call (i.e., ask you to deposit more capital into the account), and \nif you cannot make the margin call, the broker will liquidate the position \n(most brokers shoot first and ask questions later, simply closing out the \nposition and selling other assets to cover the loss at the first sign margin \nrequirements will not be met). If this happens, you can be 100 percent \ncorrect on your valuation long term but still fail to benefit economically \nbecause the position has been forcibly closed. In the case of options, the \nunderlying stock can lose 20 percent in asingle day, and the owner of acall option will never receive amargin call. The flip side of this benefit \nis that although you are not at risk of losing aposition to amargin call, \noption ownership does not guarantee that you will receive an economic \nreward either. \nFor example, if the option mentioned in the preceding example ex-\npires in two years when the stock is trading at $64.99 and the stock has paid \n$2.10 in dividends over the previous two years, the option holder ends up \nwith neither the stock nor the dividend check.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:185", "doc_id": "674e7e9bec8ddc5c92e1287ede8f4103edb63ef941bf500bbffa7cb7a85760a9", "chunk_index": 0}
{"text": "Understanding and Managing Leverage    • 169\nSimple Ways of Measuring Option \nInvestment Leverage\nThere are several single-point, easily calculable numbers to measure \noption-based investment leverage. There are uses for these simple measures \nof leverage, but unfortunately, for reasons Iwill discuss, the simple num-\nbers are not enough to help an investor intelligently manage aportfolio \ncontaining option positions. \nThe two simple measures are lambda and notional exposure. Both are \nexplained in the following sections.\nLambda\nThe standard measure investors use to determine the leverage in an option \nposition is one called lambda . Lambda—sometimes known as percent \ndelta—is aderivative of the delta\n1 factor we discussed in Chapter 7 and is \nfound using the following equation:\n= ×Lambda deltas tock price\noptionprice\nLet’slook at an actual example. The other day, Ibought adeep in-\nthe-money (ITM) long-tenor call option struck at $20 when the stock \nwas trading at $30.50. The delta of the option at that time was 0.8707, \nand the price was $11. The leverage in my option position was calculated \nas follows:\n= × = × =Lambda deltas tock price\noptionprice\n0.87 30.50\n11 2.40\n \nWhat this figure of 2.4 is telling us is that when Ibought that option, if the \nprice of the underlying moved by 1 percent, the value of my position would \nmove by about 2.4 percent. This is not ahard and fast number—achange in \nprice of either the stock or the option (as aresult of achange in volatility or \ntime value or whatever) will change the delta, and the lambda will change \nbased on those things.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:186", "doc_id": "7bc1b41b86cd9eb177742a9212207377ca2eb2c569d642db75ccfd6f560c9ff1", "chunk_index": 0}
{"text": "170  •   The Intelligent Option Investor\nBecause investment leverage comes about by changing the amount \nof your own capital that is at risk vis-à-vis the total size of the investment, \nyou can imagine that moneyness has alarge influence on lambda. Let’stake alook at how investment leverage changes for in-the-money (ITM), \nat-the-money (ATM), and out-of-the-money (OTM) options. The stock \nunderlying the following options was trading at $31.25 when these data \nwere taken, so I’mshowing the $29 and $32 strikes as ATM: \nStrike Price K /S Ratio Call Price Delta Lambda\n15.00 0.48 17.30 0.91 1.64\n20.00 0.64 11.50 0.92 2.50 ITM\n21.00 0.67 11.30 0.86 2.38\n22.00 0.70 9.60 0.89 2.90\n… \n…\n…\n…\n…\n29.00 0.93 3.40 0.68 6.25\n30.00 0.96 2.74 0.61 6.96 ATM\n31.00 0.99 2.16 0.54 7.81\n…\n…\n…\n…\n…\n39.00 1.25 0.18 0.09 15.63\n40.00 1.28 0.13 0.06 14.42 OTM\n41.00 1.31 0.09 0.05 17.36\nWhen an option is deep ITM, as in the case of the $20-strike call, we \nare making asignificant expenditure of our own capital compared with \nthe size of the investment. Buying acall option struck at $20, we are—\nas explained in the preceding section—effectively borrowing an amount \nequal to the $20 strike price. In addition to this, we are spending $11.50 in \npremium. Of this amount, $11.25 is intrinsic value, and $0.25 is time value. \nWe can look at the time value portion as the prepaid interest we discussed \nin the preceding section, and we can even calculate the interest rate im-\nplied by this price (this option had 189 days left before expiration, implying \nan annual interest charge of 2.4 percent, for example). This prepaid interest \ncan be offset partially or fully by profit realized on the position, but it can \nnever be recaptured so must be considered asunk cost. Time value always \ndecays independent of the price changes of the underlying, so although an", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:187", "doc_id": "ffc51b0c0178d0b5790916e06f4fa1faebf7ff96da157396abc6b9cb1d304fe3", "chunk_index": 0}
{"text": "Understanding and Managing Leverage    • 171\nupward movement in the stock will offset the money spent on time value, \nthe amount spent on time value is never recoverable.\nThe remaining $11.25 of the premium paid for a $20-strike call op-\ntion is intrinsic value . Buying intrinsic value means that we are exposing \nour own capital to the risk of an unrealized loss if the stock falls below \n$31.25. Lambda is directly related to the amount of capital we are exposing \nto an unrealized loss versus the size of the “loan” from the option, so be-\ncause we are risking $11.25 of our own capital and borrowing $20 with the \noption (ahigh capital-to-loan proportion), our investment leverage meas-\nured by lambda is arelatively low 2.50.\nNow direct your attention to afar OTM call option—the one struck \nat $39. If we invest in the $39-strike option, we are again effectively \ntaking out a $39 contingent loan to buy the shares. Again, we take the \ntime-value portion of the option’sprice—in this case the entire premi-\num of $1.28—to be the prepaid interest (an implied annualized rate of \n6.3 percent) and note that we are exposing none of our own capital to \nthe risk of an unrealized loss. Because we are subjecting none of our \nown capital in this investment and taking out alarge loan, our invest-\nment leverage soars to avery high value of 15.63. This implies that a \n1 percentage point move in the underlying stock will boost our invest-\nment return by over 15 percent!\nObviously, these calculations tell us that our investment returns are \ngoing to be much more volatile for small changes in the underlying’sprice \nwhen buying far OTM options than when buying far ITM options. This is \nfine information for someone interested in more speculative strategies—if \naspeculator has the sense that astock will rise quickly, he or she could, \nrather than buying the stock, buy OTM options, and if the stock went up \nfast enough and soon enough offset any drop of implied volatility and time \ndecay, he or she would pocket anice, highly levered profit.\nHowever, there are several factors that limit the usefulness of lambda. \nFirst, because delta is not aconstant, the leverage factor does not stay put \nas the stock moves around. For someone who intends to hold aposition for \nalonger time, then, lambda provides little information regarding how the \nposition will perform over their investment horizon. \nIn addition, reading the preceding descriptions of lambda, it is ob-\nvious that this measure deals exclusively with the percentage change in", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:188", "doc_id": "1957b16e5100be253bcaff6cc2cb8a2cfad7c78781f7325fe17b17b2f5b47f00", "chunk_index": 0}
{"text": "172  •   The Intelligent Option Investor\nthe option’svalue. Although everyone (especially fly-by-night investment \nnewsletter editors) likes to tout their percentage returns, we know from \nour earlier investigations of leverage that percentage returns are only part \nof the story of successful investing. Let’ssee why using the three invest-\nments Imentioned earlier—an ITM call struck at $20, an OTM call struck \nat $39, and along stock position at $31. \nIbelieve that there is agood chance that this stock is worth north of \n$40—in the $43 range, to be precise (my worst-case valuation was $30, and \nmy best-case valuation was in the mid-$50 range). If Iam right, and if this \nstock hits the $43 mark just as my options expire,\n2 what do Istand to gain \nfrom each of these investments?\nLet’stake alook. \nSpent Gross Profit Net Profit Percent Profit\n$39-strike call 0.18 4.00 3.82 2,122\n$20-strike call 11.50 23.00 11.50 100\nShares 31.25 43.00 11.75 38\nThis table means that in the case of the $20-strike call, we spent \n$11.50 to win gross proceeds of $23.00 (= $43 − $20) and aprofit net of \ninvestment of $11.50. Netting $11.50 on an $11.50 investment generates apercentage profit of 100 percent.\nLooking at this chart, the first thing you are liable to notice is the \n“Percent Profit” column. That 2,122 percent return looks like something \nyou might see advertised on an option tout service, doesn’tit? Yes, that \npercentage return is wonderful, until you realize that the absolute value \nof your dollar winnings will not allow you to buy alatte at Starbuck’s. \nLikewise, the 100 percent return on the $20-strike options looks heads and \nshoulders better than the measly 38 percent on the shares, until you again \nrealize that the latter is still giving you more money by aquarter.\nRecall the definition of leverage as away of “boosting investment re-\nturns calculated as apercentage, ” and recall that in my previous discussion \nof financial leverage, Imentioned that the absolute dollar value is always \nhighest in the unlevered case. The fact is that many people get excited about \nstratospheric percentage returns, but stratospheric percentage returns only", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:189", "doc_id": "c892d9698f0d25ebdd24bc17dec0adfed1b17948b1f53c2ef2373ef1cf1f01b1", "chunk_index": 0}
{"text": "Understanding and Managing Leverage    • 173\nmatter if asignificant chunk of your portfolio is exposed to those returns!\nLambda is agood measure to show how sensitive percentage returns are to \namove in the stock price, but it is useless when trying to understand what \nthe portfolio effects of those returns will be on an absolute basis.\nNotional Exposure\nLook back at the preceding table. Let’ssay that we wanted to make \nlambda more useful in understanding portfolio effects by seeing how \nmany contracts we would need to buy to match the absolute return of \nthe underlying stock. Because our expected dollar return of one of the \n$39-strike calls only makes up about athird of the absolute return of the \nstraight stock investment ($3.82 / $11.75 = 32.5% ≈ 1/3), it follows that if \nwe wanted to make the same dollar return by investing in these call options \nthat we expect to make by buying the shares, we would have to buy three \nof the call options for every share we wanted to buy. Recalling that op-\ntions are transacted in contract sizes of 100 shares, we know that if we were \nwilling to buy 100 shares of Oracle’sstock, we would have to buy options \nimplying control over 300 shares to generate the same absolute profit for \nour portfolio.\nIcall this implied control figure notional exposure. Continuing with \nthe $39-strike example, we can see that the measure of our leverage on the \nbasis of notional exposure is 3:1. The value of the notional exposure is cal-\nculated by multiplying it by the strike; in this case, the notional exposure \nof 300 shares multiplied by the strike price of $39 gives anotional value \nfor the contracts of $11,700. This value is called the notional amount of the \noption position. \nSome people calculate aleverage figure by dividing the notional amount \nby the total cost of the options. In our example, we would pay $18 per con-\ntract for three contracts, so leverage measured in this way would work out to \nbe 217 (= $11,700 ÷ $54). Iactually do not believe this last measure of lever-\nage to be very helpful, but notional control will become important when we \ntalk about the leverage of short-call spreads later in this chapter.\nThese simple methods of measuring leverage have their place in ana-\nlyzing option investment strategies, but in order to really master leverage, \nyou must understand leverage in the context of portfolio management.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:190", "doc_id": "7e5d184cfbd61ccf85f64a2746e0c8c092dff5aa1504411d179605378df054ac", "chunk_index": 0}
{"text": "174  •   The Intelligent Option Investor\nUnderstanding Leverage’s Effects on a Portfolio\nLooking at leverage from alambda or notional control perspective gives \nsome limited information about leverage, but Ibelieve that the best way \nto think about option-based investment leverage is to think about the ef-\nfect of leverage on an actual portfolio allocation basis. This gives aricher, \nmore nuanced view of how leverage stands to help or hurt our portfolio \nand allows us more insight into how we can intelligently structure amixed \noption-stock portfolio.\nLet’sstart our discussion of leverage in aportfolio context by thinking \nabout how to select investments into aportfolio. We will assume that we \nhave $100 in cash and want to use some or all of that cash to invest in risky \nsecurities. Cash is riskless (other than inflation risk, but let’signore that \nfor amoment), so the risk we take on in the portfolio will be dampened \nby keeping cash, and the returns we will win from the portfolio will be \nsimilarly dampened.\nWe have alimited amount of capital and want to allocate that capital \nto risky investments in proportion to two factors:\n1. The amount we think we can gain from the investment\n2. Our conviction in the investment, which is ameasure of our per -\nception of the riskiness of the investment\nWe might see apotential investment that would allow us to reap aprofit \nof $9 for every $1 invested (i.e., we would gain agreat deal), but if our \nconviction in that investment is low (i.e., we think the chance of winning \n$9 for every $1 invested is very low), we would likely not allocate much of \nour portfolio to it.\nIn constructing aportfolio, most people set alimit on the proportion \nof their portfolio they want to allocate to any one investment. Ipersonally \nfavor more concentrated positions, but let’ssay that you paid better atten-\ntion to your finance professor in school than Idid and figure that you want \nto limit your risk exposure to any one security to amaximum of $5 of your \n$100 portfolio. \nAn unlevered portfolio means that each $5 allocation would be made \nby spending $5 of your own capital. You would know that if the value of \nthe underlying security decreases by $2.50, the value of the allocation will", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:191", "doc_id": "1a82f3b7e29fd3110ad6380a24fdc912237ec8e5b88c05e5bfee97d94855da34", "chunk_index": 0}
{"text": "Understanding and Managing Leverage    • 175\nalso fall to $2.50. If, instead, the value of the underlying security increases \nby $2.50, the value of that allocation will rise to $7.50.\nIn alevered portfolio, each $5 allocation uses some proportion of \ncapital that is not yours—borrowed in the case of amargin loan and con-\ntingently borrowed in the case of an option. This means that for every \n$1 increase or decrease in the value of the underlying security, the lev-\nered allocation increases or decreases by more than $1. Leverage, in this \ncontext, represents the rate at which the value of the allocation increases \nor decreases for every one-unit change in the value of the underlying \nsecurity.\nWhen thinking about the risk of leverage, we must treat different types \nof losses differently. Arealized loss represents apermanent loss of capital—asunk cost for which future returns can offset but never undo. An unrealized \nloss may affect your psychology but not your wealth (unless you need to \nrealize the loss to generate cash flow for something else—Italk about this \nin Chapter 11 when Iaddress hedging). For this reason, when we measure \nhow much leverage we have when the underlying security declines, we will \nmeasure it on the basis of how close we are to suffering arealized loss rather \nthan on the basis of the unrealized value of the loss. Leverage on the profit \nside will be handled the same way: we will treat our fair value estimate as the \nprice at which we will realize again. Because the current market price of asecurity may not sit exactly between our fair value estimate and the point at \nwhich we suffer arealized loss, our upside and downside leverage may be \ndifferent.\nLet’ssee how this comes together with an actual example. For this ex-\nample, Ilooked at the price of Intel’s (INTC) shares and options when the \nformer were trading at $22.99. Let’ssay that we want to commit 5 percent \nof our portfolio value to an investment in Intel, which we believe is worth \n$30 per share. For every $100,000 in our portfolio, this would mean buying \n217 shares. This purchase would cost us $4,988.83 (neglecting taxes and \nfees, of course) and would leave us with $11.17 of cash in reserve. After we \nmade the buy, the stock price would fluctuate, and depending on what its \nprice was at the end of 540 days [I’musing as an investment horizon the \ndays to expiration of the longest-tenor long-term equity anticipation secu-\nrities (LEAPS)], the allocation’sprofit and loss profile would be represented \ngraphically like this:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:192", "doc_id": "024eb9206cc9b99a739c9b3bda290952b76a742bf25973b8a59ea3e3524af9c4", "chunk_index": 0}
{"text": "176  •   The Intelligent Option Investor\n02468 10 12 14 16 18 20 22 24\nStock Price\nUnlevered Investment (Full Allocation)\nGain (Loss) on Allocation\n26 28 30 32 34 36 38 40 42 44 46 48 50(6,000)\n(4,000)\n(2,000)\n-\n2,000\n4,000\n6,000\n8,000\nUnrealized Gain\nUnrealized Loss\nCash Value\nNet Gain (Loss) - Unlevered\nRealized Loss\nHere the future stock price is listed from 0 to 50 on the horizontal axis, \nand the net profit or loss to this position is listed on the vertical axis. Obvious-\nly, any gain or loss would be unrealized unless Intel’sstock price went to zero, \nat which point the total position would only be worth whatever spare cash we \nhad. The black profit and loss line is straight—the position will lose or gain on \naone-for-one basis with the price of the stock, so our leverage is 1.0.\nNow that we have asense of what the graph for astraight stock \nposition looks like, let’stake alook at afew different option positions. \nWhen Idrew the data for this example, the following 540-day expiration \ncall options were available:\nStrike Price Ask Price Delta\n15 8.00 0.79\n22 2.63 0.52\n25 1.43 0.35\nLet’sstart with the ITM option and construct asimple-minded posi-\ntion that attempts to buy as many of these option contracts as possible with \nthe $5,000 we have reserved for this investment. We will pay $8 per share", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:193", "doc_id": "f41169e85808e61f8cb3ffaad9e7065021ebfc21023bcb5bc9f5727a6f540429", "chunk_index": 0}
{"text": "Understanding and Managing Leverage    • 177\nor $800 per contract, which would allow us to buy six contracts in all for \n$4,800. There is only $0.01 worth of time value (= $15.00 + $8.00 − $22.99) \non these options because they are so far ITM. This means that we are pay-\ning $1 per contract worth of time value that is never recoverable, so we \nshall treat it as arealized loss. If we were to graph our potential profit and \nloss profile using this option, assuming that we are analyzing the position \njust as the 540-day options expire, we would get the following\n3:\nNet Gain (Loss) - Levered\n0246810 12 14 16 18 20 22 24\nStock Price\nLevered Strategy Overview\nGain (Loss) on Allocation\n26 28 30 32 34 36 38 40 42 44 46 48 50(10,000)\n(5,000)\n-\n5,000\n10,000\nUnrealized Gain\nUnrealized Loss\nCash Value\nRealized Loss\n15,000\n20,000\nThe most obvious differences from the diagram of the unlevered po-\nsition are (1) that the net gain/loss line is kinked at the strike price and \n(2) that we will realize atotal loss of invested capital—$4,800 in all—if \nIntel’sstock price closes at $15 or below. The kinked line demonstrates the \nmeaning of the first point made earlier regarding option-based investment \nleverage—an asymmetrical return profile for profits and losses. Note that \nthis kinked line is just the hockey-stick representation of option profit and \nloss at expiration that one sees in every book about options except this \none. Although Idon’tbelieve that hockey-stick diagrams are terribly useful \nfor understanding individual option transactions, at aportfolio level, they \ndo represent the effect of leverage very well. This black line represents a", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:194", "doc_id": "f41bc6fc1373300b570f57c51ac0a5a7c83224b56ed3954728d2141b59cd29b4", "chunk_index": 0}
{"text": "Understanding and Managing Leverage    • 179\nIn this example, we suffer arealized loss of 96 percent (= $4,800 ÷ \n$5,000) if the stock falls 35 percent, so the equation becomes\n= − =− ×Lossleverage 96%\n35% 2.8\n \n(By convention, I’ll always write the loss leverage as anegative.) This \nequation just means that it takes adrop of 35 percent to realize aloss on \n96 percent of the allocation.\nThe profit leverage is simply aratio of the levered portfolio’snet profit \nto the unlevered portfolio’snet profit at the fair value estimate. For this \nexample, we have\n== ×Profitleverage $4,200\n$1,472 3.0\n \nLet’sdo the same exercise for the ATM and OTM options and see \nwhat fully levered portfolios with each of these options would look like \nfrom arisk-return perspective. If we bought as many $22-strike options as \na $5,000 position size would allow (19 contracts in all), our profit and loss \ngraph and table would look like this:\n02468 10 12 14 16 18 20 22 24\nStock Price\nLevered Strategy Overview\nGain (Loss) on Allocation\n26 28 30 32 34 36 38 40 42 44 46 48 50(20,000)\n-\n40,000\n60,000\n80,000\n100,000\n20,000\nUnrealized Gain\nUnrealized Loss\nCash Value\nNet Gain (Loss) - Levered\nRealized Loss", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:196", "doc_id": "0610bb0ced46352cc6ade9e058ab974789e394da49e83ea71345d1de13dae515", "chunk_index": 0}
{"text": "180  •   The Intelligent Option Investor\nInstrument Maximum-Loss Price Net Profit at Fair Value Estimate\nStock $0 $1,472\nOption $22 (23.2 × stock loss) $10,203 (6.9 × stock profit)\nThis is quite ahandsome potential profit—6.9 times higher than we \ncould earn using astraight stock position—but at an enormous risk. Each \n$1 drop in the stock price equates to a $23.20 drop in the value of the posi-\ntion. Note that the realized loss shows astep up from $22 to $23. This just \nshows that above the strike price, our only realized loss is the money we \nspent on time value.\nThe last example is that of the fully levered OTM call options. Here is \nthe table illustrating this case:\nInstrument Maximum-Loss Price Net Profit at Fair Value Estimate\nStock $0 $1,472\nOption $25 (IRL 5 percent) $12,495 (8.5 × stock profit)\nThere is no intrinsic value to this option, so the entire cost of \nthe option is treated as an immediate realized loss (IRL) from inception. \nThe “IRL 5 percent” notation means that there is an immediate realized \nloss of 5 percent of the total portfolio. The maximum net loss is again at \nthe strike price of $25. The leverage factor at our fair value estimate price \nis 8.5, but again this leverage comes at the price of having to realize a \n5 percent loss on your portfolio—500 basis points of performance—and \nthere is no certainty that you will have enough or any profits to offset this \nrealized loss.\nOf course, investing choices are not as black and white as what Ihave \npresented here. If you want to commit 5 percent of your portfolio to astraight stock idea, you have to spend 5 percent of your portfolio value on \nstock, but this is not true for options. For example, Imight choose to spend \n2.5 percent of my portfolio’sworth on ATM calls (nine contracts in this ex-\nample), considering the position in terms of a 5 percent stock investment, \nand then leave the rest as cash reserve. Here is what this investment would \nlook like from aleverage perspective:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:197", "doc_id": "695132b320b2b84e823c5ab7df224d9dd540d8f439d85d044ae2006ea33cf60e", "chunk_index": 0}
{"text": "Understanding and Managing Leverage    • 181\n02468 10 12 14 16 18 20 22 24\nStock Price\nLevered Strategy Overview\nGain (Loss) on Allocation\n26 28 30 32 34 36 38 40 42 44 46 48 50(5,000)\n-\n15,000\n10,000\n20,000\n25,000\n30,000\n5,000\nUnrealized Gain\nUnrealized Loss\nCash Value\nNet Gain (Loss) - Levered\nRealized Loss\nInstrument Maximum-Loss Price Net Profit at Fair Value Estimate\nStock $0 $1,472\nOption $22 (11 × stock loss) $4,833 (5.1 × stock profit)\nThe 11 times loss figure was calculated in the following way: there is atotal of 47.3 percent of my allocation to this investment that is lost if the price \nof the stock goes down by 4.3 percent, so −47.3 percent/4.3 percent = −11.0. \nObviously, this policy of keeping some cash in reserve represents asensible ap-\nproach to portfolio management when leverage is used. An investor in straight \nstock who makes 20 investments that do not hit his or her expected fair value \nwithin the investment horizon might have afew bad years of performance, but \nan investor who uses maximum option leverage and allocates 5 percent to 20 \nideas will end up bankrupt if these don’twork out by expiration time!\nSimilar to setting acash reserve, you also might decide to make an \ninvestment that combines cash, stock, and options. For example, Imight \nbuy 100 shares of Intel, three ITM option contracts, and leave the rest of \nmy 5 percent allocation in cash. Here is what that profit and loss profile \nwould look like:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:198", "doc_id": "1404f15ae53f314e61ee815858236068751ae7469b838c0563a244895e082213", "chunk_index": 0}
{"text": "182  •   The Intelligent Option Investor\n0 24681 01 21 41 61 82 02 22 4\nStock Price\nLevered Strategy Overview\nGain (Loss) on Allocation\n26 28 30 32 34 36 38 40 42 44 46 48 50(6,000)\n(4,000)\n(2,000)\n-\n4,000\n2,000\n6,000\n10,000\n12,000\n8,000 Unrealized Gain\nUnrealized Loss\nCash Value\nNet Gain (Loss) - Levered\nRealized Loss\nInstrument Maximum-Loss Price Net Profit at Fair Value Estimate\nStock $0 $1,472\nOption $15 (1.8 × stock loss) $3,803 (2.6 × stock profit)\nThree $800 option contracts represent $2,400 of capital or 48 percent of \nthis allocation’scapital. Thus 48 percent of the capital was lost with a 34.8 per-\ncent move downward in the stock, generating a −1.4 times value for the options \nplus we add another −0.4 times value to represent the loss on the small stock \nallocation; together these generate the −1.8 times figure you see on the loss side. \nOf course, if the option loss is realized, we still own 100 shares, so the maximum \nloss will not be felt until the shares hit $0, as shown in the preceding diagram.\nFor the remainder of this book Iwill describe leverage positions us-\ning the two following terms: loss leverage and profit leverage . Iwill write \nthese in the following way: \n− X.x\nY.ywhere the first number will be the loss leverage ratio, and the second \nnumber will be the profit leverage ratio based on the preceding rules that", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:199", "doc_id": "b8ded9d052178628b6cd96badbecb05427000e656761787c8d6271f3884cc1f9", "chunk_index": 0}
{"text": "Understanding and Managing Leverage    • 183\nI’ve used for calculation. All OTM options will be marked with an IRL fol-\nlowed by the percentage of the total portfolio used in the option purchase \n(not the percentage of the individual allocation but the total percentage \namount of your investment capital). On my website, you’ll find an online \nleverage tool that allows you to calculate these numbers yourself.\nManaging Leverage\nArealized loss is, to me, serious business. There are times when an inves-\ntor must take arealized loss—specifically when his or her view of the fair \nvalue or fair value range of acompany changes materially enough that an \ninvestment position becomes unattractive. However, if you find yourself \ntaking realized losses because of material changes in valuation too often, \nyou should either figure out where you are going wrong in the valuation \nprocess or just put your money into alow-load mutual fund and spend \nyour time doing something more productive.\nThe point is that taking arealized loss is not something you have to do \ntoo often if you are agood investor, and hopefully, when those losses are taken, \nthey are small. As such, Ibelieve that there are two ways to successfully manage \nleverage. First is to use leverage sparingly by investing in combinations of ITM \noptions and stocks. ITM option prices mainly represent intrinsic value, and be-\ncause the time-value component is that which represents arealized loss right out \nof the gate, buying ITM options means that you are minimizing realized losses.\nThe second method for managing leverage when you cannot resist \ntaking ahigher leverage position is spending as little as possible of your \ninvestment capital on it. This means that when you see that there is acom-\npany that has amaterial chance of being worth alot more or alot less than \nit is traded for at present but that material chance is still much less likely \nthan other valuation scenarios, you should invest your capital in the idea \nsparingly. By making smaller investments with higher leverage, you will \nnot realize aloss on too much of your capital at one time, and if you are \nright at least some of the time on these low-probability, high-potential-\nreward bets, you will come out ahead in the end.\nOf course, you also can use acombination of these two methods. For \nexample, Ihave found it helpful to take the main part of aposition using a", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:200", "doc_id": "843dcfa96fa78a5716314c839b24f4ca4012df70b44dafa52c3e2d6fbba14839", "chunk_index": 0}
{"text": "184  •   The Intelligent Option Investor\ncombination of stock and ITM call options but also perhaps buying afew \nOTM call options as well. As the investment ages and more data about the \ncompany’soperations come in, if this information leads me to be more \nbullish about the prospects of the stock, Imay again increase my leverage \nusing OTM call options—especially when Isee implied volatility trading at \naparticularly low level or if the stock price itself is depressed because of agenerally weak market. \nIused to be of the opinion that if you are confident in your valuation \nand your valuation implies abig enough unlevered return, it is irrational \nnot to get exposure to that investment with as much leverage as possible. \nAfew large and painful losses of capital have convinced me that where-\nas levering up on high-conviction investments is theoretically arational \ninvestment regime, practically, it is asucker’sgame that is more likely to \ndeplete your investment capital than it is to allow you to hit home runs.\nYounger investors, who still have along investing career ahead of \nthem and plenty of time to make up for mistakes early on, probably can \nfeel more comfortable using more leverage, but as you grow closer to the \ntime when you need to use your investments (e.g., paying for retirement, \nkids’ college expenses, or whatever), using lower leverage is better.\nLooking back at the preceding tables, one row in one table in particular \nshould stand out to you. This is the last row of the last table, where the leverage is \n−1.8/2.6. To me, this is avery attractive leverage ratio because of the asymmetry \nin the risk-reward balance. This position is levered, but the leverage is lopsided \nin the investor’sfavor, so the investor stands to win more than he or she loses. \nThis asymmetry is the key to successful investing—not only from aleverage standpoint but also from an economic standpoint as well. Ibelieve \nan intelligent, valuation-centric method for investing in companies such as \nthe ones outlined in this book that allow investors an edge up by allowing \nthem to identify cases in which the valuation simply does not line up with \nthe market price. This in itself presents an asymmetrical profit opportunity, \nand the real job of an intelligent investor is to find as large an asymmetry \nas possible and courageously invest in that company. If you can also tailor \nyour leverage such that your payout is asymmetrical in your favor as well, \nthis only adds potential for outsized returns, in my opinion.\nThe other reason that the −1.8/2.6 leverage ratio investment interests \nme is because of the similarity it has to the portfolio of Warren Buffett’s", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:201", "doc_id": "bd764068f564625f46a2c250a2dcbfa402b067ab815f800d971f2b30f5ff9c60", "chunk_index": 0}
{"text": "Understanding and Managing Leverage    • 185\nBerkshire Hathaway (BRK.A). In arecent academic paper written by re-\nsearchers at AQR Capital titled, “Buffett’s Alpha, ”4 the researchers found \nthat asignificant proportion of Buffett’slegendary returns can be attributed \nto finding firms that have low valuation risk and investing in them using aleverage ratio of roughly 1.8. The leverage comes from the float from his in-\nsurance companies (the monies paid in premium by clients over and above \nthat required to pay out claims). As individual investors, we do not have acaptive insurance company from which we can receive continual float, but \nby buying options and using leverage prudently, it is possible to invest in amanner similar to amaster investor.\nIn this section, we have only discussed leverage considerations when \nwe gain exposure by buying options. There is agood reason to ignore the \ncase where we are accepting exposure by selling options that we will dis-\ncuss when we talk about margining in Chapter 10. We now continue with \nchapters on gaining, accepting, and mixing exposure. In these chapters, we \nwill use all of what we have learned about option pricing, valuation, and \nleverage to discuss practical option investment strategies.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:202", "doc_id": "e0cceb8531cd6c9e7541360630034eafdeee5f1e393553aa09e6554becab7a42", "chunk_index": 0}
{"text": "187\nChapter 9\nGaininG ExposurE\nThis chapter is designed as an encyclopedic listing of the main strategies \nfor gaining exposure (i.e., buying options) that an intelligent option inves-\ntor should understand. Gaining exposure seems easy in the beginning be-\ncause it is straightforward—simply pay your premium up front, then if the \nstock moves into your option’srange of exposure by expiration time, you \nwin. However, the more you use these strategies in investing exposure, the \nmore nuances arise.\nWhat tenor should Ichoose? What strike price should Ichoose? \nShould Iexercise early if my option is in the money (ITM)? How much \ncapital should Icommit to agiven trade? If the stock price goes in the \nopposite direction from my option’srange of exposure, should Iclose \nmy option position? All these questions are examples of why gaining \nexposure by buying options is not as straightforward aprocess as it \nmay seem at first and are all the types of questions Iwill cover in the \nfollowing pages.\nGaining exposure means buying options, and the one thing that an \noption buyer must never lose sight of is that time is always working against \nhim or her. Options expire. If your options expire out of the money (OTM), \nthe capital you spent on premiums on those options is arealized loss. No \nmatter how confident you are about your valuation call, you should al-\nways keep this immutable truth of option buying in mind. Indeed, there \nare ways to reduce the risk of this happening or to manage aportfolio in", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:204", "doc_id": "7120af02a3541d5e5955456746eb0a46da7320c4cb39e7b1416aceb301d1206e", "chunk_index": 0}
{"text": "188  •   The Intelligent Option Investor\nsuch away that such aloss of capital becomes just acost of doing business \nthat will be made up for in another investment down the line.\nFor each of the strategies mentioned in this chapter, Ipresent \nastylized graphic representing the Black-Scholes-Merton model \n(BSM) cone and the option’srange of exposure plus best- and worst-\ncase valuation scenarios. These are two of the required inputs for an \nintelligent option investing strategy—an intelligently determined valu-\nation range and the mechanically determined BSM forecast range. Iwill \nalso provide asummary of the relative pricing of upside and downside \nexposure vis-à-vis an intelligent valuation range (e.g., “Upside expo-\nsure is undervalued”), the steps taken to execute the strategy, and its \npotential risks and return.\nAfter this summary section, Iprovide textual discussions of tenor se-\nlection, strike price selection, portfolio management (i.e., rolling, exercise, \netc.), and any miscellaneous items of interest to note. Understanding the \nstrategies well and knowing how to use the tools at your disposal to tilt \nthe balance of risk and reward in your favor are the hallmark and pinnacle \nof intelligent option investing. Intelligent option investors gain exposure \nwhen the market underestimates the likelihood of avaluation that the in-\nvestor believes is arational outcome. In graphic terms, this means that ei-\nther one or both of the investor’sbest- and worst-case valuation scenarios \nlie outside the BSM cone.\nSimple (one-option) strategies to gain exposure include\n• Long calls\n• Long puts\nComplex (multioption) strategies to gain exposure include\n• Long strangles\n• Long straddles\nJargon introduced in this chapter includes the following:\nRoll\nRatio(ing)", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:205", "doc_id": "4faa6ba1f44a1037545983c8942ab79aaad3f9c5297a2e506acc50f38ac1f6e6", "chunk_index": 0}
{"text": "Gaining Exposure • 189\nLong Call\nGREEN\nDownside: Fairly priced\nUpside: Undervalued\nExecute: Buy acall option\nRisk: Amount equal to premium paid\nReward: Unlimited less amount of premium paid\nThe Gist\nAn investor uses this strategy when he or she believes that there is amaterial \nchance that the value of acompany is much higher than the present market price. \nThe investor must pay apremium to initiate the position, and the proportion of \nthe premium that represents time value should be recognized as arealized loss \nbecause it cannot be recovered. If the stock fails to move into the area of exposure \nbefore option expiration, there will be no profit to offset this realized loss.\nIn economic terms, this transaction allows an investor to go long an \nundervalued company without accepting an uncertain risk of loss if the \nstock falls. Instead of the uncertain risk of loss, one must pay the fixed pre-\nmium. This strategy obeys the same rules of leverage as discussed earlier \nin this book, with in-the-money (ITM) call options offering less leverage \nbut being much more forgiving regarding timing than are at-the-money \n(ATM) or especially out-of-the-money (OTM) options.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:206", "doc_id": "d9945dae00234bc55f6de6d40d37c78e6e751772d2be1c4eb600641990a933d5", "chunk_index": 0}
{"text": "190  •   The Intelligent Option Investor\nTenor Selection\nIn general, the rule for gaining exposure is to buy as long atenor as is \navailable. If astock moves up faster than you expected, the option will still \nhave time value left on it, and you can sell it to recoup the extra money you \nspent to buy the longer-tenor option. In addition, long-tenor options are \nusually proportionally less expensive than shorter-tenor ones. You can see \nthis through the following table. These ask prices are for call options on \nGoogle (GOOG) struck at whatever price was closest to the 50-delta mark \nfor every tenor available.\nDays to Expiration Ask Price Marginal Price/Day Delta\n3 6.00 2.00 52\n10 10.30 0.61 52\n17 12.90 0.37 52\n24 15.50 0.37 52\n31 17.70 0.31 52\n59 22.40 0.17 49\n87 34.40 0.43 50\n150 42.60 0.13 50\n178 47.30 0.17 50\n241 56.00 0.14 50\n542 86.40 0.10 50\nThe “Marginal Price/Day” column is simply the extra that you pay to get \nthe extra days on the contract. For example, the contract with three days left is \n$6.00. For seven more days of exposure, you pay atotal of $4.30 extra, which \nworks out to aper-day rate of $0.61. We see blips in the marginal price per \nday field as we go from 59 to 87 to 150 days, but these are just artifacts of data \navailability; the closest strikes did not have the same delta for each expiration.\nThe preceding chart, it turns out, is just the inverse of the rule we \nalready learned in Chapter 3: “time value slips away fastest as we get closer \nto expiration. ” If time value slips away more quickly nearer expiration, it \nmust mean that the time value nearer expiration is proportionally worth \nmore than the time value further away from expiration. The preceding \ntable simply illustrates this fact.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:207", "doc_id": "9a233b9cefa3337baf27f74191b30d554c837eb7391b3519684f599d39bfa8c1", "chunk_index": 0}
{"text": "Gaining Exposure • 191\nValue investors generally like bargains and to buy in bulk, so we \nshould also buy our option time value “in bulk” by buying the longest \ntenor available and getting the lowest per-day price for it. It follows that if \nlong-term equity anticipation securities (LEAPS) are available on astock, \nit is usually best to buy one of those. LEAPS are wonderful tools because, \naside from the pricing of time value illustrated in the preceding table, if \nyou find astock that has undervalued upside potential, you can win from \ntwo separate effects:\n1. The option market prices options as if underlying stocks were ef-\nficiently priced when they may not be (e.g., the market thinks that \nthe stock is worth $50 when it’sworth $70). This discrepancy gives \nrise to the classic value-investor opportunity.\n2. As long as interest rates are low, the drift term understates the ac-\ntual, probable drift of the stock market of around 10 percent per \nyear. This effect tends to work for the benefit of along-tenor call \noption whether or not the pricing discrepancy is as profound as \noriginally thought.\nThere are acouple of special cases in which this “buy the longest \ntenor possible” rule of thumb should not be used. First, if you believe \nthat acompany may be acquired, it is best to spend as little on time value \nas possible. Iwill discuss this case again when Idiscuss selecting strike \nprices, but when acompany agrees to be acquired by another (and the \nmarket does not think there will be another offer and regulatory approv-\nals will go through), the time value of an option drops suddenly because \nthe expected life of the stock as an independent entity has been short-\nened by the acquiring company. This situation can get complicated for \nstock-based acquisitions (i.e., those that use stocks as the currency of \nacquisition either partly or completely) because owners of the acquiree’soptions receive astake in the acquirer’soptions with strike price adjusted \nin proportion to the acquisition terms. In this case, the time value on \nyour acquiree options would not disappear after the acquisition but be \ntransferred to the acquirer’scompany’soptions. The real point is that it \nis impossible, as far as Iknow, to guess whether an acquisition will be \nmade in cash or in shares, so the rule of thumb to buy as little time value \nas possible still holds.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:208", "doc_id": "10da50dfc46681dd89b1bb99fee0384a3d5f1b7e088df880c7f833100aac98d8", "chunk_index": 0}
{"text": "192  •   The Intelligent Option Investor\nIn general, attempting to profit from potential mergers is dif-\nficult using options because you have to get both the timing of the \nsuspected transaction and the acquisition price correct. Iwill discuss \napossible solution to this situation in the next section about picking \nstrike prices.\nThe second case in which it is not necessary to buy as long atenor as \npossible is when you are trading in expectation of aparticular company \nannouncement. In general, this game of anticipating stock price move-\nments is ahard one to win and one that value investors usually steer clear \nof, but if you are sure that some announcement scheduled for aparticular \nday or week is likely to occur but do not want to make along-term invest-\nment on the company, you can buy ashorter-tenor option that obviously \nmust include the anticipated announcement date. It is probably not abad \nidea to build in alittle cushion between your expiration and the anticipated \ndate of the announcement because sometimes announcements are pushed \nback and rescheduled.\nStrike Price Selection \nFrom the discussion regarding leverage in the preceding section, it is \nclear that selecting strike prices has alot to do with selecting what level \nof leverage you have on any given bet. Ultimately, then, strike selec-\ntion—the management of leverage, in other words—is intimately tied \nto your own risk profile and the degree to which you are risk averse or \nrisk seeking.\nMy approach, which Iwill talk more about in the following section \non portfolio management, may be too conservative for others, but Iput it \nforward as one alternative among many that Ihave found over time to be \nsensible. Any investment has risk to the extent that there is never perfect \ncertainty regarding acompany’svaluation. Some companies have afairly \ntight valuation range—meaning that the confluence of their revenue stream, \nprofit stream, and investment efficacy does not vary agreat deal from best to \nworst case. Other companies’ valuation ranges are wide, with afew clumps \nof valuation scenarios far apart or with just one or two outlying valuation \nscenarios that, although not the most likely, are still materially probable.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:209", "doc_id": "4fde7f55056bc5ddd3a021be6422f4858117eef117b41f58cc17f9a6929526ee", "chunk_index": 0}
{"text": "Gaining Exposure • 193\nOn the rare occasion in which we find acompany that has avaluation \nrange that is far different from the present market price (either tight \nor wide), Iwould rather commit more capital to the idea, and for me, \ncommitting more capital to asingle idea means using less leverage. In other \nwords, Iwould prefer to buy an ITM call and lever at areasonable rate (e.g., \nthe −1.8 × /2.6 × level we saw in the Intel example earlier). Graphically, my \napproach would look like this:\nAdvanced Building Corp. (ABC)\n110\n100\n90\n80\n70\n60\n50\n40\n30\n20\n5/18/2012 5/20/2013 249 499 749 999\nDate/Day Count\nStock Price\nGREEN\nORANGE\nHere Ihave bought adeep ITM call option LEAPS that gives me lev-\nerage of about −1.5/2.0. Ihave maximized my tenor and minimized my \nleverage ratio with the ITM call. This structure will allow me to profit as \nlong as the stock goes up by the time my option expires, even if the stock \nprice does not hit acertain OTM strike price.\nIn the more common situation, in which we find acompany that is \nprobably about fairly valued in most scenarios but that has an outlying \nvaluation scenario or two that doesn’tseem to be priced in properly by \nthe market, Iwill commit less capital to the idea but use more leverage. \nGraphically, my approach would look more like this:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:210", "doc_id": "68d2d0faa6b983a2609e75653b13b369c21c5eceed2a74518f572ac0ae3de5c0", "chunk_index": 0}
{"text": "194  •   The Intelligent Option Investor\nAdvanced Building Corp. (ABC)\n100\n90\n80\n70\n60\n50\n40\n30\n20\n5/18/2012 5/20/2013 249 499 749 999\nDate/Day Count\nStock Price\nGREEN\nHere Ihave again maximized my tenor by buying LEAPS, but this \ntime Iincrease my leverage to something like an “IRL/10.0” level in case \nthe stars align and the stock price sales to my outlier valuation. \nSome people would say that the IIM approach is absolutely the op-\nposite of arational one. If you are—the counterargument goes—confident \nin your valuation range, you should try to get as much leverage on that idea \nas possible; buying an ITM option is stupid because you are not using the \nleverage of options to their fullest potential. This counterargument has its \npoint, but Ifind that there is just too much uncertainty in the markets to be \ntoo bold with the use of leverage. \nOptions are time-dependent instruments, and if your option expires \nworthless, you have realized aloss on whatever time value you original-\nly spent on it. Economies, now deeply intertwined all over the globe, are \nphenomenally complex things, so it is the height of hubris to claim that \nIcan perfectly know what the future value of afirm is and how long it will \ntake for the market price to reflect that value. In addition, Ias ahuman \ndecision maker am analyzing the world and investments through acon-\ngenital filter based on behavioral biases.\nRetaining my humility in light of the enormous complexity of the \nmarketplace and my ingrained human failings and expressing this humility", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:211", "doc_id": "274585cd5278a04ca75aedc53658d837a491be66ce423b10e9a8da1157c5e9cc", "chunk_index": 0}
{"text": "Gaining Exposure • 195\nby using relatively less leverage when Iwant to commit asignificant amount \nof capital to an idea constitute, Ihave found, given my risk tolerance and \nexperience, the best path for me for ageneral investment.\nIn contrast, we all have special investment loves or wild hares or \nwhatever, and sometimes we must express ourselves with acommitment \nof capital. For example, “If XYZ really can pull it off and come up with acure for AIDS, its stock will soar. ” In instances such as these, Iwould rather \ncommit less capital and express my doubt in the outcome with asmaller \nbut more highly levered bet. If, on average, my investment wild hares come \ntrue every once in awhile and, when they do, the options I’ve bought on \nthem pay off big enough to more than cover my realized losses on all those \nthat did not, Iam net further ahead in the end.\nThese rules of thumb are my own for general investments. In the spe-\ncial situation of investing in apossible takeover target, there are afew extra \nconsiderations. Acompany is likely to be acquired in one of two situations: \n(1) it is asound business with customers, product lines, or geographic \nexposure that another company wants, or (2) it is abad business, either \nbecause of management incompetence, asecular decline in the business, or \nsomething else, but it has some valuable asset(s) such as intellectual prop-\nerty that acompany might want to have.\nIf you think that acompany of the first sort may be acquired, Ibe-\nlieve that it is best to buy ITM call options to attempt to minimize the time \nvalue spent on the investment (you could also sell puts, and Iwill discuss \nthis approach in Chapter 10). In this case, you want to minimize the time \nvalue spent because you know that the time value you buy will drain away \nwhen atakeover is announced and accepted. By buying an ITM contract, \nyou are mainly buying intrinsic value, so you lose little time value if and \nwhen the takeover goes through. If you think that acompany of the second \nsort (abad company in decline) may be acquired, Ibelieve that it is best to \nminimize the time value spent on the investment by not buying alot of call \ncontracts and by buying them OTM. In this case, you want to minimize the \ntime value spent using OTM options by limiting the number of contracts \nbought because you do not want to get stuck losing too much capital if \nand when the bad company’sstock loses value while you are holding the \noptions. Typical buyout premiums are in the 30 percent range, so buy-\ning call options 20 percent OTM or so should generate adecent profit if", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:212", "doc_id": "1817a702c69c2ebc4f8e90ba9e539f24c7bf289d0856c29b26f6884aeafe5f1b", "chunk_index": 0}
{"text": "196  •   The Intelligent Option Investor\nthe company is taken out. Just keep in mind that the buyout premium is \n30 percent over the last price, not 30 percent over the price at which you \ndecided to make your investment. If you buy 20 percent OTM call options \nand the stock decreases by 10 percent before a 30 percent premium buyout \nis announced, you will end up with nothing, as shown in the following \ntimeline:\n$12-Strike Options Bought When the Stock Is Trading for $10\n• Stock falls to $9.\n• Buyout is announced at 30 percent above last price—$11.70.\n• 12-strike call owner’sprofit = $0.\nHowever, there is absolutely no assurance that an acguirer will pay some-\nthing for aprospective acguiree. Depending on how keen the acquirer is to get \nits hands on the assets of the target, it may actually allow the target company \nto go bankrupt and then buy its assets at $0.30 on the dollar or whatever. It is \nprecisely this uncertainty that makes it unwise to commit too much capital to \nan idea involving abad company—even if you think it may be taken out.\nPortfolio Management\nIlike to think of intelligent option investing as ameal. In our investment \nmeal, the underlying instrument—the stock—should, in most cases, form \nthe main course. \nPeople have different ideas about diversification in asecurities portfolio \nand about the maximum percentage of aportfolio that should be allocated to \naspecific idea. Clearly, most people are more comfortable allocating agreater \npercentage of their portfolio to higher-confidence ideas, but this is normal-\nly framed in terms of relative levels (i.e., for some people, ahigh-conviction \nidea will make up 5 percent of their portfolio and alower-conviction one \n2.5 percent; for others, ahigh-conviction idea will make up 20 percent of their \nportfolio and alower-conviction one 5 percent). Rather than addressing what \nsize of investment meal is best to eat, let’sthink about the meal’scomposition.\nConsidering the underlying stock as the main course, Iconsider the \nleverage as sauces and side dishes. ITM options positions are the main", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:213", "doc_id": "d91ed8baaeee178eef58e6fd15bb9380eeb75a2a5f345396ddc91641c383c7bb", "chunk_index": 0}
{"text": "Gaining Exposure • 197\nsauce to make the main course more interesting and flavorful. You can \nlayer ITM options onto the stock to increase leverage to alevel with which \nyou feel comfortable. This does not have to be Buffett’s 1.8:1 leverage of \ncourse. Levering more lightly will provide less of akick when acompany \nperforms according to your best-case scenario, but also carries less risk \nof asevere loss if the company’sperformance is mediocre or worse. OTM \noption positions (and “long diagonals” to be discussed in Chapter 11) can \nbe thought of as aspicy side dish to the main meal. They can be added \nopportunistically (when and if the firm in which you are investing has abad quarter and its stock price drops for temporary reasons involving sen-\ntiment rather than substance) for extra flavor. OTM options can also be \nused as asnack to be nibbled on between proper meals. Snack, in this case, \nmeans asmaller sized position in firms that have asmall but real upside \npotential but agreater chance that it is fairly valued as is, or in acompany \nin which you don’thave the conviction in its ability to create much value \nfor you, the owner. \nAnother consideration regarding the appropriate level of investment \nleverage one should apply to agiven position is how much operational \nand financial leverage (both are discussed in detail in Appendix B) afirm \nhas. Afirm that is highly levered will have amuch wider valuation range \nand will be much more likely to be affected by macroeconomic considera-\ntions that are out of the control of the management team and inscrutable \nto the investor. In these cases, Ithink the best response is to adjust one’sinvestment leverage according to the principles of “margin of safety” and \ncontrarianism. \nBy creating avaluation range, rather than thinking only of asingle point-\nestimate for the value of the firm, we have unwittingly allowed ourselves to \nbecome very skillful at picking appropriate margins of safety. For example, Irecently looked at the value of acompany whose stock was trading for around \n$16 per share. The company had very high operational and financial lever-\nage, so my valuation range was also very large—from around $6 per share \nworst case to around $37 per share best case with amost likely value of around \n$25 per share. The margin of safety is 36 percent (= ($25 − $16)/ $25). \nWhile some might think this is areasonable margin of safety to take abold, \nconcentrated position, Ielected instead to take asmall, unlevered one because \nto me, the $9 margin of safety for this stock is still not wide enough. The best", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:214", "doc_id": "62cbd331380a7765916edf1b685d3c158c467a0615772e274ff05843595619bd", "chunk_index": 0}
{"text": "198  •   The Intelligent Option Investor\ntime to take alarger position and to use more leverage is when the market is \npricing astock as if it were almost certain that acompany will face aworst-case \nfuture when you consider this worst-case scenario to be relatively unlikely. In \nthis illustration, if the stock price were to fall by 50 percent—to the $8 per share \nlevel—while my assessment of the value of the company remained unchanged \n(worst, likely, and best case of $6, $25, and $37, respectively), Iwould think Ihad the margin of safety necessary to commit alarger proportion of my portfo-\nlio to the investment and add more investment leverage. With the stock sitting \nat $8 per share, my risk ($8 − $6 = $2) is low and unlikely to be realized while \nmy potential return is large and much closer to being assured. With the stock’spresent price of $16 per share, my risk ($16 − $6 = $10) is large and when bad-\ncase scenarios are factored in along with the worst-case scenario, more likely \nto occur.\nThinking of margins of safety from this perspective, it is obvious that \none should not frame them in terms of arbitrary levels (e.g., “Ihave arule \nto only buy stocks that are 30% or lower than my fair value estimate. ”), but \nrather in terms informed by an intelligent valuation range. In this example, \na 36 percent margin of safety is sufficient for me to commit asmall \nproportion of my portfolio to an unlevered investment, but not to go “all \nin. ” For aconcentrated, levered position in this investment, Iwould need amargin of safety approaching 76 percent (= ($25 − $6)/$25) and at least over \n60 percent (= ($25 - $10)/$25).\nWhen might such alarge margin of safety present itself? Just when \nthe market has lost all hope and is pricing in disaster for the company. \nThis is where the contrarianism comes into play. The best time to make \nalevered investment in acompany with high levels of operational lever -\nage is when the rest of the market is mainly concerned about the possible \nnegative effects of that operational leverage. For example, during areces-\nsion, consumer demand drops and idle time at factories increases. This \nhas aquick and often very negative effect on profitability for companies \nthat own the idle factories, and if conditions are bad enough or look to \nhave no near-term (i.e., within about six months) resolution, the price of \nthose companies’ stocks can plummet. Market prices often fall so low as to \nimply, from avaluation perspective, that the factories are likely to remain \nidled forever. In these cases, Ibelieve that not using investment leverage in \nthis case may carry with it more real risk than using investment leverage", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:215", "doc_id": "0b8f121fe30c1909b45bd6867830de88047f5d2ff18f947bf3e07d8af457472e", "chunk_index": 0}
{"text": "200  •   The Intelligent Option Investor\nAfter you enter aposition and some time passes, it becomes clearer \nwhat valuation scenario the company is tending toward. In some cases, \nabit of information will come out that is critical to your valuation of the \ncompany on which other market participants may not be focused. Obvi-\nously, if abit of information comes out that has abig, positive or negative \nimpact on your assessment of the company’svalue, you should adjust your \nposition size accordingly. If you believe the impact is positive, it makes \nsense to build to aposition by increasing your shares owned and/or by \nadding “spice” to that meal by adjusting your target leverage level. If the \nimpact is negative, it makes sense to start by reducing leverage (or you \ncan think of it as increasing the proportion of cash supporting aparticular \nposition), even if this reduction means realizing aloss. If the impact of the \nnews is so negative that the investment is no longer attractive from arisk-\nreward perspective, Ibelieve that it should be closed and the lumps taken \nsooner rather than later. Considering what we know about prospect theory, \nthis is psychologically adifficult thing to do, but in my experience, waiting \nto close aposition in which you no longer have confidence seldom does \nyou any good.\nObviously, the risk/reward equation of an investment is also influ-\nenced by astock’smarket price. If the market price starts scraping against \nthe upper edge of your valuation range, again, it is time to reduce leverage \nand/or close the position.\nIf your options are in danger of expiring before astock has reached \nyour fair value estimate, you may roll your position by selling your option \nposition and using the proceeds to buy another option position at amore \ndistant tenor. At this time, you must again think about your target leverage \nand adjust the strikes of your options accordingly. If the price of the stock \nhas decreased over the life of the option contract, this will mean that you \nrealize aloss, which is not an easy thing to do psychologically, but consid-\nering the limitations imposed by time for all option investments, this is an \nunavoidable situation in this case.\nOne of the reasons Idislike investing in non-LEAPS call options is \nthat rolling means that not only do we have to pay another set of bro-\nker and exchange fees, but we also must pay both sides of the bid-ask \nspread. Keeping in mind how wide the bid-ask spread can be with options \nand what an enormous drag this can be on returns, you should carefully", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:217", "doc_id": "2c9cb70c64da4778eaf91583d05c0192d9576fe50b053b35e7bc5571782bae35", "chunk_index": 0}
{"text": "Gaining Exposure • 201\nconsider whether the prospective returns justify entering along call posi-\ntion that will likely have to be rolled multiple times before the stock hits \nyour fair value estimate.\nBy the way, it goes without saying that to the extent that an option \nyou want to roll has asignificant amount of time value on it, it is better \nto roll before time decay starts to become extreme. This usually occurs at \naround three months before expiration. It turns out that option liquidity \nincreases in the last three months before expiration, and rolling is made \neasier with the greater liquidity.\nHaving discussed gaining bullish exposure with this section about \nlong calls, let’snow turn to gaining bearish exposure in the following sec-\ntion on long puts.\nLong Put\nGREEN\nDownside: Undervalued\nUpside: Fairly priced\nExecute: Buy aput option\nRisk: Amount of premium paid\nReward: Amount equal to strike price—premium\nThe Gist\nAn investor uses this strategy when he or she believes that it is very likely \nthat the value of acompany is much lower than the present market price. \nThe investor must pay apremium to initiate the position, and the propor-\ntion of the premium that represents time value should be recognized as a", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:218", "doc_id": "f8f92bffd5ddaa8d01124def02056b22b0049bd222f46d9ccd69062e1390742f", "chunk_index": 0}
{"text": "202  •   The Intelligent Option Investor\nrealized loss because it cannot be recovered. If the stock fails to move into \nthe area of exposure before option expiration, there will be no profit to \noffset this realized loss.\nIn economic terms, this transaction allows an investor to sell short \nan overvalued company without accepting an uncertain risk of loss if the \nstock rises. Instead of the uncertain risk of loss, the investor must pay the \nfixed premium. This strategy obeys the same rules of leverage as discussed \nearlier in this book, with ITM put options offering less leverage but agreat-\ner cushion before realizing aloss than do ATM or OTM put options.\nTenor Selection\nShorting stocks, which is what you are doing when you buy put op-\ntions, is hard work, not for the faint of heart. There are acouple of \nreasons for this:\n1. Markets generally go up, and for better or worse, arising tide usu-\nally does lift all boats.\n2. Even when acompany is overvalued, it is hard to know what cata-\nlyst will make that fact obvious to the rest of the market and when.\nIn the words of Jim Chanos, head of the largest short-selling hedge fund \nin the world, the market is a “giant positive reinforcement machine. ”\n1 \nIt is psychologically difficult to hold abearish position when it seems \nlike the whole world disagrees with you. All these difficulties in taking \nbearish positions are amplified by options because options are levered \ninstruments, and losses feel all the more acute when they occur on alevered position.\nMy rule for gaining bullish exposure is to pick the longest-tenor op-\ntion possible. Imade the point that by buying LEAPS, you can enjoy alikely upward drift that exceeds the drift assumed by option pricing. When \nbuying puts, you are on the opposite side of this drift factor (i.e., the “ris-\ning tide lifts all boats” factor), and every day that the stock does not fall is \nanother day of time value that has decayed without you enjoying aprofit. \nOn the other hand, if you decide not to spend as much on time value and \nbuy ashorter-tenor put option, unless the market realizes that the stock is", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:219", "doc_id": "b7f69fc8554cf32cba273303737bc2f7c2ee34821ec42d11d3da8791600ab579", "chunk_index": 0}
{"text": "Gaining Exposure • 203\novervalued and it drops before the shorter option expires, you must pay the \nentire bid-ask spread and the broker and exchange fees again when you roll \nyour put option.\nThe moral of the story is that when selecting tenors for puts, you need \nto balance the existence of upward market drift (which lends weight to the \nargument for choosing shorter tenors) with bid-ask spreads and other fees \n(which lends weight to the argument for longer tenors). If you can iden-\ntify acatalyst, you can plan the tenor of the option investment based on \nthe expected catalyst. However, it’sunfortunate but mysteriously true that \nbearish catalysts have atendency to be ignored by the market’s “happy ma-\nchine” until the instant when suddenly they are not and the shares collapse. \nThe key for ashort seller is to be in the game when the market realizes the \nstock’sovervaluation.\nStrike Price Selection\nWhen it comes to strike prices, short sellers find themselves fighting drift \nin much the same way as they did when selecting tenors. Ashort seller with \naposition in stocks can be successful if the shares he or she is short go up \nless than other stocks in the market. The short exposure acts as ahedge to \nthe portfolio as awhole, and if it loses less money than the rest of the port-\nfolio gains, it can be thought of as asuccessful investment.\nHowever, the definition for success is different for buyers of aput \noption, who must not only see their bearish bets not go up by much but \nrather must see their bearish bets fall if they are to enjoy aprofit. If the \ninvestor wanting bearish exposure decides to gain it by buying OTM puts, \nhe or she must—as we learned in the section about leverage—accept arealized loss as soon as the put is purchased. If, on the other hand, the \ninvestor wants to minimize the realized loss accepted up front, he or she \nmust accept that he or she is in alevered bearish position so that every \n1 percent move to the upside for the stock generates aloss larger than 1 \npercent for the position.\nThere is another bearish strategy that you can use by accepting \nexposure that Iwill discuss in the next section, but for investors who are \ngaining bearish exposure, there is no way to work around the dilemma of \nthe option-based short seller just mentioned.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:220", "doc_id": "c79348b219bef027cc99a15073b7ab38fa501088791fa961e1f863f0ab526808", "chunk_index": 0}
{"text": "204  •   The Intelligent Option Investor\nPortfolio Management\nThere is certainly no way around the tradeoff between OTM and ITM \nrisk—the rules of leverage are immutable whether in abullish or abear -\nish investment—but there are some ways of framing the investment that \nwill allow intelligent investors to feel more comfortable with making \nthese types of bearish bets. First, Ibelieve that losses associated with abearish position are treated differently within our own minds than those \nassociated with bullish positions. The reason for this might be the fact \nthat if you decide to proactively invest in the market, you must buy se-\ncurities, but you need not sell shares short. The fact that you are losing \nwhen you are engaged in an act that you perceive as unnecessary just \nadds to asense of regret and self-doubt that is necessarily part of the \ninvesting process.\nIn addition, investors seem to be able to accept underperform-\ning bullish investments in aportfolio context (e.g., “XYZ is losing, but \nit’sonly 5 percent of my holdings, and the rest of my portfolio is up, so \nit’sokay”) but look at underperforming bearish investments as if they \nwere the only investments they held (e.g., “I’mlosing 5 percent on that \ndamned short. Why did Iever short that stock in the first place?”). In gen-\neral, people have ahard time looking at investments in aportfolio con-\ntext (Iwill discuss this more when Italk about hedging in Chapter 11), \nbut this problem seems to be orders of magnitude worse in the case of abearish position.\nMy solution to this dilemma—perhaps not the best or most rational \nfrom aperformance standpoint but most manageable to me from apsy-\nchological one—is to buy OTM puts with much smaller position sizes than \nImight for bullish bets with the same conviction level. This means that Ihave smaller, more highly levered positions. The reason this works for me \nis that once Ispend the premium on the put option, Iconsider the money \ngone—asunk cost—and do not even bother to look at the mark-to-market \nvalue of the option after that unless there is alarge drop in the stock price. \nSomehow this acknowledgment of arealized loss up front is easier to han-\ndle psychologically than watching my ITM put position suffer unrealized \nlosses of 1.5 times the rise of the stock every day.\nThis strategy may well be proof that Isimply am not anatural-born \nshort seller, and you are encouraged, now that you understand the issues", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:221", "doc_id": "1a895452bdf6ae607e7a005b87432f4d748530b921235631f71da2e39d92d610", "chunk_index": 0}
{"text": "206  •   The Intelligent Option Investor\navoid this extreme downside are worth much more than they are presently \ntrading at.\nThe entire premium paid must be treated as arealized loss because \nit can never be recovered. If the stock fails to move into one of the areas \nof exposure before option expiration, there will be no profit to offset this \nrealized loss.\nThere is no reason why you have to buy puts and calls in equal num-\nbers. If you believe that both upside and downside scenarios are materially \npossible but believe that the downside scenario is more plausible, you can \nbuy more puts than calls. This is called ratioing aposition. \nTenor Selection\nBecause the strangle is acombination of two strategies we have already \ndiscussed, the considerations regarding tenor are the same as for each of \nthe components—that is, using the drift advantage in long-term equity an-\nticipating securities (LEAPS) and buying them or the longest-tenor calls \navailable and balancing the fight against drift and the cost of rolling and \nbuying perhaps shorter-tenor puts.\nStrike Price Selection\nAstrangle is slightly different in nature from its two components—long \ncalls and long puts. Astrangle is an option investor’sway of expressing \nthe belief that the market in general has underestimated the intrinsic \nuncertainty in the valuation of afirm. Options are directional instru-\nments, but astrangle is astrategy that acknowledges that the investor \nhas no clear idea of which direction astock will move but only that \nits future value under different scenarios is different from its present \nmarket price.\nBecause both purchased options are OTM ones, this implies, in my \nmind, amore speculative investment and one that lends itself to taking \nprofit on it before expiration. Nonetheless, my conservatism forces me to \nselect strike prices that would allow aprofit on the entire position if the \nstock price is at one of the two strikes at expiration. Because Iam buying \nexposure to both the upside and the downside, Ialways like to make sure", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:223", "doc_id": "be8d0e02b7196be90f0aa1da5ad66386fe4f0e4de560605212a0bfbb9ae42460", "chunk_index": 0}
{"text": "Gaining Exposure • 207\nthat if the option expires when the stock price is at either edge of my valu-\nation range, it is far enough in-the-money to pay me back for both legs of \nthe investment (plus an attractive return).\nPortfolio Management\nAs mentioned earlier, this is naturally amore speculative style of option \ninvestment, and it may well be more beneficial to close the successful leg of \nthe strategy before expiration than to hold the position to expiration. Com-\npared with the next strategy presented here (the straddle), the strangle ac-\ntually generates worse returns if held to expiration, so if you are happy with \nyour returns midway through the investment, you should close the posi-\ntion rather than waiting for expiration. The exception to this rule is that if \nnews comes out that convinces you that the value of the firm is materially \nhigher or lower than what you had originally forecast and uncertainty in \nthe other direction has been removed, you should assess the possibility of \nmaking amore substantial investment in the company.\nOne common problem with investors—even experienced and sophis-\nticated ones—is that they check the past price history of astock and decide \nwhether the stock has “more room” to move in aparticular direction. The \nmost important two things to know when considering an investment are its \nvalue and the uncertainty surrounding that value. Whether the stock was \ncheaper three years ago or much more expensive does not matter—these are \nbackward-looking measures, and you cannot invest with arear-view mirror.\nOne final note regarding this strategy is what to do with the unused \nleg. If the stock moves up strongly and you take profits on the call, what \nshould you do with the put, in other words. Unfortunately, the unused leg is \nalmost always worthless, and often it will cost more than it’sworth to close \nit. Iusually keep this leg open because you never know what may happen, \nand perhaps before it expires, you will be able to close it at abetter price.\nThis is aspeculative strategy—abit of spice or an after-dinner mint \nin the meal of investing. Don’texpect to get rich using it (if you do get rich \nusing it, it means that you were lucky because you would have had to have \nused alot of leverage in the process), but you may be pleasantly surprised \nwith the boost you get from these every once in awhile.\nLet’snow turn briefly to arelated strategy—the straddle.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:224", "doc_id": "9b0536d8773117611cd009ab4a29787778212ee108ee67e9e9d31e37369ed37f", "chunk_index": 0}
{"text": "208  •   The Intelligent Option Investor\nStraddle\nGREEN\nDownside: Undervalued\nUpside: Undervalued\nExecute: Simultaneously buy an ATM put and an ATM call\nRisk: Amount of premium paid\nReward: Unlimited?\nThe Gist\nIinclude the straddle here for completeness sake. Ihave not included alot of the fancier multioption strategies in this book because Ihave found \nthem to be more expensive than they are worth, especially for someone \nwith adefinite directional view on asecurity. However, the straddle is re-\nferred to commonly and is deceptively attractive, so Iinclude it here to \nwarn investors against its use, if for no other reason.\nThe straddle shares many similarities with the strangle, of course, but \nstraddles are enormously expensive because you are paying for every pos-\nsible price the stock will move to over the term of the options. For example, \nIjust looked up option prices for BlackBerry (BBRY), whose stock was \ntrading at $9.00. For the 86 days to expiry, $9-strike calls (delta = 0.56) and \n$9-strike puts (delta = –0.44) were priced at $1.03 and $1.13, respectively.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:225", "doc_id": "6afd7b9a6569c8375faac557ad4c4b1b6dbb9dae1b549bde68aa3701920a8629", "chunk_index": 0}
{"text": "Gaining Exposure • 209\nThe total premium of $2.16 represents 24 percent of the stock’sprice, which \nmeans that if the implied volatility (around 60 percent) remains constant, \nthe stock would have to move 24 percent before an investor even breaks \neven. It is true that during sudden downward stock price moves, implied \nvolatility usually rises, so it might take alittle less of astock price move-\nment to the downside to break even. However, during sudden upside \nmoves, implied volatility often drops, which would make it more difficult \nto break even to the upside.\nDespite this expense, astraddle will still give an investor alower \nbreakeven point than astrangle on the same stock if held to expiration. \nThe key is that astrangle will almost always generate ahigher profit than \nastraddle if it is closed before expiration simply because the initial cost of \nthe strangle is lower and the relative leverage of each of its legs is higher. \nThis is yet another reason to consider closing astrangle early if and when \nyou are pleased with the profits made. \nIf you do not know whether astock will move up or down, the best \nyou can hope for is to make aspeculative bet on the company. When you \nmake speculative bets, it is best to reduce the amount spent on it or you will \nwhittle down all your capital on what amounts to aroulette wheel. Reduc-\ning the amount spent on asingle bet is the reason an intelligent investor \nshould stay away from straddles.\nWith all the main strategies for gaining exposure covered, let’snow \nturn to accepting exposure by selling options.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:226", "doc_id": "74e88ba8d224aa81e41090a92952e7b49e1dc67b0d1609f3d1770591d60b2214", "chunk_index": 0}
{"text": "211\nChapter 10\nAccepting exposure\nBrokerages and exchanges treat the acceptance of exposure by counter -\nparties in avery different way from counterparties who want to gain expo-\nsure. There is agood reason for this: although an investor gaining exposure \nhas an option to transact in the future, his or her counterparty—an investor \naccepting exposure—has acommitment to transact in the future at the sole \ndiscretion of the option buyer. If the investor accepting exposure does not \nhave the financial wherewithal to carry out the committed transaction, the \nbroker or exchange is on the hook for the liability.\n1\nFor example, an investor selling aput option struck at $50 per share \nis committing to buy the stock in question for $50 ashare at some point \nin the future—this is the essence of accepting exposure. If, however, \nthe investor does not have enough money to buy the stock at $50 at \nsome point in the future, the investor’scommitment to buy the shares is \neconomically worthless.\nTo guard against this eventuality, brokers require exposure-accepting \ninvestors to post asecurity deposit called margin that will fully cover the fi-\nnancial obligation to which the investor is committing. In the preceding ex-\nample, for instance, the investor would have to keep $5,000 (= $50 per share × \n100 shares/contract) in reserve and would not be able to spend those reserved \nfunds for stock or option purchases until the contract has expired worthless.\nBecause of this margin requirement, it turns out that one of our strat-\negies for accepting leverage—short puts—always carries with it aloss lev-\nerage of –1.0—exactly the same as the loss leverage of astock. Think about \nit this way: what difference is there between using $50 to buy astock and", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:228", "doc_id": "4a4d3585dda3bd65c4308391ef7c055c7d64dfa65a25329b587f0b976159b56a", "chunk_index": 0}
{"text": "212  •   The Intelligent Option Investor\nsetting $50 aside in an escrow account you can’ttouch and promising that \nyou will buy the stock with the escrow funds in the future if requested to \ndo so? From arisk perspective, “very little” is the answer. \nShort calls are more complicated, but Iwill discuss the leverage car -\nried by them using elements of the structure Iset forth in Chapter 8. In the \nfollowing overviews, Iadd one new line item to the tables that details the \nmargin requirements of the positions.\nIntelligent option investors accept exposure when the market over -\nestimates the likelihood of avaluation that the investor believes is not arational outcome. In graphic terms, this means that either one or both of \nthe investor’sbest- and worst-case valuation scenarios lie well within the \nBlack-Scholes-Merton model (BSM) cone.\nSimple (one-option) strategies to accept exposure include \n1. Short put\n2. Short call (call spread)\nComplex (multioption) strategies to accept exposure include the following:\n1. Short straddle\n2. Short strangle\nJargon introduced in this chapter includes the following:\nMargin Put-call parity\nEarly exercise Cover (aposition)\nWriting (an option)\nShort Put\nRED", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:229", "doc_id": "9d2a1855f8d7bc3df091c30e0532c59affca2795ce59b3ce842bc7f6229bce6a", "chunk_index": 0}
{"text": "Accepting Exposure   • 213\nDownside: Overvalued\nUpside: Fairly valued\nExecute: Sell aput contract\nRisk: Strike price minus premium received [same as stock inves-\ntor at the effective buy price (EBP)]\nReward: Limited to premium received\nMargin: Notional amount of position\nThe Gist\nThe market is pricing in arelatively high probability that the stock price \nwill fall. An investor, from alonger investment time frame perspective, \nbelieves that the value of the stock is likely worth at least the present mar-\nket value and perhaps more. The investor agrees to accept the downside \nrisk perceived by the market and, in return, receives apremium for doing \nso. The premium cannot be fully realized unless the option expires out- \nof-the money (OTM). If the option expires in-the-money (ITM), the \ninvestor pays an amount equal to the strike price for the stock but can \npartially offset the cost of the stock by the premium received. The inves-\ntor thus promises to buy the stock in question at aprice of the strike \nprice of the option less the premium received—what Icall the effective \nbuy price.\nIthink of the short-put strategy as being very similar to buying cor -\nporate bonds and believe that the two investment strategies share many \nsimilarities. Abond investor is essentially looking to receive aspecific \nmonetary return (in the form of interest) in exchange for accepting \nthe risk of the business failing. The only time abond investor owns acompany’sassets is after the value of the firm’sequity drops to zero, and \nthe assets revert to the control of the creditors. Similarly, ashort-put in-\nvestor is looking to receive aspecific monetary return (in the form of an \noption premium) in exchange for accepting the risk that the company’sstock will decrease in value. The only time ashort-put investor owns acompany’sshares is after the market value of the shares expires below the \npreagreed strike price.\nBecause the strategies are conceptually similar, Iusually think of short-\nput exposure in similar terms and compare the “yield” Iam generating", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:230", "doc_id": "72e57e20793ad70462ea26ee528696a3e40e08b069d051d3fbe6988aa032c792", "chunk_index": 0}
{"text": "214  •   The Intelligent Option Investor\nfrom aportfolio of short puts with the yield Imight generate from acor -\nporate bond portfolio. With this consideration, and keeping in mind that \nthese investments are unlevered, 2 the name of the game is to generate as \nhigh apercentage return as possible over the investing time horizon while \nminimizing the amount of real downside risk you are accepting.\nTenor Selection\nTo maximize percentage return, in general, it is better to sell options with \nrelatively short-term expirations (usually tenors of from three to nine \nmonths before expiration). This is just the other side of the coin of the \nrule to buy long-tenor options: the longer the time to expiration, the less \ntime value there is on aper-day basis. The rule to sell shorter-tenor options \nimplies that you will make ahigher absolute return by chaining together \ntwo back-to-back 6-month short puts than you would by selling asingle \n12-month option at the beginning of the period.\nDuring normal market conditions, selling shorter-tenor options is \nthe best tactical choice, but during large market downdrafts, when there \nis terror in the marketplace and implied volatilities increase enormously \nfor options on all companies, you might be able to make more by sell-\ning alonger-tenor option than by chaining together aseries of shorter-\ntenor ones (because, presumably, the implied volatilities of options will \ndrop as the market stabilizes, and this drop means that you will make \nless money on subsequent put sales). At these times of extreme market \nstress, there are situations where you can find short-put opportunities \non long-tenor options that defy economic logic and should be invested \nin opportunistically. \nFor example, during the terrible market drops in 2009, Ifound acompany whose slightly ITM put long-term equity anticipation securities \n(LEAPS) were trading at such ahigh price that the effective buy price of \nthe stock was less than the amount of cash the firm had on its balance \nsheet. Obviously, for afirm producing positive cash flows, the stock should \nnot trade at less than the value of cash presently on the balance sheet! Ief-\nfectively got the chance to buy afirm with $6 of cash on the balance sheet \nand the near certainty of generating about $2 more over the economic life \nof the options for $5.50. The opportunity to buy $6–$8 worth of cash for", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:231", "doc_id": "318ecdedb81149d297e7239de591ee42c15da10defdeee9cabf0bb8008857d31", "chunk_index": 0}
{"text": "Accepting Exposure   • 215\n$5.50 does not come along very often, so you should take advantage of it \nwhen you see it.\nOf course, the absolute value of premium you will receive by writing \n(jargon that means selling an option) ashort-term put is less than the ab-\nsolute value of the premium you will receive by writing along-term one.\n3 \nAs such, an investor must balance the effective buy price of the stock (the \nstrike price of the option less the amount of premium to be received) in \nwhich he or she is investing in the short-put strategy with the percentage \nreturn he or she will receive if the put expires OTM.\nIwill talk more about effective buy price in the next section, but keep \nin mind that we would like to generate the highest percentage return pos-\nsible and that this usually means choosing shorter-tenor options.\nStrike Price Selection\nIn general, the best policy is to sell options at as close to the 50-delta [at-\nthe-money (ATM)] mark as one can because that is where time value for \nany option is at its absolute maximum. Our expectation is that the option’stime value will be worthless at expiration, and if that is indeed the case, \nwe will be selling time value at its maximum and “closing” our time value \nposition at zero—its minimum. In this way, we are obeying (in reverse \norder) the old investing maxim “Buy low, sell high. ” Selling ATM puts \nmeans that our effective buy price will be the strike price at which we sold \nless the amount of the premium we received. It goes without saying that \nan intelligent investor would not agree to accept the downside exposure \nto astock if he or she were not prepared to buy the stock at the effective \nbuy price.\nSome people want to sell OTM puts, thereby making the effective buy \nprice much lower than the present market price. This is an understandable \nimpulse, but simply attempting to minimize the effective buy price means \nthat you must ignore the other element of asuccessful short put strategy: \nmaximizing the return generated. There are times when you might like to \nsell puts on acompany but only at alower strike price. Rather than accept-\ning alower return for accepting that risk, Ifind that the best strategy is \nsimply to wait awhile until the markets make ahiccup and knock down the \nprice of the stock to your desired strike price.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:232", "doc_id": "dd687eaa86e1409dee8beeb0daac2a78b2f9f4dca8353f2e38aa25c68ab531e7", "chunk_index": 0}
{"text": "216  •   The Intelligent Option Investor\nPortfolio Management\nAs we have discussed, the best percentage returns on short-put investments \ncome from the sale of short-tenor ATM options. Ifind that each quarter there \nare excellent opportunities to find afairly constant stream of this type of short-\nterm bet that, when strung together in aportfolio, can generate annualized \nreturns in the high-single-digit to low-teens percentage range. This level of \nreturns—twice or more the yield recently found on ahigh-quality corporate \nbond portfolio and closer to the bond yield on highly speculative small com-\npanies with low credit ratings—is possible by investing in strong, high-quality \nblue chip stocks. In my mind, it is difficult to allocate much money to corpo-\nrate bonds when this type of alternative is available.\nSome investors prefer to sell puts on stocks that are not very vola-\ntile or that have had asignificant run-up in price,\n4 but if you think about \nhow options are priced, it is clear that finding stocks that the market \nperceives as more volatile will allow you to generate higher returns. You \ncan confirm this by looking at the diagrams of ashort-put investment \ngiven two different volatility scenarios. First, adiagram in which implied \nvolatility is low:\nAdvanced Building Corp. (ABC)\n80\n70\n60\n50\n40\n30\n20\n5/18/2012 5/20/2013 249 499 749 999\nDate/Day Count\nStock Price\nRED", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:233", "doc_id": "7c89994843fc3cc91fdf04d852cc21d4167c159fc19462ba5b899426de17278d", "chunk_index": 0}
{"text": "Accepting Exposure   • 217\nNow adiagram when implied volatility is higher:\nRED\nAdvanced Building Corp. (ABC)\n80\n70\n60\n50\n40\n30\n20\n5/18/2012 5/20/2013 249 499 749 999\nDate/Day Count\nStock Price\nObviously, there is much more of the put option’srange of exposure \nbounded by the BSM cone in the second, high-volatility scenario, and this \nmeans that the price received for accepting the same downside risk will be \nsubstantially higher when implied volatility is elevated.\nThe key to setting up asuccessful allocation of short puts is to find \ncompanies that have relatively low downside valuation risk but that also \nhave asignificant amount of perceived price risk (as seen by the market)—\neven if this risk is only temporary in nature. Quarterly earnings seasons are \nnearly custom made for this purpose. Sell-side analysts (and the market \nin general) mainly use multiples of reported earnings to generate atarget \nprice for astock. As such, asmall shortfall in reported earnings as aresult \nof atransitory and/or nonmaterial accounting technicality can cause sell-\nside analysts and other market participants to bring down their short-term \ntarget price estimates sharply and can cause stock prices to drop sharply \nas well.\n5\nThese times, when ahigh-quality company drops sharply as are-\nsult of perceived risk by other investors, are awonderful time to replen-\nish aportfolio of short puts. If you time the tenors well, your short-put", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:234", "doc_id": "a1772dba6df09ad233022e10aae3135b3184d8386b4ae3f7ea1c0a8c33cf8265", "chunk_index": 0}
{"text": "218  •   The Intelligent Option Investor\ninvestment will be expiring just about the time another short-put invest-\nment is becoming attractive, so you can use the margin that has until re-\ncently been used to support the first position to support the new one.\nObviously, this strategy only works when markets are generally trend-\ning upward or at least sideways over the investment horizon of your short \nputs. If the market is falling, short-put positions expire ITM, so you are left \nwith aposition in the underlying stocks. For an option trader (i.e., ashort-\nterm speculator), being put astock is anightmare because he or she has \nno concept of the underlying value of the firm. However, for an intelligent \noption investor, being put astock simply means the opportunity to receive \nadividend and enjoy capital appreciation in astrong stock with very little \ndownside valuation risk.\nThe biggest problem arises when an investor sells aput and then re-\nvises down his or her lowest-case valuation scenario at alater time. For in-\nstance, the preceding diagram shows aworst-case scenario of $55 per share. \nWhat if new material information became known to you that changed your \nlower valuation range to $45 per share just as the market price for the stock \ndropped, as in the following diagram?\nAdvanced Building Corp. (ABC)\n80\n70\n60\n50 EBP = $47.50\nOvervaluation of\ndownside exposure\n40\n30\n20\n5/18/2012 5/20/2013 249 499 749 999\nDate/Day Count\nStock Price\nRED", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:235", "doc_id": "d0f14d4715156d6172b37ba5501e146adc9f7496af2d169ef97abe4df99511e3", "chunk_index": 0}
{"text": "Accepting Exposure   • 219\nLooking at this diagram closely, you should be able to see several \nthings:\n1. The investor who is short this put certainly has anotable unrealized \nloss on his or her position. You can tell this because the put the \ninvestor sold is now much more valuable than at the time of \nthe original sale (more of the range of exposure is carved out by \nthe BSM cone now). When you sell something at one price and the \nvalue of that thing goes up in the future, you suffer an opportunity \nloss on your original sale.\n2. With the drop in price and the cut in fair value, the downside ex-\nposure on this stock still looks overvalued.\n3. If the company were to perform so that its share price eventually \nhit the new, reduced best-case valuation mark, the original short-\nput position would generate aprofit—albeit asmaller profit than \nthe one originally envisioned.\nAt this point, there are acouple of choices open to the investor:\n1. Convert the unrealized loss on the short-put position to arealized \none by buying $50-strike puts to close the position (a.k.a. cover the \nposition).\n2. Leave the position open and manage it in the same way that the \ninvestor would manage astruggling stock position.\nIt is rarely asound idea to close ashort put immediately after the re-\nlease of information that drives down the stock price (the first choice above, \nin other words). At these times, investors are generally panicked, and this \npanic will cause the price of the option you buy to cover to be more expen-\nsive than justified. Waiting afew days or weeks for the fear to drain out of \nthe option prices (i.e., for the BSM cone to narrow) and for the stock price \nto stabilize some will usually allow you to close the option position at amore \nfavorable price. There is one exception to this rule: if your new valuation \nsuggests afair value at or below the present market price, it is better to close \nthe position immediately and realize those losses. If you do not close the \nposition, you are simply gambling (as opposed to investing) because you no \nlonger have abetter than even chance of making money on the investment.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:236", "doc_id": "b07878ebd33a028736c0590912558723f5e37a3494ddb2d41353cc4caa2231a1", "chunk_index": 0}
{"text": "220  •   The Intelligent Option Investor\nThe decision to leave the position open must depend on what other \npotential investments you are able to make and how the stock position that \nwill likely be put to you at expiration of the option contract stacks up on arelative basis. For instance, let’sassume that you had received apremium \nof $2.50 for writing the puts struck at $50. This gives you an effective buy \nprice of $47.50. The stock is now trading at $43 per share, so you can think \nof your position as an unlevered, unrealized loss of $4.50, or alittle under \n10 percent of your EBP . Your new worst-case valuation is $55 per share, \nwhich implies again of about 15 percent on your EBP; your new best-case \nvaluation is $65 per share, which implies again of 37 percent.\nHow do these numbers compare with other investments in your port-\nfolio? How much spare capacity does your portfolio have for additional \ninvestments? (That is, do you have enough spare cash to increase the size \nof this investment by selling more puts at the new market price or buying \nshares of stock? And if so, would your portfolio be weighted too heavily on asingle industry or sector?) By answering these questions and understanding \nhow this presently losing investment compares with other existing or poten-\ntial investments should govern your portfolio management of the position.\nAn investor cannot change the price at which he or she transacted \nin asecurity. The best he or she can do is to develop arational view of the \nvalue of asecurity and judge that security by its relative merit versus other \npossible investments. Whether you ever make an option transaction, this \nis agood rule to keep in mind.\nLet us now take alook at short calls and short-call spreads—the \nstrategy used for accepting upside exposure.\nShort Call (Call Spread)\nRED", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:237", "doc_id": "d6b71c29cfbe965558049a55a664d95ebf3c553aa9f8cd0cc6e84056da5900c8", "chunk_index": 0}
{"text": "Accepting Exposure   • 221\nDownside: Fairly valued\nUpside: Overvalued\nExecute: Sell acall contract (short call); sell acall contract while \nsimultaneously buying acall contract at ahigher strike \nprice (short-call spread)\nRisk: Unlimited for short call; difference between strike prices \nand premium received (short-call spread)\nReward: Limited to the amount of premium received\nMargin: Variable for ashort call; dollar amount equal to the differ-\nence between strike prices for ashort-call spread\nThe Gist\nThe market overestimates the likelihood that the value of afirm is above its pre-\nsent market price. An investor accepts the overvalued upside exposure in return \nfor afixed payment of premium. The full amount of the premium will only flow \nthrough to the investor if the price of the stock falls and the option expires OTM.\nThere are two variations of this investment—the short call and the \nshort-call spread. This book touches on the former but mainly addresses \nthe latter. Ashort call opens up the investor to potentially unlimited capital \nlosses (because stocks theoretically do not have an upper bound for their \nprice), and abroker will not allow you to invest using this strategy except \nfor the following conditions:\n1. You are ahedge fund manager and have the ability to borrow \nstocks through your broker and sell them short.\n2. You are short calls not on astock but on adiversified index (such \nas the Dow Jones Industrial Index or the Standard and Poor’s 500 \nIndex) through an exchange-traded fund (ETF) or afutures con-\ntract and hold adiversified stock portfolio.\nFor investors fitting the first condition, short calls are margined in the \nsame way as the rest of your short portfolio. That is, you must deposit initial \nmargin on the initiation of the investment, and if the stock price goes up, you \nmust pay in variance margin to support the position. Obviously, as the stock \nprice falls, this margin account is settled in your favor. For investors fitting the \nsecond condition, when you originally sell the call option, your broker should", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:238", "doc_id": "f747e713a628a408fb588fa73510757a33fb13e8066dee2559940eabcae049fc", "chunk_index": 0}
{"text": "222  •   The Intelligent Option Investor\nindicate on your statements that acertain proportion of your account effec-\ntively will be treated as margin. This means that you stand to receive the eco-\nnomic benefit from your diversified portfolio of securities but will not be able \nto liquidate all of it. If the market climbs higher, alarger proportion of your \nportfolio will be considered as margin; if it falls lower, asmaller proportion \nof your portfolio will be considered as margin. Basically, aproportion of any \ngains from your diversified stock portfolio will be reapportioned to serve as \ncollateral for your short call when the market is rising, and aproportion of any \nlosses from your diversified stock portfolio will be offset by afreeing of margin \nrelated to your profits on the short call when the market is falling.\nMost brokers restrict the ability of individual investors to write un-\ncovered calls on individual stocks, so the rest of this discussion will cover \nthe short-call spread strategy for individual stocks.\nTenor Selection\nTenors for short-call spreads should be fairly short under the same reason-\ning as that for short puts—one receives more time value per day for short-\ner-tenor options. Look for calls in the three- to nine-month tenor range. \nThe tenor of the purchased call (at the higher strike price) should be the \nsame as the tenor of the sold calls (at the lower strike price). Theoretically, \nthe bought calls could be longer, but it is hard to think of avaluation justifi-\ncation for such astructure. By buying alonger-tenor call for the upside leg \nof the investment, you are expressing an investment opinion that the stock \nwill likely rise over the long term—this exactly contradicts the purpose of \nthis strategy: expressing abearish investment opinion.\nStrike Price Selection\nTheoretically, you can choose any two strike prices, sell the call at the lower \nprice, and buy the call at the higher price and execute this investment. If you \nsold an ITM call, you would receive premium that consists of both time and \nintrinsic value. If the stock fell by expiration, you would realize all the wasted \ntime value plus the difference between the intrinsic value at initiation and the \nintrinsic value at expiration.\nDespite the theory, however, in practice, the lower strike option is usually \nsold ATM or OTM because of the threat of assignment. Assignment is the pro-\ncess the exchange goes through when investors choose to exercise the option", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:239", "doc_id": "84258fd1cbd27f0509d2f86922cbc4fa41e556278d2efbebd6a3542ecb7fc93b", "chunk_index": 0}
{"text": "Accepting Exposure   • 223\nthey own rather than trade them away for aprofit. Recall from Chapter 2 \nthat experienced option investors do not do this most of the time; they \nknow that because of the existence of time value, it is usually more beneficial \nfor them to sell their option in the market and use the proceeds to buy the stock \nif they want to hold the underlying. Inexperienced investors, however, often are \nnot conscious of the time-value nuance and sometimes elect to exercise their \noption. In this case, the exchange randomly pairs the option holders who wish \nto exercise with an option seller who has promised to sell at that exercise price.\nThere is one case in which asophisticated investor might chose to \nexercise an ITM call option early, related to aprinciple in option pricing \ncalled put-call parity. This rule, which was used to price options before \nadvent of the BSM, simply states that acertain relationship must exist be-\ntween the price of aput at one strike price, the price of acall at that same \nstrike price, and the market price of the underlying stock. Put-call parity \nis discussed in Appendix C. In this appendix, you can learn what the exact \nput-call parity rule is (it is ridiculously simple) and then see how it can be \nused to determine when it is best to exercise early in case you are long acall and when your short-call (spread) position is in danger of early exercise \nbecause of atrading strategy known as dividend arbitrage.\nThe assignment process is random, but obviously, the more contracts \nyou sell, the better the chance is that you will be assigned on some part or all \nof your sold contracts. Even if you hold until expiration, there is still achance \nthat you may be assigned to fulfill acontract that was exercised on settlement.\nClearly, from the standpoint of option sale efficiency, an ATM call is the \nmost sensible to sell for the same reason that ashort put also was most efficient \nATM. As such, the discussion that follows assumes that you are selling the \nATM strike and buying back ahigher strike to cover.\nIn acall-spread strategy, the capital you have at risk is the difference be-\ntween the two strike prices—this is the amount that must be deposited into \nmargin. Depending on which strike price you use to cover, the net premium \nreceived differs because the cost of the covering call is cheaper the further \nOTM you cover. As the covering call becomes more and more OTM, the ratio \nof premium received to capital at risk changes. Put in these terms, it seems \nthat the short-call spread is alevered strategy because leverage has to do with \naltering the capital at risk in order to change the percentage return. This con-\ntrasts with the short-call spread’smirror strategy on the put side—short puts—\nin that the short-put strategy is unlevered.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:240", "doc_id": "0e45eee97310677f945965366733a1e40c5222f714cc125cd81d563f9f528a2b", "chunk_index": 0}
{"text": "224  •   The Intelligent Option Investor\nFor instance, here are data from ATM and OTM call options on IBM \n(IBM) expiring in 80 days. Itook these data when IBM’sshares were trad-\ning at $196.80 per share.\nSell a Call at 195\nCover at ($) Net Premium Received ($) Percent Return Capital at Risk ($)\n200 2.40 48 5\n205 4.26 43 10\n210 5.47 36 15\n215 6.17 31 20\n220 6.51 26 25\n225 6.70 22 30\n230 6.91 20 35\n235 6.90 17 40\n240 6.96 15 45\nIn this table, net premium received was calculated by selling at the $195 \nstrike’sbid price and buying at each of the listed strike price’sask prices. Percent \nreturn is the proportion of net premium received as apercentage of the capital \nat risk—the width of the spread. This table clearly shows that accepting expo-\nsure with acall spread is alevered strategy. The potential return on apercent-\nage basis can be raised simply by lowering the amount of capital at risk.\nHowever, although accepting exposure with acall spread is un-\ndeniably levered from this perspective, there is one large difference: un-\nlike the leverage discussed earlier in this book for apurchase of call op-\ntions—in which your returns were potentially unlimited—the short-call \nspread investor receives premium up front that represents the maximum \nreturn possible on the investment. As such, in the sense of the investor’spotential gains being limited, the short-call spread position appears to be \nan unlevered investment.\nConsidering the dual nature of ashort-call spread, it is most help-\nful to think about managing these positions using atwo-step process with \nboth tactical and strategic aspects. We will investigate the tactical aspect \nof leverage in the remainder of this section and the strategic aspect in the \nportfolio management section.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:241", "doc_id": "2472b76cc9fe0ffd0dd0fbac91f709835a735279cfaf6562868cd1fcacd8a3fa", "chunk_index": 0}
{"text": "Accepting Exposure   • 225\nTactically, once an investor has decided to accept exposure to astock’supside potential using acall spread, he or she has arelatively limited choice \nof investments. Let’sassume that we sell the ATM strike; in the IBM ex-\nample shown earlier, there is achoice of nine strike prices at which we \ncan cover. The highest dollar amount of premium we can receive—what Iwill call the maximum return—is received by covering at the most distant \nstrike. Every strike between the ATM and the most distant strike will at \nmost generate some percentage of this maximum return.\nNow let’slook at the risk side. Let’ssay that we sell the $195-strike call \nand cover using the $210-strike call. Now assume that some bit of good \nnews about IBM comes out, and the stock suddenly moves to exactly $210. \nIf the option expires when IBM is trading at $210, we will have lost the \nentire amount of margin we posted to support this investment—$15 in all. \nThis $15 loss will be offset by the amount of premium we received from \nselling the call spread—$5.47 in the IBM example—generating anet loss of \n$9.53 (= $5.47 − $15). Compare this with the loss that we would suffer if we \nhad covered using the most distant call strike. In this case, we would have \nreceived $6.96 in premium, so if the option expires when IBM is trading at \nthe same $210 level as earlier, our net loss would be $8.04 (= $6.96 − $15). \nBecause our maximum return is generated with the widest spread, it fol-\nlows that our minimum loss for the stock going to any intermediate strike \nprice also will be generated with the widest spread.\nAt the same time, if we always select the widest spread, we face an \nentirely different problem. That is, the widest spread exposes us to the great-\nest potential loss. If the stock goes only to $210, it is true that the widest \nspread will generate asmaller loss than the $195–$210 spread. However, in \nthe extreme, if the stock moves up strongly to $240, we would lose the $45 \ngross amount supporting the margin account and anet amount of $38.04 \n(= $45 – $6.96). Contrast this with anet loss of $9.53 for the $195–$210 \nspread. Put simply, if the stock moves up only abit, we will do better with \nthe wider spread; if it moves up alot, it is better to choose anarrower \nspread. \nIn short, when thinking about call spreads, we must balance our \namount of total exposure against the exposure we would have for an inter-\nmediate outcome against the total amount of premium we are receiving. If \nwe are too protective and initiate the smallest spread possible, our chance", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:242", "doc_id": "2462bee4c59035ff450ab88669a147eccad4e8c92f51380233722c05eb39cdbd", "chunk_index": 0}
{"text": "226  •   The Intelligent Option Investor\nof losing the entire margin amount is higher, but the margin amount lost \nis smaller. On the other hand, if we attempt to maximize our winnings \nand initiate the widest spread possible, our total exposure is greatest, even \nthough the chance of losing all of it is lower.\nPlotting these three variables on agraph, here is what we get:\n200 (11%)\n0%\n20%\n40%\n60%\n80%\n106% 102%\n94%89%\n100%\n120%\n140%\n160%\n180%\n200%\n205 (22%) 210 (33%) 215 (44%) 220 (56%) 225 (67%) 230 (78%) 235 (89%) 240 (100%)\nStrike (% of Total Exposure)\nRisk & Return of Call Spreads vs. Maximum Spread\nRisk Comparison Return Comparison\nHere, on the horizontal axis, we have the value of the covering strike and \nthe size of the corresponding spread as apercentage of the widest spread. \nThis shows how much proportional capital is at risk (e.g., at the $215-strike, \nwe are risking atotal of $20 of margin; $20 is 44 percent of total exposure \nof $45 if we covered at the $240-strike level). The top line shows how much \ngreater the loss would be if we used that strike to cover rather than the \nmaximum strike and the option expired at that strike price (e.g., if we cover \nat the $215-strike and the option expires when the stock is trading at $215, \nour loss would be 6 percent greater than the loss we would suffer if we \ncovered at the $240-strike). The bottom line shows the premium we will \nrealize as income if the stock price declines as apercentage of the total pre-\nmium possible if we covered at the maximum strike price. Here are the val-\nues from the graph in tabular format so that you can see the numbers used:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:243", "doc_id": "e71b0e74520a82d9680898ccc52d7c98c645b38d9a7a6e36ef269b73d3e32370", "chunk_index": 0}
{"text": "228  •   The Intelligent Option Investor\nWith atable like this, you can balance, on the one hand, the degree \nyou are reducing your overall exposure in aworst-case scenario (by look-\ning at column a) against how much risk you are taking on for abad-case \n(intermediary upward move of the stock) scenario (by looking at column \nb) against how much less premium you stand to earn if the stock does go \ndown as expected (by looking at column c). \nThere are no hard and fast rules for which is the correct covering strike to \nselect—that will depend on your confidence in the valuation and timing, your \nrisk profile, and the position size—but looking at the table, Itend to be drawn \nto the $215 and $220 strikes. With both of those strikes, you are reducing your \nworst-case exposure by about half, increasing your bad-case exposure just \nmarginally, and taking only asmall haircut on the premium you are receiving.\n6\nNow that we have an idea of how to think about the potential risk and \nreturn on aper-contract basis, let’sturn to leverage in the strategic sense—\nfiguring out how much capital to commit to agiven bearish idea.\nPortfolio Management\nWhen we thought about leverage from acall buyer’sperspective, we \nthought about how large of an allocation we wanted to make to the idea \nitself and changed our leverage within that allocation to modify the profits \nwe stood to make. Let’sdo this again with IBM—again assuming that we are \nwilling to allocate 5 percent of our portfolio to an investment in the view \nthat this company’sstock price will not go higher. At aprice of $196.80, a \n5 percent allocation would mean controlling alittle more than 25 shares for \nevery $100,000 of portfolio value.\n7 Because options have acontract size of \n100 shares, an unlevered 5 percent allocation to this investment would \nrequire aportfolio size of $400,000.\nThe equation to calculate the leverage ratio on the basis of notional \nexposure is\n× =Notional valueo fo ne contract\nDollarv alue of allocation number of contractsl everager atio\nSo, for instance, if we had a $100,000 portfolio of which we were willing to \ncommit 5 percent to this short-call spread on IBM, our position would have aleverage ratio of", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:245", "doc_id": "cb7196a6d3cf131d307f1ad811da31bc241ac2a769c58630dd4e22bb5e6e3650", "chunk_index": 0}
{"text": "Accepting Exposure   • 229\n×= ≈$19,500\n$5,000 13 .9 4: 1leverage\nSelling the $195/$220 call spread will generate $651 worth of pre-\nmium income and put at risk $2,500 worth of capital. Nothing can change \nthese two numbers—in this sense, the short-call spread has no leverage. \nThe 4:1 leverage figure merely means that the percentage return will ap-\npear nearly four times as large on agiven allocation as a 1:1 allocation \nwould appear. The following table—assuming the sale of one contract of \nthe $195/$220 call spread—shows this in detail:\nWinning Case Losing Case\nPremium \nReceived \n($)\nTarget \nAllocation \n($) Leverage\nStock \nMove ($)\nPercent \nReturn on \nAllocation\nStock \nMove \n($)\nDollar \nReturn\nPercent \nReturn on \nAllocation\n651 20,000 1:1 –2 3.3 +25 –1,849 –9.2\n651 10,000 2:1 –2 6.5 +25 –1,849 –18.5\n651 5,000 4:1 –2 13.0 +25 –1,849 –37.0\nNote: The dollar return in the losing case is calculated as the loss of the $2,500 of margin \nper contract less than the premium received of $651.\nNotice that the premium received never changes, nor does the worst-\ncase return. Only the perception of the loss changes with the size of our \ntarget allocation.\nNow that we have asense of how to calculate what strategic leverage \nwe are using, let’sthink about how to size the position and about how much \nrisk we are willing to take. When we are selling acall or call spread, we are \ncommitting to sell astock at the strike price. If we were actually selling the \nstock at that price rather than committing to do so, where would we put \nour stop loss—in other words, when would we close the position, assuming \nthat our valuation or our timing was not correct?\nLet’ssay that for this stock, if the price rose to $250, you would be \nwilling to admit that you were wrong and would realize aloss of $55 per share, \nor $5,500 per hundred shares. This figure—the $5,500 per hundred shares \nyou would be willing to lose in an unlevered short stock position—can be \nused as aguide to select the size of your levered short-call spread.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:246", "doc_id": "76b8bd2c1581d3eb4742cb0fabb27e60588a02d59a171bf799f60f5474d83d4a", "chunk_index": 0}
{"text": "230  •   The Intelligent Option Investor\nIn this case, you might choose to sell asingle $195–$240 call spread, in \nwhich case your maximum exposure would be $4,500 [= 1 × (240 – 195) × 100] \nat the widest spread. This investment would have aleverage ratio of approxi-\nmately 1:1. Alternatively, you could choose to sell two $195–$220 spreads, in \nwhich case your maximum exposure would be $5,000 [= 2 × (220 − 195) × \n100], with aleverage ratio of approximately 2:1. Which choice you select will \ndepend on your assessment of the valuation of the stock, your risk tolerance, \nand the composition of your portfolio (i.e., how much of your portfolio is al-\nlocated to the tech sector, in this example of an investment in IBM). Because \nthe monetary returns from ashort-call or call-spread strategy are fixed and \nthe potential for losses are rather high, Iprefer to execute bearish investments \nusing the long-put strategy discussed in the “Gaining Exposure” section.\nWith this explanation of the short-call spread complete, we have all the \nbuilding blocks necessary to understand all the other strategies mentioned \nin this book. Let’snow turn to two nonrecommended complex strategies \nfor accepting exposure—the short straddle and the short strangle—both of \nwhich are included not because they are good strategies but rather for the \nsake of completeness.\nShort Straddle/Short Strangle\nShort Straddle\nRED\nDownside: Overvalued\nUpside: Overvalued\nExecute: Sell an ATM put; simultaneously sell an ATM call spread", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:247", "doc_id": "132093084c55c0d2cb1b45b37e030460877cf17027baa169f1409b7110b5d5d5", "chunk_index": 0}
{"text": "Accepting Exposure   • 231\nRisk: Amount equal to upper strike price minus premium received\nReward: Limited to premium received\nMargin: Dollar amount equal to upper strike price\nShort Strangle\nRED\nRED\nDownside: Overvalued\nUpside: Overvalued\nExecute: Sell an OTM put; simultaneously sell an OTM call spread\nRisk: Call-spread leg: Amount equal to difference between \nstrikes and premium received. Put leg: Amount equal to \nstrike price minus premium received. Total exposure is \nthe sum of both legs.\nReward: Limited to premium received\nMargin: Call-spread leg: Amount equal to difference between \nstrikes. Put leg: Amount equal to strike price. Total mar -\ngin is the sum of both legs.\nThe Gist\nIn my opinion, these are short-term trades rather than investments. Even \nthough ashort put uses ashort-tenor option, the perspective of the inves-\ntor is that he or she is buying shares. These strategies are away to express \nthe belief that the underlying stock price will not move over ashort time. \nIn my experience, there is simply no way to develop arational view of how \nasingle stock will move over ashort time frame. In the short term, markets", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:248", "doc_id": "1ef87fa5296cdf16507bea67574d58f39ff239919249025714c47594d5142b01", "chunk_index": 0}
{"text": "233\nChapter 11\nMixing ExposurE\nMixing exposure uses combinations of gaining and accepting exposure, \nemploying strategies that we already discussed to create what amounts to \nsort of ashort-term synthetic position in astock (either long or short). \nThese strategies, nicknamed “diagonals” can be extremely attractive and \nextremely financially rewarding in cases where stocks are significantly mis-\npriced (in which case, exposure to one direction is overvalued, whereas the \nother is extremely undervalued). \nFrequently, using one of these strategies, an investor can enter apo-\nsition in alevered out-of-the-money (OTM) option for what, over time, \nbecomes zero cost (or can even net acash inflow) and zero downside expo-\nsure. This is possible because the investor uses the sale of one shorter-tenor \nat-the-money (ATM) option to subsidize the purchase of another longer-\ntenor OTM one. Once the sold option expires, another can be sold again, \nand whatever profit is realized from that sale goes to further subsidize the \nposition.\nThis strategy works well because of acouple of rules of option pricing \nthat we have already discussed:\n1. ATM options are more expensive than OTM options of the same \ntenor.\n2. Short-tenor options are worth less than long-tenor options, but \nthe value per day is higher for the short-tenor options.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:250", "doc_id": "1c201be4a6b931a70c6b379811cef2de38506a59dd7d13a0cdfa8994265edb53", "chunk_index": 0}
{"text": "234  •   The Intelligent Option Investor\nIprovide actual market examples of these strategies in this chapter and will \npoint out the effect of both these points in those examples.\nBecause these strategies are amix of exposures, it makes sense \nthat they are just complex (i.e., multioption) positions. Iwill discuss the \nfollowing:\n1. Long diagonal\n2. Short diagonal\nNote that the nomenclature Iuse here is abit different from what others \nin the market may use. What Iterm adiagonal in this book is what others \nmight call a “spit-strike synthetic stock. ” Since Bernie Madoff ’sinfamous \n“split-strike conversion” fraud, this term doesn’thave avery good ring to \nit. For other market participants, adiagonal means simultaneously buying \nand selling options of the same type (i.ecalls or puts). In this book, it means \nselling an option of one kind and buying the other kind.\nIwill also talk about what is known in the options world as overlays. One \nof the most useful things about options is the way that they can be grafted or \noverlain onto an existing common stock position in away that alters the port-\nfolio’soverall risk-reward profile. The strategies Iwill review here are as follows:\n1. Covered calls\n2. Protective puts\n3. Collars\nThese strategies are popular but often misunderstood ways to alter your \nportfolio’srisk-reward profile.\nComing this far in this book, you already have agood understand-\ning about how options work, so the concepts presented here will not be \ndifficult, but Iwill discuss some nuances that will help you to evaluate \ninvestment choices and make sound decisions regarding the use of these \nstrategies. Iwill refer to strike selection and tenor selection in the following \npages, but for these, along with “The Gist” section, I’ll include an “Execu-\ntion” section and a “Common Pitfalls” section.\nCovered calls are an easy strategy to understand once you understand \nshort puts, so Iwill discuss those first. Protective puts share alot of simi-\nlarities with in-the-money (ITM) call options, and Iwill discuss those next.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:251", "doc_id": "eb894876bdaf7e4bcccbc4171c52e20afead6ecb5cf85dbcbaf2b94c060cb5a7", "chunk_index": 0}
{"text": "Mixing Exposure  •  235\nCollars are just acombination of the other two overlay strategies and so are \neasiest left to the end.\nLong Diagonal\nGREEN\nRED\nDownside: Overvalued\nUpside: Undervalued\nExecute: Sell an ATM put option (short put) and simultaneously \nbuy an OTM call option (long call)\nRisk: Sum of put’sstrike price and net premium paid for call\nReward: Unlimited\nMargin: Amount equal to put’sstrike price\nThe Gist\nOther than the blank space in the middle of the diagram and the disparity \nbetween the lengths of the tenors, the preceding diagram looks very much like \nthe risk-return profile diagram for along stock—accepting downside exposure \nin return for gaining upside exposure. As you can see from the diagram, the \nrange of exposure for the short put lies well within the Black-Scholes-Merton \nmodel (BSM) cone, but the range of exposure for the long call is well outside \nthe cone. It is often possible to find short-put–long-call combinations that al-\nlow for an immediate net credit when setting up this investment.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:252", "doc_id": "dc3e506119e877d79cb0f78c98d7c306af8ad3a4aa2e17d30afde4406b3cf485", "chunk_index": 0}
{"text": "236  •   The Intelligent Option Investor\nBecause we must fully margin ashort-put investment, that leg of \nthe long diagonal carries with it aloss leverage ratio of –1.0. However, the \nOTM call leg represents an immediate realized loss coupled with avery \nhigh lambda value for gains. As such, if the put option expires ITM, the \nlong diagonal is simply alevered strategy; if the put option expires OTM, \nthe investment is avery highly levered one because the unlevered put \nceases to influence the leverage equation. Another short put may be written \nafter the previous short put expires; this further subsidizes the cost of the \ncalls and so greatly increases the leverage on the strategy.\nIf the stock moves quickly toward the upper valuation range, this \nstructure becomes extremely profitable on an unrealized basis. If the put \noption expires ITM, the investor is left with alevered long investment in \nthe stock in addition to the long position in the OTM. As in any other \ncomplex structure, the investment may be ratioed—for instance, by buying \none call for every two puts sold or vice versa.\nStrike Price Selection\nThe put should be sold ATM or close to ATM in order to maximize the time \nvalue sold, as explained earlier in the short-put summary. The call strike may be \nbought at any level depending on the investor’sappetite for leverage but is usu-\nally purchased OTM. The following table shows the net debit or credit associated \nwith the long diagonal between the ATM put ($55 strike price, delta of –0.42, \npriced at the bid price) with an expiration of 79 days and each call strike (at the \nask price) listed, all of which are long-term equity anticipated securities (LEAPS) \nhaving expirations in 534 days. The lambda figure for the OTM calls is also given \nto provide an idea of the comparative leverage of each call option. For this exam-\nple, Iam using JP Morgan Chase (JPM) when its stock was trading for $56.25.\nStrike Delta (Debit) Credit Call Lambda (%)\n57.50 0.43 (2.52) 5.6\n60.00 0.37 (1.57) 6.1\n62.50 0.31 (0.76) 6.7\n65.00 0.26 (0.25) 7.0\n70.00 0.16 0.78 8.4\n75.00 0.10 1.28 9.5\n80.00 0.06 1.56 10.5", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:253", "doc_id": "dd70bf79d8e038d564b6c477d04d84fe294a5063a5735c73180583bdde22669e", "chunk_index": 0}
{"text": "Mixing Exposure  •  237\nHere we can see that for along diagonal using 79-day ATM puts \nand 594-day LEAPS that are OTM by just over 15 percent, we are \npaying anet of only $25 per contract for notional control of 100 \nshares. On aper-contract basis, at the following settlement prices, \nwe would generate the following profits (or losses, in the case of the \nfirst row):\nSettlement Price ($) Dollar Profit per Contract\nPercentage Return on Original \nInvestment (%)\n65 0 –100\n66 100 300\n67 200 700\n68 300 1,100\n69 400 1,500\n70 500 1,900\n71 600 2,300\n72 700 2,700\n73 800 3,100\n74 900 3,500\n75 1,000 3,900\nIf the stock price moves up very quickly, it might be more beneficial \nto close the position or some portion of the position before expiration. Let’ssay that my upper-range estimate for this stock was $75. From the preced-\ning table, Ican see that my profit per contract if the stock settles at my fair \nvalue range is $1,000. If there is enough time value on acontract when \nthe stock is trading in the upper $60 range to generate arealized profit of \n$1,000, Iam likely to take at least some profits at that time rather than wait-\ning for the calls to expire.\nIn Chapter 9, Idiscussed portfolio composition and likened the use \nof leverage as aside dish to amain course. This is an excellent side dish that \ncan be entered into when we see achance to supplement the main meal of \nalong stock–ITM call option position with abit more spice. Let’snow turn \nto its bearish mirror—the short diagonal.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:254", "doc_id": "140d697b897e977f4a340f7a26ac852d2f362245ff2eeefb19fb1c0df4ca7d19", "chunk_index": 0}
{"text": "238  •   The Intelligent Option Investor\nShort Diagonal\nRED\nGREEN\nDownside: Undervalued\nUpside: Overvalued\nExecute: Sell an ATM call option while buying one to cover at ahigher price (short-call spread) and simultaneously buy \nan OTM put option (long put)\nRisk: Sum of put’sstrike price and net premium paid for call\nReward: Amount equal to the put’sstrike price minus any net \npremium paid for it \nMargin: Amount equal to spread between call options\nThe Gist\nThe diagram for ashort diagonal is just the inverse of the long diagonal and, of \ncourse, looks very similar to the risk-return profile diagram for ashort stock—\naccepting upside exposure in return for gaining downside exposure. The gist \nof this strategy is simply the short-exposure equivalent to the long diagonal, so \nthe comments about the long diagonal are applicable to this strategy as well. \nThe one difference is that because you must spend money to cover the short \ncall on the upside, the subsidy that the option sale leg provides to the option \npurchase leg is less than in the case of the long diagonal. Also, of course, astock \nprice cannot turn negative, so your profit upside is capped at an amount equal \nto the effective sell price. This investment also may be ratioed (e.g., by using \none short-call spread to subsidize two long puts).", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:255", "doc_id": "12d0fb300cc56a22bf13c2c391bad06a8ee9eeb98b5e65f8ca2a60d3ea33a256", "chunk_index": 0}
{"text": "Mixing Exposure  •  239\nStrike Price Selection\nStrike price selection for ashort diagonal is more difficult because there \nare three strikes to price this time. Looking at the current pricing for acall spread with the short call struck at $55, Iget the following selection of \ncredits:\nUpper Call Strike ($)\nCall Spread \nNet Credit ($)\nPercent Total \nRisk Percent Total Return\n57.50 1.27 17 49\n60.00 2.14 33 83\n62.50 2.44 50 94\n65.00 2.51 67 97\n70.00 2.59 100 100\nLooking at this, let’ssay we decide to go with the $55.00/$62.50 call \nspread. Doing so, we would receive anet credit of $2.44. Now selecting the \nput to purchase is amatter of figuring out the leverage of the position with \nwhich you are comfortable.\nStrike ($) Delta (Debit) Credit ($) Put Lambda (%)\n20.00 –0.02 2.20 –4.5\n23.00 –0.02 2.11 –4.6\n25.00 –0.03 2.05 –4.6\n28.00 –0.04 1.91 –4.8\n30.00 –0.05 1.78 –4.8\n33.00 –0.07 1.57 –4.8\n35.00 –0.09 1.38 –4.8\n38.00 –0.12 0.99 –4.8\n40.00 –0.15 0.67 –4.7\n42.00 –0.17 0.30 –4.7\n45.00 –0.23 (0.43) –4.5\n47.00 –0.26 (1.01) –4.4\n50.00 –0.33 (1.91) –4.4\n52.50 –0.39 (3.11) –4.0", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:256", "doc_id": "37806c5cac2e251945ba9f60ed8e50c125ecb97590addc74b96247e4be2dd6f1", "chunk_index": 0}
{"text": "240  •   The Intelligent Option Investor\nNotice that there is much less leverage on the long-put side than on \nthe long-call side. This is afunction of the volatility smile and the abnor -\nmally high pricing on the far OTM put side. It turns out that the $20-strike \nputs have an implied volatility of 43.3 percent compared to an ATM im-\nplied volatility of 22.0 percent.\nObviously, the lower level of leverage will make closing before expira-\ntion less attractive, so it is important to select aput strike price between the \npresent market price and your worst-case fair value estimate. In this way, \nif the option does expire when the stock is at that level, you will at least be \nable to realize the profit of the intrinsic value.\nWith these explanations of the primary mixed-exposure strategies, \nnow let’sturn to overlays—where an option position is added to astock \nposition to alter the risk-return characteristics of the investor’sportfolio.\nCovered Call\nContingent Upside Exposure\nContingent Downside Exposure\nLIGHT GREEN\nRED\nLIGHT RED\nDownside: Overvalued\nUpside: Fairly valued or undervalued", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:257", "doc_id": "60018e7fe2b6117e435d596987a748266720efba1549cfeff39c202cc650a1c0", "chunk_index": 0}
{"text": "242  •   The Intelligent Option Investor\nWe accepted\ndownside\nexposure when\nwe sold this\nput, so have no\nexposure to the\nupside here.\nRED\nThe top of the “Covered call” diagram is grayed out because we have \nsold away the upside exposure to the stock by selling the call option, and \nwe are left only with the acceptance of the stock’sdownside exposure. The \npictures are slightly different, but the economic impact is the same.\nThe other difference you will notice is that after the option expires, in the \ncase of the covered call, we have represented the graphic as though there is some \nresidual exposure. This is represented in this way because if the option expires \nITM, you will have to deliver your stock to the counterparty who bought your \ncall options. As such, your future exposure to the stock is contingent on another \ninvestor’sactions and the price movement of the stock. This is an important point \nto keep in mind, and Iwill discuss it more in the “Common Pitfalls” section.\nExecution\nBecause this strategy is identical from arisk-reward perspective to short \nputs, the execution details should be the same as well. Indeed, covered \ncalls should—like short puts—be executed ATM to get the most time value \npossible and preferably should be done on astock that has had arecent fall \nand whose implied volatility has spiked. However, these theoretical points \nShort put", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:259", "doc_id": "d30848e45b1dddbe81601ca3ee12b2fb9ab2649d3eb74592d36a3a6faf704731", "chunk_index": 0}
{"text": "Mixing Exposure  •  243\nignore the fact that most people simply want to generate abit of extra in-\ncome out of the holdings they already have and so are psychologically re-\nsistant to both selling ATM (because this makes it more likely for their \nshares to be called away) and selling at atime when the stock price sud-\ndenly drop (because they want to reap the benefit of the shares recovering).\nAlthough Iunderstand these sentiments, it is important to realize \nthat options are financial instruments and not magical ones. It would be \nnice if we could simply find an investment tool that we could bolt onto \nour present stock holdings that would increase the dividend anice amount \nbut that wouldn’tput us at risk of having to deliver our beloved stocks to acomplete stranger; unfortunately, this is not the case for options.\nFor example, let’ssay that you own stock in acompany that is paying out \navery nice dividend yield of 5 percent at present prices. This is amature firm \nthat has tons of cash flow but few opportunities for growth, so management \nhas made the welcome choice to return cash to shareholders. The stock is trad-\ning at $50 per share, but because the dividend is attractive to you, you are loathe \nto part with the stock. As such, you would prefer to write the covered call at a \n$55 or even a $60 strike price. Aquick look at the BSM cone tells us why you \nshould not be expecting abig boost in yield from selling the covered calls:\n80\nSold call\nrange of\nexposure\n70\n60\n50\n40\n30\n20\n5/18/2012 5/20/2013 249 499 749 999\nCash Flows R Us, Inc. (CASH)\nDate/Day Count\nStock Price\nGREEN\nLIGHT GREENGRAY\nLIGHT REDRED", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:260", "doc_id": "bf006718feffb141d3e771e9c6882938cc47d3be1852e80f5ae25dee70a26a2a", "chunk_index": 0}
{"text": "244  •   The Intelligent Option Investor\nClearly, the range of exposure for the $55-strike call is well above the \nBSM cone. The BSM cone is pointing downward because the dividend rate \nis 5 percent—higher than the risk-free rate. This means that BSM drift will \nbe lower. In addition, because this is an old, mature, steady-eddy kind of \ncompany, the expected forward volatility is low. Basically, this is aperfect \nstorm for alow option price.\nMy suggestion is to either write calls on stocks you don’tmind de-\nlivering to someone else—stocks for which you are very confident in the \nvaluation range and are now at or above the upper bound—or simply to \nlook for aportfolio of short-put/covered-call investments and treat it like \nahigh-yield bond portfolio, as Idescribed in Chapter 10 when explaining \nshort puts. It goes without saying that if you think that astock has alot of \nunappreciated upside potential, it’snot agood idea to sell that exposure \naway!\nOne other note about execution: as Ihave said, short puts and cov-\nered calls are the same thing, but agood many investors do not realize this \nfact or their brokerages prevent them from placing any trade other than acovered call. This leads to asituation in which there is atremendous sup-\nply of calls. Any time there is alot of supply, the price goes down, and you \nwill indeed find covered calls on some companies paying alot less than \nthe equivalent short put. Because you will be accepting the same downside \nexposure, it is better to get paid more for it, so my advice is to write the put \nrather than the covered call in such situations.\nTo calculate returns for covered calls, Icarry out the following steps:\n1. Assume that you buy the underlying stock at the market price.\n2. Deduct the money you will receive from the call sale as well as \nany projected dividends—these are the two elements of your cash \ninflow—from the market price of the stock. The resulting figure is \nyour effective buy price (EBP).\n3. Divide your total cash inflow by the EBP .\nIalways include the projected dividend payment as long as Iam writ-\ning ashort-tenor covered call and there are no issues with the company \nthat would prevent it from paying the dividend. Owners of record have aright to receive dividends, even after they have written acovered call on the", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:261", "doc_id": "bfb7aaa7c403a50c81dc9810538dcbd32de62a1f67dd60cf00fe28d355780480", "chunk_index": 0}
{"text": "Mixing Exposure  •  245\nstock, so it makes sense to count the dividend inflow as one element that \nreduces your EBP . In formula form, this turns out to be\n−−Coveredc allr eturn= premiumr eceivedf romc all+ projectedd ividends\nstockp rice premiumf romc allp rojected dividends\nFor ashort put, you have no right to receive the dividend, so Ifind the \nreturn using the following formula:\n−Shortp ut return= premiumr eceivedf roms hort put\nstrikepricep remium from shortp ut\nCommon Pitfalls\nTaking Profit\nOne mistake Ihear people make all the time is saying that they are going \nto “take profit” using acovered call. Writing acovered call is taking profit \nin the sense that you no longer enjoy capital gains from the stock’sappre-\nciation, but it is certainly not taking profit in the sense of being immune \nto falls in the market price of the stock. The call premium you receive will \ncushion astock price drop, but it will certainly not shield you from it. If \nyou want to take profits on asuccessful stock trade, hit the “Sell” button.\nLocking in a Loss\nAperson sent me an e-mail telling me that she had bought astock at $17, \nsold covered calls on it when it got to $20 (in order to “take profits”), and \nnow that the stock was trading for $11, she wanted to know how she could \n“repair” her position using options. Unfortunately, options are not magical \ntools and cannot make up for aprior decision to buy astock at $17 and ride \nit down to $11.\nIf you are in such aposition, don’tpanic. It will be tempting to write \nanew call at the lower ATM price ($11 in this example) because the cash \ninflow from that covered call will be the most. Don’tdo it. By writing acovered call at the lower price, you are—if the shares are called away—\nlocking in arealized loss on the position. You can see this clearly if you list \neach transaction in the example separately.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:262", "doc_id": "847bc8b56edb3856705556f9618b05c5b6b89a2a80e474ad6629c6ccfd95f68b", "chunk_index": 0}
{"text": "246  •   The Intelligent Option Investor\nNo. Buy/Sell Instrument\nPrice of \nInstrument\nEffective \nBuy (Sell) \nPrice of \nStock Note\n1 Buy Stock $17/share $17/share Original purchase\n2 Sell Call option $1/share $16/share Selling acovered call \nto take profits when \nstock reaches $20/\nshare leaves the \ninvestor with down-\nside exposure and $1 \nin premium income.\n3 Sell Call option $0.75 ($11.75/\nshare)\nStock falls to $11, and \ninvestor sells another \ncovered call to \ngenerate income to \nameliorate the loss.\nIn transaction 1, the investor buys the shares for $17. In transaction 2, \nwhen the stock hits $20 per share, the investor sells acovered call and receives \n$1 in premium. This reduces the effective buy price to $16 per share and \nmeans that the investor will have to deliver the shares if the stock is trad-\ning at $20 or above at expiration. When the stock instead falls to $11, the \ninvestor—wanting to cushion the pain of the loss—sells another ATM cov-\nered call for $0.75. This covered call commits the investor to sell the shares \nfor $11.75. No matter how you look at it, buying at $16 per share and sell-\ning at $11.75 per share is not arecipe for investing success.\nThe first step in such asituation as this—when the price of astock \non which you have accepted downside exposure falls—is to look back \nto your valuation. If the value of the firm has indeed dropped because \nof some material negative news and the position no longer makes sense \nfrom an economic perspective, just sell the shares and take the lumps. \nIf, however, the stock price has dropped but the valuation still makes \nfor acompelling investment, stay in the position; if the investment is", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:263", "doc_id": "b3ebd5ecdbaf499a02d6d8e4b93d296528a87ed1b3fb035507b9bf69321456e0", "chunk_index": 0}
{"text": "Mixing Exposure  •  247\ncompelling enough, this is the time to figure out aclever way to get more \nexposure to it. \nYou can write calls as long as they are at least at the same strike \nprice as your previous purchase price or EBP; this just means that you \nare buying at $16 and agreeing to sell at at least $16, in other words. Also \nkeep in mind that any dividend payment you receive you can also think \nof as areduction of your EBP—that cash inflow is offsetting the cost of \nthe shares. Factoring in dividends and the (very small) cash inflow as-\nsociated with writing far OTM calls will, as long as you are right about \nthe valuation, eventually reduce your EBP enough so that you can make \naprofit on the investment.\nOver-/Underexposure\nOptions are transacted in contract sizes of 100 shares. If you hold anumber \nof shares that is not evenly divisible by 100, you must decide whether you \nare going to sell the next number down of contracts or the next number \nup. For example, let’ssay that you own 250 shares of ABC. You can either \nchoose to sell two call contracts (in which case you will not be receiving \nyield on 50 of your shares) or sell three call contracts (in which case you \nwill be effectively shorting 50 shares). My preference is to sell fewer con-\ntracts controlling fewer shares than Ihold, and in fact, your broker may or \nmay not insist that you do so as well. If not, it is an unpleasant feeling to get \nacall from abroker saying that you have amargin call on aposition that \nyou didn’tknow you had.\nGetting Assigned\nIf you write covered calls, you live with the risk that you will have to deliver \nyour beloved shares to astranger. You can deliver your shares and use the \nproceeds from that sale (the broker will deposit an amount equal to the \nstrike price times the contract multiplier into your account, and you get \nto keep the premium you originally received) to buy the shares again, but \nthere is no way around delivering the shares if assigned.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:264", "doc_id": "2d3427986194c27d61bce324a59236d96498a0d7ebd9b25660a44b4f9d7ba773", "chunk_index": 0}
{"text": "250  •   The Intelligent Option Investor\nThe graphic conventions are alittle different, but both diagrams show \nthe acceptance of anarrow band of downside exposure offset by abound-\nless gain of upside exposure. The area below the protective put’sstrike price \nshows that economic exposure has been neutralized, and the area below \nthe ITM call shows no economic exposure. The pictures are slightly differ-\nent, but the economic impact is the same.\nThe objective of aprotective put is obvious—allow yourself the \neconomic benefits from gaining upside exposure while shielding yourself \nfrom the economic harm of accepting downside exposure. The problem is \nthat this protection comes at aprice. Iwill provide more infromation about \nthis in the next section.\nExecution\nEveryone understands the concept of protective puts—it’sjust like the \nhome insurance you buy every year to insure your property against dam-\nage. If you buy an OTM protective put (let’ssay one struck at 90 percent of \nthe current market price of the stock), the exposed amount from the stock \nprice down to the put strike can be thought of as your “deductible” on your \nhome insurance policy. The premium you pay for your put option can be \nthought of as the “premium” you pay on your home insurance policy.\nOkay—let’sgo shopping for stock insurance. Apple (AAPL) is trad-\ning for $452.53 today, so I’ll price both ATM and OTM put insurance for \nthese shares with an expiration of 261 days in the future. I’ll also annualize \nthat rate.\nStrike ($) “Deductible” ($) “Premium” ($)\nPremium as \nPercent of \nStock Price\nAnnualized \nPremium (%)\n450 2.53 40.95 9.1 12.9\n405 47.53 20.70 4.6 6.5\n360 92.53 8.80 1.9 2.7\nNow, given these rates and assuming that you are insuring a $500,000 \nhouse, the following table shows what equivalent deductibles, annual \npremiums, and total liability to ahome owner would be for deductibles \nequivalent to the strike prices I’ve picked for Apple:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:267", "doc_id": "a7511c1e0727b1c36008e8215574cb42c94f79687efd6c1c52dd2dbe8d312807", "chunk_index": 0}
{"text": "Mixing Exposure  •  251\nEquivalent \nAAPL Strike ($) Deductible ($) Annual Premium ($)\nTotal Liability to Home \nOwner ($)\n450 2,795 64,500 67,295\n405 52,516 32,500 85,016\n360 102,236 13,500 115,736\nIknow that Iwould not be insuring my house at these rates and under \nthose conditions! In light of these prices, the first thing you must consider \nis whether protecting aparticular asset from unrealized price declines is \nworth the huge realized losses you must take to buy put premium. Buying \nATM put protection on AAPL is setting up a 12.9 percent hurdle rate that \nthe stock must surpass in one year just for you to start making aprofit on \nthe position, and 13 percent per year is quite ahurdle rate!\nIf there is some reason why you believe that you need to pay for insurance, \nabetter option—cheaper from arealized loss perspective—would be to sell \nthe shares and use part of the proceeds to buy call options as an option-based \nreplacement for the stock position. This approach has afew benefits:\n1. The risk-reward profile is exactly the same between the two \nstructures.\n2. Any ATM or ITM call will be more lightly levered than any OTM \nput, meaning alower realized loss on initiation.\n3. For dividend-paying stocks, call owners do not have the right to \nreceive dividends, but the amount of the projected dividend is de-\nducted from the premium (as part of the drift calculation shown \nin the section on covered calls). As such, although not being paid \ndividends over time, you are getting what amounts to aone-time \nupfront dividend payment.\n4. If you do not like the thought of leverage in your portfolio, you can \nself-margin the position (i.e., keep enough cash in reserve such that \nyou are not “borrowing” any money through the call purchase).\nIdo not hedge individual positions, but Ido like the ITM call op-\ntion as an alternative for people who feel the need to do so. For hedg-\ning of ageneral portfolio, rather than hedging of aparticular holding in \naportfolio, options on sector or index exchange-traded funds (ETFs) are \nmore reasonably priced. Here are the ask prices for put options on the SPX", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:268", "doc_id": "e76b976fe254f7fcc0c42a0f226ae487ec0d0ec3ba52fc4def14415650ca5636", "chunk_index": 0}
{"text": "252  •   The Intelligent Option Investor\nETF [tracking the Standard and Poor’s 500 Index (S&P 500), which closed \nat 1,685.73 when these data were retrieved] expiring in about 10 months:\nStrike/Stock ($) Ask Price ($) Premium as Percent of Stock Price\n0.99 106.60 6.3\n0.89 50.90 3.0\n0.80 25.80 1.5\nThis is still ahefty chunk of change to pay for protection on an index but \nmuch less than the price of protection on individual stocks.\n1\nCommon Pitfalls\nHedge Timing\nAssume that you had talked to me ayear ago and decided to take my ad-\nvice and avoid buying protective puts on single-name options. Instead, you \ntook aprotective put position on the S&P 500. Good for you. \nSetting aside for amoment how much of your portfolio to hedge, let’stake alook at what happened since you bought the downside protection:\nS&P 500\n1,800\n1,700\n1,600\n1,500\n1,400\n1,300\n1,200\n1,100\n1,000\n8/1/20129/1/201210/1/201211/1/201212/1/20121/1/20132/1/20133/1/20134/1/20135/1/20136/1/20137/1/2013\nGREEN", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:269", "doc_id": "1a15fee52bfd0a50a068288e7835bab64071305a7922881d4b01793b7f477615", "chunk_index": 0}
{"text": "Mixing Exposure  •  253\nWhen you bought the protection, the index was trading at 1,375, so \nyou bought one-year puts about 5 percent OTM at $1,300. If the market \nhad fallen heavily or even moderately during the first five months of the \ncontract, your puts would have served you very well. However, now the \nputs are not 5 percent OTM anymore but 23 percent OTM, and it would \ntake another Lehman shock for the market to make it down to your put \nstrike.\nKeeping in mind that buying longer-tenor options gives you abetter \nannualized cost than shorter-tenor options, you should be leery of entering \ninto ahedging strategy such as the one pictured here:\nS&P 500\n1,800\n1,700\n1,600\n1,500\n1,400\n1,300\n1,200\n1,100\n1,000\n8/1/20129/1/201210/1/201211/1/201212/1/20121/1/20132/1/20133/1/20134/1/20135/1/20136/1/20137/1/2013\nGREEN\nBuying short-tenor puts helps in terms of providing nearer to \nATM protection, but the cost is higher, and it gets irritating to keep \nbuying expensive options and never benefiting from them (funny—\nno one ever says this about home insurance). Although there are no \nperfect solutions to this quandary, Ibelieve the following approach \nhas merit:", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:270", "doc_id": "e605dfa2011bc4e409bf3211d7b5debd4ca70fb76e5fc9cdac65c30a13b0fb5f", "chunk_index": 0}
{"text": "254  •   The Intelligent Option Investor\nS&P 500\n1,800\n1,700\n1,600\n1,500\n1,400\n1,300\n1,200\n1,100\n1,000\n8/1/20129/1/201210/1/201211/1/201212/1/20121/1/20132/1/20133/1/20134/1/20135/1/20136/1/20137/1/2013\nGREEN GREENLIGHT GREEN\nLIGHT GREEN\nLIGHT GREEN\nHere Ibought fewer long-term put contracts at the outset and then add-\ned put contracts at higher strikes opportunistically as time passed. Ihave left \nmyself somewhat more exposed at certain times, and my protection doesn’tall \npick up at asingle strike price, so the insurance coverage is spotty, but Ihave \nlikely reduced my hedging cost agreat deal while still having apotential source \nof investible cash on hand in the form of options with time value on them.\nThe Unhappy Case of a Successful Hedge\nMarkets are down across the board. Your brokerage screen is awash in red. \nThe only bright spot is the two or three lines of your screen showing your \nS&P 500 puts, which are strongly positive. You bought your protection \nwhen the market was going up, so it was very cheap to purchase. Now, with \nthe market in aterror, the implied volatilities have shot up, and you are sit-\nting on ahuge positive unrealized value.\nNow what?\nThe psychological urge to keep that hedge on will be strong. Such apo-\nsition is safe after all, and with the rest of the world falling apart, it feels nice to \nhave somewhere safe to go. What should you do with this unrealized profit?", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:271", "doc_id": "b62327e39bf031293bc1a4269d33ca5a652f0745a7ef2e84db027f611aa2305d", "chunk_index": 0}
{"text": "258  •   The Intelligent Option Investor\nplan like this in place will allow you to size and time your hedges appropri-\nately and will help you to make the most out of whatever temporary crisis \nmight come your way.\n2\nNow that you have agood understanding of protective puts and \nhedging, let’sturn to the last overlay strategy—the collar.\nCollar\nContingent Exposure\nContingent Exposure\nContingent Exposure\nGREEN\nLIGHT GREEN\nLIGHT ORANGE\nLIGHT RED\nORANGE\nRED\nDownside: Irrelevant\nUpside: Undervalued\nExecute: Sell acall option on astock or index that you own and on \nwhich you have again, and use the proceeds from the call \nsale to buy an OTM put \nRisk: Flexible, depending on selection of strikes\nReward: Limited to level of sold call strike\nMargin: None because the long position in the hedged security \nserves as collateral for the sold call option, and the OTM \nput option is purchased, so it does not require margining", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:275", "doc_id": "51efb11b9fed2c7d9200e7040477ae03748040ea8b30d0135840164c9fdfdbb9", "chunk_index": 0}
{"text": "Mixing Exposure  •  259\nThe Gist\nThis structure is really much simpler and has amuch more straightfor -\nward investment purpose than it may seem when you look at the preceding \ndiagram. When people talk about “taking profits” using acovered call, the \ncollar is actually the strategy they should be using.\nImagine that you bought astock some time ago and have anice \nunrealized gain on it. The stock is about where you think its likely fair \nvalue is, but you do not want to sell it for whatever reason (e.g., it is \npaying anice dividend or you bought it less than ayear ago and do not \nwant to be taxed on short-term capital gains or whatever). Although you \ndo not want to sell it, you would like to protect yourself from downside \nexposure.\nYou can do this cheaply using acollar. The collar is acovered call, \nwhich we have already discussed, whose income subsidizes the purchase of \naprotective put at some level that will allow you to keep some of the unre-\nalized gains on your securities position. The band labeled “Orange” on the \ndiagram shows an unrealized gain (or, conversely, apotential unrealized \nloss). If you buy aput that is within this orange band or above, you will be \nguaranteed of making at least some realized profit on your original stock \nor index investment. Depending on how much you receive for the covered \ncall and what strike you select for the protective put, this collar may rep-\nresent completely “free” downside protection or you might even be able to \nrealize anet credit.\nExecution\nThe execution of this strategy depends agreat deal on personal prefer -\nence and on the individual investor’ssituation. For example, an investor \ncan sell ashort-tenor covered call and use those proceeds to buy alonger-\ntenor protective put. He or she can sell the covered call ATM and buy aprotective put that is close to ATM; this means the maximum and mini-\nmum potential return on the previous security purchase is in afairly tight \nband. Conversely, the investor might sell an OTM covered call and buy \naprotective put that is also OTM. This would lock in awider range of \nguaranteed profits over the life of the option.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:276", "doc_id": "61d000cc5f17bab69bddf7dad9b99c2fc8640ef6035786587e69ae361035c6c2", "chunk_index": 0}
{"text": "260  •   The Intelligent Option Investor\nIshow acouple of examples below that give you the flavor of the \npossibilities of the collar strategy. With these examples, you can experi-\nment yourself with astructure that fits your particular needs. Look on \nmy website for acollar scenario calculator that will allow you to visualize \nthe collar and understand the payoff structure given different conditions. \nFor these examples, Iam assuming that Ibought Qualcomm stock at \n$55 per share. Qualcomm is now trading for $64.71—an unrealized gain \nof 17.7 percent.\nCollar 1: 169 Days to Expiration\nStrike Price ($) Bid (Ask) Price ($)\nSold call 65.00 3.40\nPurchased put 60.00 (2.14)\nNet credit $1.26\nThis collar yields the following best- and worst-case effective sell prices \n(ESPs) and corresponding returns (assuming a $55 buy price):\nESP ($) Return (%)\nBest case 66.26 20.5\nWorst case 61.26 11.4\nHere we sold the $65-strike calls for $3.40 and used those proceeds to \nbuy the $60-strike put options at $2.14. This gave us anet credit of $1.26, \nwhich we simply add to both strike prices to calculate our ESP . We add the \nnet credit to the call strike because if the stock moves above the call strike, \nwe will end up delivering the stock at the strike price while still keeping the \nnet credit. We add the net credit to the put strike because if the stock closes \nbelow the put strike, we have the right to sell the shares at the strike price \nand still keep the net credit. The return numbers are calculated on the basis \nof a $55 purchase price and the ESPs listed. Thus, by setting up this collar in", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:277", "doc_id": "231431f8549a7f6a790a6dbe3200d4fb5f3b18cb543f1a5a874f40cd6ef98d1b", "chunk_index": 0}
{"text": "Mixing Exposure  •  261\nthis way, we have locked in aworst possible gain of 11.4 percent and abest \npossible gain of 20.5 percent for the next five and ahalf months.\nLet’slook at another collar with adifferent profit and loss profile:\nCollar 2: 78 Days to Expiration\nStrike Price ($) Bid (Ask) Price ($)\nSold call 70 0.52\nPurchased put 62.50 (1.55)\nNet debit (1.03)\nThis collar yields the following best- and worst-case ESPs and corresponding \nreturns (assuming a $55 buy price):\nESP ($) Return (%)\nBest case 68.97 25.4\nWorst case 61.47 11.8\nThis shows ashorter-tenor collar—about two and ahalf months be-\nfore expiration—that allows for more room for capital gains. This might be \nthe strategy of ahedge fund manager who is long the stock and uncertain \nabout the next quarterly earnings report. For his or her own business rea-\nsons, the manager does not want to show an unrealized loss in case Qual-\ncomm’sreport is not good, but he or she also doesn’twant to restrict the \npotential capital gains much either.\nCalculating the ESPs and the returns in the same way as described \nhere, we get aguaranteed profit range from around 12 to over 25 percent. \nOne thing to note as well is that the protection is provided by aput, and \naput option can be sold any time before expiry to generate acash inflow \nfrom time value. Let’ssay then that when Qualcomm reports its quarterly \nearnings, the stock price drops to $61—amild drop that the hedge fund \nmanager considers apositive sign. Now that the manager is less worried \nabout the downside exposure, he or she can sell the put for aprofit.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:278", "doc_id": "c14c66202948e7da135f1eeb526cfafa5d2736c50d55e057e0b53850861be19b", "chunk_index": 0}
{"text": "263\nChapter 12\nRisk and the intelligent \nOptiOn investOR\nThe preceding 11 chapters have given you agreat deal of information about \nthe mechanics of option investing and stock valuation. In this last chapter, \nlet’slook at asubject that Ihave mentioned throughout this book—risk—\nand see how an intelligent option investor conceives of it. \nThere are many forms of risk—some of which we discussed earlier \n(e.g., the career risk of an investment business agent, solvency risk of aretiree looking to maintain agood quality of life, and liquidity risk of aparent needing to make abig payment for achild’swedding). The two risks \nIdiscuss here are those that are most applicable to an owner of capital \nmaking potentially levered investments in complex, uncertain assets such \nas stocks. These two risks are market risk and valuation risk.\nMarket Risk\nMarket risk is unavoidable for anyone investing capital. Markets fluctuate, and \nin the short term, these fluctuations often have little to do with the long-term \nvalue of agiven stock. Short term, it must be noted, is also relative. In words \nattributed to John Maynard Keynes, but which is more likely an anonymous \naphorism, “The market can remain irrational longer than you can remain sol-\nvent. ” Indeed, it is this observation and my own painful experience of the truth \nof it that has brought me to my appreciation for in-the-money (ITM) options \nas away to preserve my capital and cushion the blow of timing uncertainty.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:280", "doc_id": "9c2763a8429a158d37247dae0be429e16cd01bcc103a32feb57343773dc1bdbf", "chunk_index": 0}
{"text": "264  •   The Intelligent Option Investor\nMarket risk is afactor that investors in levered instruments must \nalways keep in mind. Even an ITM call long-term equity anticipated \nsecurity (LEAPS) in the summer of 2007 might have become ashort-tenor \nout-of-the-money (OTM) call by the fall of 2008 after the Lehman shock \nbecause of the sharp decline in stock prices in the interim. Unexpected \nthings can and do happen. Aportfolio constructed oblivious to this fact is \nadangerous thing.\nAs long as market fluctuations only cause unrealized losses, market \nrisk is manageable. But if alevered loss must be realized, either because of \nan option expiration or in order to fund another position, it has the poten-\ntial to materially reduce your available investment capital. You cannot ma-\nterially reduce your investment capital too many times before running out.\nA Lehman shock is aworst-case scenario, and some investors live \ntheir entire lives without experiencing such severe and material market \nrisk. In most cases, rather than representing amaterial threat, market risk \nrepresents awonderful opportunity to an intelligent investor.\nMost human decision makers in the market are looking at either \ntechnical indicators—which are short term by nature—or some sort of \nmultiple value (e.g., price-to-something ratio). These kinds of measures are \nwonderful for brokers because they encourage brokerage clients to make \nfrequent trades and thus pay the brokerages frequent fees. \nThe reaction of short-term traders is also wonderful for intelligent \ninvestors. This is so because amarket reaction that might look sensible or \nrational to someone with an investment time horizon measured in days or \nmonths will often look completely ridiculous to an investor with alonger-\nterm perspective. For example, let’ssay that acompany announces that its \nearnings will be lower next quarter because of adelay in the release of anew product. Investors who are estimating ashort-term value for the stock \nbased on an earnings multiple will sell the stock when they see that earn-\nings will likely fall. Technical traders see that the stock has broken through \nsome line of “resistance” or that one moving average has crossed another \nmoving average, so they sell it as well. Perhaps an algorithmic trading \nengine recognizes the sharp drop and places aseries of sell orders that are \ncovered almost as soon as they are filled. In the meantime, someone who \nhas held the stock for awhile and has again on it gets protective of this gain \nand decides to buy aput option to protect his or her gains.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:281", "doc_id": "ff1b3b22332e628ddb95016d2dc3052685a151acf3c2738fbd3321d881554487", "chunk_index": 0}
{"text": "Risk and the Intelligent Option Investor   • 265\nFor an intelligent option investor who has along-term worst-case \nvaluation that is now 20 percent higher than the market price, there is awonderful opportunity to sell aput and receive afat premium (with the \npossibility of owning the stock at an attractive discount to the likely fair \nvalue), sell aput and use the proceeds to buy an OTM call LEAPS, or sim-\nply buy the stock to open aposition.\nIndeed, this strategy is perfectly in keeping with the dictum, “Be fear-\nful when others are greedy and greedy when others are fearful. ” This strat-\negy is also perfectly reasonable but obviously rests on the ability of the \ninvestor to accurately estimate the actual intrinsic value of astock. This \nbrings us to the next form of risk—valuation risk.\nValuation Risk\nAlthough valuation is not adifficult process, it is one that necessarily in-\ncludes unknowable elements. In our own best- and worst-case valuation \nmethodology, we have allowed for these unknowns by focusing on plausi-\nble ranges rather than precise point estimates. Of course, our best- or worst-\ncase estimates might be wrong. This could be due to our misunderstanding \nof the economic dynamics of the business in which we have invested or \nmay even come about because of the way we originally framed the problem. \nThinking back to how we defined our ranges, recall that we were focusing \non one-standard-deviation probabilities—in other words, scenarios that \nmight plausibly be expected to materialize two times out of three. Obvi-\nously, even if we understand the dynamics of the business very well, one \ntime out of three, our valuation process will generate afair value range that \nis, in fact, materially different from the actual intrinsic value of the stock.\nIn contrast to market risk, which most often is anonmaterial and tem-\nporary issue, misestimating the fair value of astock represents amaterial \nrisk to capital, whether our valuation range is too low or too high. If we esti-\nmate avaluation range that is too low, we are likely to end up not allocating \nenough capital to the investment or using inappropriately light leverage. \nThis means that we will have missed the opportunity to generate as much \nreturn on this investment as we may have. If we estimate avaluation range \nthat is too high, we are likely to end up allocating too much capital to the", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:282", "doc_id": "5461e44f7d61e41413b3bc3de01964ed29fa804269adf2be07c2d6991e623c67", "chunk_index": 0}
{"text": "Risk and the Intelligent Option Investor   • 267\nLet’sassume that the present market value of the shares is $16 per \nshare. This share price assumes agrowth in FCFO of 8 percent per year for \nthe next 5 years and 5 percent per year in perpetuity after that—roughly \nequal to what we consider our most likely operational performance \nscenario. We see the possibility of faster growth but realize that this faster \ngrowth is unlikely—the valuation layer associated with this faster growth \nis the $18 to $20 level. We also see the possibility of aslowdown, and the \nvaluation layer associated with this worst-case growth rate is the $11 to \n$13 level.\nNow let’sassume that because of some market shock, the price of the \nshares falls to the $10 range. At the same time, let’sassume that the likely \neconomic scenario, even after the stock price fall, is still the same as before—\nmost likely around $16 per share; the best case is $20 per share, and the worst \ncase is $11 per share. Let’salso say that you can sell aput option, struck at \n$10, for $1 per share—giving you an effective buy price of $9 per share.\nIn this instance, the valuation risk is indeed small as long as we are \ncorrect about the relative levels of our valuation layers. Certainly, in this \ntype of scenario, it is easier to commit capital to your investment idea than \nit would be, say, to sell puts struck at $16 for $0.75 per share!\nThinking of stock prices in this way, it is clear that when the market \nprice of astock is within avaluation layer that implies unrealistic economic \nassumptions, you will more than likely be able to use acombination of \nstocks and options to tilt the balance of risk and reward in your own \nfavor—the very definition of intelligent option investing.\nIntelligent Option Investing\nIn my experience, most stocks are mostly fairly priced most of the time. \nThere may be scenarios at one tail or the other that might be inappropriately \npriced by the option market (and, by extension, by the stock market), but \nby and large, it is difficult to find profoundly mispriced assets—an asset \nwhose market price is significantly different from its most likely valuation \nlayer.\nOpportunities tend to be most compelling when the short-term pic-\nture is the most uncertain. Short-term uncertainties make investing boldly", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:284", "doc_id": "0f1a9a888d5658e6aa925da77c6780246cd8f4a21894150290f07b690309d271", "chunk_index": 0}
{"text": "270  •   The Intelligent Option Investor\nShort Investment Time Horizons\nWhen the scholars developing the BSM were researching financial \nmarkets for the purpose of developing their model, the longest-tenor \noptions had expirations only afew months distant. Most market partic-\nipants tended to trade in the front-month contracts (i.e., the contracts \nthat will expire first), as is still mainly the case. Indeed, thinking back \nto our preceding discussion about price randomness, over short time \nhorizons, it is very difficult to prove that asset price movements are not \nrandom.\nAs such, the BSM is almost custom designed to handle short time \nhorizons well.\nPerhaps not unsurprisingly, agents\n1 are happy to encourage clients to \ntrade options with short tenors because\n1. It gives them more opportunities per year to receive fees and com-\nmissions from their clients. \n2. They are mainly interested in reliably generating income on the \nbasis of the bid-ask spread, and bid-ask spreads differ on the basis \nof liquidity, not time to expiration. \n3. Shorter time frames offer fewer chances for unexpected price \nmovements in the underlying that the market makers have ahard \ntime hedging.\nIn essence, agood option market maker is akin to aused car sales-\nman. He knows that he can buy at alow price and sell at ahigh one, so his \nmain interest is in getting as many customers to transact as possible. With \nthis perspective, the market maker is happy to use the BSM, which seems \nto give reasonable enough option valuations over the time period about \nwhich he most cares.\nIn the case of short-term option valuations, the theory describes \nreality accurately enough, and structural forces (such as wide bid-ask \nspreads) make it hard to exploit mispricings if and when they occur. \nTo see an example of this, let’stake alook at what the BSM assumes is \nareasonable range of prices for acompany with assumed 20 percent \nvolatility over aperiod of 30 days.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:287", "doc_id": "77bba2c7621155044f9047bec8197dc2e8bd3ee93cb181c7ba8b4b076dd5c20f", "chunk_index": 0}
{"text": "272  •   The Intelligent Option Investor\nIt is important to realize that the fact that options are usually \nefficiently priced in the short term does not prevent us from transacting \nin short-tenor options. In fact, some strategies discussed in Part III are \nactually more attractive when an investor uses shorter-tenor options or \ncombines short- and long-tenor options into asingle strategy.\nHopefully, the distinction between avoiding short-tenor option \nstrategies and making long-term investments in short-tenor options is \nclear after reading through Part III.\nFungible Underlying Assets\nAgain, returning for amoment to the foundation of the BSM, the scholars built \ntheir mathematical models by studying short-term agricultural commodity \nmarkets. Acommodity is, by definition, afungible or interchangeable asset; \none bushel of corn of acertain quality rating is completely indistinguishable \nfrom any other bushel of corn of the same quality rating.\nStocks, on the other hand, are idiosyncratic assets. They are intangible \nmarkers of value for incredibly complex systems called companies, no two \nof which is exactly alike (e.g., GM and Ford—the pair that illustrates the \nidea of “paired” investments in many people’sminds—are both American \ncar companies, but as operating entities, they have some significant differ-\nences. For example, GM has amuch larger presence in China and has adifferent capital and governance structure since going bankrupt than Ford, \nwhich avoided bankruptcy during the mortgage crisis).\nThe academics who built the BSM were not hesitant to apply amodel \nthat would value idiosyncratic assets such as stocks because they had as-\nsumed from the start that financial markets are efficient—meaning that \nevery idiosyncratic feature for agiven stock was already fully “priced in” \nby the market. This allowed them to overlook the complexity of individual \ncompanies and treat them as interchangeable, homogeneous entities.\nThe BSM, then, did not value idiosyncratic, multidimensional \ncompanies; rather, it valued single-dimensional entities that the scholars \nassumed had already been “standardized” or commoditized in some sense \nby the communal wisdom of the markets. You will see in the next sec-\ntion that the broad, implicit assumption by option market participants \nthat markets are efficient actually brings about the greatest opportunity", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:289", "doc_id": "f8eb15000fb57eada58703afc2ae2d2a5172899e71cd8d736c84f83efb99a049", "chunk_index": 0}
{"text": "276  •   The Intelligent Option Investor\nIf someone wanted to make extra income by selling calls to accept expo-\nsure to the stock’supside, what price would they likely charge for someone \nwanting to buy this call option?\na. Almost nothing\nb. Alittle\nc. Agood bit\nObviously, the correct answer to the put option question is c. This option \nwould be pretty expensive because its range of exposure overlaps with so \nmuch of the BSM cone. Conversely, the answer to the call option question \nis a. This option would be really cheap because its range of exposure is well \nabove the BSM cone.\nRemember, though, that we have our crystal ball, and we know \nthat this stock will likely be somewhere between $70 and $110 per share \nin afew years. With this confidence, wouldn’tit make sense to take the \nopposite side of both the preceding trades? Doing so would look like \nthis:\n5/18/2012\n10\n20\n30\n40\n50\n60\n70\n80\n90\n100\n110\n120\n5/20/2013 249 499 749 999\nDate/Day Count\nAdvanced Building Corp. (ABC)\nStock Price\nBest Case, 110\nWorst Case, 70\n-\nGREEN\nRED\nIn this investment, which Iexplain in detail in Chapter 11, we are \nreceiving agood bit of money by selling an expensive put and paying", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:293", "doc_id": "2cab391f533f3a48c601c4d57e698c1515ef147c4d170af45a080e8e827d459a", "chunk_index": 0}
{"text": "Appendix A: Choose Your Battles Wisely   • 277\nvery little money to buy acheap call. It may happen that the money we \nreceive for selling the put actually may be greater than the money we \npay for the call, so we actually get paid anet fee when we make this \ntransaction!\nWe can sell the put confidently because we know that our worst-case \nvaluation is $70 per share; as long as we are confident in our valuation—atopic covered in Part II of this book—we need not worry about the price \ndeclining. We do not mind spending money on the call because we think \nthat the chance is very good that at expiration or before the call will be \nworth much, much more than we paid for it.\nTruly, the realization that the BSM is pricing options on inefficiently \npriced stocks as if they were efficiently priced is the most profound and \ncompelling source of profits for intelligent investors. Furthermore, finding \ngrossly mispriced stocks and exploiting the mispricing using options rep-\nresents the most compelling method for tilting the risk-reward equation in \nour direction.\nThe wonderful thing about investing is that it does not require you to \nswing at all the pitches. Individual investors have agreat advantage in that \nthey may swing at only the pitches they know they can hit. The process of \nintelligent investing is simply one of finding the right pitches, and intel-\nligent option investing simply uses an extremely powerful bat to hit that \nsweet pitch.\nBimodal Outcomes\nSome companies are speculative by nature—for instance, adrug company \ndoing cancer research. The company has nothing but some intangible as-\nsets (the ideas of the scientists working there) and agreat deal of costs \n(the salaries going to those scientists, the payments going to patent attor -\nneys, and the considerable costs of paying for clinical trials). If the research \nproves fruitful, the company’svalue is great—let’ssay $500 per share. If \nthe clinical trials show low efficacy or dangerous side effects, however, the \ncompany’sworth goes to virtually nil. What’smore, it may take years before \nit is clear which of these alternatives is true.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:294", "doc_id": "e180c6f27220b8fb4e38341a9d488e465c05af5ac58a0f97d0e2bf8e67932bf8", "chunk_index": 0}
{"text": "278  •   The Intelligent Option Investor\nGiven what you know about the BSM, does this seem like the kind of \nsituation conducive to accurate option pricing? This example certainly does \nnot sound like the pricing scenario of ashort-term agricultural commodity, \nafter all. If this hypothetical drug company’sstock price was sitting at $50 per \nshare, what is the value of the upper range the option market might be \npricing in? Let’sassume that this stock is trading with aforward volatility of \n100 percent per year (on the day Iam writing this, there are only four stocks \nwith options trading at aprice that implies aforward volatility of greater than \n100 percent). What price range does this 100 percent per year volatility imply, \nand can we design an option structure that would allow us to profit from abig \nmove in either direction? Here is adiagram of this situation:\n5/18/2012\n-\n500\n50\n100\n150\n200\n250\n300\n350\n400\n450\n5/20/2013 249 499\nDate/Day Count\nAdvanced Biotechnology Co. (ABC)\nStock Price\n749 999\nGREEN\nGREEN\nIndeed, even boosting volatility assumptions to avery high level, \nit seems that we can still afford to gain exposure to both the upside and \ndownside of this stock at avery reasonable price. You can see from the pre-\nceding diagram that both regions of exposure on the put side and the call \nside are outside the BSM cone, meaning that they will be relatively cheap. \nThe options market is trying to boost the price of the options enough so \nthat the calls and puts are fairly priced, but for various reasons (including \nbehavioral biases), most of the time it fails miserably.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:295", "doc_id": "a42b2e695df90a68f7270068bd3c24482715a3cad92e3edda59f62e62af31626", "chunk_index": 0}
{"text": "280  •   The Intelligent Option Investor\nClearly, there is not much of adifference between the BSM expected \nvalue (shown by the dotted line) and the dot representing a 10 percent \nupward drift in the stock. However, if we extend this analysis out for three \nyears, look what happens:\n5/18/2012 5/20/2013 249 499\nDate/Day Count\nAdvanced Building Corp. (ABC)\n749 999\n20\n30\n40\n50\n60\n70Stock Price\n80\nWith the longer time horizon, our assumed stock price is significantly \nhigher than what the BSM calculates as its expected price. If we take “assumed \nfuture stock price” to mean the price at which we think there is an equal chance \nthat the true stock price will be above or below that mark, we can see that the \ndifference, marked by the double-headed arrow in the preceding diagram, is the \nadvantage we have over the option market.\n3 This advantage again means that \ndownside exposure will be overvalued and upside exposure will be undervalued.\nHow, you may ask, can this discrepancy persist? Shouldn’tsomeone \nfigure out that these options are priced wrong and take advantage of an \narbitrage opportunity? The two reasons why these types of opportunities \ntend to persist are\n1. Most people active in the option market are trading on avery \nshort-term basis. Long-term equity anticipated securities \n(LEAPS)—options with tenors of ayear or more—do exist, but", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:297", "doc_id": "e8acd4610f7ffa0ddd30fcc54d8c8ce8a055a9cbf25f9bdba1e9f1687d610cef", "chunk_index": 0}
{"text": "Appendix A: Choose Your Battles Wisely   • 281\ngenerally the volumes are light because the people in the option \nmarkets generally are not willing to wait longer than 60 days for \ntheir “investment” to work out. Because the time to expiration for \nmost option contracts is so short, the difference between the BSM’sexpected price based on a 5 percent risk-free rate and an expected \nprice based on a 10 percent equity return is small, so no one real-\nizes that it’sthere (as seen on the first diagram).\n2. The market makers are generally able to hedge out what little ex-\nposure they have to the price appreciation of LEAPS. They don’tcare about the price of the underlying security, only about the size \nof the bid-ask spread, and they always price the bid-ask spread on \nLEAPS in as advantageous away as they can. Also, the career of an \nequity option trader on the desk of abroker-dealer can change agreat deal in asingle year. As discussed in Part II, market makers \nare not incentivized in such away that they would ever care what \nhappened over the life of a LEAPS.\nCongratulations. After reading Part Iof this book and this appendix, \nyou have abetter understanding of the implications of option investing \nfor fundamental investors than most people working on Wall Street. \nThere are many more nuances to options that Idiscuss in Part III of this \nbook—especially regarding leverage and the sensitivity of options to input \nchanges—but for now, simply understanding how the BSM works puts you \nat agreat advantage over other market participants.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:298", "doc_id": "76a0cf100e98ff05cb7d7da4f2fcaedb8ae99160405f079dc3283783d225cdb6", "chunk_index": 0}
{"text": "287\nAppendix c\nPUT-cALL PArITy\nBefore the Black-Scholes-Merton model (BSM), there was no way to \ndirectly calculate the value of an option, but there was away to triangulate \nput and call prices as long as one had three pieces of data:\n1. The stock’sprice\n2. The risk-free rate\n3. The price of acall option to figure the fair price of the put, and vice \nversa\nIn other words, if you know the price of either the put or acall, as long \nas you know the stock price and the risk-free rate, you can work out the \nprice of the other option. These four prices are all related by aspecific rule \ntermed put-call parity.\nPut-call parity is only applicable to European options, so it is not ter-\nribly important to stock option investors most of the time. The one time it \nbecomes useful is when thinking about whether to exercise early in order \nto receive astock dividend—and that discussion is abit more technical. I’ll \ndelve into those technical details in amoment, but first, let’slook at the big \npicture. Using the intelligent option investor’sgraphic format employed in \nthis book, the big picture is laughably trivial.\nDirect your attention to the following diagrams. What is the differ -\nence between the two?", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:304", "doc_id": "b8b63c8e58234815730507d9f9d20312b4bef65a00034c930a57295d1a0faf08", "chunk_index": 0}
{"text": "288  •   The Intelligent Option Investor\n-\n20\n5/18/2012 5/20/2013\n40\n60\n80\n100\n120Stock Price\n140\n160\n180\n200\n-\n20\n5/18/2012 5/20/2013\n40\n60\n80\n100\n120Stock Price\n140\n160\n180\n200\nGREENGREEN\nREDRED\nIf you say, “Nothing, ” you are practically right but technically \nwrong. The image on the left is actually the risk-reward profile of apur -\nchased call option struck at $50 paired with asold put option struck at \n$50. The image on the right is the risk-reward profile of astock trading \nat $50 per share.\nThis simple comparison is the essence of put-call parity. The parity \npart of put-call parity just means that accepting downside exposure by sell-\ning aput while gaining upside exposure by buying acall is basically the \nsame thing as accepting downside exposure and gaining upside exposure \nby buying astock.\nWhat did Isay? It is laughably trivial. Now let’sdelve into the details \nof how the put-call parity relationship can be used to help decide whether \nto exercise acall option or not (or whether the call option you sold is likely \nto be exercised or not).\nDividend Arbitrage and Put-call Parity\nAny time you see the word arbitrage , the first thing that should jump to \nmind is “small differences. ” Arbitrage is the science of observing small dif-\nferences between two prices that should be the same (e.g., the price of IBM", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:305", "doc_id": "d3a4086c7217ef8d463fb96ff271bd9cc79c570c89a0eb4bd346603fb0bebeee", "chunk_index": 0}
{"text": "Appendix C: Put-Call Parity   • 289\ntraded on the New York Stock Exchange and the price of IBM traded in \nPhiladelphia) but are not. An arbitrageur, once he or she spots the small \ndifference, sells the more expensive thing and buys the less expensive one \nand makes aprofit without accepting any risk. \nBecause we are going to investigate dividend arbitrage, even abig-\npicture guy like me has to get down in the weeds because the differences we \nare going to try to spot are small ones. The weeds into which we are wading \nare mathematical ones, I’mafraid, but never fear—we’ll use nothing more \nthan alittle algebra. We’ll use these variables in our discussion:\nK = strike price\nC\nK = call option struck at K\nPK = put option struck at K\nInt = interest on arisk-free instrument \nDiv = dividend payment\nS = stock price\nBecause we are talking about arbitrage, it makes sense that we are \ngoing to look at two things, the value of which should be the same. We \nare going to take adetailed look at the preceding image, which means that \nwe are going to compare aposition composed of options with aposition \ncomposed of stock.\nLet’ssay that the stock at which we were looking to build aposition is \ntrading at $50 per share and that options on this stock expire in exactly one \nyear. Further, let’ssay that this stock is expected to yield $0.25 in dividends \nand that the company will pay these dividends the same day that the op-\ntions expire.\nLet’scompare the two positions in the same way as we did in the \npreceding big-picture image. As we saw in that image, along call and ashort put are the same as astock. Mathematically, we would express this \nas follows:\nC\nK − PK = SK\nAlthough this is simple and we agreed that it’sabout right, it is not \ntechnically so.\nThe preceding equation is not technically right because we know that \nastock is an unlevered instrument and that options are levered ones. In the", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:306", "doc_id": "9765833f00571d3cce1130f6870a694e9d2eaa878e99be899631ac86dd5deeac", "chunk_index": 0}
{"text": "290  •   The Intelligent Option Investor\npreceding equation, we can see that the left side of the equation is levered \n(because it contains only options, and options are levered instruments), \nand the right side is unlevered. Obviously, then, the two cannot be exactly \nthe same.\nWe can fix this problem by delevering the left side of the preceding \nequation. Any time we sell aput option, we have to place cash in amar -\ngin account with our broker. Recall that ashort put that is fully margined \nis an unlevered instrument, so margining the short put should delever \nthe entire option position. Let’sadd amargin account to the left side and \nput $Kin it:\nC\nK − PK + K = S\nThis equation simply says that if you sell aput struck at Kand put $Kworth of margin behind it while buying acall option, you’ll have the same \nrisk, return, and leverage profile as if you bought astock—just as in our \nbig-picture diagram.\nBut this is not quite right if one is dealing with small differences. \nFirst, let’ssay that you talk your broker into funding the margin ac-\ncount using arisk-free bond fund that will pay some fixed amount of \ninterest over the next year. To fund the margin account, you tell your \nbroker you will buy enough of the bond account that one year from \nnow, when the put expires, the margin account’svalue will be exactly \nthe same as the strike price. In this way, even by placing an amount less \nthan the strike price in your margin account originally, you will be able \nto fulfill the commitment to buy the stock at the strike price if the put \nexpires in the money (ITM). The amount that will be placed in margin \noriginally will be the strike price less the amount of interest you will \nreceive from the risk-free bond. In mathematical terms, the preceding \nequation becomes \nC\nK − PK + (K – Int) = S\nNow all is right with the world. For anon-dividend-paying stock, this fully \nexpresses the technical definition of put-call parity.\nHowever, because we are talking about dividend arbitrage, we have to \nthink about how to adjust our equation to include dividends. We know that \nacall option on adividend-paying stock is worth less because the dividend", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:307", "doc_id": "3fbcd225fe372a143179a3746264b51d426240ecae5f946bc738c3f7a7bcba08", "chunk_index": 0}
{"text": "Appendix C: Put-Call Parity   • 291\nacts as a “negative drift” term in the BSM. When adividend is paid, theory \nsays that the stock price should drop by the amount of the dividend. Be-\ncause adrop in price is bad for the holder of acall option, the price of acall \noption is cheaper by the amount of the expected dividend.\nThus, for adividend-paying stock, to establish an option-based position \nthat has exactly the same characteristics as astock portfolio, we have to keep \nthe expected amount of the dividend in our margin account.\n1 This money \nplaced into the option position will make up for the dividend that will be \npaid to the stock holder. Here is how this would look in our equation:\nC\nK − PK + (K − Int) + Div = S\nWith the dividend payment included, our equation is complete.\nNow it is time for some algebra. Let’srearrange the preceding equa-\ntion to see what the call option should be worth:\nCK = PK + Int − Div + (S − K)\nTaking alook at this, do you notice last term (S – K )? Astock’sprice \nminus the strike price of acall is the intrinsic value. And we know that \nthe value of acall option consists of intrinsic value and time value. This \nmeans that\n/dncurlybracketleft/dncurlybracketmid/horizcurlybracketext/horizcurlybracketext/dncurlybracketright/horizcurlybracketext/horizcurlybracketext/dncurlybracketleft/dncurlybracketmid/dncurlybracketright=+ −−CP SKKK IntD iv + ()\nTime valueI ntrinsic value\nSo now let’ssay that time passes and at the end of the year, the stock \nis trading at $70—deep ITM for our $50-strike call option. On the day \nbefore expiration, the time value will be very close to zero as long as the op-\ntion is deep ITM. Building on the preceding equation, we can put the rule \nabout the time value of adeep ITM option in the following mathematical \nequation:\nP\nK + Int − Div ≈ 0\nIf the time value ever falls below 0, the value of the call would trade for less \nthan the intrinsic value. Of course, no one would want to hold an option \nthat has negative time value. In mathematical terms, that scenario would \nlook like this:\nP\nK + Int − Div < 0", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:308", "doc_id": "1e1eabac16fae39da4a1472d738c58b063a29f994bd2a079b6505fe304d258a4", "chunk_index": 0}
{"text": "292  •   The Intelligent Option Investor\nFrom this equation, it follows that if\nPK + Int < Div\nyour call option has anegative implied time value, and you should sell the \noption in order to collect the dividend. \nThis is what is meant by dividend arbitrage . But it is hard to get the \nflavor for this without seeing areal-life example of it. The following table \nshows the closing prices for Oracle’sstock and options on January 9, 2014, \nwhen they closed at $37.72. The options had an expiration of 373 days in \nthe future—as close as Icould find to one year—the one-year risk-free rate \nwas 0.14 percent, and the company was expected to pay $0.24 worth of \ndividends before the options expired.\nCalls Puts\nBid Ask Delta Strike Bid Ask Delta\n19.55 19.85 0.94 18 0.08 0.13 −0.02\n17.60 17.80 0.94 20 0.13 0.15 −0.03\n14.65 14.85 0.92 23 0.25 0.28 −0.05\n12.75 12.95 0.91 25 0.36 0.39 −0.07\n10.00 10.25 0.86 28 0.66 0.69 −0.12\n8.30 8.60 0.81 30 0.97 1.00 −0.17\n6.70 6.95 0.76 32 1.40 1.43 −0.23\n4.70 4.80 0.65 35 2.33 2.37 −0.34\n3.55 3.65 0.56 37 3.15 3.25 −0.43\n2.22 2.26 0.42 40 4.80 4.90 −0.57\n1.55 1.59 0.33 42 6.15 6.25 −0.65\n0.87 0.90 0.22 45 8.25 8.65 −0.75\n0.31 0.34 0.10 50 12.65 13.05 −0.87\nIn the theoretical option portfolio, we are short aput, so its value to \nus is the amount we would have to pay if we tried to flatten the position by \nbuying it back—the ask price. Conversely, we are long acall, so its value to \nus is the price we could sell it for—the bid price.\nLet’suse these data to figure out which calls we might want to exercise \nearly if adividend payment was coming up.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:309", "doc_id": "436e6e4e39a6bf457be7ac38f6728d34505ed05cfc7482f218e795076a647970", "chunk_index": 0}
{"text": "Appendix C: Put-Call Parity   • 293\nStrike Call\nPut\n(a)\nInterest2\n(b)\nPut + Interest\n(a + b) Dividend P + I − D Notes\n18 19.55 0.13 0.03 0.16 0.24 (0.08) P + I < D, \narbitrage\n20 17.60 0.15 0.03 0.18 0.24 (0.06) P + I < D, \narbitrage\n23 14.65 0.28 0.03 0.31 0.24 0.07 No arbitrage\n25 12.75 0.39 0.04 0.43 0.24 0.19 No arbitrage\n28 10.00 0.69 0.04 0.73 0.24 0.49 No arbitrage\n30 8.30 1.00 0.04 1.04 0.24 0.80 No arbitrage\n32 6.70 1.43 0.05 1.48 0.24 1.24 No arbitrage\n35 4.70 2.37 0.05 2.42 0.24 2.18 No arbitrage\n37 3.55 3.25 0.05 3.30 0.24 3.06 No arbitrage\n40 2.22 4.90 0.06 4.96 0.24 4.72 No arbitrage\n42 1.55 6.25 0.06 6.31 0.24 6.07 No arbitrage\n45 0.87 8.65 0.06 8.71 0.24 8.47 No arbitrage\n50 0.31 13.05 0.07 13.12 0.24 12.88 No arbitrage\nThere are only two strikes that might be arbitraged for the \ndividends—the two furthest ITM call options. In order to realize the \narbitrage opportunity, you would wait until the day before the ex-dividend \ndate, exercise the stock option, receive the dividend, and, if you didn’twant \nto keep holding the stock, sell it and realize the profit.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:310", "doc_id": "ad9fae94db1a690e0b0d7e3d1783ea60e509325b2657fb9e42a696c7d3b7a583", "chunk_index": 0}
{"text": "295\nNotes\nIntroduction\n1. Options, Futures, and Other Derivatives by John C. Hull (New York: \nPrentice Hall, Eighth Edition, February 12, 2011), is considered the \nBible of the academic study of options.\n2. Option Volatility and Pricing by Sheldon Natenberg (New York: \nMcGraw-Hill, Updated and Expanded Edition, August 1, 1994), is \nconsidered the Bible of professional option traders.\n3. The Greeks are measures of option sensitivity used by traders to man-\nage risk in portfolios of options. They are named after the Greek \nsymbols used in the Black-Scholes-Merton option pricing model.\n4. “To invest successfully over alifetime does not require astratospheric \nIQ, unusual business insights, or inside information. What’sneeded \nis asound intellectual framework for making decisions and the abil-\nity to keep emotions from corroding that framework. ” Preface to The \nIntelligent Investor by Benjamin Graham (New York: Collins Business, \nRevised Edition, February 21, 2006). \nChapter 1\n1. In other words, if all option contracts were specific and customized, \nevery time you wanted to trade an option contract as an individual in-\nvestor, you would have to first find acounterparty to take the other side \nof the trade and then do due diligence on the counterparty to make \nsure that he or she would be able to fulfill his or her side of the bargain. \nIt is hard to imagine small individual investors being very interested in \nthe logistical headaches that this process would entail!", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:312", "doc_id": "7cd1a79e3ae78453961ac9eb7a4f9d46b48aaaaa6cd17d1b7fd598185e99f73c", "chunk_index": 0}
{"text": "296 •   Notes\n2. One more bit of essential but confusing jargon when investing in \noptions is related to exercise. There are actually two styles of exercise; \none can be exercised at any time before expiration—these are termed \nAmerican style—and the other can only be exercised at expiration—\ntermed European style. Confusingly, these styles have nothing to do \nabout the home country of agiven stock or even on what exchange \nthey are traded. American-style exercise is normal for all single-stock \noptions, whereas European-style exercise is normal for index futures. \nBecause this book deals almost solely with single-stock options (i.e., \noptions on IBM or GOOG, etc.), Iwill not make abig deal out of this \ndistinction. There is one case related to dividend-paying stocks where \nAmerican-style exercise is beneficial. This is discussed in Appendix C. \nMost times, exercise style is not aterribly important thing.\n3. Just like going to Atlantic City, even though the nominal odds for rou-\nlette are 50:50, you end up losing money in the long run because you \nhave to pay—the house at Atlantic City or the broker on Wall Street—\njust to play the game.\nChapter 3\n1. We adjusted and annualized the prices of actual option contracts so \nthat they would correspond to the probability levels we mentioned \nearlier. It would be almost impossible to find astock trading at exactly \n$50 and with the option market predicting exactly the range of future \nprice that we have shown in the diagrams. This table is provided simply \nto give you an idea of what one might pay for call options of different \nmoneyness in the open market.\n2. Eighty-four percent because the bottom line marks the price at which \nthere is only a 16 percent chance that the stock will go any lower. If \nthere is a 16 percent chance that the stock will be lower than $40 in \none year’stime, this must mean that there is an 84 percent chance \nthat the stock will be higher than $40 in one year’stime. We write \n“alittle better than 84 percent chance” because you’ll notice that the \nstock price corresponding to the bottom line of the cone is around \n$42—alittle higher than the strike price. The $40 mark might corre-\nspond to achance of, let’ssay, 13 percent that the stock will be lower;", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:313", "doc_id": "8da9b331c743a425c6952634df91e0b51e188146fec3041820b7812d83a738dd", "chunk_index": 0}
{"text": "Notes  • 297\nthis would, in turn, imply an 87 percent chance of being higher than \n$40 in ayear.\n3. Tenor is just aspecialty word used for options and bonds to mean the \nremaining time before expiration/maturity. We will see later that op-\ntion tenors usually range from one month to one year and that special \nlong-term options have tenors of several years.\n4. We’re not doing any advanced math to figure this out. We’re just eye-\nballing the area of the exposure range within the cone in this diagram \nand recalling that the area within the cone of the $60 strike, one-year \noption was about the same.\n5. In other words, in this style of trading, people are anchoring on recent \nimplied volatilities—rather than on recent statistical volatilities—to \npredict future implied volatilities.\n6. Note that even though this option is now ITM, we did not pay for any \nintrinsic value when we bought the option. As such, we are shading the \nentire range of exposure in green.\nChapter 4\n1. The “capital” we have discussed so far is strategic capital. There is an-\nother form of tactical capital that is vital to companies, termed working \ncapital. Working capital consists of the short-term assets essential for \nrunning abusiness (e.g., inventory and accounts receivables) less the \nshort-term liabilities accrued during the course of running the busi-\nness (e.g., accounts payable). Working capital is tactical in the sense \nthat it is needed for day-to-day operation of the business. Acompany \nmay have the most wonderful productive assets in the world, but if it \ndoes not have the money to buy the inventory of raw materials that will \nallow it to produce its widgets, it will not be able to generate revenues \nbecause it will not be able to produce anything.\n2. The law of large numbers is actually alaw of statistics, but when most \npeople in the investing world use this phrase, it is the colloquial version \nto which they are referring. \n3. Apple Computer, for instance, was aspecialized maker of computers \nmainly used by designers and artists in the late 1990s. Through some", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:314", "doc_id": "540f16240ac12856ed610016f80a1e9dedf47e1885ddd0a71b6d521f2eba33b2", "chunk_index": 0}
{"text": "300 •   Notes\n4. The original academic paper discussing prospect theory was published \nin Econometrica, Volume 47, Number 2, in March 1979 under the title: \n“Prospect Theory: An Analysis of Decision Under Risk. ”\n5. Over the years, the paradigm for broker-dealers has changed, so some \nof what is written here is abit dated. Broker-dealers have one part of \nits business dedicated to increasing customer “flow” as is described \nhere. Over the last 20 years or so, however, they have additionally \nbegun to capitalize what amounts to in-house hedge funds, called \n“proprietary trading desks” or “prop traders. ” While the prop traders \nare working on behalf of corporations that were historically known as \nbroker-dealers (e.g., Goldman Sachs, Morgan Stanley), they are in fact \nbuy-side institutions. In the interest of clarity in this chapter, Itreat \nbroker-dealers as purely sell-side entities even though they in fact have \nelements of both buy- and sell-sides.\nChapter 7\n1. Round-tripping means buying asecurity and selling it later.\n2. This bit of shorthand just means abid volatility of 22.0 and an ask \nvolatility of 22.5.\nChapter 8\n1. This is one of the reasons why Icalled delta the most useful of the \nGreeks.\n2. When Ipulled these data, Ipulled the 189-day options, so my chance \nof this stock hitting that high aprice in this short time period is slim, \nbut the point Iam making here about percentage versus absolute re-\nturns still holds true.\n3. Atool to calculate all the downside and upside leverage figures shown \nin this chapter is available on the intelligent option investor website.\n4. “Buffett’s Alpha, ” Andrea Frazzini, David Kabiller, and Lasse H. Ped-\nersen, 2012, National Bureau of Economic Research, NBER Working \nPaper No. 19681.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:317", "doc_id": "922fc2deae66bcce4f9aa911fb29039ab612a4ff6dbdd205ba9da91b51e0efef", "chunk_index": 0}
{"text": "Notes  • 303\nAppendix B\n1. The idea behind this process is to match the timing of the costs of \nequipment with revenues from the items produced with that equip-\nment. This is akey principle of accountancy called matching.\n2. The problem is that troughs, by definition, follow peaks. Usually, just \nlike the timing of large acquisitions, companies decide to spend huge \namounts to build new production capacity at just about the same time \nthat economic conditions peak, and the factories come online just as \nthe economy is starting to sputter and fail.\nAppendix C\n1. Apenny saved is apenny earned. We can think of the option being \ncheaper by the amount of the dividend, so we will place the amount \nthat we save on the call option in savings.\n2. This is calculated using the following equation:\nInterest = strike × r × percent of 1 year\nIn the case of the $18 strike, interest = 18 × 0.14% × (373 days/365 days \nper year) = $0.03.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:320", "doc_id": "d063ac2e9efdb4e83f60dbe2d5a9c57afa3435c34e9f8e3b50e25e8b68024d10", "chunk_index": 0}
{"text": "305\nA\nAbsolute dollar value of returns, \n172–173\nAccuracy, confidence vs., 119–121\nAcquisitions (see Mergers and \nacquisitions)\nActivist investors, 110\nAgainst the Gods (Peter Bernstein), 9\nAgents:\nbuy-side, 132–136\ndefined, 131\ninvestment strategies of, 137–138\nprincipals vs., 131–132\nsell-side, 136–137\nAIG, 301n1\nAllocation:\nand leverage in portfolios, \n174–183\nand liquidity risk, 256\nand portfolio management with \nshort-call spreads, 228–229\nAlpha, 134\nAmerican-style options, 296n2 \n(Chapter 1)\nAnalysis paralysis, 120\nAnchoring, 60, 97\nAnnouncements:\nand creating BSM cones, 156, 157\nmarket conditions following, 68–69, \n72–73\ntenor and trading in expectation \nof, 192\nAOL, 103\nApple Computer, 101, 250–251, \n297–298n3\nArbitrage:\ndefined, 288–289\ndividend, 223, 288–293\nAsk price, 147\nAsset allocation, liquidity risk \nand, 256\nAssets:\ndefined, 78–79\nfungible, 272–273\nin golden rule of valuation, 77\nhidden, 110, 111\nidiosyncratic, 272\ninterchangeable, 272–273\nmispriced, 274–277\noperating, 110\nprice vs. value of, 79–80\nunderlying, 33–34, 272–273\nAssets under management (AUM), 132\nAssignment:\nwith covered calls, 247–248\ndefined, 222–223\nAssumptions:\nBSM model, 32–33, 40–47, 78, 150\ndividend yield, 67\nwith forward volatility number, \n156–157\ntime-to-expiration, 64–67\nvolatility, 60–64\nAt-the-money (ATM) options:\nBSM cone for, 53\ncollars, 259\ncovered calls, 242–243, 245, 246\ndefined, 13, 16, 17\nlong calls, 189\nlong diagonals, 235–237\nIndex", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:322", "doc_id": "914e8c776e647279a520f7e5902eebb4484df16c62f0f129352cc62752c6032a", "chunk_index": 0}
{"text": "306  •   Index\nAt-the-money (ATM) options: (continued)\nlong straddles, 208–209\nOTM options vs., 233–234\nprotective puts, 250–251, 253\nshort diagonals, 238, 240\nshort puts, 215, 216\nshort straddles, 230\nshort-call spreads, 222–225\nAUM (assets under management), 132\nB\nBalance-sheet effects, 92, 108–111\nBehavior, efficient market hypothesis \nas model for, 41–42\nBehavioral biases, 114–130\noverconfidence, 118–122\npattern recognition, 114–118\nperception of risk, 123–130\nBehavioral economics, 42, 114\nBentley, 97–98\nBerkshire Hathaway, 185\nBernstein, Peter, 9\nBiases, behavioral (see Behavioral \nbiases)\nBid price, 147\nBid-ask spreads, 147–149\nBimodal outcomes, companies with, \n277–278\nBlack, Fischer, 8–9\nBlackBerry, 208–209\nBlack-Scholes-Merton (BSM) model, 9\nassumptions of, 32–33, 40–47, 78, 150\nconditions favoring, 269–273\nconditions not favoring, 273–281\nincorrect facets of, 29\npredicting future stock prices from, \n32–39\nranges of exposure and price \npredictions from, 50–56\ntheory of, 32\n(See also BSM cone)\nBonds, investing in short puts vs., \n213–214\nBooms, leverage during, 199\nBreakeven line, 25\nfor call options, 15, 16\nfor long strangle, 26–27\nfor put options, 17, 18\n(See also Effective buy price [EBP])\nBroker-dealers, 137, 299–300n5\nBrokers, benefits of short-term trading \nfor, 64\nBSM cone:\nfor call options, 50–55\nfor collars, 258\nfor covered calls, 240–244\ncreating, 156–160\ndefined, 38–39\ndelta-derived, 151–155\ndiscrepancies between valuation and, \n160–162\nfor ITM options, 57–58\nfor long calls, 189\nfor long diagonals, 235\nfor long puts, 201\nfor long strangles, 205\noverlaying valuation range on, 160\nfor protective puts, 248, 249\nfor put options, 54–55\nfor short diagonals, 238\nfor short puts, 212, 216, 217\nfor short straddles, 230\nfor short strangles, 231\nfor short-call spreads, 220\nwith simultaneous changes in variables, \n68–74\nand time-to-expiration assumptions, \n64–67\nand volatility assumptions, \n60–64\nBSM model (see Black-Scholes-Merton \n(BSM) model)\nBubbles, 42–43\nBuffett, Warren, xv, 184–185\nBuying options (see Exposure-gaining \nstrategies)\nBuy-side structural impediments, \n132–136", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:323", "doc_id": "7444e1741b61ee68e1726c4eac3573a62d478ec3a6b67da0ccb720b7ae279e28", "chunk_index": 0}
{"text": "308  •   Index\nd\nDebt, investment leverage from, 165–166\nDell, 101\nDelta, 151–155, 300n1 (Chapter 8)\nDemand-side constraints, 84–86\nDepreciation, 282–284\nDiagonals, 233\nlong, 235–237\nshort, 238–240\nDirectionality of options, 9–20\ncalls, 12–16\nand exposure, 18–20\nimportance of, 27–28\nputs, 16–18\nand stock, 10–11\nvolatility and predications about, \n68–74\nDiscount rate, 87–89, 298n5\nDispersion, 302n1 (Chapter 11)\nDistribution of returns:\nfat-tailed, 45\nleptokurtic, 45\nlognormal, 36–37\nnormal, 32, 36, 40, 43–45\nDividend arbitrage, 223, 288–293\nDividend yield, 67\nDividend-paying stocks, prices of, \n35–36\nDividends, 86\nDownturns, short puts during, 214–215\nDrift:\nassumptions about, 32, 35–36\neffects of, 67\nand long calls, 202–203\nand long puts, 191\nand long strangles, 206\nDrivers of value (see Value drivers)\ne\nEarly exercise, 223\nEarnings before interest, taxes, \ndepreciation, and amortization \n(EBITDA), 99\nEarnings before interest and taxes \n(EBIT), 99\nEarnings per share (EPS), 99\nEarnings seasons:\nand tenor of short puts, 217–218\nvolatility in, 301n5\nEBIT (earnings before interest and \ntaxes), 99\nEBITDA (earnings before interest, \ntaxes, depreciation, and \namortization), 99\nEBP (see Effective buy price)\nEconomic environment, profitability \nand, 101\nEconomic life of companies:\nand golden rule of valuation, \n82–86\nimproving valuations by \nunderstanding, 93–94\nEconomic value of companies, \n137–139\nEffective buy price (EBP), 24–25, \n213, 244\nEffective sell price (ESP), 25–26\nEfficacy (see Investing level and \nefficacy)\nEfficient market hypothesis (EMH), \n33, 34, 40–43\nEndowments, 135, 136\nEnron, 110\nEPS (earnings per share), 99\nESP (effective sell price), 25–26\nEuropean-style options, 296n2 \n(Chapter 1)\nExchange-traded funds (ETFs), \noptions on, 251–252\nExecution of option overlay strategies:\ncollars, 259–262\ncovered calls, 242–245\nprotective puts, 250–252\nExercising options, 13, \n296n2 (Chapter 1)\nExpansionary cash flows, 82, 104–108", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:325", "doc_id": "151ece07d2558184d3cbacec88180041f7f06dfcb8ffbb8b43dbdba273f8d6a3", "chunk_index": 0}
{"text": "310  •   Index\nGross domestic product (GDP), 104–108\nGrowth:\nbuying call options for, 22\nnominal GDP , 104–108\nrevenue, 92, 97–99\nstructural growth stage, 94, 95\nH\nHedge funds, 132–134, 136\nHedge funds of funds (HFoF), 134\nHedges:\nreinvesting profit from, 254–255\nsize of, 255–258\ntiming of, 252–254\nHedging:\nplanning for, 255–258\nfor portfolios, 251–252\nHerding, 138, 299n1\nHFoF (hedge funds of funds), 134\nHistorical volatility, 60\nHostile takeovers, 110\nThe Human Face of Big Data (Rick \nSmolan), 114\nI\nIBM, 224–230, 299n5 (Chapter 5), \n301n6\nIdiosyncratic assets, 272\nImmediate realized loss (IRL), 180, 183\nImplied volatility:\nbid/ask, 149–151\nchanging assumptions about, 60–64\nand short puts, 216–217\nIncome, selling put options for, 23\nIndexing, closet, 133\nInsurance, 5, 250\nInsurance companies, 135, 136\nIntel, 175\nInterchangeable assets, 272–273\nInterest:\ncalculating, 303n2\noptions and payment on, 168\nprepaid, 170\nInterest rates, 67\nIn-the-money (ITM) options:\ncalls vs. puts, 27\ncovered calls, 242\ndefined, 13, 16, 17\ninvestment leverage for, 170–172\nlevered strategy with, 176–180\nlong calls, 189, 193–197\nlong diagonals, 236\nlong puts, 204\nmanaging leverage with, 183–184\nand market risk, 263–264\npricing of, 56–59, 150\nprotective puts, 249–251\nshort puts, 213–215\nshort-call spread, 222, 223\ntime decay for, 66–67\nIntrinsic value, 56–59, 171\nInvesting level and efficacy, 92, \n103–108\nInvestment capital, leverage and, \n183–184\nInvestment leverage, 163–185\nfrom debt, 165–166\ndefined, 164\nmanaging, 183–185\nmargin of safety for, 197–199\nmeasuring, 169–173\nfrom options, 166–168\nand portfolio management, \n196–197\nin portfolios, 174–183\nunlevered investments, 164–165\nInvestment phase (investment stage), \n86, 93–96\nInvestors:\nactivist, 110\nrisk-averse, 123, 125–127\nrisk-neutral, 124–126\nrisk-seeking, 123, 125–127\nIRL (immediate realized loss), \n180, 183\nITM (see In-the-money options)", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:327", "doc_id": "c4fb9f9c3b5a9ee1ec739fe0b550ae628d4a856d876520dca73e57c9573a2caa", "chunk_index": 0}
{"text": "312  •   Index\nMarket conditions (continued)\ntime-to-expiration assumptions, 64–67\nand types of volatility, 59–60\nvolatility assumptions, 60–64\nMarket efficiency, 32–34, 40–43\nMarket makers, 147, 281\nMarket risk, 263–265\nMatching, 302n1 (Appendix B)\nMaximum return, 225\nMergers and acquisitions:\nstrike prices selection and, 195–196\ntenor and, 191–192\nMerton, Robert, 8–9\nMiletus, 6–7\nMispriced assets, 274–277\nMispriced options, 143–162\ndeltas of, 151–155\nreading option quotes, 144–151\nand valuation risk, 266\nand valuation vs. BSM range, 155–162\nMoneyness of options:\ncalls, 13–14\nputs, 16–17\nMorningstar, 132\nMost likely (term), 38\nMotorola Mobility Systems, 84\nMueller Water, 148–149, 154, 158–160\nMultiples-based valuation, 99–100\nMutual funds, 132–133, 136\nn\nNominal GDP growth:\nowners’ cash profit vs., 104–108\nas structural constraint, 104\nNormal distribution, 32, 36, 40, 43–45\nNotional amount of position, 173\nNotional exposure, 173\nO\nOCC (Options Clearing \nCorporation), 8\nOCP (see Owners’ cash profit)\nOperating assets, 110\nOperating leverage (operational \nleverage):\ndefined, 282–284\nand level of investment leverage, \n197–199\nand profitability, 101\nOperational details of companies, \nxiii–xiv, 110–111\nOption investing:\nchoices in, 22–24\nconditions favoring BSM, 269–273\nconditions not favoring BSM, 273–281\nflexibility in, 20–28\nlong-term strategies, 1\nmisconceptions about, 1\nrisk in, 268\nshortcuts for valuation in, 93–97\nstock vs., 21–22\nstrategies for, 142 (See also specific \ntypes of strategies)\nstructural impediments in, 131–139\nthree-step process, xiv\nvaluation in, 75\nOption pricing, 29–47, 49–74\nand base assumptions of BSM, 40–47\nmarket conditions in, 59–74\npredicting future stock prices from, \n32–39\nand ranges of exposure, 50–56\ntheory of, 30–32\ntime vs. intrinsic value in, 56–59\nOption pricing models:\nbase assumptions of, 40–47\nhistory of, 8–9\noperational details of companies in, \nxiii–xiv\npredicting future stock prices with, \n32–39\nranges of exposure and price \npredictions from, 50–56\n(See also Black-Scholes-Merton \n[BSM] model)\nOption quotes, 144–151", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:329", "doc_id": "a9e48116e288ff6d97c43f34e61713de63ac0db690283bb4d93e1c7567cb38c5", "chunk_index": 0}
{"text": "314  •   Index\nProcter & Gamble, 84\nProductivity, 102\nProfit:\nfrom covered calls, 245\nfrom hedging, 254–255\nowners’ cash, 82\npercent, 172–173\nProfit leverage, 179–180, 182–183\nProfitability:\nand financial leverage, 285–286\nand operational leverage, \n283–284\nas value driver, 92, 99–102\nProprietary trading desks (prop \ntraders), 300n5\nProspect theory, 123–127\nProtective puts, 248–258\nabout, 248–250\nBSM cone, 248, 249\nwith covered calls, 259–262\nexecution of, 250–252\npitfalls with, 252–258\nPure Digital, 299n6 (Chapter 5)\nPut options (puts):\nBSM cone for, 54–55\nbuying, for protection, 23\ndefined, 11\ndelta for, 151\non quotes, 145\nselling, for income, 23\ntailoring exposure with, 24\nvisual representation of, 16–18\n(See also Long puts; Protective puts; \nShort puts)\nPut-call parity, 223, 287–293\ndefined, 287–288\nand dividend arbitrage, 288–293\nfor non-dividend-paying stock, \n289–290\nQ\nQualcomm, 260–262\nQuotes, option, 144–151\nR\nRandom-walk principal, 41\nRanges of exposure, 3\nfor call options, 12–13, 15\nfor ITM options, 58–59\nand option pricing, 50–56\nRankine, Graeme, 41–42\nRatioing, 206, 238\nRealized losses:\nand buying puts, 203\nimmediate, 180, 183\nmanaging leverage to minimize, \n183–185\nand option buying, 187–188\nunrealized vs., 175–176\nRecessions, leverage during, 198, 199\nReflective thought processes, 116–118\nReflexive thought processes, 116–118\nReturn(s):\nabsolute dollar value of, 172–173\nfor covered calls, 244–245\nmaximum, 225\npercentage, 229\nfor short puts, 245\n(See also Distribution of returns)\nRevenue growth, 92, 97–99\nRisk, 263–268\ncareer, 263\ncounterparty, 7–8\nliquidity, 256, 263\nmarket, 263–265\nin option investing, 267–268\nperception of, 123–130\nand size of hedges, 255–256\nsolvency, 256, 263\nvaluation, 265–267\nRisk-averse investors, 123, 125–127\nRisk-free rate:\nborrowing at, 32, 40, 46\nBSM model assumption about, 32, \n35–36, 40, 45–46\nRisk-neutral investors, 124–126\nRisk-seeking investors, 123, 125–127", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:331", "doc_id": "ba9d4c9dbece5f81bb14e7cee61658311c2353af3d40909a79a9a368872475b3", "chunk_index": 0}
{"text": "316  •   Index\nStrike prices: (continued )\nlong strangle, 206–207\nshort diagonal, 239–240\nshort put, 215\nshort-call spread, 222–228\nStrike–stock price ratio (K/S):\nand change in closing price, \n146–147\ndefined, 53–54\nand forward volatility, 67–74\nStructural constraints, 86, 104\nStructural downturns, 302n2 \n(Chapter 11)\nStructural growth stage, 94, 95\nStructural impediments, 131–139\nbuy-side, 132–136\nand investment strategies, \n137–139\nprincipals vs. agents, 131–132\nsell-side, 136–137\nSun Microsystems, 108\nSupply-side constraints, 83\nSymmetry, bias associated with, \n114–118\nT\n“Taking profit” with covered calls, 245\nTaxes, BSM model assumption about, \n32, 40, 46\nTechnical analysis, 115\nTenor, 297n3 (Chapter 3)\ndefined, 59\nfor long calls, 190–192\nfor long puts, 202–203\nfor long strangles, 206\nfor protective puts, 252–254\nfor short puts, 214–215\nfor short-call spreads, 222\nTerminal phase, 86\nTime decay, 65–67\nTime horizons:\nlong, 279–281\nshort, 270–272\nTime value:\nintrinsic vs., 56–59\nof money, 87, 93–95\nTime Warner, 103\nTime-to-expiration assumptions, \n64–67\nToyota, 97\nTrading restrictions, 32, 40, 46\nTroughs (business-cycle):\noperational leverage in, 283–284\nand peaks, 302–303n2\nTversky, Amos, 123, 126\n“2-and-20” arrangements, 134\nU\nUncertainty, 118–119\nUnderexposure, 247\nUnderlying assets:\nfungible, 272–273\nand future stock price, 33–34\nUniversity of Chicago, 41\nUnlevered investments:\nlevered vs., 164–165\nin portfolios, 175–176, 178\nUnrealized losses, 175–176\nUnrealized profit, 254–255\nUnused leg, long strangle, 207\nU.S. Treasury bonds, 45–46\nUtility curves, 124–126\nV\nValuation:\ngolden rule of, 77–89\nmultiples-based, 99–100\nshortcuts for, 93–97\nvalue drivers in, 91–97\nValuation range:\nBSM cone vs., 160–162\ncreating, 122\nand margins of safety, 197–199\noverlaying BSM cone with, 160\nand strike price selection, 192–194\nValuation risk, 265–267", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf#page:333", "doc_id": "141dd4b290c8bcc99f1ffc91f27469b611afe3cb3c1f09ce47dadb420ecd83c0", "chunk_index": 0}
{"text": "Preface \nWhen the listed option market originated in April 1973, anew world of investment \nstrategies was opened to the investing public. The standardization of option terms \nand the formation of aliquid secondary market created new investment vehicles that, \nadapted properly, can enhance almost every investment philosophy, from the con\nservative to the speculative. This book is about those option strategies -which ones \nwork in which situations and why they work. \nSome of these strategies are traditionally considered to be complex, but with \nthe proper knowledge of their underlying principles, most investors can understand \nthem. While this book contains all the basic definitions concerning options, little time \nor space is spent on the most elementary definitions. For example, the reader should \nbe familiar with what acall option is, what the CBOE is, and how to find and read \noption quotes in anewspaper. In essence, everything is contained here for the novice \nto build on, but the bulk of the discussion is above the beginner level. The reader \nshould also be somewhat familiar with technical analysis, understanding at least the \nterms support and resistance. \nCertain strategies can be, and have been, the topic of whole books - call buy\ning, for example. While some of the strategies discussed in this book receive amore \nthorough treatment than others, this is by no means abook about only one or two \nstrategies. Current literature on stock options generally does not treat covered call \nwriting in agreat deal of detail. But because it is one of the most widely used option \nstrategies by the investing public, call writing is the subject of one of the most in\ndepth discussions presented here. The material presented herein on call and put \nbuying is not particularly lengthy, although much of it is of an advanced nature -\nespecially the parts regarding buying volatility and should be useful even to sophis\nticated traders. In discussing each strategy, particular emphasis is placed on showing \nwhy one would want to implement the strategy in the first place and on demonstrat-\nxv", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:15", "doc_id": "863fc25b537fb70449cd4a50fe9b4cd2a0d071acc1b969c66c2e0c164a6f0bea", "chunk_index": 0}
{"text": "xviii Preface \nare made for using the computer as atool in follow-up action, including an example \nprintout of an advanced follow-up analysis. \nTHIRD EDITION \nThere were originally six new chapters in the third edition. There were new chapters \non LEAPS, CAPS, and PERCS, since they were new option or option-related prod\nucts at that time. \nLEAPS are merely long-term options. However, as such, they require alittle \ndifferent viewpoint than regular short-term options. For example, short-term inter\nest rates have amuch more profound influence on alonger-term option than on ashort-term one. Strategies are presented for using LEAPS as asubstitute for stock \nownership, as well as for using LEAPS in standard strategies. \nPERCS are actually atype of preferred stock, with aredemption feature built \nin. They also pay significantly larger dividends than the ordinary common stock. The \nredemption feature makes a PERCS exactly like acovered call option write. As such, \nseveral strategies apply to PERCS that would also apply to covered writers. \nMoreover, suggestions are given for hedging PERCS. Subsequently, the PERCS \nchapter was enveloped into alarger chapter in the fourth edition. \nThe chapters on futures and other non-equity options that were written for the \nsecond edition were deleted and replaced by two entirely new chapters on futures \noptions. Strategists should familiarize themselves with futures options, for many prof\nit opportunities exist in this area. Thus, even though futures trading may be unfamil\niar to many customers and brokers who are equity traders, it behooves the serious \nstrategist to acquire aknowledge of futures options. Achapter on futures concentrates \non definitions, pricing, and strategies that are unique to futures options; another chap\nter centers on the use of futures options in spreading strategies. These spreading \nstrategies are different from the ones described in the first part of the book, although \nthe calendar spread looks similar, but is really not. Futures traders and strategists \nspend agreat deal of time looking at futures spreads, and the option strategies pre\nsented in this chapter are designed to help make that type of trading more profitable. \nAnew chapter dealing with advanced mathematical concepts was added near \nthe end of the book. As option trading matured and the computer became more of \nan integral way of life in monitoring and evaluating positions, more advanced tech\nniques were used to monitor risk. This chapter describes the six major measures of \nrisk of an option position or portfolio. The application of these measures to initialize \npositions that are doubly or triply neutral is discussed. Moreover, the use of the com\nputer to predict the results and \"shape\" of aposition at points in the future is \ndescribed.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:16", "doc_id": "b2716c3c7bc349d589fef39ff6590f8e377245f23b069438729f1b0f6eea97c6", "chunk_index": 0}
{"text": "Preface xix \nThere were substantial revisions to the chapters on index options as well. Part \nof the revisions are due to the fact that these were relatively new products at the time \nof the writing of the second edition; as aresult, many changes were made to the prod\nucts - delisting of some index options and introduction of others. Also, after the crash \nof 1987, the use of index products changed somewhat (with introduction of circuit \nbreakers, for example). \nFOURTH EDITION \nOnce again, in the ever-changing world of options and derivatives, some new \nimportant products have been introduced and some new concepts in trading have \ncome to the forefront. Meanwhile, others have been delisted or fallen out of favor. \nThere are five new chapters in the fourth edition, four of which deal with the most \nimportant approach to option trading today - volatility trading. \nThe chapter on CAPS was deleted, since CAPS were delisted by the option \nexchanges. Moreover, the chapter on PERCS was incorporated into amuch larger \nand more comprehensive chapter on another relatively new trading vehicle - struc\ntured products. Structured products encompass afairly wide range of securities -\nmany of which are listed on the major stock exchanges. These versatile products \nallow for many attractive, derivative-based applications - including index funds that \nhave limited downside risk, for example. Many astute investors buy structured prod\nucts for their retirements accounts. \nVolatility trading has become one of the most sophisticated approaches to \noption trading. The four new chapters actually comprise anew Part 6 - Measuring \nAnd Trading Volatility. This new part of the book goes in-depth into why one should \ntrade volatility (it'seasier to predict volatility than it is to predict stock prices), how \nvolatility affects common option strategies - sometimes in ways that are not initially \nobvious to the average option trader, how stock prices are distributed ( which is one \nof the reasons why volatility trading \"works\"), and how to construct and monitor avolatility trade. Anumber of relatively new techniques regarding measuring and pre\ndicting volatility are presented in these chapters. Personally, Ithink that volatility \nbuying of stock options is the most useful strategy, in general, for traders of all levels \n- from beginners through experts. If constructed properly, the strategy not only has \nahigh probability of success, but it also requires only amodest amount of work to \nmonitor the position after it has been established. This means that avolatility buyer \ncan have a \"life\" outside of watching ascreen with dancing numbers on it all day. \nMoreover, most of the previous chapters were expanded to include the latest \ntechniques and developments. For example, in Chapter 1 (Definitions), the entire \narea of option symbology has been expanded, because of the wild movements of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:17", "doc_id": "7707bd58d3a9a733c14e4e1820175c9fcd1ce0f3a93661e366b90855fa36750d", "chunk_index": 0}
{"text": "xx Preface \nstocks in the past few years. Also, the margin rules were changed in 2000, and those \nchanges are noted throughout the book. \nThose chapters dealing with the sale of options - particularly naked options -\nhave been expanded to include more discussion of the way that stocks behave and \nhow that presents problems and opportunities for the option writer. For example, in \nthe chapter on Reverse Spreads, the reverse calendar spread is described in detail \nbecause - in ahigh-volatility environment - the strategy becomes much more viable. \nAnother strategy that receives expanded treatment is the \"collar\" - the purchase \nof aput and simultaneous sale of acall against an underlying instrument. In fact, asimilar strategy can be used - with aslight adjustment - by the outright buyer of an \noption (see the chapter on Spreads Combining Puts and Calls). \nIam certain that many readers of this book expect to learn what the \"best\" \noption strategy is. While there is achapter discussing this subject, there is no defin\nitively \"best\" strategy. The optimum strategy for one investor may not be best for \nanother. Option professionals who have the time to monitor positions closely may be \nable to utilize an array of strategies that could not possibly be operated diligently by \napublic customer employed in another full-time occupation. Moreover, one'spartic\nular investment philosophy must play an important part in determining which strat\negy is best for him. Those willing to accept little or no risk other than that of owning \nstock may prefer covered call writing. More speculative strategists may feel that low\ncost, high-profit-potential situations suit them best. \nEvery investor must read the Options Clearing Corporation Prospectus before \ntrading in listed options. Options may not be suitable for every investor. There are \nrisks involved in any investment, and certain option strategies may involve large risks. \nThe reader must determine whether his or her financial situation and investment \nobjectives are compatible with the strategies described. The only way an investor can \nreasonably make adecision on his or her own to trade options is to attemptto acquire \naknowledge of the subject. \nSeveral years ago, Iwrote that \"the option market shows every sign of becom\ning astronger force in the investment world. Those who understand it will be able to \nbenefit the most.\" Nothing has happened in the interim to change the truth of that \nstatement, and in fact, it could probably be even more forcefully stated today. For \nexample, the Federal Reserve Board now often makes decisions with an eye to how \nderivatives will affect the markets. That shows just how important derivatives have \nbecome. The purpose of this book is to provide the reader with that understanding \nof options. \nIwould like to express my appreciation to several people who helped make this \nbook possible: to Ron Dilks and Howard Whitman, who brought me into the bro-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:18", "doc_id": "7a69daa4149e2541ba5f57da09216c2f311e5321023940f67dcdf35feb4e9084", "chunk_index": 0}
{"text": "CHAPTER 1 \nDefinitions \nThe successful implementation of various investment strategies necessitates asound \nworking knowledge of the fundamentals of options and option trading. The option \nstrategist must be familiar with awide range of the basic aspects of stock options \nhow the price of an option behaves under certain conditions or how the markets \nfunction. Athorough understanding of the rudiments and of the strategies helps the \ninvestor who is not familiar with options to decide not only whether astrategy seems \ndesirable, but also - and more important - whether it is suitable. Determining suit\nability is nothing new to stock market investors, for stocks themselves are not suitable \nfor every investor. For example, if the investor'sprimary objectives are income and \nsafety of principal, then bonds, rather than stocks, would be more suitable. The need \nto assess the suitability of options is especially important: Option buyers can lose their \nentire investment in ashort time, and uncovered option writers may be subjected to \nlarge financial risks. Despite follow-up methods designed to limit risk, the individual \ninvestor must decide whether option trading is suitable for his or her financial situa\ntion and investment objective. \nELEMENTARY DEFINITIONS \nAstock option is the right to buy or sell aparticular stock at acertain price for alim\nited period of time. The stock in question is called the underlying security. Acall \noption gives the owner ( or holder) the right to buy the underlying security, while aput option gives the holder the right to sell the underlying security. The price at \nwhich the stock may be bought or sold is the exercise price, also called the striking \nprice. (In the listed options market, \"exercise price\" and \"striking price\" are synony\nmous.) Astock option affords this right to buy or sell for only alimited period of time; \n3", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:23", "doc_id": "d17839ed3e2f36a354f70464a975dc1265ff9ca56a1835c742c039bbf8b03e46", "chunk_index": 0}
{"text": "4 Part I: Basic Properties of Stodc Options \nthus, each option has an expiration date. Throughout the book, the term \"options\" is \nalways understood to mean listed options, that is, options traded on national option \nexchanges where asecondary market exists. Unless specifically mentioned, over-the\ncounter options are not included in any discussion. \nDESCRIBING OPTIONS \nFour specifications uniquely describe any option contract: \n1. the type (put or call), \n2. the underlying stock name, \n3. the expiration date, and \n4. the striking price. \nAs an example, an option referred to as an \"XYZ July 50 call\" is an option to buy (acall) 100 shares (normally) of the underlying XYZ stock for $50 per share. The option \nexpires in July. The price of alisted option is quo!_ed on aper-share basis, regardless \nof how many shares of stock can be bought with the option. Thus, if the price of the \nXYZ July 50 call is quoted at $5, buying the option would ordinarily cost $500 ($5 x \n100 shares), plus commissions. \nTHE VALUE OF OPTIONS \nAn option is a \"wasting\" asset; that is, it has only an initial value that declines (or \n\"wastes\" away) as time passes. It may even expire worthless, or the holder may have \nto exercise it in order to recover some value before expiration. Of course, the holder \nmay sell the option in the listed option market before expiration. \nAn option is also asecurity by itself, but it is aderivative security. The option is \nirrevocably linked to the underlying stock; its price fluctuates as the price of the \nunderlying stock rises or falls. Splits and stock dividends in the underlying stock \naffect the terms of listed options, although cash dividends do not. The holder of acall \ndoes not receive any cash dividends paid by the underlying stock. \nSTANDARDIZATION \nThe listed option exchanges have standardized the terms of option contracts. The \nterms of an option constitute the collective name that includes all of the four descrip\ntive specifications. While the type (put or call) and the underlying stock are self-evi\ndent and essentially standardized, the striking price and expiration date require more \nexplanation.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:24", "doc_id": "adbd4f0ab32dd04068b97cf53c97e700f5e1daf90411ea12b1125ab26af6a969", "chunk_index": 0}
{"text": "Chapter 1: Definitions s \nStriking Price. Striking prices are generally spaced 5 points apart for stocks, \nalthough for more expensive stocks, the striking prices may be 10 points apart. \nA $35 stock might, for example, have options with striking prices, or \"strikes,\" of \n30, 35, and 40, while a $255 stock might have one at 250 and one at 260. \nMoreover, some stocks have striking prices that are 2½ points apart - generally \nthose selling for less than $35 per share. That is, a $17 stock might have strikes \nat 15, 17½, and 20. \nThese striking price guidelines are not ironclad, however. Exchange officials \nmay alter the intervals to improve depth and liquidity, perhaps spacing the strikes 5 \npoints apart on anonvolatile stock even if it is selling for more than $100. For exam\nple, if a $155 stock were very active, and possibly not volatile, then there might well \nbe astrike at 155, in addition to those at 150 and 160. \nExpiration Dates. Options have expiration dates in one of three fixed cycles: \nLthe January/April/July/October cycle, \n2. the February/May/August/November cycle, or \n3. the March/June/September/December cycle. \nIn addition, the two nearest months have listed options as well. However, at any given \ntime, the longest-term expiration dates are normally no farther away than 9 months. \nLonger-term options, called LEAPS, are available on some stocks (see Chapter 25). \nHence, in any cycle, options may expire in 3 of the 4 major months (series) plus the \nnear-term months. For example, on February 1 of any year, XYZ options may expire \nin February, March, April, July, and October - not in January. The February option \n( the closest series) is the short- or near-term option; and the October, the far- or long\nterm option. If there were LEAPS options on this stock, they would expire in January \nof the following year and in January of the year after that. \nThe exact date of expiration is fixed within each month. The last trading day for \nan option is the third Friday in the expiration month. Although the option actually \ndoes not expire until the following day (the Saturday following), apublic customer \nmust invoke the right to buy or sell stock by notifying his broker by 5:30 P.M., New \nYork time, on the last day of trading. \nTHE OPTION ITSELF: OTHER DEFINITIONS \nClasses and Series. Aclass of options refers to all put and call contracts on the \nsame underlying security. For instance, all IBM options - all the puts and calls at \nvarious strikes and expiration months - form one class. Aseries, asubset of aclass,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:25", "doc_id": "2cdc647ba115cff4420e01c90498faeece058638ace2c23be6d378b06d5831df", "chunk_index": 0}
{"text": "6 Part I: Basic Properties of Stock Options \nconsists of all contracts of the same class (IBM, for example) having the same expi\nration date and striking price. \nOpening and Closing Transactions. An opening transaction is the ini\ntial transaction, either abuy or asell. For example, an opening buy transaction \ncreates or increases along position in the customer'saccount. Aclosing trans\naction reduces the customer'sposition. Opening buys are often followed by clos\ning sales; correspondingly, opening sells often precede closing buy trades. \nOpen Interest. The option exchanges keep track of the number of opening \nand closing transactions in each option series. This is called the open interest. \nEach opening transaction adds to the open interest and each closing transaction \ndecreases the open interest. The open interest is expressed in number of option \ncontracts, so that one order to buy 5 calls opening would increase the open \ninterest by 5. Note that the open interest does not differentiate between buyers \nand sellers - there is no way to tell if there is apreponderance of either one. \nWhile the magnitude of the open interest is not an extremely important piece of \ndata for the investor, it is useful in determining the liquidity of the option in \nquestion. If there is alarge open interest, then there should be little problem in \nmaking fairly large trades. However, if the open interest is small - only afew \nhundred contracts outstanding - then there might not be areasonable second\nary market in that option series. \nThe Holder and Writer. Anyone who buys an option as the initial transac\ntion - that is, buys opening - is called the holder. On the other hand, the \ninvestor who sells an option as the initial transaction - an opening sale - is called \nthe writer of the option. Commonly, the writer ( or seller) of an option is referred \nto as being short the option contract. The term \"writer\" dates back to the over\nthe-counter days, when adirect link existed between buyers and sellers of \noptions; at that time, the seller was the writer of anew contract to buy stock. In \nthe listed option market, however, the issuer of all options is the Options \nClearing Corporation, and contracts are standardized. This important difference \nmakes it possible to break the direct link between the buyer and seller, paving \nthe way for the formation of the secondary markets that now exist. \nExercise and Assignment. An option owner ( or holder) who invokes the \nright to buy or sell is said to exercise the option. Call option holders exercise to \nbuy stock; put holders exercise to sell. The holder of most stock options may \nexercise the option at any time after taking possession of it, up until 8:00 P.M. on", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:26", "doc_id": "fa128275dd5090c4198736d4f7b9aa4a213bebaf4adcac72627e5e0bcef74623", "chunk_index": 0}
{"text": "O,apter 1: Definitions 7 \nthe last trading day; the holder does not have to wait until the expiration date \nitself before exercising. (Note: Some options, called \"European\" exercise \noptions, can be exercised only on their expiration date and not before - but they \nare generally not stock options.) These exercise notices are irrevocable; once \ngenerated, they cannot be recalled. In practical terms, they are processed only \nonce aday, after the market closes. Whenever aholder exercises an option, \nsomewhere awriter is assigned the obligation to fulfill the terms of the option \ncontract: Thus, if acall holder exercises the right to buy, acall writer is assigned \nthe obligation to sell; conversely, if aput holder exercises the right to sell, aput \nwriter is assigned the obligation to buy. Amore detailed description of the exer\ncise and assignment of call options follows later in this chapter; put option exer\ncise and assignment are discussed later in the book. \nRELATIONSHIP OF THE OPTION PRICE AND STOCK PRICE \nIn- and Out-of-the-Money. Certain terms describe the relationship between \nthe stock price and the option'sstriking price. Acall option is said to be out-of-the\nmoney if the stock is selling below the striking price of the option. Acall option is in\nthe-money if the stock price is above the striking price of the option. (Put options \nwork in aconverse manner, which is described later.) \nExample: XYZ stock is trading at $47 per share. The XYZ July 50 call option is out\nof-the-money, just like the XYZ October 50 call and the XYZ July 60 call. However, \nthe XYZ July 45 call, XYZ October 40, and XYZ January 35 are in-the-money. \nThe intrinsic value of an in-the-money call is the amount by which the stock \nprice exceeds the striking price. If the call is out-of-the-money, its intrinsic value is \nzero. The price that an option sells for is commonly referred to as the premium. The \npremium is distinctly different from the time value premium ( called time premium, \nfor short), which is the amount by which the option premium itself exceeds its intrin\nsic value. The time value premium is quickly computed by the following formula for \nan in-the-money call option: \nCall time value premium = Call option price + Striking price - Stock price \nExample: XYZ is trading at 48, and XYZ July 45 call is at 4. The premium - the total \nprice - of the option is 4. With XYZ at 48 and the striking price of the option at 45, \nthe in-the-money amount (or intrinsic value) is 3 points (48-45), and the time value \nisl(4-3).", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:27", "doc_id": "abc18ae847e40d8e92a748db5c08df3d108923075ce585a55df2db10eab4026a", "chunk_index": 0}
{"text": "8 Part I: Basic Properties ol Stoclc Options \nIf the call is out-of-the-money, then the premium and the time value premium \nare the same. \nExample: With XYZ at 48 and an XYZ July 50 call selling at 2, both the premium and \nthe time value premium of the call are 2 points. The call has no intrinsic value by \nitself with the stock price below the striking price. \nAn option normally has the largest amount of time value premium when the \nstock price is equal to the striking price. As an option becomes deeply in- or out-of\nthe-money, the time value premium shrinks substantially. Table 1-1 illustrates this \neffect. Note that the time value premium increases as the stock nears the striking \nprice (50) and then decreases as it draws away from 50. \nParity. An option is said to be trading at parity with the underlying security if \nit is trading for its intrinsic value. Thus, if XYZ is 48 and the xyz July 45 call is \nselling for 3, the call is at parity. Acommon practice of particular interest to \noption writers ( as shall be seen later) is to refer to the price of an option by relat\ning how close it is to parity with the common stock. Thus, the XY2 July 45 call \nis said to be ahalf-point over parity in any of the cases shown in Table 1-2. \nTABLE 1-1. \nChanges in time value premium. \nXYZ Stock XYZ Jul 50 Intrinsic Time Value \nPrice Call Price Value Premium \n40 1/2 0 ¼ \n43 1 0 1 \n35 2 0 2 \n47 4 0 3 \n➔50 5 0 5 \n53 7 3 4 \n55 8 5 3 \n57 9 7 2 \n60 101/2 10 ¼ \n70 191/2 20 -1/20 \nasimplistically, adeeply in-the-money call may actually trade at adiscount from intrinsic value, \nbecause call buyers are more interested in less expensive calls that might return better percentage \nprofits on an upward move in the stock. This phenomenon is discussed in more detail when arbitrage \ntechniques are examined.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:28", "doc_id": "4a4ef3ffed4813ea2a172a983d34192fe6ea600b1d4d29379f91dc80b570846a", "chunk_index": 0}
{"text": "Cl,apter 1: Definitions 9 \nTABLE 1-2. \nComparison of XYZ stock and call prices. \nXYZ July 45 XYZ Stock Over \nStriking Price + Coll Price Price Parity \n(45 + 45 1/2) 1/2 \n(45 + 21/2 47 ) 1/2 \n(45 + 51/2 50 ) ½ \n(45 + 151/2 60 ) 1/2 \nFACTORS INFLUENCING THE PRICE OF AN OPTION \nAn option'sprice is the result of properties of both the underlying stock and the terms \nof the option. The major quantifiable factors influencing the price of an option are \nthe: \n1.. price of the underlying stock, \n2. striking price of the option itself, \n3. time remaining until expiration of the option, \n4. volatility of the underlying stock, \n5. current risk-free interest rate (such as for 90-day Treasury bills), and \n6. dividend rate of the underlying stock. \nThe first four items are the major determinants of an option'sprice, while the latter \ntwo are generally less important, although the dividend rate can be influential in the \ncase of high-yield stock. \nTHE FOUR MAJOR DETERMINANTS \nProbably the most important influence on the option'sprice is the stock price, \nbecause if the stock price is far above or far below the striking price, the other fac\ntors have little influence. Its dominance is obvious on the day that an option expires. \nOn that day, only the stock price and the striking price of the option determine the \noption'svalue; the other four factors have no bearing at all. At this time, an option is \nworth only its intrinsic value. \nExample: On the expiration day in July, with no time remaining, an XYZ July 50 call \nhas the value shown in Table 1-3; each value depends on the stock price at the time.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:29", "doc_id": "0e40b9109b35072611a6825dce76edd23f9d9c7ae1c58708883e5475e4dec588", "chunk_index": 0}
{"text": "10 Part I: Basic Properties of Stock Options \nTABLE 1-3. \nXYZ option'svalues on the expiration day. \nXYZ July 50 Coll \n(Intrinsic) Value \nXYZ Stock Price ot Expiration \n40 \n45 \n48 \n50 \n52 \n55 \n60 \n0 \n0 \n0 \n0 \n2 \n5 \n10 \nThe Call Option Price Curve. The call option price curve is acurve that \nplots the prices of an option against various stock prices. Figure 1-1 shows the \naxes needed to graph such acurve. The vertical axis is called Option Price. The \nhorizontal axis is for Stock Price. This figure is agraph of the intrinsic value. \nWhen the option is either out-of-the-money or equal to the stock price, the \nintrinsic value is zero. Once the stock price passes the striking price, it reflects \nthe increase of intrinsic value as the stock price goes up. Since acall is usually \nworth at least its intrinsic value at any time, the graph thus represents the min\nimum price that acall may be worth. \nFIGURE 1-1. \nThe value of an option at expiration, its intrinsic value. \n~ \nit \nC: \n.Q \n15.. \n0 The intrinsic value line \nbends at the \nst~iking ~ \npnce. ~ \nStock Price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:30", "doc_id": "59e872e6164c3376ec575a09c814f235f36d76b1ff1af2a3a67e6836847c7e9c", "chunk_index": 0}
{"text": "Chapter 1: Definitions 11 \nWhen acall has time remaining to its expiration date, its total price consists of \nits intrinsic value plus its time value premium. The resultant call option price curve \ntakes the form of an inverted arch that stretches along the stock price axis. If one \nplots the data from Table 1-4 on the grid supplied in Figure 1-2, the curve assumes \ntwo characteristics: \n1. The time value premium ( the shaded area) is greatest when the stock price and \nthe striking price are the same. \n2. When the stock price is far above or far below the striking price (near the ends \nof the curve), the option sells for nearly its intrinsic value. As aresult, the curve \nnearly touches the intrinsic value line at either end. [Figure 1-2 thus shows both \nthe intrinsic value and the option price curve.] \nThis curve, however, shows only how one might expect the XYZ July 50 call \nprices to behave with 6 months remaining until expiration. As the time to expiration \ngrows shorter, the arched line drops lower and lower, until, on the final day in the life \nof the option, it merges completely with the intrinsic value line. In other words, the \ncall is worth only its intrinsic value at expiration. Examine Figure 1-3, which depicts \nthree separate XYZ calls. At any given stock price (afixed point on the stock price \nscale), the longest-term call sells for the highest price and the nearest-term call sells \nfor the lowest price. At the striking price, the actual differences in the three option \nprices are the greatest. Near either end of the scale, the three curves are much clos\ner together, indicating that the actual price differences from one option to another \nare small. For agiven stock price, therefore, option prices decrease as the expiration \ndate approaches. \nTABLE 1-4. \nThe prices of ahypothetical July 50 call with 6 months of time \nremaining, plotted in Figure 1-2. \nXYZ Stock Price \n(Horizontal Axis) \n40 \n45 \n48 \n➔SO \n52 \n55 \n60 \nXYZ July 50 \nCall Price \n(Vertical Axis) \n2 \n3 \n4 \n5 \n61/2 \n11 \nIntrinsic \nValue \n0 \n0 \n0 \n0 \n2 \n5 \n10 \nTime Value \nPremium \n(Shading) \n2 \n3 \n4 \n3 \n11/2 \n1", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:31", "doc_id": "c71ad24b4ff3fa4195fb9e3c42e1806515b9889cab2be03e5da1e6f514599c59", "chunk_index": 0}
{"text": "Chapter 1: Definitions 13 \nThis statement is true no matter what the stock price is. The only reservation is \nthat with the stock deeply in- or out-of-the-money, the actual difference between the \nJanuary, April, and July calls will be smaller than with XYZ stock selling at the strik\ning price of 50. \nTime Value Premium Decay. In Figure 1-3, notice that the price of the 9-\nmonth call is not three times that of the 3-month call. Note next that the curve \nin Figure 1-4 for the decay of time value premium is not straight; that is, the rate \nof decay of an option is not linear. An option'stime value premium decays much \nmore rapidly in the last few weeks of its life ( that is, in the weeks immediately \npreceding expiration) than it does in the first few weeks of its existence. The rate \nof decay is actually related to the square root of the time remaining. Thus, a 3-\nmonth option decays (loses time value premium) at twice the rate of a 9-month \noption, since the square root of 9 is 3. Similarly, a 2-month option decays at \ntwice the rate of a 4-month option (-..f4 = 2). \nThis graphic simplification should not lead one to believe that a 9-month option \nnecessarily sells for twice the price of a 3-month option, because the other factors \nalso influence the actual price relationship between the two calls. Of those other fac\ntors, the volatility of the underlying stock is particularly influential. More volatile \nunderlying stocks have higher option prices. This relationship is logical, because if a \nFIGURE 1-4. \nTime value premium decay, assuming the stock price remains con\nstant. \n9 4 \nTime Remaining Until Expiration \n(Months) \n0", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:33", "doc_id": "15a671fb7789649a4477656c1dbac1fd075515a3c48509f8f25e15898cc7d3e5", "chunk_index": 0}
{"text": "14 Part I: Basic Properties ol Stodc Options \nstock has the ability to move arelatively large distance upward, buyers of the calls are \nwilling to pay higher prices for the calls - and sellers demand them as well. For exam\nple, if AT&Tand Xerox sell for the same price (as they have been known to do), the \nXerox calls would be more highly priced than the AT&Tcalls because Xerox is amore \nvolatile stock than AT&T. \nThe interplay of the four major variables - stock price, striking price, time, and \nvolatility can be quite complex. While arising stock price (for example) is directing \nthe price of acall upward, decreasing time may be simultaneously driving the price \nin the opposite direction. Thus, the purchaser of an out-of-the-money call may wind \nup with aloss even after arise in price by the underlying stock, because time has \neroded the call value. \nTHE TWO MINOR DETERMINANTS \nThe Risk-Free Interest Rate. This rate is generally construed as the current \nrate of 90-day Treasury bills. Higher interest rates imply slightly higher option pre\nmiums, while lower rates imply lower premiums. Although members of the financial \ncommunity disagree as to the extent that interest rates actually affect option price, \nthey remain afactor in most mathematical models used for pricing options. (These \nmodels are covered much later in this book.) \nThe Cash Dividend Rate of the Underlying Stock. Though not clas\nsified as amajor determinant in option prices, this rate can be especially impor\ntant to the writer (seller) of an option. If the underlying stock pays no dividends \nat all, then acall option'sworth is strictly afunction of the other five items. \nDividends, however, tend to lower call option premiums: The larger the dividend \nof the underlying common stock, the lower the price of its call options. One of \nthe most influential factors in keeping option premiums low on high-yielding \nstock is the yield itself. \nExample: XYZ is arelatively low-priced stock with low volatility selling for $25 per \nshare. It pays alarge annual dividend of $2 per share in four quarterly payments of \n$.50 each. What is afair price of an XYZ call with striking price 25? \nAprospective buyer of XYZ options is determined to figure out afair price. In \nsix months XYZ will pay $1 per share in dividends, and the stock price will thus be \nreduced by $1 per share when it goes ex-dividend over that time period. In that case, \nif XYZ'sprice remains unchanged except for the ex-dividend reductions, it will then \nbe $24. Moreover, since XYZ is anonvolatile stock, it may not readily climb back to \n25 after the ex-dividend reductions. Therefore, the call buyer makes alow bid - even", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:34", "doc_id": "fd945289d88b86014c6e0854d9e86639f946de107dcc57983db7f7a180b3fdfe", "chunk_index": 0}
{"text": "Chapter I: Definitions 15 \nfor a 6-month call - because the underlying stock'sprice will be reduced by the ex\ndividend reduction, and the call holder does not receive the cash dividends. \nThis particular call buyer calculated the value of the XYZ July 25 call in terms \nof what it was worth with the stock discounted to 24 - not at 25. He knew for certain \nthat the stock was going to lose 1 point of value over the next 6 months, provided the \ndividend rate of XYZ stock did not change. In actual practice, option buyers tend to \ndiscount the upcoming dividends of the stock when they bid for the calls. However, \nnot all dividends are discounted fully; usually the nearest dividend is discounted \nmore heavily than are dividends to be paid at alater date. The less-volatile stocks with \nthe higher dividend payout rates have lower call prices than volatile stocks with low \npayouts. In fact, in certain cases, an impending large dividend payment can substan\ntially increase the probability of an exercise of the call in advance of expiration. (This \nphenomenon is discussed more fully in the following section.) In any case, to one \ndegree or another, dividends exert an important influence on the price of some calls. \nOTHER INFLUENCES \nThese six factors, major and minor, are only the quantifiable influences on the price \nof an option. In practice, nonquantitative market dynamics - investor sentiment -\ncan play various roles as well. In abullish market, call premiums often expand \nbecause of increased demand. In bearish markets, call premiums may shrink due to \nincreased supply or diminished demand. These influences, however, are normally \nshort-lived and generally come into play only in dynamic market periods when emo\ntions are running high. \nEXERCISE AND ASSIGNMENT: THE MECHANICS \nThe holder of an option can exercise his right at any time during the life of an option: \nCall option holders exercise to buy stock, while put option holders exercise to sell \nstock. In the event that an option is exercised, the writer of an option with the same \nterms is assigned an obligation to fulfill the terms of the option contract. \nEXERCISING THE OPTION \nThe actual mechanics of exercise and assignment are fairly simple, due to the role of \nthe Options Clearing Corporation (OCC). As the issuer of all listed option contracts, \nit controls all listed option exercises and assignments. Its activities are best explained \nby an example.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:35", "doc_id": "6301787730b3f51835eec93b1a2c3cc5f118f3261648edc9ec9ec6cc94c8b398", "chunk_index": 0}
{"text": "16 Part I: Bask Properties ol Stock Options \nExample: The holder of an XYZ January 45 call option wishes to exercise his right to \nbuy XYZ stock at $45 per share. He instructs his broker to do so. The broker then \nnotifies the administrative section of the brokerage firm that handles such matters. \nThe firm then notifies the OCC that they wish to exercise one contract of the XYZ \nJanuary 45 call series. \nNow the OCC takes over the handling. OCC records indicate which member \n(brokerage) firms are short or which have written and not yet covered XYZ Jan 45 \ncalls. The OCC selects, at random, amember firm that is short at least one XYZ Jan \n45 call, and it notifies the short firm that it has been assigned. That firm must then \ndeliver 100 shares of XYZ at $45 per share to the firm that exercised the option. The \nassigned firm, in tum, selects one of its customers who is short the XYZ January 45 \ncall. This selection for the assignment may be either: \n1. at random, \n2. on afirst-in/first-out basis, or \n3. on any other basis that is fair, equitable, and approved by the appropriate \nexchange. \nThe selection of the customer who is short the XYZ January 45 completes the \nexercise/assignment process. (If one is an option writer, he should obviously deter\nmine exactly how his brokerage firm assigns its option contracts.) \nHONORING THE ASSIGNMENT \nThe assigned customer must deliver the stock - he has no other choice. It is too late \nto try buying the option back in the option market. He must, without fail, deliver 100 \nshares of XYZ stock at $45 per share. The assigned writer does, however, have achoice as to how to fulfill the assignment. If he happens to be already long 100 shares \nof XYZ in his account, he merely delivers that 100 shares as fulfillment of the assign\nment notice. Alternatively, he can go into the stock market and buy XYZ at the cur\nrent market price - presumably something higher than $45 - and then deliver the \nnewly purchased stock as fulfillment. Athird alternative is merely to notify his bro\nkerage firm that he wishes to go short XYZ stock and to ask them to deliver the 100 \nshares of XYZ at 45 out of his short account. At times, borrowing stock to go short \nmay not be possible, so this third alternative is not always available on every stock. \nMargin Requirements. If the assigned writer purchases stock to fulfill acontract, reduced margin requirements generally apply to the transaction, so \nthat he would not have to fully margin the purchased stock merely for the pur\npose of delivery. Generally, the customer only has to pay aday-trade margin of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:36", "doc_id": "a5a3c2d81b07d26d40ee445b03202c958916e4b416a56ca51205d75e4cb9dd39", "chunk_index": 0}
{"text": "Oapter 1: Definitions 17 \nthe difference between the current price of XYZ and the delivery price of $45 \nper share. If he goes short to honor the assignment, then he has to fully margin \nthe short sale at the current rate for stock sold short on amargin basis. \nAFTER EXERCISING THE OPTION \nThe OCC and the customer exercising the option are not concerned with the actual \nmethod in which the delivery is handled by the assigned customer. They want only to \nensure that the 100 shares of XYZ at 45 are, in fact, delivered. The holder who exer\ncised the call can keep the stock in his account if he wants to, but he has to margin it \nfully or pay cash in acash account. On the other hand, he may want to sell the stock \nimmediately in the open market, presumably at ahigher price than 45. If he has an \nestablished margin account, he may sell right away without putting out any money. If \nhe exercises in acash account, however, the stock must be paid for in full - even if it \nis subsequently sold on the same day. Alternatively, he may use the delivered stock to \ncover ashort sale in his own account if he happens to be short XYZ stock. \nCOMMISSIONS \nBoth the buyer of the stock via the exercise and the seller of the stock via the assign\nment are charged afull stock commission on 100 shares, unless aspecial agreement \nexists between the customer and the brokerage firm. Generally, option holders incur \nhigher commission costs through assignment than they do selling the option in the \nsecondary market. So the public customer who holds an option is better off selling the \noption in the secondary market than exercising the call. \nExample: XYZ is $55 per share. Apublic customer owns the XYZ January 45 call \noption. He realizes that exercising the call, buying XYZ at 45, and then immediately \nselling it at 55 in the stock market would net aprofit of 10 points - or $1,000. \nHowever, the combined stock commissions on both the purchase at 45 and the sale \nat 55 might easily exceed $100. The net gain would actually be only $900. \nOn the other hand, the XYZ January 45 call is worth (and it would normally sell \nfor) at least 10 points in the listed options market. The commission for selling one call \nat aprice of 10 is roughly $30. The customer therefore decides to sell his XYZ \nJanuary 45 call in the option market. He receives $1,000 (10 points) for the call and \npays only $30 in commissions - for anet of $970. The benefit of his decision is obvi\nous. \nOf course, sometimes acustomer wants to own XYZ stock at $45 per share, \ndespite the stock commissions. Perhaps the stock is an attractive addition that will", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:37", "doc_id": "84a7b6e548566e56f7c9133a4f0af9ac361d991170f3933bd9b0b7caeaf7e218", "chunk_index": 0}
{"text": "18 Part I: Basic Properties of Stock Options \nbring greater potential to aportfolio. Or if the customer is already short the XYZ \nstock, he is going to have to buy 100 shares and pay the commissions sooner or later \nin any case; so exercising the call at the lower stock price of 45 may be more desir\nable than buying at the current price of 55. \nANTICIPATING ASSIGNMENT \nThe writer of acall often prefers to buy the option back in the secondary market, \nrather than fulfill the obligation via astock transaction. It should be strJssed again that \nonce the writer receives an assignment notice, it is too late to attempt to buy back \n(cover) the call. The writer must buy before assignment, or live up to the terms upon \nassignment. The writer who is aware of the circumstances that generally cause the \nholders to exercise can anticipate assignment with afair amount of certainty. In antic\nipation of the assignment, the writer can then close the contract in the secondary mar\nket. As long as the writer covers the position at any time during atrading day, he can\nnot be assigned on that option. Assignment notices are determined on open positions \nas of the close of trading each day. The crucial question then becomes, \"How can the \nwriter anticipate assignment?\" Several circumstances signal assignments: \n1. acall that is in-the-money at expiration, \n2. an option trading at adiscount prior to expiration, or \n3. the underlying stock paying alarge dividend and about to go ex-dividend. \nAutomatic Exercise. Assignment is all but certain if the option is in-the\nmoney at expiration. Should the stock close even ahalf-point above the striking \nprice on the last day of trading, the holder will exercise to take advantage of the \nhalf-point rather than let the option expire. Assignment is nearly inevitable even \nif acall is only afew cents in-the-money at expiration. In fact, even if the call \ntrades in-the-money at any time during the last trading day, assignment may be \nforthcoming. Even if aholder forgets that he owns an option and fails to exer\ncise, the OCC automatically exercises any call that is ¾-point in-the-money at \nexpiration, unless the individual brokerage firm whose customer is long the call \ngives specific instructions not to exercise. This automatic exercise mechanism \nensures that no investor throws away money through carelessness. \nExample: XYZ closes at 51 on the third Friday of January (the last day of trading for \nthe January option series). Since options don'texpire until Saturday, the next day, the \nOCC and all brokerage firms have the opportunity to review their records to issue \nassignments and exercises and to see if any options could have been profitably exer-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:38", "doc_id": "5416f89f8083e83255164ab1710df771f80dba8e7d4c49e017b9afd3b7de7041", "chunk_index": 0}
{"text": "Gapter 1: Definitions 19 \ncised but were not. If XYZ closed at 51 and acustomer who owned a January 45 call \noption failed to either sell or exercise it, it is automatically exercised. Since it is worth \n$600, this customer stands to receive asubstantial amount of money back, even after \nstock commissions. \nIn the case of an XYZ January 50 call option, the automatic exercise procedure \nis not as clear-cut with the stock at 51. Though the OCC wants to exercise the call \nautomatically, it cannot identify aspecific owner. It knows only that one or more XYZ \nJanuary calls are still open on the long side. When the OCC checks with the broker\nage firm, it may find that the firm does not wish to have the XYZ January 50 call exer\ncised automatically, because the customer would lose money on the exercise after \nincurring stock commissions. Yet the OCC must attempt to automatically exercise \nany in-the-money calls, because the holder may have overlooked along position. \nWhen the public customer sells acall in the secondary market on the last day of \ntrading, the buyer on the other side of the trade is very likely amarket-maker. Thus, \nwhen trading stops, much of the open interest in in-the-money calls held long \nbelongs to market-makers. Since they can profitably exercise even for an eighth of apoint, they do so. Hence, the writer may receive an assignment notice even if the \nstock has been only slightly above the strike price on the last trading day before expi\nration. \nAny writer who wishes to avoid an assignment notice should always buy back ( or \ncover) the option if it appears the stock will be above the strike at expiration. The \nprobabilities of assignment are extremely high if the option expires in-the-money. \nEarly Exercise Due to Discount. When options are exercised prior to \nexpiration, this is called early, or premature, exercise. The writer can usually \nexpect an early exercise when the call is trading at or below parity. Aparity or \ndiscount situation in advance of expiration may mean that an early exercise is \nforthcoming, even if the discount is slight. Awriter who does not want to deliv\ner stock should buy back the option prior to expiration if the option is apparently \ngoing to trade at adiscount to parity. The reason is that arbitrageurs (floor \ntraders or member firm traders who pay only minimal commissions) can take \nadvantage of discount situations. (Arbitrage is discussed in more detail later in \nthe text; it is mentioned here to show why early exercise often occurs in adis\ncount situation.) \nExample: XYZ is bid at $50 per share, and an XYZ January 40 call option is offered \nat adiscount price of 9.80. The call is actually \"worth\" 10 points. The arbitrageur can \ntake advantage of this situation through the following actions, all on the same day:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:39", "doc_id": "375dd30e579655a0dc4124e00c6c4e6cf4b5150e7f7b549a7f613e4c946eb32b", "chunk_index": 0}
{"text": "20 Part I: Basic Properties ol Stoclc Options \n1. Buy the January 40 call at 9.80. \n2. Sell short XYZ common stock at 50. \n3. Exercise the call to buy XYZ at 40. \nThe arbitrageur makes 10 points from the short sale of XYZ (steps 2 and 3), from \nwhich he deducts the 9.80 points he paid for the call. Thus, his total gain is 20 cents \n- the amount of the discount. Since he pays only aminimal commission, this trans-\naction results in anet profit. ' \nAlso, if the writer can expect assignment when the option has no time value pre\nmium left in it, then conversely the option will usually not be called if time premium \nis left in it. \nExample: Prior to the expiration date, XYZ is trading at 50½, and the January 50 call \nis trading at 1. The call is not necessarily in imminent danger of being called, since it \nstill has half apoint of time premium left. \nTime value Call Striking Stock \n= + premium price price price \n= 1 + 50 50½ \n= ½ \nEarly Exercise Due to Dividends on the Underlying Stock. Some\ntimes the market conditions create adiscount situation, and sometimes alarge \ndividend gives rise to adiscount. Since the stock price is almost invariably \nreduced by the amount of the dividend, the option price is also most likely \nreduced after the ex-dividend. Since the holder of alisted option does not receive \nthe dividend, he may decide to sell the option in the secondary market before the \nex-date in anticipation of the drop in price. If enough calls are sold because of \nthe impending ex-dividend reduction, the option may come to parity or even to adiscount. Once again, the arbitrageurs may move in to take advantage of the sit\nuation by buying these calls and exercising them. \nIf assigned prior to the ex-date, the writer does not receive the dividend for he \nno longer owns the stock on the ex-date. Furthermore, if he receives an assignment \nnotice on the ex-date, he must deliver the stock with the dividend. It is therefore very \nimportant for the writer to watch for discount situations on the day prior to the ex\ndate.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:40", "doc_id": "f6fa849390a1870019dfdba61089913976e7f948f1332a076076f4d8a5e67f50", "chunk_index": 0}
{"text": "0.,,,,, I: Definitions 21 \nAword of caution: Do not conclude from this discussion that acall will be exer\ncised for the dividend if the dividend is larger than the remaining time premium. It \nwon't. An example will show why. \nEmmple: XYZ stock, at 50, is going to pay a $1 dividend with the ex-date set for the \nnext day. An XYZ January 40 call is selling at 10¼; it has aquarter-point of time pre\nmium. (TVP = 10¼ + 40 - 50 = ¼). The same type of arbitrage will not work \nSuppose that the arbitrageur buys the call at 10¼ and exercises it: He now owns the \nstock for the ex-date, and he plans to sell the stock immediately at the opening on the \nex-date, the next day. On the ex-date, XYZ opens at 49, because it goes ex-dividend \nby $1. The arbitrageur'stransactions thus consist of: \n1. Buy the XYZ January 40 call at 10¼. \n2. Exercise the call the same day to buy XYZ at 40. \n3. On the ex-date, sell XYZ at 49 and collect the $1 dividend. \nHe makes 9 points on the stock (steps 2 and 3), and he receives a 1-point dividend, \nfor atotal cash inflow of 10 points. However, he loses 10¼ points paying for the call. \nThe overall transaction is aloser and the arbitrageur would thus not attempt it. \nAdividend payment that exceeds the time premium in the call, therefore, does \nnot imply that the writer will be assigned. \nMore of apossibility, but amuch less certain one, is that the arbitrageur may \nattempt a \"risk arbitrage\" in such asituation. Risk arbitrage is arbitrage in which the \narbitrageur runs the risk of aloss in order to try for aprofit. The arbitrageur may sus\npect that the stock will not be discounted the full ex-dividend amount or that the \ncall'stime premium will increase after the ex-date. In either case (or both), he might \nmake aprofit: If the stock opens down only 60 cents or if the option premium \nexpands by 40 cents, the arbitrageur could profit on the opening. In general, howev\ner, arbitrageurs do not like to take risks and therefore avoid this type of situation. So \nthe probability of assignment as the result of adividend payment on the underlying \nstock is small, unless the call trades at parity or at adiscount. \nOf course, the anticipation of an early exercise assumes rational behavior on the \npart of the call holder. If time premium is left in the call, the holder is always better \noff financially to sell that call in the secondary market rather than to exercise it. \nHowever, the terms of the call contract give acall holder the right to go ahead and \nexercise it anyway - even if exercise is not the profitable thing to do. In such acase, \nawriter would receive an assignment notice quite unexpectedly. Financially unsound \nearly exercises do happen, though not often, and an option writer must realize that,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:41", "doc_id": "c43cbf5c64c1c5ff0456ca77841816f7432332510e57ca15e5f5141df50aeefc", "chunk_index": 0}
{"text": "22 Part I: Basic Properties of Stock Options \nin avery small percentage of cases, he could be assigned under very illogical cir\ncumstances. \nTHE OPTION MARKETS \nThe trader of stocks does not have to become very familiar with the details of the way \nthe stock market works in order to make money. Stocks don'texpire, nor Cal} an \ninvestor be pulled out of his investment unexpectedly. However, the option trader is \nrequired to do more homework regarding the operation of the option markets. In \nfact, the option strategist who does not know the details of the working of the option \nmarkets will likely find that he or she eventually loses some money due to ignorance. \nMARKET-MAKERS \nIn at least one respect, stock and listed option markets are similar. Stock markets use \nspecialists to do two things: First, they are required to make amarket in astock by \nbuying and selling from their own inventory, when public orders to buy or sell the \nstock are absent. Second, they keep the public book of orders, consisting of limit \norders to buy and sell, as well as stop orders placed by the public. When listed option \ntrading began, the Chicago Board Options Exchange (CBOE) introduced asimilar \nmethod of trading, the market-maker and the board broker system. The CBOE \nassigns several market-makers to each optionable stock to provide bids and offers to \nbuy and sell options in the absence of public orders. Market-makers cannot handle \npublic orders; they buy and sell for their own accounts only. Aseparate person, the \nboard broker, keeps the book of limit orders. The board broker, who cannot do any \ntrading, opens the book for traders to see how many orders to buy and sell are placed \nnearest to the current market (consisting of the highest bid and lowest offer). (The \nspecialist on the stock exchange keeps amore closed book; he is not required to for\nmally disclose the sizes and prices of the public orders.) \nIn theory, the CBOE system is more efficient than the stock exchange system. \nWith several market-makers competing to create the market in aparticular security, \nthe market should be amore efficient one than asingle specialist can provide. Also, \nthe somewhat open book of public orders should provide amore orderly market. In \npractice, whether the CBOE has amore efficient market is usually asubject for heat\ned discussion. The strategist need not be concerned with the question. \nThe American Stock Exchange uses specialists for its option trading, but it also \nhas floor traders who function similarly to market-makers. The regional option \nexchanges use combinations of the two systems; some use market-makers, while oth\ners use specialists.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:42", "doc_id": "b2bc8f81d1731eb838ec6b1a126b942ea62399548b065a4459cc23d7defa98a2", "chunk_index": 0}
{"text": "Cl,apter 1: Definitions 23 \nOPTION SYMBOLOGY \nIt is probably agood idea for an option trader to understand how option symbols are \ncreated and used, for it may prove to be useful information. If one has asophisticat\ned option quoting and pricing system, the quote vendor will usually provide the \ntranslation between option symbols and their meanings. The free option quote sec\ntion on the CBOE's Web site, www.cboe.com, can be useful for that purpose as well. \nEven with those aids, it is important that an option trader understand the concepts \nsurrounding option symbology. \nTHE OPTION BASE SYMBOL \nThe basic option symbol consists of three parts: \nOption symbol = Base symbol + Expiration month code + Striking price code \nThe base symbol is never more than three characters in length. In its simplest form, \nthe base symbol is the same as the stock symbol. That works well for stocks with three \nor fewer letters in their symbol, such as General Electric (GE) or IBM (IBM), but \nwhat about NASDAQ stocks? For NASDAQ stocks, the OCC makes up athree-let\nter symbol that is used to denote options on the stock. Afew examples are: \nStock \nCisco \nMicrosoft \nQualcomm \nStock Symbol \ncsco \nMSFT \nQCOM \nOption Base Symbol \nCYQ \nMSQ \nQAQ \nIn the three examples, there is aletter \"Q\" in each of the option base symbols. \nHowever, that is not always the case. The option base symbol assigned by the OCC \nfor a NASDAQ stock may contain any three letters (or, rarely, only two letters). \nTHE EXPIRATION MONTH CODE \nThe next part of an option symbol is the expiration month code, which is aone-char\nacter symbol. The symbology that has been created actually uses the expiration \nmonth code for two purposes: (1) to identify the expiration month of the option, and \n(2) to designate whether the option is acall or aput. \nThe concept is generally rather simple. For call options, the letter Astands for \nJanuary, Bfor February, and so forth, up through Lfor December. For put options, \nthe letter Mstands for January, Nfor February, and so forth, up through Xfor \nDecember. The letters Yand Zare not used for expiration month codes.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:43", "doc_id": "e4a0cfa04dbb0765fb3000922e83ee6598294c5906ab6989750e583450e41ac5", "chunk_index": 0}
{"text": "24 Part I: Basic Properties ol Stock Options \nTHE STRIKING PRICE CODE \nThis is also aone-character symbol, designed to identify the striking price of the \noption. Things can get ve:iy complicated where striking price codes are concerned, \nbut simplistically the designations are that the letter Astands for 5, Bstands for 10, \non up to Sfor 95 and Tfor 100. If the stock being quoted is more expensive - say, \ntrading at $150 per share - then it is possible that Awill stand for 105, Bfor 110, Sfor 195 and Tfor 200 (although, as will be shown later, amore complicated approach \nmight have to be used in cases such as these). It should be noted that the exchanges \n- who designate the striking price codes and their numerical meaning - do not have • \nto adhere to any of the generalized conventions described here. They usually adhere \nto as many of them as they can, in order to keep things somewhat standardized, but \nthey can use the letters in any way they want. Typically, they would only use any strik\ning price code letter outside of its conventional designation after astock has split or \nperhaps paid aspecial dividend of some sort. \nBefore getting into the more complicated option symbol constructions, let'slook at afew simple, straightforward examples: \nStock Stock Symbol Description Option Symbol \nIBM IBM IBM July 125 call IBMGE \nCisco csco Cisco April 75 put CYQPO \nFord Motor F Ford March 40 call FCH \nGeneral Motors GM GM December 65 put GMXM \nIn each option symbol, the last two characters are the expiration month code and the \nstriking price code. Preceding them is the option base symbol. For the IBM July 125, \nthe option symbol is quite straightforward. IBM is the option base symbol (as well as \nthe stock symbol), Gstands for July, and Efor 125, in this case. \nFor the Cisco April 75 put, the option base symbol is CYQ (this was given in the \nprevious table, but if one didn'tknow what the base symbol was, you would have to \nlook it up on the Internet or call abroker). The expiration month code in this case is \nP, because Pstands for an April put option. Finally, the striking price code is 0, which \nstands for 75. \nThe Ford March 40 call and the GM December 65 put are similar to the oth\ners, except that the stock symbols only require one and two characters, respectively, \nso the option symbol is thus ashorter symbol as well - first using the stock symbol, \nthen the standard character for the expiration month, followed by the standard char\nacter for the striking price.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:44", "doc_id": "8ad38a66d384b8f86730a9cdaf0ea5e9fd1deeff4784b2f744be641a490217ac", "chunk_index": 0}
{"text": "Chapter 1: Definitions 25 \nMORE STRIKING PRICE CODES \nThe letters Athrough Tcannot handle all of the possible striking price codes. Recall \nthat many stocks, especially lower-priced ones, have striking prices that are spaced \n2½ points apart. In those cases, aspecial letter designation is usually used for the \nstriking price codes: \nStriking Price Code \nu \nVw \nXyz \nPossible Meanings \n7.5 or 37.5 or 67.5 or 97.5 or even 127.5! \n12.5 or 42.5 or 72.5 or 102.5 or 132.5 \n17.5 or 47.5 or 77.5 or 107.5 or 137.5 \n22.5 or 52.5 or 82.5 or 112.5 or 142.5 \n27.5 or 57.5 or 87.5 or 117.5 or 147.5 \n32.5 or 62.5 or 92.5 or 122.5 or 152.5 \nTypically, only the first or second meaning is used for these letters. The higher-priced \nones only occur after avery expensive stock splits 2-for-l (say, astock that had astrike \nprice of 155 and split 2-for-l, creating astrike. price of 155 divided by 2, or 77.50). \nWRAPS \nNote that any striking price code can have only one meaning. Thus, if the letter Ais \nbeing used to designate astrike price of 5, and the underlying stock has atremen\ndous rally to over $100 per share, then the letter Acannot also be used to designate \nthe strike price of 105. Something else must be done. In the early years of option \ntrading, there was no need for wrap symbols, but in recent - more volatile - times, \nstocks have risen 100 points during the life of an option. \nFor example, if XYZ was originally trading at 10, there might be a 9-month, XYZ \nDecember 10 call. Its symbol would be XYZLB. If, in the course of the next few \nmonths, XYZ traded up to nearly 110 while the December 10 call was still in exis\ntence, the exchange would want to trade an XYZ December 110 call. But anew let\nter would have to be designated for any new strikes (Aalready stands for 5, so it can\nnot stand for 105; Balready stands for 10, so it cannot stand for 110, etc.). There \naren'tenough letters in the alphabet to handle this, so the exchange creates an addi\ntional option base symbol, called awrap symbol. \nIn this case, the exchange might say that the option base symbol XYA is now \ngoing to be used to designate strike prices of 105 and higher ( up to 200) for the com\nmon stock whose symbol is XYZ. Having done that, the letter Acan be used for 105, \nBfor 110, etc.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:45", "doc_id": "5921e942976a13aa286a4c2e7f781f961ddd3721b06d5a7fc30f73665e3740ef", "chunk_index": 0}
{"text": "26 \nOption \nXYZ December 10 call \nXYZ December 110 call \nPart I: Basic Properties ol Stock Options \nSymbol \nXYZLB \nXYALB (wrap symbol is XYA) \nNote that the wrap symbol now allows the usage of Bin its standard interpretati<,nonce again. \nThis process can be extended. Suppose that, by some miracle, this stock rose to \n205 prior to the December expiration. Things like this happened to Yahoo (YHOO), \nAmazon (AMZN), Qualcomm (QCOM), and others during the 1990s. If that hap\npened, the exchange would now create another wrap symbol and use it to designate \nstrike prices from 205 to 300. Suppose XYZ traded up to 210, and the exchange then \nsaid that YYA would now be the wrap symbol for the higher strikes. In that case, these \nsymbols would exist: \nOption \nXYZ December 10 call \nXYZ December 110 call \nXYZ December 210 call \nSymbol \nXYZLB \nXYALB (wrap symbol is XYA) \nYYALB (wrap symbol is YYA) \nNote that there doesn'thave to be any particular relationship between the wrap sym\nbols and the stock itself; any three-character designation could be used. \nLEAPS SYMBOLS \nA LEAPS option is one that is very long-term, expiring one or more years hence. \nConsequently, the expiration month codes encounter aproblem with LEAPS similar \nto the one seen for striking price codes where wraps are concerned. The letter Astands for January as an expiration month code. However, if there is a LEAPS option \non this same stock, and that LEAPS option expires in January of the next year, the \nletter Acannot be used to designate the expiration month of the LEAPS option, since \nit is already being used for the \"standard\" option. Consequently, LEAPS options have \nadifferent base option symbol than the \"standard\" base option symbol. \nExample: The current year is 2001. The OCC might have designated that, for IBM, \nLEAPS options expiring in the year 2002 will have the option base symbol VBM, and \nthose expiring in the year 2003 will have the option base symbol WBM. Thus, the fol\nlowing symbols would be used to describe the designated options:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:46", "doc_id": "c6fbbcb99062d13e2b13e162e718e97f65c38c4b52287e8cd3e206fcb415df2c", "chunk_index": 0}
{"text": "Chapter 1: Definitions \nOption Description \nIBM January 125 call (expiring in 2001) \nIBM January 125 call (expiring in 2002) \nIBM January 125 call (expiring in 2003) \nIBM January 125 put (expiring in 2003) \n27 \nOption Symbol \nIBMAE \nVBMAE \nWBMAE \nWBMME \nNote that the last line shows a LEAPS put option symbol. The letter Mstands for a \nJanuary put option - the standard usage for the expiration month code. \nSTOCK SPLITS \nStock splits often wreak havoc on option symbols, as the exchanges are forced to use \nthe standard characters in nonstandard ways in order to accommodate all the addi\ntional strikes that are created when astock splits. The actual discussion of stock splits \nand the resultant option symbology is deferred to the next section. \nSYMBOLOGY SUMMARY \nThe exchanges do agood job of making symbol information available. Each exchange \nhas a Web site where memos detailing the changes required by LEAPS, wraps, and \nsplits are available for viewing. \nThe OCC and the exchanges have been forced to create multiple option base \nsymbols for asingle stock in order to accommodate the various strike price and expi\nration month situations - to avoid duplication of the standardized character used for \nthe strike or expiration month. This is unwieldy and confusing for option traders and \nfor data vendors as well. In some rare cases, mistakes are made, and there can briefly \nbe two designations for the same option symbol. The only way to eliminate this con\nfusion would be to use alonger, more descriptive option symbol that included the \nexpiration year and the striking price as numerical values, much as is done with \nfutures options. It is the member firms themselves and some of the quote vendors \nwho object to the transformation to this less confusing system, because they would \nhave to recode their software and alter their databases. \nDETAILS OF OPTION TRADING \nThe facts that the strategist should be concerned with are included in this section. \nThey are not presented in any particular order of importance, and this list is not nec\nessarily complete. Many more details are given in the discussion of specific strategies \nthroughout this text.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:47", "doc_id": "cb2cecc32924eaf3f95d4e914235e61afab14951c71693ce02d209abb1b9871c", "chunk_index": 0}
{"text": "28 Part I: Basic Properties of Stock Options \n1. Options expire on the Saturday following the third Friday of the expiration \nrrwnth, although the third Friday is the last day of trading. In general, however, \nwaiting past 3:30 P.M. on the last day to place orders to buy or sell the expiring \noptions is not advisable. In the \"crush\" of orders during the final minutes of trad- • \ning, even amarket order may not have enough time to be executed. \n2. Option trades have aone-day settlement cycle. The trade settles on the next busi\nness day after the trade. Purchases must be paid for in full, and the credits from \nsales \"hit\" the account on the settlement day. Some brokerage firms require set\ntlement on the same day as the trade, when the trade occurs on the last trading \nday of an expiration series. \n3. Options are opened for trading in rotation. When the underlying stock opens for \ntrading on any exchange, regional or national, the options on that stock then go \ninto opening rotation on the corresponding option exchange. The rotation system \nalso applies if the underlying stock halts trading and then reopens during atrad\ning day; options on that stock .reopen via arotation. \nIn the rotation itself, interested parties make bids and offers for each particular \noption series one at atime - the XYZ January 45 call, the XYZ January 50 call, \nand so on - until all the puts and calls at various expiration dates and striking \nprices have been opened. Trades do not necessarily have to take place in each \nseries, just bids and offers. Orders such as spreads, which involve more than one \noption, are not executed during arotation. \nWhile the rotation is taking place, it is possible that the underlying stock could \nmake asubstantial move. This can result in option prices that seem unrealistic \nwhen viewed from the perspective of each option'sopening. Consequently, the \nopening price of an option can be asomewhat suspicious statistic, since none of \nthem open at exactly the same time. \nAlso, it should be noted that most option traders do not trade during rotation, so \namarket order may receive avery poor price. Hence, if one is considering trad\ning during rotation, alimit order should be used. ( Order entry is discussed in \nmore detail in alater section of this chapter.) \n4. When the underlying stock splits or pays astock dividend, the terms of its options \nare adjusted. Such an adjustment may result in fractional striking prices and in \noptions for other than 100 shares per contract. No adjustments in terms are made \nfor cash dividends. The actual details of splits, stock dividends, and rights offer\nings, along with their effects on the option terms, are always published by the \noption exchange that trades those options. Notices are sent to all member firms, \nwho then make that information available to their brokers for distribution to \nclients. In actual practice, the option strategist should ascertain from the broker", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:48", "doc_id": "da500f34bdba2233b3915e676618b1cdf63bdb1c81c46c9e0d55c8d5c63c3d26", "chunk_index": 0}
{"text": "28 Part I: Bask Properties of Stock Options \nl. Options expire on the Saturday following the third Friday of the expiration \nrrwnth, although the third Friday is the last day of trading. In general, however, \nwaiting past 3:30 P.M. on the last day to place orders to buy or sell the expiring \noptions is not advisable. In the \"crush\" of orders during the final minutes of trad- , \ning, even amarket order may not have enough time to be executed. \n2. Option trades have aone-day settlement cycle. The trade settles on the next busi\nness day after the trade. Purchases must be paid for in full, and the credits from \nsales \"hit\" the account on the settlement day. Some brokerage firms require set\ntlement on the same day as the trade, when the trade occurs on the last trading \nday of an expiration series. \n3. Options are opened for trading in rotation. When the underlying stock opens for \ntrading on any exchange, regional or national, the options on that stock then go \ninto opening rotation on the corresponding option exchange. The rotation system \nalso applies if the underlying stock halts trading and then reopens during atrad\ning day; options on that stock reopen via arotation. \nIn the rotation itself, interested parties make bids and offers for each particular \noption series one at atime - the XYZ January 45 call, the XYZ January 50 call, \nand so on - until all the puts and calls at various expiration dates and striking \nprices have been opened. Trades do not necessarily have to take place in each \nseries, just bids and offers. Orders such as spreads, which involve more than one \noption, are not executed during arotation. \nWhile the rotation is taking place, it is possible that the underlying stock could \nmake asubstantial move. This can result in option prices that seem unrealistic \nwhen viewed from the perspective of each option'sopening. Consequently, the \nopening price of an option can be asomewhat suspicious statistic, since none of \nthem open at exactly the same time. \nAlso, it should be noted that most option traders do not trade during rotation, so \namarket order may receive avery poor price. Hence, if one is considering trad\ning during rotation, alimit order should be used. ( Order entry is discussed in \nmore detail in alater section of this chapter.) \n4. When the underlying stock splits or pays astock dividend, the terms of its options \nare adjusted. Such an adjustment may result in fractional striking prices and in \noptions for other than 100 shares per contract. No adjustments in terms are made \nfor cash dividends. The actual details of splits, stock dividends, and rights offer\nings, along with their effects on the option terms, are always published by the \noption exchange that trades those options. Notices are sent to all member firms, \nwho then make that information available to their brokers for distribution to \nclients. In actual practice, the option strategist should ascertain from the broker", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:49", "doc_id": "2e62f0ae68a63705b7c36fc02e0d78fd2cec41eeebebb703204a7461341fccc3", "chunk_index": 0}
{"text": "28 Part I: Basic Properties ol Stock Options \n1. Options expire on the Saturday following the third Friday of the expiration \nmonth, although the third Friday is the last day of trading. In general, however, \nwaiting past 3:30 P.M. on the last day to place orders to buy or sell the expiring \noptions is not advisable. In the \"crush\" of orders during the final minutes of trad- , \ning, even amarket order may not have enough time to be executed. \n2. Option trades have aone-day settlement cycle. The trade settles on the next busi\nness day after the trade. Purchases must be paid for in full, and the credits from \nsales \"hit\" the account on the settlement day. Some brokerage firms require set\ntlement on the same day as the trade, when the trade occurs on the last trading \nday of an expiration series. \n3. Options are opened for trading in rotation. When the underlying stock opens for \ntrading on any exchange, regional or national, the options on that stock then go \ninto opening rotation on the corresponding option exchange. The rotation system \nalso applies if the underlying stock halts trading and then reopens during atrad\ning day; options on that stock reopen via arotation. \nIn the rotation itself, interested parties make bids and offers for each particular \noption series one at atime - the XYZ January 45 call, the XYZ January 50 call, \nand so on - until all the puts and calls at various expiration dates and striking \nprices have been opened. Trades do not necessarily have to take place in each \nseries, just bids and offers. Orders such as spreads, which involve more than one \noption, are not executed during arotation. \nWhile the rotation is taking place, it is possible that the underlying stock could \nmake asubstantial move. This can result in option prices that seem unrealistic \nwhen viewed from the perspective of each option'sopening. Consequently, the \nopening price of an option can be asomewhat suspicious statistic, since none of \nthem open at exactly the same time. \nAlso, it should be noted that most option traders do not trade during rotation, so \namarket order may receive avery poor price. Hence, if one is considering trad\ning during rotation, alimit order should be used. ( Order entry is discussed in \nmore detail in alater section of this chapter.) \n4. When the underlying stock splits or pays astock dividend, the terms of its options \nare adjusted. Such an adjustment may result in fractional striking prices and in \noptions for other than 100 shares per contract. No adjustments in terms are made \nfor cash dividends. The actual details of splits, stock dividends, and rights offer\nings, along with their effects on the option terms, are always published by the \noption exchange that trades those options. Notices are sent to all member firms, \nwho then make that information available to their brokers for distribution to \nclients. In actual practice, the option strategist should ascertain from the broker", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:50", "doc_id": "d0cdc6ef42158b8431d5d4dbc520e3f38fe41f0b0cb382db3450f80a0f2e6306", "chunk_index": 0}
{"text": "a.,,., 1: Definitions 29 \nthe specific terms of the new option series, in case the broker has overlooked the \ninformation sent. \nE«ample 1: XYZ is a $50 stock with option striking prices of 45, 50, and 60 for the \nJanuary, April, and July series. It declares a 2-for-lstock split. Usually, in a 2-for-lsplit situation, the number of outstanding option contracts is doubled and the strik\ning prices are halved. The owner of 5 XYZ January 60 calls becomes the owner of 10 \nXYZ January 30 calls. Each call is still for 100 shares of the underlying stock. \nIf fractional striking prices arise, the exchange also publishes the quote symbol \nthat is to be used to find the price of the new option. The XYZ July 45 call has asym\nbol ofXYZGI: Gstands for July and Iis for 45. After the 2-for-lsplit, one July 45 call \nbecomes 2 July 22½ calls. The strike of 22½ is assigned aletter. The exchanges usu\nally attempt to stay with the standard symbols as much as possible, meaning that Xwould be designated for 22½. Hence, the symbol for the XYZ July 22½ call would be \nXYZGX. \nAfter the split, XYZ has options with strikes of 22½, 25, and 30. In some cases, \nthe option exchange officials may introduce another strike if they feel such astrike is \nnecessary; in this example, they might introduce astriking price of 20. \nE«ample 2: UVW Corp. is now trading at 40 with strikes of 35, 40, and 45 for the \nJanuary, April, and July series. UVW declares a 2½ percent stock dividend. The con\ntractually standardized 100 shares is adjusted up to 102, and the striking prices are \nreduced by 2 percent (rounded to the nearest eighth). Thus, the \"old\" 35 strike \nbecomes a \"new\" strike of 343/s: 1.02 divided into 35 equals 34.314, which is 343/swhen rounded to the nearest eighth. The \"old\" 40 strike becomes a \"new\" strike of \n39¼, and the \"old\" 45 strike becomes 441/s. Since these new strikes are all fraction\nal, they are given special symbols - probably U, V, and W. Thus, the \"old\" symbol \nUVWDH (UVW April 40) becomes the \"new\" symbol UVWDV (UVW April 39¼). \nAfter the split, the exchange usually opens for trading new strikes of 35, 40, and \n45 - each for 100 shares of the underlying stock. For awhile, there are six striking \nprices for UVW options. As time passes, the fractional strikes are eliminated as they \nexpire. Since they are not reintroduced, they eventually disappear as long as UVW \ndoes not issue further stock dividends. \nExample 3: WWW Corp. (symbol WWW) is trading at $120 per share, with strike \nprices of ll0, ll5, 120, 125, and 130. WWW declares a 3-for-lsplit. In this case, the \nstrike prices would be divided by 3 (and rounded to the nearest eighth); the number \nof contracts in every account would be tripled; and each option would still be an \noption on 100 shares of WWW stock. The general rule of thumb is that when asplit \nresults in round lots (2-for-l, 3-for-l, 4-for-l, etc.), the number of option contracts is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:51", "doc_id": "aac01e911e17457f569b1c3a155515f79a105997c1ff4366c6709c22d9ddf1fd", "chunk_index": 0}
{"text": "30 Part I: Basic Properties ol Stock Options \nincreased and the strike price is decreased, and each option still represents 100 \nshares of the underlying stock. \nIn this case, the strikes listed above (110 through 130) would be adjusted to• \nbecome new strikes: 36.625, 38.375, 40, 41.625, and 43.375. The 40 strike would be \nassigned the standard strike price symbol of the letter H. However, the others would \nneed to be designated by the exchange, so Umight stand for 38.375, Vfor 41.625, \nand so forth. \nExample 4: When asplit does not result in around lot, adifferent adjustment must \nbe used for the options. Suppose that AAA Corp. (symbol: AAA) is trading at $60 per \nshare and declares a 3-for-2 split. In this case, each option'sstrike will be multiplied \nby two-thirds (to reflect the 3-for-2 split), but the number of contracts held in an \naccount will remain the same and each option will be an option on 150 shares of AAA \nstock. \nSuppose that there were strikes of 55, 60, and 65 preceding this split. After the \nsplit, AAA common itself would be trading at $40 per share, reflecting the post-split \n3-for-2 adjustment from its previous price of 60. There would be new options with \nstrikes of 36.625, 40, and 43.375 (these had been the pre-split strikes of 55, 60, and \n65). \nSince each of these options would be for 150 shares of the underlying stock, the \nexchange creates anew option base symbol for these options, because they no longer \nrepresent 100 shares of AAA common. Suppose the exchange says that the post-split, \n150-share option contracts will henceforth use the option symbol AAX. \nAfter the split, the exchange will then list \"normal\" 100-share options on AAA, \nperhaps with strike prices of 35, 40, and 45. This creates asituation that can some\ntimes be confusing for traders and can lead to problems. There will actually be two \noptions with striking prices of 40 - one for 100 shares and the other for 150 shares. \nSuppose the July contract is being considered. The option with symbol AAAGH is a \nJuly 40 option on 100 shares of AAA Corp., while the option with symbol AAXGH is \na July 40 option on 150 shares of AAA Corp. Since option prices are quoted on aper\nshare basis, they will have nearly identical price quotes on any quote system (see item \n5). If one is not careful, you might trade the wrong one, thereby incurring arisk that \nyou did not intend to take. \nFor example, suppose that you sell, as an opening transaction, the AAXGH July \n40 call at aprice of 3. Furthermore, suppose that you did not realize that you were \nselling the 150-share option; this was amistake, but you don'tyet realize it. Acouple \nof days later, you see that this option is now selling at 13 - aloss of 10 points. You \nmight think that you had just lost $1,000, but upon examining your brokerage state\nment (or confirms, or day trading sheet), you suddenly see that the loss is $1,500 on", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:52", "doc_id": "97a5ea607e850cb34c0c7664fab7fdf6d10cea4ea57531874d628ceeff105174", "chunk_index": 0}
{"text": "0.,,,, 1: Definitions 31 \nthat contract! Quite adifference, especially if multiple contracts are involved. This \ncould come as ashock if you thought you were hedged (perhaps you bought 100 \nshares of AAA common when you sold this call), only to find out later that you didn'thave acorrectly hedged position in place after all. \nEven more severe problems can arise if this stock splits again during the life \nof this option. Sometimes the options will be adjusted so that they represent anon\nstandard number of shares, such as the 150-share options involved here; and after \nmultiple splits, the exchange may even apply amultiplier to the option, rather than \nadjusting its strike price repeatedly. This type of thing wouldn'thappen on the first \nstock split, but it might occur on subsequent stock splits, spaced closely together \nover the life of an option. In such acase, the dollar value of the option moves much \nfaster than one would expect from looking at aquote of the contract. \nSo you must be sure that you are trading the exact contract you intend to, and \nnot relying on the fact that the striking price is correct and the option price quote \nseems to be in line. One must verify that the option being bought or sold is exactly \nthe one intended. In general, it is agood idea, after asplit or similar adjustment, to \nestablish opening positions solely with the standard contracts and to leave the split\nadjusted contracts alone. \n5. All options are quoted on aper-share basis, regardless of how many shares of \nstock the option involves. Normally the quote assumes 100 shares of the under\nlying stock. However, in acase like the UVW options just described, aquote of 3 \nfor the UVW April 39¼ means adollar price of $306 ($3 x 102). \n6. Changes in the price of the underlying stock can also bring about new striking \nprices. XYZ is a $47 stock with striking prices of 45 and 50. If the price of XYZ \nstock falls to $40, the striking prices of 45 and 50 do not give option traders \nenough opportunities in XYZ. So the exchange might introduce anew striking \nprice of 40. In practice, anew series is generally opened when the stock trades \nat the lowest (or highest) existing strike in any series. For example, if XYZ is \nfalling, as soon as it traded at or below 45, the striking price of 40 may be intro\nduced. The officials of the option exchange that trades XYZ options make the \ndecision as to the exact day when the strike begins trading. \nPOSITION LIMIT AND EXERCISE LIMIT \n1. An investor or agroup of investors cannot be long or short more than aset limit \nof contracts in one stock on the same side of the market. The actual limit varies \naccording to the trading activity in the underlying stock. The most heavily trad\ned stocks with alarge number of shares outstanding have position limits of 75,000", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:53", "doc_id": "1972f44861be0a101c4175bf5d3be64e5c5ea24b82e47617f9aa320ade74bf4b", "chunk_index": 0}
{"text": "32 Part I: Basic Properties ol Stock Options \ncontracts. Smaller stocks have position limits of 60,000, 31,000, 22,500, or 13,500 \ncontracts. These limits can be expected to increase over time, if stocks' capital\nizations continue to increase. The exchange on which the option is listed makes \navailable alist of the position limits on each of its optionable stocks. So, if one \nwere long the limit of XYZ call options, he cannot at the same time be short any \nXYZ put options. Long calls and short puts are on the same side of the market; \nthat is, both are bullish positions. Similarly, long puts and short calls are both on \nthe bearish side of the market. While these position limits generally exceed by far \nany position that an individual investor normally attains, the limits apply to \"relat\ned\" accounts. For instance, amoney manager or investment advisor who is man\naging many accounts cannot exceed the limit when all the accounts' positions are \ncombined. \n8. The numher of contracts that can be exercised in aparticular period of time ( usu\nally 5 business days) is also limited to the same arrwunt as the position limit. This \nexercise limit prevents an investor or group from \"cornering\" astock by repeat\nedly buying calls one day and exercising them the next, day after day. Option \nexchanges set exact limits, which are subject to change. \nORDER ENTRY \nOrder Information \nOf the various types of orders, each specifies: \n1. whether the transaction is abuy or sell, \n2. the option to be bought or sold, \n3. whether the trade is opening or closing aposition, \n4. whether the transaction is aspread (discussed later), and \n5. the desired price. \nTYPES OF ORDERS \nMany types of orders are acceptable for trading options, but not all are acceptable on \nall exchanges that trade options. Since regulations change, information regarding \nwhich order is valid for agiven exchange is best supplied by the broker to the cus\ntomer. The following orders are acceptable on all option exchanges: \nMarket Order. This is asimple order to buy or sell the option at the best pos\nsible price as soon as the order gets to the exchange floor.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:54", "doc_id": "4b790644bbb802caea39e8b5caa17be88c0d78b33a677b64c92fa44044d27168", "chunk_index": 0}
{"text": "Cl,apter 1: Definitions 33 \nMarket Not Held Order. The customer who uses this type of order is giv\ning the floor broker discretion in executing the order. The floor broker is not \nheld responsible for the final outcome. For example, if afloor broker has a \"mar\nket not held\" order to buy, and he feels that the stock will \"downtick\" (decline \nin price) or that there is asurplus of sellers in the crowd, he may often hold off \non the execution of the buy order, figuring that the price will decline shortly and \nthat the order can then be executed at amore favorable price. In essence, the \ncustomer is giving the floor broker the right to use some judgment regarding the \nexecution of the order. If the floor broker has an opinion and that opinion is cor\nrect, the customer will probably receive abetter price than if he had used areg\nular market order. If the broker'sopinion is wrong, however, the price of the \nexecution may be worse than aregular market order. \nLimit Order. The limit order is an order to buy or to sell at aspecified price \n- the limit. It may be executed at abetter price than the limit - alower one for \nbuyers and ahigher one for sellers. However, if the limit is never reached, the \norder may never be executed. \nSometimes alimit order may specify adiscretionary margin for the floor broker. \nIn other words, the order may read \"Buy at 5 with dime discretion.\" This instruction \nenables the floor broker to execute the order at 5.10 if he feels that the market will \nnever reach 5. Under no circumstances, however, can the order be executed at aprice higher than 5.10. Other orders may or may not be accepted·on some option \nexchanges. \nStop Order. This order is not always valid on all option exchanges. Astop \norder becomes amarket order when the security trades at or through the price \nspecified on the order. Buy stop orders are placed above the current market \nprice, and sell stop orders are entered below the current market price. Such \norders are used to either limit loss or protect aprofit. For example, if aholder'soption is selling for 3, asell stop order for 2 is activated if the market drops \ndown below the 2 level, whereupon the floor broker would execute the order as \nsoon as possible. The customer, however, is not guaranteed that the trade will be \nexactly at 2. \nStop-Limit Order. This order becomes alimit order when the specified price \nis reached. Whereas the stop order has to be executed as soon as the stop price \nis reached, the stop-limit may or may not be filled, depending on market behav\nior. For instance, if the option is trading at 3 while astop-limit order is placed \nat aprice of 2, the floor broker may not be able to get atrade exactly at 2. If the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:55", "doc_id": "51412f8d0c1239d1b87e2210017caaeab1ca82102cde4ae55857a6d941f27ede", "chunk_index": 0}
{"text": "34 Part I: Basic Properties of Stock Options \noption continues to decline through 2 - 1.90, 1.80, 1.70, and so on - without ~ \never regaining the 2 level, then the broker'shands are tied. He may not execute \nwhat is now alimit order unless the call trades at 2. \nGood-Until-Canceled Order. Alimit, stop, or stop-limit order may be des\nignated \"good until canceled.\" If the conditions for the order execution do not \noccur, the order remains valid for 6 months without renewal by the customer. \nCustomers using an on-line broker will not be able to enter \"market not held\" \norders, and may not be able to use stop orders or good-until-canceled orders either, \ndepending on the brokerage firm. \nPROFITS AND PROFIT GRAPHS \nAvisual presentation of the profit potential of any position is important to the over\nall understanding and evaluation of it. In option trading, the many multi-security \npositions especially warrant strict analysis: stock versus options (as in covered or ratio \nwriting) or options versus options (as in spreads). Some strategists prefer atable list\ning the outcomes of aparticular strategy for the stock at various prices; others think \nthe strategy is more clearly demonstrated by agraph. In the rest of the text, both atable and agraph will be presented for each new strategy discussed. \nExample: Acustomer wishes to evaluate the purchase of acall option. The potential \nprofits or losses of apurchase of an XYZ July 50 call at 4 can be arrayed in either atable or agraph of outcomes at expiration. Both Table 1-5 and Figure 1-5 depict the \nsame information; the graph is merely the line representing the column marked \n\"Profit or Loss\" in the table. The vertical axis represents dollars of profit or loss, and \nthe horizontal axis shows the stock price at expiration. In this case, the dollars of prof\nit and the stock price are at the expiration date. Often, the strategist wants to deter\nmine what the potential profits and losses will be before expiration, rather than at the \nexpiration date itself. Tables and graphs lend themselves well to the necessary analy\nsis, as will be seen in detail in various places later on. \nIn practice, such an example is too simple to require atable or agraph - cer\ntainly not both - to evaluate the potential profits and losses of asimple call purchase \nheld to expiration. However, as more complex strategies are discussed, these tools \nbecome ever more useful for quickly determining such things as when aposition \nmakes money and when it loses, or how fast one'srisk increases at certain stock \nprices.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:56", "doc_id": "7ebe9b63f43013151a12f5f07fce8119c46bca75737615878b6e52d78c2a6dae", "chunk_index": 0}
{"text": "CHAPl'ER 2 \nCovered Call Writing \nCovered call writing is the name given to the strategy by which one sells acall option \nwhile simultaneously owning the obligated number of shares of underlying stock. \nThe writer should be mildly bullish, or at least neutral, toward the underlying stock. \nBy writing acall option against stock, one always decreases the risk of owning the \nstock. It may even be possible to profit from acovered write if the stock declines \nsomewhat. However, the covered call writer does limit his profit potential and there\nfore may not fully participate in astrong upward move in the price of the underlying \nstock. Use of this strategy is becoming so common that the strategist must under\nstand it thoroughly. It is therefore discussed at length. \nTHE IMPORTANCE OF COVERED CALL WRITING \nCOVERED CALL WRITING FOR DOWNSIDE PROTECTION \nExample: An investor owns 100 shares of XYZ common stock, which is currently sell\ning at $48 per share. If this investor sells an XYZ July 50 call option while still hold\ning his stock, he establishes acovered write. Suppose the investor receives $300 from \nthe sale of the July 50 call. If XYZ is below 50 at July expiration, the call option that \nwas sold expires worthless and the investor earns the $300 that he originally received \nfor writing the call. Thus, he receives $300, or 3 points, of downside protection. That \nis, he can afford to have the XYZ stock drop by 3 points and still break even on the \ntotal transaction. At that time he can write another call option if he so desires. \nNote that if the underlying stock should fall by more than 3 points, there will be \naloss on the overall position. Thus, the risk in the covered writing strategy material\nizes if the stock falls by adistance greater than the call option premium that was orig\ninally taken in. \n39", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:61", "doc_id": "d8de53cd007a2329b47baca4169d37b814826fde8c2479aede6344f0b4ebccc7", "chunk_index": 0}
{"text": "40 Part II: Call Option Strategies \nTHE BENEFITS OF AN INCREASE IN STOCK PRICE \nIf XYZ increases in price moderately, the trader may be able to have the best of both \nworlds. \nExample: If XYZ is at or just below 50 at July expiration, the call still expires worth\nless, and the investor makes the $300 from the option in addition to having asmall \nprofit from his stock purchase. Again, he still owns the stock. \nShould XYZ increase in price by expiration to levels above 50, the covered \nwriter has achoice of alternatives. As one alternative, he could do nothing, in which \ncase the option would be assigned and his stock would be called away at the striking \nprice of 50. In that case, his profits would be equal to the $300 received from selling \nthe call plus the profit on the increase of his stock from the purchase price of 48 to \nthe sale price of 50. In this case, however, he would no longer own the stock. If as \nanother alternative he desires to retain his stock ownership, he can elect to buy back \n( or cover) the written call in the open market. This decision might involve taking aloss on the option part of the covered writing transaction, but he would have acor\nrespondingly larger profit, albeit unrealized, from his stock purchase. Using some \nspecific numbers, one can see how this second alternative works out. \nExample: XYZ rises to aprice of 60 by July expiration. The call option then sells near \nits intrinsic value of 10. If the investor covers the call at 10, he loses $700 on the \noption portion of his covered write. (Recall that he originally received $300 from the \nsale of the option, and now he is buying it back for $1,000.) However, he relieves the \nobligation to sell his stock at 50 ( the striking price) by buying back the call, so he has \nan unrealized gain of 12 points in the stock, which was purchased at 48. His total \nprofit, including both realized and unrealized gains, is $500. \nThis profit is exactly the same as he would have made if he had let his stock be \ncalled from him. If called, he would keep the $300 from the sale of the call, and he \nwould make 2 points ( $200) from buying the stock at 48 and selling it, via exercise, at \n50. This profit, again, is atotal of $500. The major difference between the two cases \nis that the investor no longer owns his stock after letting it be called away, whereas \nhe retains stock ownership if he buys back the written call. Which of the two alter\nnatives is the better one in agiven situation is not always clear. \nNo matter how high the stock climbs in price, the profit from acovered write is \nlimited because the writer has obligated himself to sell stock at the striking price. The \ncovered writer still profits when the stock climbs, but possibly not by as much as he \nmight have had he not written the call. On the other hand, he is receiving $300 of \nimmediate cash inflow, because the writer may take the premium immediately and", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:62", "doc_id": "fc22569fc0e3e9988f5ad23e0822bfca6cb9a8b2c76236505df1c0d77ea9b233", "chunk_index": 0}
{"text": "Gapter 2: Covered Call Writing 41 \ndo with it as he pleases. That income can represent asubstantial increase in the \nincome currently provided by the dividends on the underlying stock, or it can act to \noffset part of the loss in case the stock declines. \nFor readers who prefer formulae, the profit potential and break-even point of acovered write can be summarized as follows: \nMaximum profit potential = Strike price Stock price + Call price \nDownside break-even point = Stock price - Call price \nQUANTIFICATION OF THE COVERED WRITE \nTable 2-1 and Figure 2-1 depict the profit graph for the example involving the XYZ \ncovered write of the July 50 call. The table makes the assumption that the call is \nbought back at parity. If the stock is called away, the same total profit of $500 results; \nbut the price involved on the stock sale is always 50, and the option profit is always \n$300. \nSeveral conclusions can be drawn. The break-even point is 45 (zero total prof\nit) with risk below 45; the maximum profit attainable is $500 if the position is held \nuntil expiration; and the profit if the stock price is unchanged is $300, that is, the cov\nered writer makes $300 even if his stock goes absolutely nowhere. \nThe profit graph for acovered write always has the shape shown in Figure 2-1. \nNote that the maximum profit always occurs at all stock prices equal to or greater \nthan the striking price, if the position is held until expiration. However, there is \ndownside risk. If the stock declines in price by too great an amount, the option pre\nmium cannot possibly compensate for the entire loss. Downside protective strategies, \nwhich are discussed later, attempt to deal with the limitation of this downside risk. \nTABLE 2-1. \nThe XYZ July 50 call. \nXYZ Price Stock July 50 Call Call Total \nat Expiration Profit at Expiration Profit Profit \n40 -$ 800 0 +$300 -$500 \n45 - 300 0 + 300 0 \n48 0 0 + 300 + 300 \n50 + 200 0 + 300 + 500 \n55 + 700 5 - 200 + 500 \n60 + 1,200 10 - 700 + 500", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:63", "doc_id": "d0c7041c882aa2665f550adc9e7012af8947990d406b884cbc2afd3da84a5130", "chunk_index": 0}
{"text": "42 \nFIGURE 2-1. \nXYZ covered write. \nC +$500 \n0 \ne ·a. \ni.ti \ncii en $0 en 0 \n...J \n0 \n~ a. \nPart II: Call Option Strategies \nMaximum Profit Range \n50 55 60 \n\"-. Downside Risk \nStock Price at Expiration \nCOVERED WRITING PHILOSOPHY \nThe primary objective of covered writing, for most investors, is increased income \nthrough stock ownership. An ever-increasing number of private and institutional \ninvestors are writing call options against the stocks that they own. The facts that the \noption premium acts as apartial compensation for adecline in price by the underly\ning stock, and that the premium represents an increase in income to the stockhold\ner, are evident. The strategy of owning the stock and writing the call will outperform \noutright stock ownership if the stock falls, remains the same, or even rises slightly. In \nfact, the only time that the outright owner of the stock will outperform acovered \nwriter is if the stock increases in price by arelatively substantial amount during the \nlife of the call. Moreover, if one consistently writes call options against his stock, his \nportfolio will show less variability of results from quarter to quarter. The total posi\ntion - long stock and short option - has less volatility than the stock alone, so on aquarter-by-quarter basis, results will be closer to average than they would be with \nnormal stock ownership. This is an attractive feature, especially for portfolio man\nagers. \nHowever, one should not assume that covered writing will outperform stock \nownership. Stocks sometimes tend to make most of their gains in large spurts. Acov\nered writer will not participate in moves such as that. The long-term gains that are \nquoted for holding stocks include periods of large gains and sometimes periods of \nlarge losses as well. The covered writer will not participate in the largest of those \ngains, since his profit potential is limited.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:64", "doc_id": "65f78069dba53ef1a18ee5f924e9847f9215600816bd3e134d91e3d889a4eb12", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing 43 \nPHYSICAL LOCATION Of THE STOCK \nBefore getting more involved in the details of covered writing strategy, it may be use\nful to review exactly what stock holdings may be written against. Recall that this dis\ncussion applies to listed options. If one has deposited stock with his broker in either \nacash or amargin account, he may write an option for each 100 shares that he owns \nwithout any additional requirement. However, it is possible to write covered options \nwithout actually depositing stock with abrokerage firm. There are several ways in \nwhich to do this, all involving the deposit of stock with abank. \nOnce the stock is deposited with the bank, the investor may have the bank issue \nan escrow receipt or letter of guarantee to the brokerage firm at which the investor \ndoes his option business. The bank must be an \"approved\" bank in order for the bro\nkerage firm to accept aletter of guarantee, and not all firms accept letters of guaran\ntee. These items cost money, and as anew receipt or letter is required for each new \noption written, the costs may become prohibitive to the customer if only 100 or 200 \nshares of stock are involved. The cost of an escrow receipt can range from as low as \n$15 to upward of $40, depending on the bank involved. \nThere is another alternative open to the customer who wishes to write options \nwithout depositing his stock at the brokerage firin. He may deposit his stock with abank that is amember of the Depository Trust Corporation (DTC). The DTC guar\nantees the Options Clearing Corporation that it will, in fact, deliver stock should an \nassignment notice be given to the call writer. This is the most convenient method for \nthe investor to use, and is the one used by most of the institutional covered writing \ninvestors. There is usually no additional charge for this service by the bank to insti\ntutional accounts. However, since only alimited number of banks are members of \nDTC, and these banks are generally the larger banks located in metropolitan centers, \nit may be somewhat difficult for many individual investors to take advantage of the \nDTC opportunity. \nTYPES Of COVERED WRITES \nWhile all covered writes involve selling acall against stock that is owned, different \nterms are used to describe various categories of covered writing. The two broadest \nterms, under which all covered writes can be classified, are the out-of the-rrwney cov\nered write and the in-the-rrwney covered write. These refer, obviously, to whether the \noption itself was in-the-money or out-of-the-money when the write was first estab\nlished. Sometimes one may see covered writes classified by the nature of the stock \ninvolved (low-priced covered write, high-yield covered write, etc;), but these are only \nsubcases of the two broad categories.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:65", "doc_id": "6618714ae3628ea05a169203e76d6b68eb0fafb9ba2dbbfca8290d50a0e0acb5", "chunk_index": 0}
{"text": "44 Part II: Call Option Strategies. \nIn general, out-of-the-money covered writes offer higher potential rewards but \nhave less risk protection than do in-the-money covered writes. One can establish an \naggressive or defensive covered writing position, depending on how far the call \noption is in- or out-of-the-money when the write is established. In-the-money writes \nare more defensive covered writing positions. \nSome examples may help to illustrate how one covered write can be consider\nably more conservative, from astrategy viewpoint, than another. \nExample: XYZ common stock is selling at 45 and two options are being considered \nfor writing: an XYZ July 40 selling for 8, and an XYZ July 50 selling for 1. Table 2-2 \ndepicts the profitability of utilizing the July 40 or the July 50 for the covered writing. \nThe in-the-money covered write of the July 40 affords 8 points, or nearly 18% pro\ntection down to aprice of 37 (the break-even point) at expiration. The out-of-the\nmoney covered write of the July 50 offers only 1 point of downside protection at expi\nration. Hence, the in-the-rrwney covered write offers greater downside protection \nthan does the out-of-the-rrwney covered write. This statement is true in general - not \nmerely for this example. \nIn the balance of the financial world, it is normally true that investment posi\ntions offering less risk also have lower reward potential. The covered writing exam\nple just given is no exception. The in-the-money covered write of the July 40 has amaximum potential profit of $300 at any point above 40 at the time of expiration. \nHowever, the out-of-the-money covered write of the July 50 has amaximum poten\ntial profit of $600 at any point above 50 at expiration. The maximum potential profit \nof an out-of-the-rrwney covered write is generally greater than that of an in-the\nrrwney write. \nTABLE 2-2. \nProfit or loss of the July 40 and July 50 calls. \nIn-the-Money Write Out-of-the-Money Write \nof July 40 of July SO \nStock of Total Stock at Total \nExpiration Profit Expiration Profit \n35 -$200 35 -$900 \n37 0 40 - 400 \n40 + 300 44 0 \n45 + 300 45 + 100 \n50 + 300 50 + 600 \n60 + 300 60 + 600", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:66", "doc_id": "0969d80f04775dc89e02022ad714673581bc04c7be85e57d736e558a86bc0261", "chunk_index": 0}
{"text": "Cl,apter 2: Covered Call Writing 45 \nTo make atrue comparison between the two covered writes, one must look at \nwhat happens with the stock between 40 and 50 at expiration. The in-the-money \nwrite attains its maximum profit anywhere within that range. Even a 5-point decline \nby the underlying stock at expiration would still leave the in-the-money writer with \nhis maximum profit. However, realizing the maximum profit potential with an out-of \nthe-money covered write always requires arise in price by the underlying stock. This \nfurther illustrates the more conservative nature of the in-the-money write. It should \nbe noted that in-the-money writes, although having asmaller profit potential, can still \nbe attractive on apercentage return basis, especially if the write is done in amargin \naccount. \nOne can construct amore aggressive position by writing an out-of-the-money \ncall. One'soutlook for the underlying stock should be bullish in that case. If one is \nneutral or moderately bearish on the stock, an in-the-money covered write is more \nappropriate. If one is truly bearish on astock he owns, he should sell the stock instead \nof establishing acovered write. \nTHE TOTAL RETURN CONCEPT \nOF COVERED WRITING \nWhen one writes an out-of-the-money option, the overall position tends to reflect \nmore of the result of the stock price movement and less of the benefits of writing the \ncall. Since the premium on an out-of-the-money call is relatively small, the total posi\ntion will be quite susceptible to loss if the stock declines. If the stock rises, the posi\ntion will make money regardless of the result in the option at expiration. On the other \nhand, an in-the-money write is more of a \"total\" position - taking advantage of the \nbenefit of the relatively large option premium. If the stock declines, the position can \nstill make aprofit; in fact, it can even make the maximum profit. Of course, an in\nthe-money write will also make money if the stock rises in price, but the profit is not \ngenerally as great in percentage terms as is that of an out-of-the-money write. \nThose who believe in the total return concept of covered writing consider both \ndownside protection and maximum potential return as important factors and are \nwilling to have the stock called away, if necessary, to meet their objectives. When \npremiums are moderate or small, only in-the-money writes satisfy the total return \nphilosophy. \nSome covered writers prefer never to lose their stock through exercise, and as \naresult will often write options quite far out-of-the-money to minimize the chances \nof being called by expiration. These writers receive little downside protection and, to \nmake money, must depend almost entirely on the results of the stock itself. Such a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:67", "doc_id": "0b30a9e240b9d3b76a42ed714f2db30b5dc1fa00f9dffc1ee5993472409c1109", "chunk_index": 0}
{"text": "46 Part II: Call Option Strategies \nphilosophy is more like being astockholder and trading options against one'sstock \nposition than actually operating acovered writing strategy. In fact, some covered \nwriters will attempt to buy back written options for quick profits if such profits mate\nrialize during the life of the covered write. This, too, is astock ownership philosophy, \nnot acovered writing strategy. The total return concept represents the true strategy \nin covered writing, whereby one views the entire position as asingle entity and is not \npredominantly concerned with the results of his stock ownership. \nTHE CONSERVATIVE COVERED WRITE \nCovered writing is generally accepted to be aconservative strategy. This is because \nthe covered writer always has less risk than astockholder, provided that he holds the \ncovered write until expiration of the written call. If the underlying stock declines, the \ncovered writer will always offset part of his loss by the amount of the option premi\num received, no matter how small. \nAs was demonstrated in previous sections, however, some covered writes are \nclearly more conservative than others. Not all option writers agree on what is meant \nby aconservative covered write. Some believe that it involves writing an option \n(probably out-of-the-money) on aconservative stock, generally one with high yield \nand low volatility. It is true that the stock itself in such aposition is conservative, but \nthe position is more aptly termed acovered write on aconservative stock. This is dis\ntinctly different from aconservative covered write. \nAtrue conservative covered write is one in which the total position is conserva\ntive - offering reduced risk and agood probability of making aprofit. An in-the-money \nwiite, even on astock that itself is not conservative, can become aconservative total \nposition when the option itself is properly chosen. Clearly, an investor cannot write \ncalls that are too deeply in-the-money. If he did, he would get large amounts of down\nside protection, but his returns would be severely limited. If all that one desired was \nmaximum protection of his money at anominal rate of profit, he could leave the \nmoney in abank. Instead, the conservative covered writer strives to make apotential\nly acceptable return while still receiving an above-average amount of protection. \nExample: Again assume XYZ common stock is selling at 45 and an XYZ July 40 call \nis selling at 8. Acovered write of the XYZ July 40 would require, in acash account, \nan investment of $3,700 - $4,500 to purchase 100 shares of XYZ, less the $800 \nreceived in option premiums. The write has amaximum profit potential of $300. The \npotential return from this position is therefore $300/$3, 700, just over 8% for the peri\nod during which the write must be held. Since it is most likely that the option has 9 \nmonths of life or less, this return would be well in excess of 10% on aper annum", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:68", "doc_id": "dc250e04bec7dafd11b6364df3859f23accf4ac2329e7d994f33bc585bbc4eed", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing 47 \nbasis. If the write were done in amargin account, the return would be considerably \nhigher. \nNote that we have ignored dividends paid by the underlying stock and commis\nsion charges, factors that are discussed in detail in the next section. Also, one should \nbe aware that if he is looking at an annualized return from acovered write, there is \nno guarantee that such areturn could actually be obtained. All that is certain is that \nthe writer could make 8% in 9 months. There is no guarantee that 9 months from \nnow, when the call expires, there will be an equivalent position to establish that will \nextend the same return for the remainder of the annualization period. Annual returns \nshould be used only for comparative purposes between covered writes. \nThe writer has aposition that has an annualized return (for comparative pur\nposes) of over 10% and 8 points of downside protection. Thus, the total position is an \ninvestment that will not lose money unless XYZ common stock falls by more than 8 \npoints, or about 18%; and is an investment that could return the equivalent of 10% \nannually should XYZ common stock rise, remain the same, or fall by 5 points (to 40). \nThis is aconservative position. Even if XYZ itself is not aconservative stock, the \naction of writing this option has made the total position aconservative one. The only \nfactor that might detract from the conservative nature of the total position would be \nif XYZ were so volatile that it could easily fall more than 8 points in 9 months. \nIn astrategic sense, the total position described above is better and more con\nservative than one in which awriter buys aconservative stock -yielding perhaps 6 or \n7% - and writes an out-of-the-money call for aminimal premium. If this conserva\ntive stock were to fall in price, the writer would be in danger of being in aloss situa\ntion, because here the option is not providing anything more than the most minimal \ndownside protection. As was described earlier, ahigh-yielding, low-volatility stock \nwill not have much time premium in its in-the-money options, so that one cannot \neffectively establish an in-the-money write on such a \"conservative\" stock. \nCOMPUTING RETURN ON INVESTMENT \nNow that the reader has some general feeling for covered call writing, it is time to \ndiscuss the specifics of computing return on investment. One should always know \nexactly what his potential returns are, including all costs, when he establishes acov\nered writing position. Once the procedure for computing returns is clear, one can \nmore logically decide which covered writes are the most attractive. \nThere are three basic elements of acovered write that should be computed \nbefore entering into the position. The first is the return if exercised. This is the return \non investment that one would achieve if the stock were called away. For an out-of-the-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:69", "doc_id": "fb737da80fa01460a98ca54fb5db1eecd1e560ee26029abd2b21dab1437267bb", "chunk_index": 0}
{"text": "48 Part II: Call Option Strategies \nmoney covered write, it is necessary for the stock to rise in price in order for the return \nif exercised to be achieved. However, for an in-the-money covered write, the return if \nexercised would be attained even if the stock were unchanged in price at option expi\nration. Thus, it is often advantageous to compute the return if unchanged - that is, the \nreturn that would be realized if the underlying stock were unchanged when the option \nexpired. One can more fairly compare out-of-the-money and in-the-money covered \nwrites by using the return if unchanged, since no assumption is made concerning stock \nprice movement. The third important statistic that the covered writer should consid\ner is the exact downside break-even point after all costs are included. Once this down\nside break-even point is known, one can readily compute the percentage of downside \nprotection that he would receive from selling the call. \nExample 1: An investor is considering the following covered write of a 6-month call: \nBuy 500 XYZ common at 43, sell 5 XYZ July 45 calls at 3. One must first compute the \nnet investment required (Table 2-3). In acash account, this investment consists of \npaying for the stock in full, less the net proceeds from the sale of the options. Note \nthat this net investment figure includes all commissions necessary to establish the \nposition. (The commissions used here are approximations, as they vary from firm to \nfirm.) Of course, if the investor withdraws the option premium, as he is free to do, \nhis net investment will consist of the stock cost plus commissions. Once the neces\nsary investment is known, the writer can compute the return if exercised. Table 2-4 \nillustrates the computation. One first computes the profit if exercised and then \ndivides that quantity by the net investment to obtain the return if exercised. Note \nthat dividends are included in this computation; it is assumed that XYZ stock will pay \n$500 in dividends on the 500 shares during the life of the call. Moreover, all com\nmissions are included as well - the net investment includes the original stock pur\nchase and option sale commissions, and the stock sale commission is explicitly listed. \nFor the return computed here to be realized, XYZ stock would have to rise in \nprice from its current price of 43 to any price above 45 by expiration. As noted ear\nlier, it may be more useful to know what return could be made by the writer if the \nstock did not move anywhere at all. Table 2-5 illustrates the method of computing the \nTABLE 2-3. \nNet investment required-cash account. \nStock cost (500 shares at 43) \nPlus stock purchase commissions \nLess option premiums received \nPlus option sale commissions \nNet cash investment \n+ \n$21,500 \n320 \n1,500 \n+ 60 \n$20,380", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:70", "doc_id": "241e48b5cb130bff16f78931482b96af600f6da5f8e9663526b2fd4ecded2b00", "chunk_index": 0}
{"text": "Oapter 2: Covered Call Writing \nTABLE 2-4. \nReturn if exercised-cash account. \nStock sale proceeds (500 shares at 45) \nLess stock sale commissions \nPlus dividends earned until expiration \nLess net investment \nNet profit if exercised \nReturn if exercised $2,290 = 11 2o/c \n$20,380 . \n0 \nTABLE 2-5. \nReturn if unchanged-cash account. \nUnchanged stock value (500 shares at 43) \nPlus dividends \nLess net investment \nProfit if unchanged \nReturn if unchanged $1,620 = 7.9'¼ \n$20,380 ° \n+ \n$22,500 \n330 \n500 \n- 20,380 \n$ 2,290 \n$21,500 \n+ 500 \n- 20,380 \n$ 1,620 \n49 \nreturn if unchanged - also called the static return and sometimes incorrectly referred \nto as the \"expected return.\" Again, one first calculates the profit and then calculates \nthe return by dividing the profit by the net investment. An important point should be \nmade here: There is no stock sale commission included in Table 2-5. This is the most \ncommon way of calculating the return if unchanged; it is done this way because in amajority of cases, one would continue to hold the stock if it were unchanged and \nwould write another call option against the same stock. Recall again, though, that if \nthe written call is in-the-rrwney, the return if unchanged is the same as the return if \nexercised. Stock sale commissions must therefore be included in that case. \nOnce the necessary returns have been computed and the writer has afeeling for \nhow much money he could make in the covered write, he next computes the exact \ndownside break-even point to determine what kind of downside protection the writ\nten call provides (Table 2-6). The total return concept of covered writing necessitates \nviewing both potential income and downside protection as important criteria for \nselecting awriting position. If the stock were held to expiration and the $500 in div\nidends received, the writer would break even at aprice of 39.8. Again, astock sale \ncommission is not generally included in the break-even point computation, because", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:71", "doc_id": "06c33fd19b8d44493a5e4e5d37e8a321eb1d33c8f02c6e30bd30e87a609b65cb", "chunk_index": 0}
{"text": "50 Part II: Call Option Strategies \nthe written call would expire totally worthless and the writer might then write anoth\ner call on the same stock. Later, we discuss the subject of continuing to write against \nstocks already owned. It will be seen that in many cases, it is advantageous to con\ntinue to hold astock and write against it again, rather than to sell it and establish acovered write in anew stock. \nTABLE 2-6. \nDownside break-even point-cash account. \nNet investment \nLess dividends \nTotal stock cost to expiration \nDivide by shares held \nBreak-even price \n$20,380 \n500 \n$19,880 \n+ 500 \n39.8 \nNext, we translate the break-even price into percent downside protection \n(Table 2-7), which is aconvenient way of comparing the levels of downside protec\ntion among variously priced stocks. We will see later that it is actually better to com\npare the downside protection with the volatility of the underlying stock. However, \nsince percent downside protection is acommon and widely accepted method that is \nmore readily calculated, it is necessary to be familiar with it as well. \nBefore moving on to discuss what kinds of returns one should attempt to strive \nfor in which situati_ons, the same example will be worked through again for acovered \nwrite in amargin account. The use of margin will provide higher potential returns, \nsince the net investment will be smaller. However, the margin interest charge \nincurred on the debit balance (the amount of money borrowed from the brokerage \nfirm) will cause the break-even point to be higher, thus slightly reducing the amount \nof downside protection available from writing the call. Again, all commissions to \nestablish the position are included in the net investment computation. \nTABLE 2-7. \nPercent downside protection-cash account. \nInitial stock price \nLess break-even price \nPoints of protection \nDivide by original stock price \nEquals percent downside protection \n43 \n-39.8 \n3.2 \n+43 \n7.4%", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:72", "doc_id": "ce8520be49d73df777e9c2eef1e915e08a1a083a905f7dd39ef58e83982fba20", "chunk_index": 0}
{"text": "Clrapter 2: Covered Call Writing 51 \nExample 2: Recall that the net investment for the cash write was $20,380. Amargin covered write requires less than half of the investment of acash write when \nthe margin rate (set by the Federal Reserve) is 50%. In amargin account, if one \ndesires to remove the premium from the account, he may do so immediately provid\ned that he has enough reserve equity in the account to cover the purchase of the \nstock. If he does so, his net investment would be equal to the debit balance calcula\ntion shown on the right in Table 2-8. \nTABLE 2-8. \nNet investment required-margin account. \nStock cost $21,500 \nPlus stock commissions + 320 Debit balance calculation: \nNet stock cost $21,820 Net stock cost $21,820 \nTimes margin rate X 50% Less equity - 10,910 \nEquity required $10,910 Debit balance $10,910 \nLess premiums received 1,500 (at 50% margin) \nPlus option commissions + 60 \nNet margin investment $ 9,470 \nTables 2-9 to 2-12 illustrate the computation of returns from writing on margin. \nIf one has already computed the cash returns, he can use method 2 most easily. \nMethod 1 involves no prior profit calculations. \nTABLE 2-9. \nReturn if exercised-margin account. \nMethod 1 Method 2 \nStock sale proceeds \nLess stock commission \nPlus dividends \n$22,500 Net profit if exercised-cash $2,290 \n+ \nLess margin interest charges \n330 \n500 \n(10% on $10,910 for 6 months) - 545 \nLess debit balance \nLess net margin investment \nNet profit-margin \n- 10,910 \n- 9 470 \n$ 1,745 \nLess margin interest charges -\nNet profit if exercised\nmargin \n$1,745 Return if exercised = $9 ,470 = 18.4% \n545 \n$1,745", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:73", "doc_id": "1781c153d74af485f8337989545dd3724f78a7ff6eb2f5440b4f569a1a67983c", "chunk_index": 0}
{"text": "52 \nTABLE 2-10. \nReturn if unchanged-margin account. \nMethod 1 \nUnchanged stock value (500 \nshares at 43) \nPlus dividends \nLess margin interest charges \n(10% on $10,910 debit for \n6 months) \nLess debit balance \nLess net investment (margin) \nNet profit if unchanged\nmargin \n$21,500 \n+ 500 \n545 \n10,910 \n- 9 470 \n$ 1,075 \nPart II: Call Option Strategies \nMethod 2 \nProfit if unchanged-cash \nLess margin interest charges -\nNet profit if unchanged\nmargin \n$1,620 \n545 \n$1,075 \nReturn if unchanged = $ l ,075 = 11 .4% \n$9,470 \nTABLE 2-11. \nBreak-even point-margin write. \nNet margin investment \nPlus debit balance \nLess dividends \nPlus margin interest charges \nTotal stock cost to expiration \nDivide by shares held \nBreak-even point-margin \nTABLE 2-12. \nPercent downside protection-margin write. \nInitial stock price \nLess break-even price-margin \nPoints of protection \nDivide by original stock price \nEquals percent downside protection-margin \n$ 9,470 \n+ 10,910 \n500 \n+ 545 \n$20,425 \n+ 500 \n40.9 \n43 \n-40.9 \n2.1 \n+43 \n4.9% \nThe return if exercised is 18.4% for the covered write using margin. In Example \n1 the return if exercised for acash write was computed as 11.2%. Thus, the return if \nexercised from amargin write is considerably higher. In fact, unless afairly deep in\nthe-money write is being considered, the return on margin will always be higher than", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:74", "doc_id": "8ff5d111dccf0e83fa8c169af21981fbbd02bfca3c960ecd76e30c9f5b26cab2", "chunk_index": 0}
{"text": "Cl,apter 2: Covered Call Writing 53 \nthe return from cash. The farther out-of-the-money that the written call is, the big\nger the discrepancy between cash and margin returns will be when the return if exer\ncised is computed. \nAs with the computation for return if exercised for awrite on margin, the return \nif unchanged calculation is similar for cash and margin also. The only difference is the \nsubtraction of the margin interest charges from the profit. The return if unchanged is \nalso higher for amargin write, provided that there is enough option premium to com\npensate for the margin interest charges. The return if unchanged in the cash example \nwas 7.9% versus 11.4% for the margin write. In general, the farther from the strike in \neither direction - out-of-the-money or in-the-money - the less the return if \nunchanged on margin will exceed the cash return if unchanged. In fact, for deeply out\nof-the-money or deeply in-the-money calls, the return if unchanged will be higher on \ncash than on margin. Table 2-11 shows that the break-even point on margin, 40.9, is \nhigher than the break-even point from acash write, 39.8, because of the margin inter\nest charges. Again, the percent downside protection can be computed as shown in \nTable 2-12. Obviously, since the break-even point on margin is higher than that on \ncash, there is less percent downside protection in amargin covered write. \nOne other point should be made regarding acovered write on margin: The bro\nkerage firm will loan you only half of the strike price amount as amaximum. Thus, it \nis not possible, for example, to buy astock at 20, sell adeeply in-the-money call struck \nat 10 points, and trade for free. In that case, the brokerage firm would loan you only \n5 - half the amount of the strike. \nEven so, it is still possible to create acovered call write on margin that has little or \neven zero margin .requirement. For example, suppose astock is selling at 38 and that along-term LEAPS option struck at 40 is selling for 19. Then the margin requirement is \nzero! This does not mean you're getting something for free, however. True, your invest\nment is zero, but your risk is still 19 points. Also, your broker would ask for some sort of \nminimum margin to begin with and would of course ask for maintenance margin if the \nunderlying stock should fall in price. Moreover, you would be paying margin interest all \nduring the life of this long-term LEAPS option position. Leverage can be agood thing or \nabad thing, and this strategy has agreat deal of leverage. So be careful if you utilize it. \nCOMPOUND INTEREST \nThe astute reader will have noticed that our computations of margin interest have \nbeen overly simplistic; the compounding effect of interest rates has been ignored. \nThat is, since interest charges are normally applied to an account monthly, the \ninvestor will be paying interest in the later stages of acovered writing position not \nonly on the original debit, but on all previous monthly interest charges. This effect is \ndescribed in detail in alater chapter on arbitrage techniques. Briefly stated, rather", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:75", "doc_id": "b9b214b83bb90598a3279ef85ca1a7f640824df4b1fcadbcef6d1997b273653b", "chunk_index": 0}
{"text": "54 Part II: Call Option Strategies \nthan computing the interest charge as the debit times the interest rate multiplied by \nthe time to expiration, one should technically use: \nMargin interest charges = Debit [(l + r/ -1] \nwhere ris the interest rate per month and tthe number of months to expiration. (It \nwould be incorrect to use days to expiration, since brokerage firms compute interest \nmonthly, not daily.) \nIn Example 2 of the preceding section, the debit was $10,910, the time was 6 \nmonths, and the annual interest rate was 10%. Using this more complex formula, the \nmargin interest charges would be $557, as opposed to the $545 charge computed \nwith the simpler formula. Thus, the difference is usually small, in terms of percent\nage, and it is therefore comrrwn practice to use the simpler method. \nSIZE OF THE POSITION \nSo far it has been assumed that the writer was purchasing 500 shares of XYZ and sell\ning 5 calls. This requires arelatively considerable investment for one position for the \nindividual investor. However, one should be aware that buying too few shares for cov\nered writing purposes can lower returns considerably. \nExample: If an investor were to buy 100 shares of XYZ at 43 and sell l July 45 call \nfor 3, his return if exercised would drop from the 11.2% return (cash) that was com\nputed earlier to areturn of9.9% in acash account. Table 2-13 verifies this statement. \nSince commissions are less, on aper-share basis, when one buys more stock and \nsells more calls, the returns will naturally be higher with a 500- or 1,000-share posi\ntion than with a 100- or 200-share position. This difference can be rather dramatic, as \nTables 2-14 and 2-15 point out. Several interesting and worthwhile conclusions can be \ndrawn from these tables. The first and most obvious conclusion is that the rrwre shares \nTABLE 2-13. \nCash investment vs. return. \nNet Investment-Cash ( l 00 shares) \nStock cost $4,300 \nPlus commissions + 85 \nLess option premium 300 \nPlus option commissions + 25 \nNet investment $4,110 \nReturn If Exercised-Cash ( l 00 shares) \nStock sale price \nStock commissions \nPlus dividend \nLess net investment \nNet profit if exercised \n$4,500 \n85 \n+ 100 \n- 4 110 \n$ 405 \nReturn if exercised = $4 05 = 9. 9% \n$4,110", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:76", "doc_id": "7776aa58653420c0a2ec72dabbd6249de826cc099f4c89e6f6f28b97b2247b8d", "chunk_index": 0}
{"text": "Cl,apter 2: Covered Call Writing 55 \none writes against, the higher his returns and the lower his break-even point will be. \nThis is true for both cash and margin and is adirect result of the way commissions are \nfigured: Larger trades involve smaller percentage commission charges. While the per\ncentage returns increase as the number of shares increases for both cash and margin \ncovered writing, the increase is much more dramatic in the case of margin. Note that \nin Table 2-14, which depicts cash transactions, the return from writing against 100 \nshares is 9.9% and increases to 12. 7% if 2,000 shares are written against. This is an \nincrease, but not aparticularly dramatic one. However, in Table 2-15, the return if \nexercised more than doubles (21.6 vs. 10.4) and the return if unchanged nearly triples \n(13.0 vs. 4.4) when the 100-share write is compared to the 2,000-share write. This \neffect is more dramatic for margin writes due to two factors - the lower investment \nrequired and the more burdensome effect of margin interest charges on the profits of \nsmaller positions. This effect is so dramatic that a 100-share write in acash account in \nour example actually offers ahigher return if unchanged than does the margin write \n- 7.1 % vs. 4.4%. This implies that one should carefully compute his potential returns \nif he is writing against asmall number of shares on margin. \nTABLE 2-14. \nCash covered writes (costs included). \nShares Written Against \n100 200 300 400 500 1,000 2,000 \nReturn if exercised (%) 9.9 10.0 10.4 10.8 11.2 12.1 12.7 \nRe~rn if unchanged(%) 7.1 7.2 7.5 7.7 7.9 8.4 8.7 \nBreak-even point 40.1 40.0 39.9 39.9 39.8 39.6 39.5 \nTABLE 2-15. \nMargin covered writes (costs included). \nShares Written Against \n100 200 300 400 500 1,000 2,000 \nReturn if exercised (%) 10.4 15.8 16.6 17.4 18.4 20.4 21.6 \nReturn if unchanged (%) 4.4 9.8 10.3 10.8 11.4 12.3 13.0 \nBreak-even point 41.2 41.1 41.0 41.0 40.9 40.7 40.6 \nWHAT A DIFFERENCE A DIME MAKES \nAnother aspect of covered writing that can be important as far as potential returns \nare concerned is, of course, the prices of the stock and option involved in the write.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:77", "doc_id": "82dedd48502aa739e5497535a2ae4ca2558b7a22bd4c642fb0c80084c8e85dca", "chunk_index": 0}
{"text": "56 Part II: Call Option Strategies \nIt may seem insignificant that one has to pay an extra few cents for the stock or pos\nsibly receives adime or 20 cents less for the call, but even arelatively small fraction \ncan alter the potential returns by asurprising amount. This is especially true for in\nthe-money writes, although any write will be affected. Let us use the previous 500-\nshare covered writing example, again including all costs. \nAs before, the results are more dramatic for the margin write than for the cash \nwrite. In neither case does the break-even point change by much. However, the \npotential returns are altered significantly. Notice that if one pays an extra dime for \nthe stock and receives adime less for the call - the far right-hand column in Table \n2-16 - he may greatly negate the effect of writing against alarger number of shares. \nFrom Table 2-16, one can see that writing against 300 shares at those prices (43 for \nthe stock and 3 for the call) is approximately the same return as writing against 500 \nshares if the stock costs 431/sand the option brings in 27/s. \nTable 2-16 should clearly demonstrate that entering acovered writing order at \nthe market may not be aprudent thing to do, especially if one'scalculations for the \npotential returns are based on last sales or on closing prices in the newspaper. In the \nnext section, we discuss in depth the proper procedure for entering acovered writ\ning order. \nTABLE 2-16. \nEffect of stock and option prices on writing returns. \nBuy Stock at 43 Buy Stock at 43.10 \nSell Call at 3 Sell Call at 3 \nReturn if exercised 11.2% cash 10.9% cash \n18.4% margin 17.7% margin \nReturn if unchanged 7.9% cash 7.6% cash \n11 .4% margin 10.7% margin \nBreak-even point 39.8 cash 39.9 cash \n40.9 margin 41.0 margin \nEXECUTION OF THE COVERED WRITE ORDER \nBuy Stock at 43. I 0 \nSell Call at 2.90 \n10.6% cash \n16. 9% margin \n7.3% cash \n9.9% margin \n40.0 cash \n41.1 margin \nWhen establishing acovered writing position, the question often arises: Which \nshould be done first - buy the stock or sell the option? The correct answer is that nei\nther should be done first! In fact, asimultaneous transaction of buying the stock and \nselling the option is the only way of assuring that both sides of the covered write are \nestablished at desired price levels.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:78", "doc_id": "3900919b63761a3ff6af831999bbf85e6af6dfe6098bf7ccf2d9f1fb25bc4612", "chunk_index": 0}
{"text": "Cl,apter 2: Covered Call Writing 57 \nIf one \"legs\" into the position - that is, buys the stock first and then attempts to \nsell the option, or vice versa - he is subjecting himself to arisk. \nExample: An investor wants to buy XYZ at 43 and sell the July 45 call at 3. Ifhe first \nsells the option at 3 and then tries to buy the stock, he may find that he has to pay \nmore than 43 for the stock. On the other hand, if he tries to buy the stock first and \nthen sell the option, he may find that the option price has moved down. In either case \nthe writer will be accepting alower return on his covered write. Table 2-16 demon\nstrated how one'sreturns might be affected ifhe has to give up an eighth by \"legging\" \ninto the position. \nESTABLISHING A NET POSITION \nWhat the covered writer really wants to do is ensure that his net price is obtained. If \nhe wants to buy stock at 43 and sell an option at 3, he is attempting to establish the \nposition at 40 net. He normally would not mind paying 43.10 for the stock if he can \nsell the call at 3.10, thereby still obtaining 40 net. \nA \"net\" covered writing order must be placed with abrokerage firm because it \nis essential for the person actually executing the order to have full access to both the \nstock exchange and the option exchange. This is also referred to as acontingent \norder. Most major brokerage firms offer this service to their clients, although some \nplace aminimum number of shares on the order. That is, one must write against at \nleast 500 or 1,000 shares in order to avail himself of the service. There are, however, \nbrokerage firms that will take net orders even for 100-share covered writes. Since the \nchances of giving away adime are relatively great if one attempts to execute his own \norder by placing separate orders on two exchanges - stock and option - he should \navail himself of the broker'sservice. Moreover, if his orders are for asmall number of \nshares, he should deal with abroker who will take net orders for small positions. \nThe reader must understand that there is no guarantee that anet order will be \nfilled. The net order is always a \"not held\" order, meaning that the customer is not \nguaranteed an execution even if it appears that the order could be filled at prevailing \nmarket bids and offers. Of course, the broker will attempt to fill the order if it can \nreasonably be accomplished, since that is his livelihood. However, if the net order is \nslightly away from current market prices, the broker may have to \"leg\" into the posi\ntion to fill the order. The risk in this is the broker'sresponsibility, not the customer's. \nTherefore, the broker may elect not to take the risk and to report \"nothing done\" -\nthe order is not filled. \nIf one buys stock at 43 and sells the call at 3, is the return really the same as buy\ning the stock at 43.10 and selling the call at 3.10? The answer is, yes, the returns are", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:79", "doc_id": "156bfcf22ad6ea9eb79267269c4287c519381e37c19cc14b1c43efc70795e5d2", "chunk_index": 0}
{"text": "58 Part II: Call Option Strategies \nvery similar when the prices differ by small amounts. This can be seen without the \nuse of atable. If one pays adime more for the stock, his investment increases by $10 \nper 100 shares, or $50 total on a 500-share transaction. However, the fact that he has \nreceived an extra dime for the call means that the investment is reduced by $62.50. \nThus, there is no effect on the net investment except for commissions. The commis\nsion on 500 shares at 43.10 may be slightly higher than the commission for 500 shares \nat 43. Similarly, the commission on 5 calls at 3.10 may be slightly higher than that on \n5 calls at 3. Even so, the increase in commissions would be so small that it would not \naffect the return by more than one-tenth of 1 %. \nTo carry this concept to extremes may prove somewhat misleading. If one were \nto buy stock at 40½ and sell the call at ½, he would still be receiving 40 net, but sev\neral aspects would have changed considerably. The return if exercised remains amaz\ningly constant, but the return if unchanged and the percentage downside protection \nare reduced dramatically. If one were to buy stock at 48 and sell the call at 8 - again \nfor 40 net - he would improve the return if unchanged and the percentage downside \nprotection. In reality, when one places a \"net\" order with abrokerage firm, he nor\nmally gets an execution with prices quite close to the ones at the time the order was \nfirst entered. It would be arare case, indeed, when either upside or downside \nextremes such as those mentioned here would occur in the same trading day. \nSELECTING A COVERED WRITING POSITION \nThe preceding sections, in describing types of covered writes and how to compute \nreturns and break-even points, have laid the groundwork for the ultimate decision \nthat every covered writer must make: choosing which stock to buy and which option \nto write. This is not necessarily an easy task, because there are large numbers of \nstocks, striking prices, and expiration dates to choose from. \nSince the primary objective of covered writing for most investors is increased \nincome through stock ownership, the return on investment is an important consider\nation in determining which write to choose. However, the decision must not be made \non the basis of return alone. More volatile stocks will offer higher returns, but they \nmay also involve more risk because of their ability to fall in price quickly. Thus, the \namount of downside protection is the other important objective of covered writing. \nFinally, the quality and technical or fundamental outlook of the underlying stock \nitself are of importance as well. The following section will help to quantify how these \nfactors should be viewed by the covered writer.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:80", "doc_id": "28ee239705e670e8571dcb69a0def0e9a72452d06ece1d61677b8c6967a4cb97", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing \nPROJECTED RETURNS \n59 \nThe return that one strives for is somewhat amatter of personal preference. In gen\neral, the annualized return if unchanged should be used as the comparative measure \nbetween various covered writes. In using this return as the measuring criterion, one \ndoes not make any assumptions about the stock moving up in price in order to attain \nthe potential return. Ageneral rule used in deciding what is aminimally acceptable \nreturn is to consider acovered writing position only when the return if unchanged is \nat least 1 % per month. That is, a 3-month write would have to offer areturn of at \nleast 3% and a 6-month write would have to have areturn if unchanged of at least \n6%. During periods of expanded option premiums, there may be so many writes that \nsatisfy this criterion that one would want to raise his sights somewhat, say to 1 ½% or \n2% per month. Also, one must feel personally comfortable that his minimum return \ncriterion - whether it be 1 % per month or 2% per month - is large enough to com\npensate for the risks he is taking. That is, the downside risk of owning stock, should \nit fall far enough to outdistance the premium received, should be adequately com\npensated for by the potential return. It should be pointed out that 1 % per month is \nnot areturn to be taken lightly, especially if there is areasonable assurance that it can \nbe attained. However, if less risky investments, such as bonds, were yielding 12% \nannually, the covered writer must set his sights higher. \nNormally, the returns from various covered writing situations are compared by \nannualizing the returns. One should not, however, be deluded into believing that he \ncan always attain the projected annual return. A 6-month write that offers a 6% \nreturn annualizes to 12%. But if one establishes such aposition, all that he can \nachieve is 6% in 6 months. One does not really know for sure that 6 months from now \nthere will be another position available that will provide 6% over the next 6 months. \nThe deeper that the written option is in-the-money, the higher the probability \nthat the return if unchanged will actually be attained. In an in-the-money situation, \nrecall that the return if unchanged is the same as the return if exercised. Both would \nbe attained unless the stock fell below the striking price by expiration. Thus, for an in\nthe-money write, the projected return is attained if the stock rises, remains unchanged, \nor even falls slightly by the time the option expires. Higher potential returns are avail\nable for out-of-the-money writes if the stock rises. However, should the stock remain \nthe same or decline in price, the out-of-the-money write will generally underperform \nthe in-the-money write. This is why the return if unchanged is agood comparison. \nDOWNSIDE PROTECTION \nDownside protection is more difficult to quantify than projected returns are. As men\ntioned earlier, the percentage of downside protection is often used as ameasure. This", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:81", "doc_id": "00d5f48213b56ce22bf071205ad27fd662cd9aa70f1fc4d10d2c11fd771ad4ff", "chunk_index": 0}
{"text": "60 Part II: Call Option Strategies \nis somewhat misleading, however, since the more volatile stocks will always offer alarge percentage of downside protection (their premiums are higher). The difficulty \narises in trying to decide if 10% protection on avolatile stock is better than or worse \nthan, say, 6% protection on aless volatile stock. There are mathematical ways to \nquantify this, but because of the relatively advanced nature of the computations \ninvolved, they are not discussed until later in the text, in Chapter 28 on mathemati\ncal applications. \nRather than go into involved mathematical calculations, many covered writers \nuse the percentage of downside protection and will only consider writes that offer acertain minimum level of protection, say 10%. Although this is not exact, it does \nstrive to ensure that one has minimal downside protection in acovered write, as well \nas an acceptable return. Astandard figure that is often used is the 10% level of pro\ntection. Alternatively, one may also require that the write be acertain percent in-the\nmoney, say 5%. This is just another way of arriving at the same concept. \nTHE IMPORTANCE OF STRATEGY \nIn aconservative option writing strategy, one should be looking for minimum returns \nif unchanged of 1 % per month, with downside protection of at least 10%, as general \nguidelines. Employing such criteria automatically forces one to write in-the-money \noptions in line with the total return concept. The overall position constructed by \nusing such guidelines as these will be arelatively conservative position - regardless \nof the volatility of the underlying stock - since the levels of protection will be large \nbut areasonable return can still be attained. There is adanger, however, in using \nfixed guidelines, because market conditions change. In the early days of listed \noptions, premiums were so large that virtually every at- or in-the-money covered \nwrite satisfied the foregoing criteria. However, now one should work with aranked \nlist of covered writing positions, or perhaps two lists. Adaily computer ranking of \neither or both of the following categories would help establish the most attractive \ntypes of conservative covered writes. One list would rank, by annualized return, the \nwrites that afford, as aminimum, the desired downside protection level, say 10%. \nThe other list would rank, by percentage downside protection, all the writes that \nmeet at least the minimum acceptable return if unchanged, say 12%. If premium lev\nels shrink and the lists become quite small on adaily basis, one might consider \nexpanding the criteria to view more potential situations. On the other hand, if pre\nmiums expand dramatically, one might consider using more restrictive criteria, to \nreduce the number of potential writing candidates. \nAdifferent group of covered writers may favor amore aggressive strategy of out\nof-the-money writes. There is some mathematical basis to believe, in the long rnn, that", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:82", "doc_id": "5183262def0495ba13b2696cec13a725dd4b8e78b8f1a0ccdb2727defc0c20df", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing 61 \nrrwderately out-of the-rrwney covered writes will peiform better than in-the-rrwney \nwrites. In falling or static markets, any covered writer, even the more aggressive one, \nwill outperform the stockowner who does not write calls. The out-of-the-money cov\nered writer has more risk in such amarket than the in-the-money writer does. But in \narising market, the out-of-the-money covered writer will not limit his returns as much \nas the in-the-money writer will. As stated earlier, the out-of-the-money writer'sper\nformance will more closely follow the performance of the underlying stock; that is, it \nwill be more volatile on aquarter-by-quarter basis. \nThere is merit in either philosophy. The in-the-money writes appeal to those \ninvestors looking to earn arelatively consistent, moderate rate of return. This is the \ntotal return concept. These investors are generally concerned with preservation of \ncapital, thus striving for the greater levels of downside protection available from in\nthe-money writes. On the other hand, some investors prefer to strive for higher \npotential returns through writing out-of-the-money calls. These more aggressive \ninvestors are willing to accept more downside risk in their covered writing positions \nin exchange for the possibility of higher returns should the underlying stock rise in \nprice. These investors often rely on abullish research opinion on astock in order to \nselect out-of-the-money writes. \nAlthough the type of covered writing strategy pursued is amatter of personal \nphilosophy, it would seem that the benefits of in-the-money strategy- more consis\ntent returns and lessened risk than stock ownership will normally provide - would \nlead the portfolio manager or less aggressive investor toward this strategy. If the \ninvestor is interested in achieving higher returns, some of the strategies to be pre\nsented later in the book may be able to provide higher returns with less risk than can \nout-of-the-money covered writing. \nThe final important consideration in selecting acovered write is the underlying \nstock itself. One does not necessarily have to be bullish on the underlying stock to \ntake acovered writing position. As long as one does not foresee apotential decline in \nthe underlying stock, he can feel free to establish the covered writing position. It is \ngenerally best if one is neutral or slightly bullish on the underlying stock. If one is \nbearish, he should not take acovered writing position on that stock, regardless of the \nlevels of protection that can be obtained. An even broader statement is that one \nshould not establish acovered write on astock that he does not want to own. Some \nindividual investors may have qualms about buying stock they feel is too volatile for \nthem. Impartially, if the return and protection are adequate, the characteristics of the \ntotal position are different from those of the underlying stock. However, it is still true \nthat one should not invest in positions that he considers too risky for his portfolio, nor \nshould one establish acovered write just because he likes aparticular stock. If the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:83", "doc_id": "120c2a4715ca9dc34b375679d467026f3fbfa049bd801aed236d635d45428d71", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing \nReturn if exercised - margin \nDownside break-even point cash \nDownside break-even point - margin \nXYZ \n7.9% \n46.3 \n47.6 \n63 \nAAA \n16.2% \n44.9 \n46.1 \nSeeing these calculations, the XYZ stockholder may feel that it is not advisable to \nwrite against his stock, or he may even be tempted to sell XYZ and buy AAA in order \nto establish acovered write. Either of these actions could be amistake. \nFirst, he should compute what his returns would be, at current prices, from \nwriting against the XYZ he already owns. Since the stock is already held, no stock buy \ncommissions would be involved. This would reduce the net investment shown below \nby the stock purchase commissions, or $345, giving atotal net investment (cash) of \n$23,077. In theory, the stockholder does not really make an investment per se; after \nall, he already owns the stock. However, for the purposes of computing returns, an \ninvestment figure is necessary. This reduction in the net investment will increase his \nprofit by the same amount - $345 - thus, bringing the profit up to $1,828. \nConsequently, the return if exercised (cash) wpuld be 7.9% on XYZ stock already \nheld. On margin, the return would increase to 11.3% after eliminating purchase com\nmissions. This return, assumed to be for a 6-month period, is well in excess of 1 % per \nTABLE 2-17. \nSummary of covered writing returns, XYZ and AAA. \nXYZ AAA \nBuy 500 shares at 50 $25,000 $25,000 \nPlus stock commissions + 345 + 345 \nLess option premiums received - 2,000 - 3,000 \nPlus option sale commissions + 77 + 91 \nNet investment-cash $23,422 $22,436 \nSell 500 shares at 50 $25,000 $25,000 \nLess stock sale commissions 345 345 \nDividend received + 250 0 \nLess net investment - 23,422 - 22,436 \nNet profit $ 1,483 $ 2,219 \nReturn if exercised-cash 6.3% 9.9%", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:85", "doc_id": "0c79bf2f41be88930c1aaac97afbd63108480ed5ff72535f2770ca928af0cb96", "chunk_index": 0}
{"text": "' 64 Part II: Call Option Strategies \nmonth, the level nominally used for acceptable covered writes. Thus, the investor \nwho already owns stock may inadvertently be overlooking apotentially attractive cov\nered write because he has not computed the returns excluding the stock purchase \ncommission on his current stock holding. \nIt could conceivably be an even more extreme oversight for the investor to \nswitch from XYZ to AAA for writing purposes. The investor may consider making this \nswitch because he thinks that he could substantially increase his return, from 6.3% to \n9.9% for the 6-month period, as shown in Table 2-17 comparing the two writes. \nHowever, the returns are not truly comparable because the investor already \nowns XYZ. To make the switch, he would first have to spend $345 in stock commis\nsions to sell his XYZ, thereby reducing his profits on AAA by $345. Referring again to \nthe preceding detailed breakdown of the return if exercised, the profit on AAA would \nthen decline to $1,874 on the investment of $22,436, areturn if exercised (cash) of \n8.4%. On margin, the comparable return from switching stocks would drop to 14.8%. \nThe real comparison in returns from writing against these two stocks should be \nmade in the following manner. The return from writing against XYZ that is already \nheld should be compared with the return from writing against AAA after switching \nfromXYZ: \nReturn if exercised - cash \nReturn if exercised - margin \nXYZ Already Held \n7.9% \n11.3% \nSwitch from XYZ to AAA \n8.4% \n14.8% \nEach investor must decide for himself whether it is worth this much smaller \nincrease in return to switch to amore volatile stock that pays asmaller dividend. He \ncan, of course, only make this decision by making the true comparison shown imme\ndiately above as opposed to the first comparison, which assumed that both stocks had \nto be purchased in order to establish the covered write. \nThe same logic applies in situations in which an investor has been doing cov\nered writing. If he owns stock on which an option has expired, he will have to decide \nwhether to write against the same stock again or to sell the stock and buy anew stock \nfor covered writing purposes. Generally, the investor should write against the stock \nalready held. This justifies the method of computation of return if unchanged for out\nof-the-money writes and also the computation of downside break-even points in \nwhich astock sale commission was not charged. That is, the writer would not nor\nmally sell his stock after an option has expired worthless, but would instead write \nanother option against the same stock. It is thus acceptable to make these computa\ntions without including astock sales commission.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:86", "doc_id": "8e6deb617ca2a1b922fd566e073587c37fe9b3ca1bbb60ec253dd64d5a3a888b", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing \nA WORD OF CAUTION \n65 \nThe stockholder who owns stock from aprevious purchase and later contemplates \nwriting calls against that stock must be aware of his situation. He must realize and \naccept the fact that he might lose his stock via assignment. If he is determined to \nretain ownership of the stock, he may have to buy back the written option at aloss \nshould the underlying stock increase in price. In essence, he is limiting the stock'supside potential. If astockholder is going to be frustrated and disappointed when he \nis not fully participating during arally in his stock, he should not write acall in the \nfirst place. Perhaps he could utilize the incremental return concept of covered writ\ning, atopic covered later in this chapter. \nAs stressed earlier, acovered writing strategy involves viewing the stock and \noption as atotal position. It is not astrategy wherein the investor is astockholder who \nalso trades options against his stock position. If the stockholder is selling the calls \nbecause he thinks the stock is going to decline in price and the call trade itself will be \nprofitable, he may be putting himself in atenuous position. Thinking this way, he will \nprobably be satisfied only if he makes aprofit on the call trade, regardless of the \nunrealized result in the underlying stock. This sort of philosophy is contrary to acov\nered writing strategy philosophy. Such an investor - he is really becoming atrader \nshould carefully review his motives for writing the call and anticipate his reaction if \nthe stock rises substantially in price after the call has been written. \nIn essence, writing calls against stock that you have no intention of selling is \ntantamount to writing naked calls! If one is going to be extremely frustrated, perhaps \neven experiencing sleepless nights, if his stock rises above the strike price of the call \nthat he has written, then he is experiencing trials and tribulations much as the writer \nof anaked call would if the same stock move occurred. This is an unacceptable level \nof emotional worry for atrue covered writing strategist. \nThink about it. If you have some very low-cost-basis stock that you don'treally \nwant to sell, and then you sell covered calls against that stock, what do you wish will \nhappen? Most certainly you wish that the options will expire worthless (i.e., that the \nstock won'tget called away) - exactly what anaked writer wishes for. \nThe problems can be compounded if the stock rises, and one then decides to \nroll these calls. Rather than spend asmall debit to close out alosing position, an \ninvestor may attempt to roll to more distant expiration months and higher strike \nprices in order to keep bringing in credits. Eventually, he runs out of room as the \nlower strikes disappear, and he has to either sell some stock or pay abig debit to buy \nback the written calls. So, if the underlying stock continues to run higher, the writer \nsuffers emotional devastation as he attempts to \"fight the market.\" There have been \nsome classic cases of Murphy'slaw whereby people have covered the calls at abig", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:87", "doc_id": "c76365bd10870fa7c9eb2d84fd4b6552dd1cf37b470b7daabcd366c11a37bf90", "chunk_index": 0}
{"text": "66 Part II: Call Option Strategies \ndebit rather than let their \"untouchable\" stock be called away, just before the stock \nitself or the stock market collapsed. \nOne should be very cautious about writing covered calls against stocks that he \ndoesn'tintend to sell. If one feels that he cannot sell his stock, for whatever reason -\ntax considerations, emotional ties, etc. - he really should not sell covered calls against \nit. Perhaps buying aprotective put ( discussed in alater chapter) would be abetter \nstrategy for such astockholder. \nDIVERSIFYING RETURN AND PROTECTION \nIN A COVERED WRITE \nFUNDAMENTAL DIVERSIFICATION TECHNIQUES \nQuite clearly, the covered writing strategist would like to have as much of acombina\ntion of high potential returns and adequate downside protection as he can obtain. \nWriting an out-of-the-money call will offer higher returns if exercised, but it usually \naffords only amodest amount of downside protection. On the other hand, writing an \nin-the-money call will provide more downside cushion but offers alower return if \nexercised. For some strategists, this diversification is realized in practice by writing \nout-of-the-money calls on some stocks and in-the-moneys on other stocks. There is no \nguarantee that writing in this manner on alist of diversified stocks will produce supe\nrior results. One is still forced to pick the stocks that he expects will perform better \n(for out-of-the-money writing), and that is difficult to do. Moreover, the individual \ninvestor may not have enough funds available to diversify into many such situations. \nThere is, however, another alternative to obtaining diversification of both returns and \ndownside protection in acovered writing situation. \nThe writer may often do best by writing half of his position against in-the-rrwn\neys and half against out-of the-rrwneys on the same stock. This is especially attractive \nfor astock whose out-of-the-money calls do not appear to provide enough downside \nprotection, and at the same time, whose in-the-money calls do not provide quite \nenough return. By writing both options, the writer may be able to acquire the return \nand protection diversification that he is seeking. \nExample: The following prices exist for 6-month calls: \nXYZ common stock, 42; \nXYZ April 40 call, 4; and \nXYZ April 45 call, 2.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:88", "doc_id": "4f1fb050e17662d88e5d6300a802bbbf08d61b3446926bf0e2d41831157889a8", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing 67 \nThe writer wishing to establish acovered write against XYZ common stock may like \nthe protection afforded by the April 40 call, but may not find the return particularly \nattractive. He may be able to improve his return by writing April 45'sagainst part of \nhis position. Assume the writer is considering buying 1,000 shares of XYZ. Table 2-18 \ncompares the attributes of writing the out-of-the-money (April 45) only, or of writing \nonly the in-the-money (April 40), or of writing 5 of each. The table is based on acash \ncovered write, but returns and protection would be similar for amargin write. \nCommissions are included in the figures. \nIt is easily seen that the \"combined\" write - half of the position against the April \n40'sand the other half against the April 45's - offers the best balance of return and \nprotection. The in-the-money call, by itself, provides over 10% downside protection, \nbut the 5% return if exercised is less than 1 % per month. Thus, one might not want \nto write April 40'sagainst his entire position, because the potential return is small. At \nthe same time, the April 45's, if written against the entire stock position, would pro\nvide for an attractive return if exercised (over 2% per month) but offer only 5% down\nside protection. The combined write, which has the better features of both options, \noffers over 8% return if exercised (11h% per month) and affords over 8% downside \nprotection. By writing both calls, the writer has potentially solved the problems inher\nent in writing entirely out-of-the-moneys or entirely in-the-moneys. The \"combined\" \nwrite frees the covered writer from having to initially take abearish (in-the-money \nwrite) or bullish (out-of-the-money write) posture on the stock ifhe does not want to. \nThis is often necessary on alow-volatility stock trading between striking prices. \nTABLE 2-18. \nAttributes of various writes. \nBuy 1,000 XYZ and sell \nReturn if exercised \nRe~rn if unchanged \nPercent protection \nIn-the-Money \nWrite \n10 April 40's \n5.1% \n5.1% \n10.5% \nOut-of-the-Money \nWrite \nl O April 45's \n12.2% \n6.0% \n5.7% \nWrite \nBoth Calls \n5 April 40'sand \n5 April 45's \n8.4% \n5.4% \n8.1% \nFor those who prefer agraphic representation, the profit graph shown in Figure \n2-2 compares the combined write of both calls with either the in-the-money write or \nthe out-of-the-money write (dashed lines). It can be observed that all three choices \nare equal if XYZ is near 42 at expiration; all three lines intersect there.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:89", "doc_id": "2b09e583f5635c21b409f8a3556716bb64a2ac51fe8b4f52d7377ba361128789", "chunk_index": 0}
{"text": "68 Part II: Call Option Strategies \nFIGURE 2-2. \nComparison: combined write vs. in-the-money write and out-of-the\nmoney write. \nOut-of-the-Money Write \n, \n.-------► ,,, Combined Write , \n/ In-the-Money Write \n-----------➔ \nStock Price at Expiration \nSince this technique can be useful in providing diversification between protec\ntion and return, not only for an individual position but for alarge part of aportfolio, \nit may be useful to see exactly how to compute the potential returns and break-even \npoints. Tables 2-19 and 2-20 calculate the return if exercised and the return if \nunchanged using the prices from the previous example. Assume XYZ will pay $1 per \nshare in dividends before April expiration. \nNote that the profit calculations are similar to those described in earlier sec\ntions, except that now there are two prices for stock sales since there are two options \ninvolved. In the \"return if exercised\" section, half of the stock is sold at 45 and half is \nsold at 40. The \"return if unchanged\" calculation is somewhat more complicated now, \nTABLE 2-19. \nNet investment-cash account. \nBuy 1,000 XYZ at 42 \nPlus stock commissions \nLess options premiums: \nSell 5 April 40'sat 4 \nSell 5 April 45'sat 2 \nPlus total option commissions \nNet investment \n+ \n$42,000 \n460 \n- 2,000 \n1,000 \n+ 140 \n$39,600", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:90", "doc_id": "3f742cc8fe82faac28f993dca02f8ec8fbef45e1a01c93ffe6d8271711d8100f", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing \nTABLE 2-20. \nNet return-cash account. \nReturn If Exercised \nSell 500 XYZ at 45 $22,500 \nSell 500 XYZ at 40 20,000 \nLess total stock sale \ncommissions 560 \nPlus dividends ($1 /share) + 1,000 \nLess net investment - 39,600 \nNet profit if exercised $ 3,340 \nReturn if exercised = 3,340 = 8_4% \n(cash) 39,600 \n69 \nReturn If Unchanged \nUnchanged stock value (500 \nshares at 42) $21,000 \nSell 500 at 40 + 20,000 \nCommissions on sale at 40 280 \nPlus dividends ($1 /share) . + 1,000 \nLess net investment - 39,600 \nNet profit if unchanged $ 2, 120 \nReturn if unchanged = 2, 120 = 5 _4% \n(cash) 39,600 \nbecause half of the stock will be called away if it remains unchanged (the in-the\nmoney portion) whereas the other half will not. This is consistent with the method of \ncalculating the return if unchanged that was introduced previously. \nThe break-even point is calculated as before. The \"total stock cost to expiration\" \nwould be the net investment of $39,600 less the $1,000 received in dividends. This is \natotal of $38,600. On aper-share basis, then, the break-even point of 38.6 is 8.1 % \nbelow the current stock price of 42. Thus, the amount of percentage downside pro\ntection is 8.1 %. \nThe foregoing calculations clearly demonstrate that the returns on the \"com\nbined\" write are not exactly the averages of the in-the-money and out-of-the-money \nreturns, because of the different commission calculations at various stock prices. \nHowever, if one is working with acomputer-generated list and does not want to both\ner to calculate exactly the return on the combined write, he can arrive at arelatively \nclose approximation by averaging the returns for the in-the-money write and the out\nof-the-money write. \nOTHER DIVERSIFICATION TECHNIQUES \nHolders of large positions in aparticular stock may want even more diversification \nthan can be provided by writing against two different striking prices. Institutions, \npension funds, and large individual stockholders may fall into this category. It is often \nadvisable for such large stockholders to diversify their writing over time as well as \nover at least two striking prices. By diversifying over time - for example, writing one-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:91", "doc_id": "4579abd51a870d83e7fd459ee77195594ae5732f947e8fc898b7139c520c3075", "chunk_index": 0}
{"text": "70 Part II: Call Option Strategies \nthird of the position against near-term calls, one-third against middle-term calls, and \nthe remaining third against long-term calls - one can gain several benefits. First, all \nof one'spositions need not be adjusted at the same time. This includes either having \nthe stock called away or buying back one written call and selling another. Moreover, \none is not subject only to the level of option premiums that exist at the time one \nseries of calls expires. For example, if one writes only 9-month calls and then rolls \nthem over when they expire, he may unnecessarily be subjecting himself to the \npotential of lower returns. If option premium levels happen to be low when it is time \nfor this 9-month call writer to sell more calls, he will be establishing aless-than-opti\nmum write for up to 9 months. By spreading his writing out over time, he would, at \nworst, be subjecting only one-third of his holding to the low-premium write. \nHopefully, premiums would expand before the next eXpiration 3 months later, and he \nwould then be getting arelatively better premium on the next third of his portfolio. \nThere is an important aside here: The individual or relatively small investor who \nowns only enough stock to write one series of options should generally not write the \nlongest-term calls for this very reason. He may not be obtaining aparticularly attrac\ntive level of premiums, but may feel he is forced to retain the position until expira\ntion. Thus, he could be in arelatively poor write for as long as 9 months. Finally, this \ntype of diversification may also lead to having calls at various striking prices as· the \nmarket fluctuates cyclically. All of one'sstock is not necessarily committed at one \nprice if this diversification technique is employed. \nThis concludes the discussion of how to establish acovered writing position \nagainst stock. Covered writes against other types of securities are described later. \nFOLLOW-UP ACTION \nEstablishing acovered write, or any option position for that matter, is only part of the \nstrategist'sjob. Once the position has been taken, it must be monitored closely so that \nadjustments may be made should the stock drop too far in price. Moreover, even if \nthe stock remains relatively unchanged, adjustments will need to be made as the writ\nten call approaches expiration. \nSome writers take no follow-up action at all, preferring to let astock be called \naway if it rises above the striking price at the expiration of the option, or preferring \nto let the original expire worthless if the stock is below the strike. These are not \nalways optimum actions; there may be much more decision making involved. \nFollow-up action can be divided into three general categories:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:92", "doc_id": "75e10e3e38b16bb3560a13b238048bf37bef36dfcc2883c45d9e1e284122bfca", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing 71 \n1. protective action to take if the stock drops, \n2. aggressive action to take when the stock rises, or \n3. action to avoid assignment if the time premium disappears from an in-the-money \ncall. \nThere may be times when one decides to close the entire position before expiration \nor to let the stock be called away. These cases are discussed as well. \nPROTECTIVE ACTION IF THE UNDERLYING STOCK DECLINES IN PRICE \nThe covered writer who does not take protective action in the face of arelatively sub\nstantial drop in price by the underlying stock may be risking the possibility of large \nlosses. Since covered writing is astrategy with limited profit potential, one should \nalso take care to limit losses. Otherwise, one losing position can negate several win\nning positions. The simplest form of follow-up action in adecline is to merely close \nout the position. This might be done if the stock declines by acertain percentage, or \nif the stock falls below atechnical support level. Unfortunately, this method of defen\nsive action may prove to be an inferior one. The investor will often do better to con\ntinue to sell more time value in the form of additional option premiums. \nFollow-up action is generally taken by buying back the call that was originally \nwritten and then writing another call, with adifferent striking price and/or expiration \ndate, in its place. Any adjustment of this sort is referred to as arolling action. When \nthe underlying stock drops in price, one generally buys back the original call - pre\nsumably at aprofit since the underlying stock has declined - and then sells acall with \nalower striking price. This is known as rolling down, since the new option has alower \nstriking price. \nExample: The covered writing position described as \"buy XYZ at 51, sell the XYZ \nJanuary 50 call at 6\" would have amaximum profit potential at expiration of 5 points. \nDownside protection is 6 points down to astock price of 45 at expiration. These fig\nures do not include commissions, but for the purposes of an elementary example, the \ncommissions will be ignored. \nIf the stock begins to decline in price, taking perhaps two months to fall to 45, \nthe following option prices might exist: \nXYZ common, 45; \nXYZ January 50 call, l; and \nXYZ January 45 call, 4.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:93", "doc_id": "42424f35cd3e70d19caacd16fb1bac9640476e3dbe0e7a9de16e771ed4d5366b", "chunk_index": 0}
{"text": "72 Part II: Call Option Strategies \n• \nThe covered writer of the January 50 would, at this time, have asmall unrealized loss \nof one point in his overall position: His loss on the common stock is 6 points, but he \nhas a 5-point gain in the January 50 call. (This demonstrates that prior to expiration, \naloss occurs at the \"break-even\" point.) If the stock should continue to fall from \nthese levels, he could have alarger loss at expiration. The call, selling for one point, \nonly affords one more point of downside protection. If afurther stock price drop is \nanticipated, additional downside protection can be obtained by rolling down. In this \nexample, if one were to buy back the January 50 call at 1 and sell the January 45 at \n4, he would be rolling down. This would increase his protection by another three \npoints - the credit generated by buying the 50 call at 1 and selling the 45 call at 4. \nHence, his downside break-even point would be 42 after rolling down. \nMoreover, if the stock were to remain unchanged - that is, if XYZ were exactly \n45 at January expiration - the writer would make an additional $300. If he had not \nrolled down, the most additional income that he could make, if XYZ remained \nunchanged, would be the remaining $100 from the January 50 call. So rolling down \ngives more downside protection against afurther drop in stock price and may also \nproduce additional income if the stock price stabilizes. \nIn order to more exactly evaluate the overall effect that was obtained by rolling \ndown in this example, one can either compute aprofit table (Table 2-21) or draw anet profit graph (Figure 2-3) that compares the original covered write with the \nrolled-down position. \nNote that the rolled-down position has asmaller maximum profit potential than \nthe original position did. This is because, by rolling down to a January 45 call, the \nwriter limits his profits anywhere above 45 at expiration. He has committed himself \nto sell stock 5 points lower than the original position, which utilized a January 50 call \nand thus had limited profits above 50. Rolling down generally reduces the maximum \nTABLE 2·21. \nProfit table. \nXYZ Price at Profit from Profit from \nExpiration January 50 Write Rolled Position \n40 -$500 -200 \n42 - 300 0 \n45 0 +300 \n48 + 300 +300 \n50 + 500 +300 \n60 + 500 +300", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:94", "doc_id": "0dae5f6e03d265be6a1979967ea9b10c49fd1922577f9db33041481b922a06c7", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing \nFIGURE 2-3. \nComparison: original covered write vs. rolled-down write. \n+$500 \nc: +$300 \n0 \n~ \n]-\niii \nen en \n0 ...J \n5 \n-ea. \n$0 \nOriginal Write \nRolled-Down Write \n50 \nStock Price at Expiration \n73 \nprofit potential of the covered write. Limiting the maximum profit may be asecond\nary consideration, however, when astock is breaking downward. Additional downside \nprotection is often amore pressing criterion in that case. \nAnywhere below 45 at expiration, the rolled-down position does $300 better \nthan the original position, because of the $300 credit generated from rolling down. \nIn fact, the rolled-down position will outperform the original position even if the \nstock rallies back to, but not above, aprice of 48. At 48 at expiration, the two posi\ntions are equal, both producing a $300 profit. If the stock should reverse direction \nand rally back above 48 by expiration, the writer would have been better off not to \nhave rolled down. All these facts are clear from Table 2-21 and Figure 2-3. \nConsequently, the only case in which it does not pay to roll down is the one in \nwhich the stock experiences areversal - arise in price after the initial drop. The \nselection of where to roll down is important, because rolling down too early or at an \ninappropriate price could limit the returns. Technical support levels of the stock are \noften useful in selecting prices at which to roll down. If one rolls down after techni\ncal support has been broken, the chances of being caught in astock-price-reversal \nsituation would normally be reduced. \nThe above example is rather simplistic; in actual practice, more complicated sit\nuations may arise, such as asudden and fairly steep decline in price by the underly\ning stock. This may present the writer with what is called alocked-in loss. This means, \nsimply, that there is no option to which the writer can roll down that will provide him", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:95", "doc_id": "90a18c62aebe82039cbdfa8c66aba9debfab3b83e6fbcfb8daabdcf567cd2350", "chunk_index": 0}
{"text": "74 Part II: Call Option Strategies \nwith enough premium to realize any profit if the stock were then called away at expi\nration. These situations arise more commonly on lower-priced stocks, where the \nstriking prices are relatively far apart in percentage terms. Out-of-the-money writes \nare more susceptible to this problem than are in-the-money writes. Although it is not \nemotionally satisfying to be in an investment position that cannot produce aprofit -\nat least for alimited period of time - it may still be beneficial to roll down to protect \nas much of the stock price decline as possible. \nExample: For the covered write described as \"buy XYZ at 20, sell the January 20 call \nat 2,\" the stock unexpectedly drops very quickly to 16, and the following prices exist: \nXYZ common, 16; \nXYZ January 20 call,½; and \nXYZ January 15 call, 2½. \nThe covered writer is faced with adifficult choice. He currently has an unrealized \nloss of 2½ points - a 4-point losson the stock which is partially offset by a 1 ½-point \ngain on the January 20 call. This represents afairly substantial percentage loss on his \ninvestment in ashort period of time. He could do nothing, hoping for the stock to \nrecover its loss. Unfortunately, this may prove to be wishful thinking. \nIf he considers rolling down, he will not be excited by what he sees. Suppose \nthat the writer wants to roll down from the January 20 to the January 15. He would \nthus buy the January 20 at ½ and sell the January 15 at 2½, for anet credit of 2 \npoints. By rolling down, he is obligating himself to sell his stock at 15, the striking \nprice of the January 15 call. Suppose XYZ were above 15 in January and were called \naway. How would the writer do? He would lose 5 points on his stock, since he origi\nnally bought it at 20 and is selling it at 15. This 5-point loss is substantially offset by \nhis option profits, which amount to 4 points: 1 ½ points of profit on the January 20, \nsold at 2 and bought back at ½, plus the 2½ points received from the sale of the \nJanuary 15. However, his net result is a 1-point loss, since he lost 5 points on the stock \nand made only 4 points on the options. Moreover, this 1-point loss is the best that he \ncan hope for! This is true because, as has been demonstrated several times, acovered \nwriting position makes its maximum profit anywhere above the striking price. Thus, \nby rolling down to the 15 strike, he has limited the position severely, to the extent of \n\"locking in aloss.\" \nEven considering what has been shown about this loss, it is still correct for this \nwriter to roll down to the January 15. Once the stock has fallen to 16, there is noth\ning anybody can do about the unrealized losses. However, if the writer rolls down, he \ncan prevent the losses from accumulating at afaster rate. In fact, he will do better by", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:96", "doc_id": "d703af3076f73c51affc962dbfd3a0b6c38744faa5b413515301dda323e8c644", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing 75 \nrolling down if the stock drops further, remains unchanged, or even rises slightly. \nTable 2-22 and Figure 2-4 compare the original write with the rolled-down position. \nIt is clear from the figure that the rolled-down position is locked into aloss. However, \nthe rolled-down position still outperforms the original position unless the stock ral\nlies back above 17 by expiration. Thus, if the stock continues to fall, if it remains \nunchanged, or even if it rallies less than 1 point, the rolled-down position actually \noutperforms the original write. It is for this reason that the writer is taking the most \nlogical action by rolling down, even though to do so locks in aloss. \nTABLE 2-22. \nProfits of original write and rolled position. \nStock Price at Profit from \nExpiration January 20 Write \n10 -$800 \n15 - 300 \n18 0 \n20 + 200 \n25 + 200 \nFIGURE 2-4. \nComparison: original write vs. \n11\nlocked-in loss.\" \nc: +$200 Original Write \n~ \nt \n«i \n~ \no -$100 \n~ a.. \n15 20 \nStock Price at Expiration \nProfit from \nRolled Position \n-$600 \n- 100 \n- 100 \n- 100 \n- 100", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:97", "doc_id": "61d6a621d71ea644451abdb187ce42214daa5b98f99121e55d89cbaa1ff4f223", "chunk_index": 0}
{"text": "76 Part II: Call Option Strategies \nTechnical analysis may be able to provide alittle help for the writer faced with \nthe dilemma of rolling down to lock in aloss or else holding onto aposition that has \nno further downside protection. IfXYZ has broken asupport level or important trend \nline, it is added evidence for rolling down. In our example, it is difficult to imagine \nthe case in which a $20 stocksuddenly drops to become a $16 stock without sub\nstantial harm to its technical picture. Nevertheless, if the charts should show that \nthere is support at 15½ or 16, it may be worth the writer'swhile to wait and see if \nthat support level can hold before rolling down. \nPerhaps the best way to avoid having to lock in losses would be to establish posi\ntions that are less likely to become such aproblem. In-the-money covered writes on \nhigher-priced stocks that have amoderate amount of volatility will rarely force the \nwriter to lock in aloss by rolling down. Of course, any stock, should it fall far enough \nand fast enough, could force the writer to lock in aloss if he has to roll down two or \nthr..ee times in afairly short time span. However, the higher-priced stock has striking \nprices that are much closer together (in percentages); it thus presents the writer with \nthe opportunity to utilize anew option with alower striking price much sooner in the \ndecline of the stock. Also, higher volatility should help in generating large enough \npremiums that substantial portions of the stock'sdecline can be hedged by rolling \ndown. Conversely, low-priced stocks, especially nonvolatile ones, often present the \nmost severe problems for the covered writer when they decline in price. \nArelated point concerning order entry can be inserted here. When one simul\ntaneously buys one call and sells another, he is executing aspread. Spreads in gener\nal are discussed at length later. However, the covered writer should be aware that \nwhenever he rolls his position, the order can be placed as aspread order. This will \nnormally help the writer to obtain abetter price execution. \nAN ALTERNATIVE METHOD OF ROLLING DOWN \nThere is another alternative that the covered writer can use to attempt to gain some \nadditional downside protection without necessarily having to lock in aloss. Basically, \nthe writer rolls down only part of his covered writing position. \nExample: One thousand shares of XYZ were bought at 20 and 10 January 20 calls \nwere sold at 2 points each. As before, the stock falls to 16, with the following prices: \nXYZ January 20 call, ½; and XYZ January 15 call, 2½. As was demonstrated in the last \nsection, if the writer were to roll all 10 calls down from the January 20 to the January \n15, he would be locking in aloss. Although there may be some justification for this \naction, the writer would naturally rather not have to place himself in such aposition. \nOne can attempt to achieve some balance between added downside protection \nand upward profit potential by rolling down only part of the calls. In this example,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:98", "doc_id": "2b33874dca8c5f5d3457f2d40620eb8157876533a8d472e9dc9b3b75000af911", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing 77 \nthe writer would buy back only 5 of the January 20'sand sell 5 January 15 calls. He \nwould then have this position: \nlong 1,000 XYZ at 20; \nshort 5 XYZ January 20'sat 2; \nshort 5 XYZ January 15'sat 2½; and \nrealized gain, $750 from 5 January 20's. \nThis strategy is generally referred to apartial roll-down, in which only aportion of \nthe original calls is rolled, as opposed to the more conventional complete roll-down. \nAnalyzing the partially rolled position makes it clear that the writer no longer locks \nin aloss. \nIfXYZ rallies back above 20, the writer would, at expiration, sell 500 XYZ at 20 \n(breaking even) and 500 at 15 (losing $2,500 on this portion). He would make $1,000 \nfrom the five January 20'sheld until expiration, plus $1,250 from the five January 15's, \nplus the $750 of realized gain from the January 20'sthat were rolled down. This \namounts to $3,000 worth of option profits and $2,500 worth of stock losses, or an \noverall net gain of $500, less commissions. Thus, the partial roll-down offers the \nwriter achance to make some profit if the stock rebounds. Obviously, the partial roll\ndown will not provide as much downside protection as the complete roll-down does, \nbut it does give more protection than not rolling down at all. To see this, compare the \nresults given in Table 2-23 if XYZ is at 15 at expiration. \nTABLE 2-23. \nStock at 15 at expiration. \nStrategy \nOriginal position \nPartial roll-down \nComplete roll-down \nStock Loss \n-$5,000 \n- 5,000 \n- 5,000 \nOption \nProfit Total Loss \n+$2,000 -$3,000 \n+ 3,000 - 2,000 \n+ 4,000 - 1,000 \nIn summary, the covered writer who would like to roll down, but who does not \nwant to lock in aloss or who feels the stock may rebound somewhat before expira\ntion, should consider rolling down only part of his position. If the stock should con\ntinue to drop, making it evident that there is little hope of astrong rebound back to \nthe original strike, the rest of the position can then be rolled down as well.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:99", "doc_id": "01db7561621babe7a4ed7411a9ab29d3e30b75a159d9e8c50937076d940c8d63", "chunk_index": 0}
{"text": "78 Part II: Call Option Strategies \nUTILIZING DIFFERENT EXPIRATION SERIES WHEN ROLLING DOWN \nIn the examples thus far, the same expiration month has been used whenever rolling\ndown action was taken. In actual practice, the writer may often want to use amore \ndistant expiration month when rolling down and, in some cases, he may even want to \nuse anearer expiration month. \nThe advantage of rolling down into amore distant expiration series is that more \nactual points of protection are received. This is acommon action to take when the \nunderlying stock has become somewhat worrisome on atechnical or fundamental \nbasis. However, since rolling down reduces the maximum profit potential - afact that \nhas been demonstrated several times - every roll-down should not be made to amore \ndistant expiration series. By utilizing alonger-term call when rolling down, one is \nreducing his maximum profit potential for alonger period of time. Thus, the longer\nterm·call should be used only if the writer has grown concerned over the stock'scapa\nbility to hold current price levels. The partial roll-down strategy is particularly \namenable to rolling down to alonger-term call since, by rolling down only part of the \nposition, one has already left the door open for profits if the stock should rebound. \nTherefore, he can feel free to avail himself of the maximum protection possible in the \npart of his position that is rolled down. \nThe writer who must roll down to lock in aloss, possibly because of circum\nstances beyond his control, such as asudden fall in the price of the underlying stock, \nmay actually want to roll down to anear-term option. This allows him to make back \nthe available time premium in the short-term call in the least time possible. \nExample: Awriter buys XYZ at 19 and sells a 6-month call for 2 points. Shortly there\nafter, however, bad news appears concerning the common stock and XYZ falls quick\nly to 14. At that time, the following prices exist for the calls with the striking price 15: \nXYZ common, 14: \nnear-term call, l; \nmiddle-term call, 1 ½; and \nfar-term call, 2. \nIf the writer rolls down into any of these three calls, he will be locking in aloss. \nTherefore, the best strategy may be to roll down into the near-term call, planning to \ncapture one point of time premium in 3 months. In this way, he will be beginning to \nwork himself out of the loss situation by availing himself of the most potential time \npremium decay in the shortest period of time. When the near-term call expires \n3 months from now, he can reassess the situation to decide if he wants to write", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:100", "doc_id": "97c0458c14def26917604314a5bd42fb1aab76b954103a0ffafbf6566e026924", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing 79 \nanother near-term call to continue taking in short-term premiums, or perhaps write \nalong-term call at that time. \nWhen rolling down into the near-term call, one is attempting to return to apotentially profitable situation in the shortest period of time. By writing short-term \ncalls one or two times, the writer will eventually be able to reduce his stock cost near\ner to 15 in the shortest time period. Once his stock cost approaches 15, he can then \nwrite along-term call with striking price 15 and return again to apotentially prof\nitable situation. He will no longer be locked into aloss. \nACTION TO TAKE IF THE STOCK RISES \nAmore pleasant situation for the covered writer to encounter is the one in which the \nunderlying stock rises in price after the covered writing position has been estab\nlished. There are generally several choices available if this happens. The writer may \ndecide to do nothing and to let his stock be called away, thereby making the return \nthat he had hoped for when he established the position. On the other hand, if the \nunderlying stock rises fairly quickly and the written call comes to parity, the writer \nmay either close the position early or roll the call up. Each case is discussed. \nExample: Someone establishes acovered writing position by buying astock at 50 and \nselling a 6-month call for 6 points. His maximum profit potential is 6 points anywhere \nabove 50 at expiration, and his downside break-even point is 44. Furthermore, sup\npose that the stock experiences asubstantial rally and that it climbs to aprice of 60 \nin ashort period of time. With the stock at 60, the July 50 might be selling for 11 \npoints and a July 60 might sell for as much as 7 points. Thus, the writer may consid\ner buying back the call that was originally written and rolling up to the call with ahigher striking price. Table 2-24 summarizes the situation. \nTABLE 2·24. \nComparison of original and current prices. \nOriginal Position Current Prices \nBuy XYZ at 50 XYZ common 60 \nSell XYZ July 50 call at 6 XYZ July 50 11 \nXYZ Jul 60 7 \nIf the writer were to roll-up - that is, buy back the July 50 and sell the July 60 \n- he would be increasing his profit potential. If XYZ were above 60 in July and were \ncalled away, he would make his option credits - 6 points from the July 50 plus 7", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:101", "doc_id": "2a09005a5347fd23be29e3c27021c679258443fb2f681ce8cbe8eeeb9a295496", "chunk_index": 0}
{"text": "80 Part II: Call Option Strategies \npoints from the July 60 - less the 11 points he paid to buy back the July 50. Thus, his \noption profits would amount to 2 points, which, added to the stock profit of 10 points, \nincreases his maximum profit potential to 12 points anywhere above 60 at July expi\nration. \nTo increase his profit potential by such alarge amount, the covered writer has \ngiven up some of his downside protection. The downside break-even point is always \nraised by the anwunt of the debit required to roll up. The debit required to roll up in \nthis example is 4 points - buy the July 50 at 11 and sell the July 60 at 7. Thus, the \nbreak-even point is increased from the original 44 level to 48 after rolling up. There \nis another method of calculating the new profit potential and break-even point. In \nessence, the writer has raised his net stock cost to 55 by taking the realized 5-point \nloss on the July 50 call. Hence, he is essentially in acovered write whereby he has \nbought stock at 55 and has sold a July 60 call for 7. When expressed in this manner, \nit may be easier to see that the break-even point is 48 and the maximum profit poten\ntial, above 60, is 12 points. \nNote that when one rolls up, there is adebit incurred. That is, the investor must \ndeposit additional cash into the covered writing position. This was not the case in \nrolling down, because credits were generated. Debits are considered by many \ninvestors to be aseriously negative aspect of rolling up, and they therefore prefer \nnever to roll up for debits. Although the debit required to roll up may not be aneg\native aspect to every investor, it does translate directly into the fact that the break\neven point is raised and the writer is subjecting himself to apotential loss if the stock \nshould pull back. It is often advantageous to roll to amore distant expiration when \nrolling up. This will reduce the debit required. \nThe rolled-up position has abreak-even point of 48. Thus, if XYZ falls back to \n48, the writer who rolled up will be left with no profit. However, if he had not rolled \nup, he would have made 4 points with XYZ at 48 at expiration in the original position. \nAfurther comparison can be made between the original position and the rolled-up \nposition. The two are equal at July expiration at astock price of 54; both have aprof\nit of 6 points with XYZ at 54 at July expiration. Thus, although it may appear attrac\ntive to roll up, one should determine the point at which the rolled-up position and \nthe original position will be equal at expiration. If the writer believes XYZ could be \nsubject to a 10% correction by expiration from 60 to 54 - certainly not out of the \nquestion for any stock - he should stay with his original position. \nFigure 2-5 compares the original position with the rolled-up position. Note that \nthe break-even point has moved up from 44 to 48; the maximum profit potential has \nincreased from 6 points to 12 points; and at expiration the two writes are equal, at 54. \nIn summary, it can be said that rolling up increases one'sprofit potential but also \nexposes one to risk of loss if astock price reversal should occur. Therefore, an ele-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:102", "doc_id": "a3c4bbd73b738d194cb478314330dfb8128489313c1eedec02687e503542d402", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing \nFIGURE 2-5. \nComparison: original write vs. rolled-up position. \n+$1,200 \nRolled-Up Write \n+$600 Original Write \n54 60 \nStock Price at Expiration \n81 \nment of risk is introduced as well as the possibility of increased rewards. Generally, \nit is not advisable to roll up if at least a 10% correction in the stock price cannot be \nwithstood. One'sinitial goals for the covered write were set when the position was \nestablished. If the stock advances and these goals are being met, the writer should be \nvery cautious about risking that profit. \nA SERIOUS BUT ALL-TOO-COMMON MISTAKE \nWhen an investor is overly intent on keeping his stock from being called away (per\nhaps he is writing calls against stock that he really has no intention of selling), then \nhe will normally roll up and/or forward to amore distant expiration month whenev\ner the stock rises to the strike of the written call. Most of these rolls incur adebit. If \nthe stock is particularly strong, or if there is astrong bull market, these rolls for deb\nits begin to weigh heavily on the psychology of the covered writer. Eventually, he \nwears down emotionally and makes amistake. He typically takes one of two roads: \n(1) He buys back all of the calls for a (large) debit, leaving the entire stock holding \nexposed to downside movements after it has risen dramatically in price and after he", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:103", "doc_id": "11e8f39ea1105d77db726ba35c0641bf53fe9ba956b17c1ca82b791f54ef1646", "chunk_index": 0}
{"text": "82 Part II: Call Option Strategies \nhas amassed afairly large series of debits from previous rolls; or (2) he begins to sell \nsome out-of-the-money naked puts to bring in credits to reduce the cost of continu\nally rolling the calls up for debits. This latter action is even worse, because the entire \nposition is now leveraged tremendously, and asharp drop in the stock price may \ncause horrendous losses - perhaps enough to wipe out the entire account. As fate \nwould have it, these mistakes are usually made when the stock is near atop in price. \nAny price decline after such adramatic rise is usually asharp and painful one. \nThe best way to avoid this type of potentially serious mistake is to allow the \nstock to be called away at some point. Then, using the funds that are released, either \nestablish anew position in another stock or perhaps even utilize another strategy for \nawhile. If that is not feasible, at least avoid making aradical change in strategy after \nthe stock has had aparticularly strong rise. Leveraging the position through naked \nput sales on top of rolling the calls up for debits should expressly be avoided. \nThe discussion to this point has been directed at rolling up before expiration. At \nor near expiration, when the time value premium has disappeared from the written \ncall, one may have no choice but to write the next-higher striking price if he wants to \nretain his stock. This is discussed when we analyze action to take at or near expiration. \nIf the underlying stock rises, one'schoices are not necessarily limited to rolling \nup or doing nothing. As the stock increases in price, the written call will lose its time \npremium and may begin to trade near parity. The writer may decide to close the posi\ntion himself - perhaps well in advance of expiration - by buying back the written call \nand selling the stock out, hopefully near parity. \nExample: Acustomer originally bought XYZ at 25 and sold the 6-month July 25 for \n3 points - anet of 22. Now, three months later, XYZ has risen to 33 and the call is \ntrading at 8 (parity) because it is so deeply in-the-money. At this point, the writer may \nwant to sell the stock at 33 and buy back the call at 8, thereby realizing an effective \nnet of 25 for the covered write, which is his maximum profit potential. This is cer\ntainly preferable to remaining in the position for three more months with no more \nprofit potential available. The advantage of closing aparity covered write early is that \none is realizing the maximum return in ashorter period than anticipated. He is there\nby increasing his annualized return on the position. Although it is generally to the \ncash writer'sadvantage (margin writers read on) to take such action, there are afew \nadditional costs involved that he would not experience if he held the position until \nthe call expired. First, the commission for the option purchase (buy-back) is an addi\ntional expense. Second, he will be selling his stock at ahigher price than the striking \nprice, so he may pay aslightly higher commission on that trade as well. If there is adividend left until expiration, he will not be receiving that dividend if he closes the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:104", "doc_id": "23df6b57d2e0cc6ec9bb7addc622601e2e8202e6363bed5b4e4964be594443ea", "chunk_index": 0}
{"text": "Chapter 2: Covered Call Writing 83 \nwrite early. Of course, if the trade was done in amargin account, the writer will be \nreducing the margin interest that he had planned to pay in the position, because the \ndebit will be erased earlier. In most cases, the increased commissions are very small \nand the lost dividend is not significant compared to the increase in annualized return \nthat one can achieve by closing the position early. However, this is not always true, \nand one should be aware of exactly what his costs are for closing the position early. \nObviously, getting out of acovered writing position can be as difficult as estab\nlishing it. Therefore, one should place the order to close the position with his bro\nkerage firm'soption desk, to be executed as a \"net\" order. The same traders who facil\nitate establishing covered writing positions at net prices will also facilitate getting out \nof the positions. One would normally place the order by saying that he wanted to sell \nhis stock and buy the option \"at parity\" or, in the example, at \"25 net.\" Just as it is \noften necessary to be in contact with both the option and stock exchanges to estab\nlish aposition, so is it necessary to maintain the same contacts to renwve aposition \nat parity. \nACTION TO TAKE AT OR NEAR EXPIRATION \nAs expiration nears and the time value premium disappears from awritten call, the \ncovered writer may often want to roll forward, that is, buy back the currently written \ncall and sell alonger-term call with the same striking price. For an in-the-money call, \nthe optimum time to roll forward is generally when the time value premium has com\npletely disappeared from the call. For an out-of-the-money call, the correct time to \nmove into the more distant option series is when the return offered by the near-term \noption is less than the return offered by the longer-term call. \nThe in-the-money case is quite simple to analyze. As long as there is time pre\nmium left in the call, there is little risk of assignment, and therefore the writer is \nearning time premium by remaining with the original call. However, when the option \nbegins to trade at parity or adiscount, there arises asignificant probability of exer\ncise by arbitrageurs. It is at this time that the writer should roll the in-the-money call \nforward. For example, if XYZ were offered at 51 and the July 50 call were bid at 1, \nthe writer should be rolling forward into the October 50 or January 50 call. \nThe out-of-the-money case is alittle more difficult to handle, but arelatively \nstraightforward analysis can be applied to facilitate the writer'sdecision. One can \ncompute the return per day remaining in the written call and compare it to the net \nreturn per day from the longer-term call. If the longer-term call has ahigher return, \none should roll forward.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:105", "doc_id": "f6f4bcd32d0299388f41112101f423e978e203b5f96ed835f6d19d7e460663a3", "chunk_index": 0}
{"text": "84 Part II: Call Option Strategies \nExample: An investor previously entered acovered writing situation in which he \nwrote five January 30 calls against 500 XYZ common. The following prices exist cur\nrently, lmonth before expiration: \nXYZ common, 29¼; \nJanuary 30 call,¼; and \nApril 30 call, 2¼. \nThe writer can only make ¼ apoint more of time premium on this covered write for \nthe time remaining until expiration. It is possible that his money could be put to bet\nter use by rolling forward to the April 30 call. Commissions for rolling forward must \nbe subtracted from the April 30'spremium to present atrue comparison. \nBy remaining in the January 30, the writer could make, at most, $250 for the 30 \ndays remaining until January expiration. This is areturn of $8.33 per day. The com\nmissions for rolling forward would be approximately $100, including both the buy\nback and the new sale. Since the current time premium in the April 30 call is $250 \nper option, this would mean that the writer would stand to make 5 times $250 less \nthe $100 in commissions during the 120-day period until April expiration; $1,150 \ndivided by 120 days is $9.58 per day. Thus, the per-day return is higher from the April \n30 than from the January 30, after commissions are included. The writer should roll \nforward to the April 30 at this time. \nRolling forward, since it involves apositive cash flow ( that is, it is acredit trans\naction) simultaneously increases the writer'smaximum profit potential and lowers the \nbreak-even point. In the example above, the credit for rolling forward is 2 points, so \nthe break-even point will be lowered by 2 points and the maximum profit potential \nis also increased by the 2-point credit. \nAsimple calculator can provide one with the return-per-day calculation neces\nsary to make the decision concerning rolling forward. The preceding analysis is only \ndirectly applicable to rolling forward at the same striking price. Rolling-up or rolling\ndown decisions at expiration, since they involve different striking prices, cannot be \nbased solely on the differential returns in time premium values offered by the options \nin question. \nIn the earlier discussion concerning rolling up, it was mentioned that at or near \nexpiration, one may have no choice but to write the next higher striking price if he \nwants to retain his stock. This does not necessarily involve adebit transaction, how\never. If the stock is volatile enough, one might even be able to roll up for even money \nor aslight credit at expiration. Should this occur, it would be adesirable situation and \nshould always be taken advantage of.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:106", "doc_id": "552673f9860ecfb97730877f8d830f35db2ea91151cefadd0532ccc87999f710", "chunk_index": 0}
{"text": "Cbapter 2: Covered Ca# Writing \nExample: The following prices exist at January expiration: \nXYZ, 50; \nXYZ January 45 call, 5; and \nXYZ July 50 call, 7. \n85 \nIn this case, if one had originally written the January 45 call, he could now roll up to \nthe July 50 at expiration for acredit of 2 points. This action is quite prudent, since \nthe break-even point and the maximum profit potential are enhanced. The break\neven point is lowered by the 2 points of credit received from rolling up. The maxi\nmum profit potential is increased substantially - by 7 points - since the striking price \nis raised by 5 points and an additional 2 points of credit are taken in from the roll up. \nConsequently, whenever one can roll up for acredit, asituation that would normally \narise only on more volatile stocks, he should do so. \nAnother choice that may occur at or near expiration is that of rolling down. The \ncase may arise whereby one has allowed awritten call to expire worthless with the \nstock more than asmall distance below the striking price. The writer is then faced \nwith the decision of either writing asmall-premium out-of-the-money call or alarg\ner-premium in-the-money call. Again, an example may prove to be useful. \nExample: Just after the January 25 call has expired worthless, \nXYZ is at 22, \nXYZ July 25 call at ¾, and \nXYZ July 20 call at 3½. \nIf the investor were now to write the July 25 call, he would be receiving only¾ of apoint of downside protection. However, his maximum profit potential would be quite \nlarge if XYZ could rally to 25 by expiration. On the other hand, the July 20 at 3½ is \nan attractive write that affords substantial downside protection, and its 1 ½ points of \ntime value premium are twice that offered by the July 25 call. In apurely analytic \nsense, one should not base his decision on what his performance has been to date, \nbut that is adifficult axiom to apply in practice. If this investor owns XYZ at ahigh\ner price, he will almost surely opt for the July 25 call. If, however, he owns XYZ at \napproximately the same price, he will have no qualms about writing the July 20 call. \nThere is no absolute rule that can be applied to all such situations, but one is usual\nly better off writing the call that provides the best balance between return and down\nside protection at all times. Only if one is bullish on the underlying stock should he \nwrite the July 25 call.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:107", "doc_id": "195d38f709128878d5fb70a6ac54cec441a9b61abd988158e46415d6cbf03697", "chunk_index": 0}
{"text": "86 Part II: Call Option Strategies \nAVOIDING THE UNCOVERED POSITION \nThere is amargin rule that the covered writer must be aware of if he is considering \ntaking any sort of follow-up action on the day that the written call ceases trading. If \nanother call is sold on that day, even though the written call is obviously going to \nexpire worthless, the writer will be considered uncovered for margin purposes over \nthe weekend and will be obligated to put forth the collateral for an uncovered option. \nThis is usually not what the writer intends to do; being aware of this rule will elimi\nnate unwanted margin calls. Furthermore, uncovered options may be considered \nunsuitable for many covered writers. \nExample: Acustomer owns XYZ and has January 20 calls outstanding on the last day \nof trading of the January series (the third Friday of January; the calls actually do not \nexpire until the following day, Saturday). IfXYZ is at 15 on the last day of trading, the \nJanuary 20 call will almost certainly expire worthless. However, should the writer \ndecide to sell alonger-term call on that day without buying back the January 20, he \nwill be considered uncovered over the weekend. Thus, if one plans to wait for an \noption to expire totally worthless before writing another call, he must wait until the \nMonday after expiration before writing again, assuming that he wants to remain cov\nered. The writer should also realize that it is possible for some sort of news item to \nbe announced between the end of trading in an option series and the actual expira\ntion of the series. Thus, call holders might exercise because they believe the stock will \njump sufficiently in price to make the exercise profitable. This has happened in the \npast, two of the most notable cases being IBM in January 1975 and Carrier Corp. in \nSeptember 1978. \nWHEN TO LET STOCK BE CALLED AWAY \nAnother alternative that is open to the writer as the written call approaches expira\ntion is to let the stock be called away if it is above the striking price. In many cases, \nit is to the advantage of the writer to keep rolling options forward for credits, there\nby retaining his stock ownership. However, in certain cases, it may be advisable to \nallow the stock to be called away. It should be emphasized that the writer often has \nadefinite choice in this matter, since he can generally tell when the call is about to \nbe exercised - when the time value premium disappears. \nThe reason that it is normally desirable to roll forward is that, over time, the \ncovered writer will realize ahigher return by rolling instead of being called. The \noption commissions for rolling forward every three or six months are smaller than the \ncommissions for buying and selling the underlying stock every three or six months, \nand therefore the eventual return will be higher. However, if an inferior return has", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:108", "doc_id": "671ed4ee9ad3119b8b6eea0a7fe8e8defa973e880cbaefee05c3ed8485d6ed63", "chunk_index": 0}
{"text": "Cl,opter 2: Covered Call Writing 87 \nto be accepted or the break-even point will be raised significantly by rolling forward, \none must consider the alternative of letting the stock be called away. \nExample: Acovered write is established by buying XYZ at 49 and selling an April 50 \ncall for 3 points. The original break-even point was thus 46. Near expiration, suppose \nXYZ has risen to 56 and the April 50 is trading at 6. If the investor wants to roll for\nward, now is the time to do so, because the call is at parity. However, he notes that \nthe choices are somewhat limited. Suppose the following prices exist with XYZ at 56: \nXYZ October 50 call, 7; and XYZ October 60 call, 2. It seems apparent that the pre\nmium levels have declined since the original writing position was established, but \nthat is an occurrence beyond the control of the writer, who must work in the current \nmarket environment. \nIf the writer attempts to roll forward to the October 50, he could make at most \n1 additional point of profit until October (the time premium in the call). This repre\nsents an extremely low rate of return, and the writer should reject this alternative \nsince there are surely better returns available in covered writes on other securities. \nOn the other hand, if the writer tries to roll up and forward, it will cost 4 points \nto do so - 6 points to buy back the April 50 less 2 points received for the October 60. \nThis debit transaction means that his break-even point would move up from the orig\ninal level of 46 to anew level of 50. If the common declines below 54, he would be \neating into profits already at hand, since the October 60 provides only 2 points of pro\ntection from the current stock price of 56. If the writer is not confidently bullish on \nthe outlook for XYZ, he should not roll up and forward. \nAt this point, the writer has exhausted his alternatives for rolling. His remaining \nchoice is to let the stock be called away and to use the proceeds to establish acov\nered write in anew stock, one that offers amore attractive rate of return with rea\nsonable downside protection. This choice of allowing the stock to be called away is \ngenerally the wisest strategy if both of the following criteria are met: \n1. Rolling forward offers only aminimal return. \n2. Rolling up and forward significantly raises the break-even point and leaves the \nposition relatively unprotected should the stock drop in price. \nSPECIAL WRITING SITUATIONS \nOur discussions have pertained directly to writing against common stock. However, \none may also write covered call options against convertible securities, warrants, or \nLEAPS. In addition, adifferent type of covered writing strategy - the incremental", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:109", "doc_id": "800da272b0443100f6110bd912151cf4ebb0d165a618483ab6ff0cbe180f9be4", "chunk_index": 0}
{"text": "88 Part II: Call Option Strategies \nreturn concept - is described that has great appeal to large stockholders, both indi\nviduals and institutions. \nCOVERED WRITING AGAINST A CONVERTIBLE SECURITY \nIt may be more advantageous to buy asecurity that is convertible into common stock \nthan to buy the stock itself, for covered call writing purposes. Convertible bonds and \nconvertible preferred stocks are securities commonly used for this purpose. One \nadvantage of using the convertible security is that it often has ahigher yield than does \nthe common stock itself. \nBefore describing the covered write, it may be beneficial to review the basics of \nconvertible securities. Suppose XYZ common stock has an XYZ convertible Preferred \nAstock that is convertible into 1.5 shares of common. The number of shares of com\nmon that the convertible security converts into is an important piece of information \nthat the writer must know. It can be found in a Standard & Poor's Stock Guide (or \nBond Guide, in the case of convertible bonds). \nThe writer also needs to determine how many shares of the convertible securi\nty must be owned in order to equal 100 shares of the common stock. This is quickly \ndetermined by dividing 100 by the conversion ratio - 1.5 in our XYZ example. Since \n100 divided by 1.5 equals 66.666, one must own 67 shares of XYZ cv Pfd Ato cover \nthe sale of one XYZ option for 100 shares of common. Note that neither the market \nprices of XYZ common nor the convertible security are necessary for this computa\ntion. \nWhen using aconvertible bond, the conversion information is usually stated in \naform such as, \"converts into 50 shares at aprice of 20.\" The price is irrelevant. What \nis important is the number of shares that the bond converts into - 50 in this case. \nThus, if one were using these bonds for covered writing of one call, he would need \ntwo (2,000) bonds to own the equivalent of 100 shares of stock. \nOnce one knows how much of the convertible security must be purchased, he \ncan use the actual prices of the securities, and their yields, to determine whether acovered write against the common or the convertible is more attractive. \nExample: The following information is known: \nXYZ common, 50; \nXYZ CV Pfd A, 80; \nXYZ July 50 call, 5; \nXYZ dividend, 1.00 per share annually; and \nXYZ cv Pfd Adividend, 5.00 per share annually.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:110", "doc_id": "e0262d90e5287ab47546cce63f918fd26eab6dabb92f17ee9af00db64a154a48", "chunk_index": 0}
{"text": "Chapter 2: Covered CaH Writing 89 \nNote that, in either case, the same call - the July 50 -would be written. The use of \nthe convertible as the underlying security does not alter the choice of which option to \nuse. To make the comparison of returns easier, commissions are ignored in the cal\nculations given in Table 2-25. In reality, the commissions for the stock purchase, \neither common or preferred, would be very similar. Thus, from anumerical point of \nview, it appears to be more advantageous to write against the convertible than against \nthe common. \nTABLE 2-25. \nComparison of common and convertible writes. \nWrite against Common Write against Convertible \nBuy underlying security $5,000(100 XYZ) $5,360 (67 XYZ CV Pfd A) \nSell one July 50 call 500 - 500 \nNet cash investment $4,500 $4,860 \nPremium collected $ 500 $ 500 \nDividends until July 50 250 \nMaximum profit potential $ 550 $ 750 \nReturn (profit divided by \ninvestment) 12.2% 15.4% \nWhen writing against aconvertible security, additional considerations should be \nlooked at. The first is the premium of the convertible security. In the example, with \nXYZ selling at 50, the XYZ cv Pfd Ahas atrue value of 1.5 times 50, or $75 per share. \nHowever, it is selling at 80, which represents apremium of 5 points above its com\nputed value of 75. Normally, one would not want to buy aconvertible security if the \npremium is too large. In this example, the premium appears quite reasonable. Any \nconvertible premium greater than 15% above computed value might be considered \nto be too large. \nAnother consideration when writing against convertible securities is the han\ndling of assignment. If the writer is assigned, he may either (1) convert his preferred \nstock into common and deliver that, or (2) sell the preferred in the market and use \nthe proceeds to buy 100 shares of common stock in the market for delivery against \nthe assignment notice. The second choice is usually preferable if the convertible \nsecurity has any premium at all, since converting the preferred into common causes \nthe loss of any premium in the convertible, as well as the loss of accrued interest in \nthe case of aconvertible bond.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:111", "doc_id": "bfa77cc26486bc3ad9566bbb8c4341c6070c7ada66ac90b05ec3cfa99007ce54", "chunk_index": 0}
{"text": "90 Part II: Call Option Strategies \nThe writer should also be aware of whether or not the convertible is catlable \nand, if so, what the exact terms are. Once the convertible has been called by the com\npany, it will no longer trade in relation to the underlying stock, but will instead trade \nat the call price. Thus, if the stock should climb sharply, the writer could be incur\nring losses on his written option without any corresponding benefit from his con\nvertible security. Consequently, if the convertible is called, the entire position should \nnormally be closed immediately by selling the convertible and buying the option \nback. \nOther aspects of covered writing, such as rolling down or forward, do not \nchange even if the option is written against aconvertible security. One would take \naction based on the relationship of the option price and the common stock price, as \nusual. \nWRITING AGAINST WARRANTS \nIt is also possible to write covered call options against warrants. Again, one must own \nenough warrants to convert into 100 shares of the underlying stock; generally, this \nwould be 100 warrants. The transaction must be acash transaction, the warrants \nmust be paid for in full, and they have no loan value. Technically, listed warrants may \nbe marginable, but many brokerage houses still require payment in full. There may \nbe an additional investment requirement. Warrants also have an exercise price. If the \nexercise price of the warrant is higher than the striking price of the call, the covered \nwriter must also deposit the difference between the two as part of his investment. \nThe advantage of using warrants is that, if they are deeply in-the-money, they \nmay provide the cash covered writer with ahigher return, since less of an investment \nis involved. \nExample: XYZ is at 50 and there are XYZ warrants to buy the common at 25. Since \nthe warrant is so deeply in-the-money, it will be selling for approximately $25 per \nwarrant. XYZ pays no dividend. Thus, if the writer were considering acovered write \nof the XYZ July 50, he might choose to use the warrant instead of the common, since \nhis investment, per 100 shares of common, would only be $2,500 instead of the \n$5,000 required to buy 100 XYZ. The potential profit would be the same in either \ncase because no dividend is involved. \nEven if the stock does pay adividend (warrants themselves have no dividend), \nthe writer may still be able to earn ahigher return by writing against the warrant than \nagainst the common because of the smaller investment involved. This would depend, \nof course, on the exact size of the dividend and on how deeply the warrant is in-the\nmoney.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:112", "doc_id": "012e0ca2b932f7af16c717701348400318744085cd1d97b137fb558ea2c9ecf0", "chunk_index": 0}
{"text": "Cbapter 2: Covered Call Writing 91 \nCovered writing against warrants is not afrequent practice because of the small \nnumber of warrants on optionable stocks and the problems inherent in checking \navailable returns. However, in certain circumstances, the writer may actually gain adecided advantage by writing against adeep in-the-money warrant. It is often not \nadvisable to write against awarrant that is at- or out-of-the-money, since it can \ndecline by alarge percentage if the underlying stock drops in price, producing ahigh\nrisk position. Also, the writer'sinvestment may increase in this case if he rolls down \nto an option with astriking price lower than the warrant'sexercise price. \nWRITING AGAINST LEAPS \nAform of covered call writing can be constructed by buying LEAPS call options and \nselling shorter-term out-of-the-money calls against them. This strategy is much like \nwriting calls against warrants. This strategy is discussed in more detail in Chapter 25 \non LEAPS, under the subject of diagonal spreads. \nPERCS \nThe PERCS (Preferred Equity Redemption Cumulative Stock) is aform of covered \nwriting. It is discussed in Chapter 32. \nTHE INCREMENTAL RETURN CONCEPT OF COVERED WRITING \nThe incremental return concept of covered call writing is away in which the covered \nwriter can earn the full value of stock appreciation between todays stock price and atarget sale price, which may be substantially higher. At the same time, the writer can \nearn an incremental, positive return from writing options. \nMany institutional investors are somewhat apprehensive about covered call \nwriting because of the upside limit that is placed on profit potential. If acall is writ\nten against astock that subsequently declines in price, most institutional managers \nwould not view this as an unfavorable situation, since they would be outperforming \nall managers who owned the stock and who did not write acall. However, if the stock \nrises substantially after the call is written, many institutional managers do not like \nhaving their profits limited by the written call. This strategy is not only for institu\ntional money managers, although one should have arelatively substantial holding in \nan underlying stock to attempt the strategy - at least 500 shares and preferably 1,000 \nshares or more. The incremental return concept can be used by anyone who is plan\nning to hold his stock, even if it should temporarily decline in price, until it reaches apredetermined, higher price at which he is willing to sell the stock.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:113", "doc_id": "39dbfd0997fcad660838b33dfb6cae38359ece4af6f537b6429ea7861c5bcbb6", "chunk_index": 0}
{"text": "92 Part II: Call Option Strategies \nThe basic strategy involves, as an initial step, selecting the target price at which \nthe writer is willing to sell his stock. \nExample: Acustomer owns 1,000 shares of XYZ, which is currently at 60, and is will\ning to sell the stock at 80. In the meantime, he would like to realize apositive cash \nflow from writing options against his stock. This positive cash flow does not neces\nsarily result in arealized option gain until the stock is called away. Most likely, with \nthe stock at 60, there would not be options available with astriking price of 80, so one \ncould not write 10 July 80's, for example. This would not be an optimum strategy \neven if the July 80'sexisted, for the investor would be receiving so little in option pre\nmiums - perhaps 10 cents per call - that writing might not be worthwhile. The incre\nmental return strategy allows this investor to achieve his objectives regardless of the \nexistence of options with ahigher striking price. \nThe foundation of the incremental return strategy is to write against only apart \nof the entire stock holding initially, and to write these calls at the striking price near\nest the current stock price. Then, should the stock move up to the next higher strik\ning price, one rolls up for acredit by adding to the number of calls written. Rolling \nfor acredit is mandatory and is the key to the strategy. Eventually, the stock reaches \nthe target price and the stock is called away, the investor sells all his stock at the tar\nget price, and in addition earns the total credits from all the option transactions. \nExample: XYZ is 60, the investor owns 1,000 shares, and his target price is 80. One \nmight begin by selling three of the longest-term calls at 60 for 7 points apiece. Table \n2-26 shows how apoor case - one in which the stock climbs directly to the target \nprice - might work. As Table 2-26 shows, if XYZ rose to 70 in one month, the three \noriginal calls would be bought back and enough calls at 70 would be sold to produce \nacredit - 5 XYZ October 70's. If the stock continued upward to 80 in another month, \nthe 5 calls would be bought back and the entire position - 10 calls - would be writ\nten against the target price. \nIf XYZ remains above 80, the stock will be called away and all 1,000 shares will \nbe sold at the target price of 80. In addition, the investor will earn all the option cred\nits generated along the way. These amount to $2,800. Thus, the writer obtained the \nfull appreciation of his stock to the target price plus an incremental, positive return \nfrom option writing. \nIn aflat market, the strategy is relatively easy to monitor. If awritten call loses \nits time value premium and therefore might be subject to assignment, the writer can \nroll forward to amore distant expiration series, keeping the quantity of written calls \nconstant. This transaction would generate additional credits as well.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:114", "doc_id": "19ec793b38f6066c252628b8afd8169d80a74dc23ba0873e7383ca53830d1941", "chunk_index": 0}
{"text": "C1,,,pter 2: Covered Call Writing \nTABLE 2-26. \nTwo months of incremental return strategy. \nDay 1 : XYZ = 60 \nSell 3 XYZ October 60'sat 7 \nOne month later: XYZ = 70 \nBuy back the 3 XYZ Oct 60'sat 11 and \nsell 5 XYZ Oct 70'sat 7 \nTwo months later: XYZ = 80 \nBuy back the 5 Oct 70'sat 11 and \nsell 10 XYZ Oct 80'sat 6 \nCOVERED CALL WRITING SUMMARY \n93 \n+$2, 100 credit \n-$3,300 debit \n+$3,500 credit \n-$5 ,500 debit \n+$6.000 credit \n+$2,800 credit \nThis concludes the chapter on covered call writing. The strategy will be referred to \nlater, when compared with other strategies. Here is abrief summary of the more \nimportant points that were discussed. \nCovered call writing is aviable strategy because it reduces the risk of stock own\nership and will make one'sportfolio less volatile to short-term market movements. It \nshould be understood, however, that covered call writing may underperform stock \nownership in general because of the fact that stocks can rise great distances, while acovered write has limited upside profit potential. The choice of which call to write \ncan make for amore aggressive or more conservative write. Writing in-the-money \ncalls is strategically more conservative than writing out-of-the-money calls, because \nof the larger amount of downside protection received. The total return concept of \ncovered call writing attempts to achieve the maximum balance between income from \nall sources - option premiums, stock ownership, and dividend income - and down\nside protection. This balance is usually realized by writing calls when the stock is near \nthe striking price, either slightly in- or slightly out-of-the-money. \nThe writer should compute various returns before entering into the position: \nthe return if exercised, the return if the stock is unchanged at expiration, and the \nbreak-even point. To truly compare various writes, returns should be annualized, and \nall commissions and dividends should be included in the calculations. Returns will be \nincreased by taking larger positions in the underlying stock - 500 or 1,000 shares. \nAlso, by utilizing abrokerage firm'scapability to produce \"net\" executions, buying the \nstock and selling the call at aspecified net price differential, one will receive better \nexecutions and realize higher returns in the long run.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:115", "doc_id": "d3f7c000d8e4bbc16e30885416f54120e07b6d87013a4de11ac4f9a3a2400b17", "chunk_index": 0}
{"text": "92 Part II: Call Option Strategies \nThe basic strategy involves, as an initial step, selecting the target price at which \nthe writer is willing to sell his stock \nExample: Acustomer owns 1,000 shares ofXYZ, which is currently at 60, and is will\ning to sell the stock at 80. In the meantime, he would like to realize apositive cash \nflow from writing options against his stock This positive cash flow does not neces\nsarily result in arealized option gain until the stock is called away. Most likely, with \nthe stock at 60, there would not be options available with astriking price of 80, so one \ncould not write 10 July 80's, for example. This would not be an optimum strategy \neven if the July 80'sexisted, for the investor would be receiving so little in option pre\nmiums - perhaps 10 cents per call - that writing might not be worthwhile. The incre\nmental return strategy allows this investor to achieve his objectives regardless of the \nexistence of options with ahigher striking price. \nThe foundation of the incremental return strategy is to write against only apart \nof the entire stock holding initially, and to write these calls at the striking price near\nest the current stock price. Then, should the stock move up to the next higher strik\ning price, one rolls up for acredit by adding to the number of calls written. Rolling \nfor acredit is mandatory and is the key to the strategy. Eventually, the stock reaches \nthe target price and the stock is called away, the investor sells all his stock at the tar\nget price, and in addition earns the total credits from all the option transactions. \nExample: XYZ is 60, the investor owns 1,000 shares, and his target price is 80. One \nmight begin by selling three of the longest-term calls at 60 for 7 points apiece. Table \n2-26 shows how apoor case - one in which the stock climbs directly to the target \nprice - might work. As Table 2-26 shows, if XYZ rose to 70 in one month, the three \noriginal calls would be bought back and enough calls at 70 would be sold to produce \nacredit - 5 XYZ October 70's. If the stock continued upward to 80 in another month, \nthe 5 calls would be bought back and the entire position - 10 calls - would be writ\nten against the target price. \nIfXYZ remains above 80, the stock will be called away and all 1,000 shares will \nbe sold at the target price of 80. In addition, the investor will earn all the option cred\nits generated along the way. These amount to $2,800. Thus, the writer obtained the \nfull appreciation of his stock to the target price plus an incremental, positive return \nfrom option writing. \nIn aflat market, the strategy is relatively easy to monitor. If awritten call loses \nits time value premium and therefore might be subject to assignment, the writer can \nroll f01ward to amore distant expiration series, keeping the quantity of written calls \nconstant. This transaction would generate additional credits as well.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:116", "doc_id": "a1bb6a0c65588d9836620b9c75bb133689bf81b2f2401de6a9f4ff1be811ae48", "chunk_index": 0}
{"text": "O.,,er 2: Covered Call Writing \nTABLE 2-26. \nTwo months of incremental return strategy. \nDoy 1 : XYZ = 60 \nSell 3 XYZ October 60'sat 7 \nOne month later: XYZ = 70 \nBuy back the 3 XYZ Oct 60'sat 11 and \nsell 5 XYZ Oct 70'sat 7 \nTwa months later: XYZ = 80 \nBuy back the 5 Oct 70'sat 11 and \nsell 10 XYZ Oct 80'sat 6 \nCOVERED CALL WRITING SUMMARY \n93 \n+$2, 100 credit \n-$3 ,300 debit \n+$3,500 credit \n-$5 ,500 debit \n+$6,000 credit \n+$2,800 credit \nThis concludes the chapter on covered call writing. The strategy will be referred to \nlater, when compared with other strategies. Here is abrief summary of the more \nimportant points that were discussed. \nCovered call writing is aviable strategy because it reduces the risk of stock own\nership and will make one'sportfolio less volatile to short-term market movements. It \nshould be understood, however, that covered call writing may underperform stock \nownership in general because of the fact that stocks can rise great distances, while acovered write has limited upside profit potential. The choice of which call to write \ncan make for amore aggressive or more conservative write. Writing in-the-money \ncalls is strategically more conservative than writing out-of-the-money calls, because \nof the larger amount of downside protection received. The total return concept of \ncovered call writing attempts to achieve the maximum balance between income from \nall sources - option premiums, stock ownership, and dividend income - and down\nside protection. This balance is usually realized by writing calls when the stock is near \nthe striking price, either slightly in- or slightly out-of-the-money. \nThe writer should compute various returns before entering into the position: \nthe return if exercised, the return if the stock is unchanged at expiration, and the \nbreak-even point. To truly compare various writes, returns should be annualized, and \nall commissions and dividends should be included in the calculations. Returns will be \nincreased by taking larger positions in the underlying stock - 500 or 1,000 shares. \nAlso, by utilizing abrokerage firm'scapability to produce \"net\" executions, buying the \nstock and selling the call at aspecified net price differential, one will receive better \nexecutions and realize higher returns in the long run.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:117", "doc_id": "31c248b8dd87e118cb5c5489c1299800758f19a052e820b3b52aa04850d7d0e2", "chunk_index": 0}
{"text": "94 Part II: Call Option Strategies \nThe selection of which call to write should be made on acomparison of avail\nable returns and downside protection. One can sometimes write part of his position \nout-of-the-money and the other part in-the-money to force abalance between return \nand protection that might not otherwise exist. Finally, one should not write against an \nunderlying stock if he is bearish on the stock. The writer should be slightly bullish, or \nat least neutral, on the underlying stock. \nFollow-up action can be as important as the selection of the initial position \nitself. By rolling down if the underlying stock drops, the investor can add downside \nprotection and current income. If one is unwilling to limit his upside potential too \nseverely, he may consider rolling down only part of his call writing position. As the \nwritten call expires, the writer should roll forward into amore distant expiration \nmonth if the stock is relatively close to the original striking price. Higher consistent \nreturns are achieved in this manner, because one is not spending additional stock \ncommissions by letting the stock be called away. An aggressive follow-up action can \nalso be taken when the underlying stock rises in price: The writer can roll up to ahigher striking price. This action increases the maximum profit potential but also \nexposes the position to loss if the stock should subsequently decline. One would want \nto take no follow-up action and let his stock be called if it is above the striking price \nand if there are better returns available elsewhere in other securities. \nCovered call writing can also be done against convertible securities - bonds or \npreferred stocks. These convertibles sometimes offer higher dividend yields and \ntherefore increase the overall return from covered writing. Also, the use of warrants \nor LEAPS in place of the underlying stock may be advantageous in certain circum\nstances, because the net investment is lowered while the profit potential remains the \nsame. Therefore, the overall return could be higher. \nFinally, the larger individual stockholder or institutional investor who wants to \nachieve acertain price for his stock holdings should operate his covered writing strat\negy under the incremental return concept. This will allow him to realize the full prof\nit potential of his underlying stock, up to the target sale price, and to earn additional \npositive income from option writing.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:118", "doc_id": "a15055977b005865ae84a6e6e8af9924ad714838bf0db760633cf22a1233b19f", "chunk_index": 0}
{"text": "Call Buying \nThe success of acall buying strategy depends primarily on one'sability to select \nstocks that will go up and to time the selection reasonably well. Thus, call buying is \nnot astrategy in the same sense of the word as most of the other strategies discussed \nin this text. Most other strategies are designed to remove some of the exactness of \nstock picking, allowing one to be neutral or at least to have some room for error and \nstill make aprofit. Techniques of call buying are important, though, because it is nec\nessary to understand the long side of calls in order to understand more complex \nstrategies correctly. \nCall buying is the simplest form of option investment, and therefore is the most \nfrequently used option \"strategy\" by the public investor. The following section out\nlines the basic facts that one needs to know to implement an intelligent call buying \nprogram. \nWHY BUY? \nThe main attraction in buying calls is that they provide the speculator with agreat \ndeal of leverage. One could potentially realize large percentage profits from only amodest rise in price by the underlying stock. Moreover, even though they may be \nlarge percentagewise, the risks cannot exceed afixed dollar amount - the price orig\ninally paid for the call. Calls must be paid for in full; they have no margin value and \ndo not constitute equity for margin purposes. Note: The preceding statements \nregarding payment for an option in full do not necessarily apply to LEAPS options, \nwhich were declared marginable in 1999. The following simple example illustrates \nhow acall purchase might work. \n95", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:119", "doc_id": "3e98a070a93f340bd3f83ba83eab548168deb8131f878d0a18c5ffe7dbd876d5", "chunk_index": 0}
{"text": "96 Part II: Call Option Strategies \nExample: Assume that XYZ is at 48 and the 6-month call, the July 50, is selling for \n3. Thus, with an investment of $300, the call buyer may participate, for 6 months, in \namove upward in the price ofXYZ common. IfXYZ should rise in price by 10 points \n(just over 20%), the July 50 call will be worth at least $800 and the call buyer would \nhave a 167% profit on amove in the stock of just over 20%. This is the leverage that \nattracts speculators to call buying. At expiration, if XYZ is below 50, the buyer'sloss \nis total, but is limited to his initial $300 investment, even if XYZ declines in price sub\nstantially. Although this risk is equal to 100% of his initial investment, it is still small \ndollarwise. One should nornwlly not invest more than 15% of his risk capital in call \nbuying, because of the relatively large percentage risks involved. \nSome investors participate in call buying on alimited basis to add some upside \npotential to their portfolios while keeping the risk to afixed amount. For example, if \nan investor normally only purchased low-volatility, conservative stocks because he \nwanted to limit his downside risk, he might consider putting asmall percentage of his \ncash into calls on more volatile stocks. In this manner, he could \"trade\" higher-risk \nstocks than he might normally do. If these volatile stocks increase in price, the \ninvestor will profit handsomely. However, if they decline substantially - as well they \nmight, being volatile - the investor has limited his dollar risk by owning the calls \nrather than the stock. \nAnother reason some investors buy calls is to be able to buy stock at areason\nable price without missing amarket. \nExample: With XYZ at 75, this investor might buy acall on XYZ at 80. He would like \nto own XYZ at 80 if it can prove itself capable of rallying and be in-the-money at expi\nration. He would exercise the call in that case. On the other hand, if XYZ declines in \nprice instead, he has not tied up money in the stock and can lose only an amount \nequal to the call premium that he paid, an amount that is generally much less than \nthe price of the stock itself. \nAnother approach to call buying is sometimes utilized, also by an investor who \ndoes not want to \"miss the market.\" Suppose an investor knows that, in the near \nfuture, he will have an amount of money large enough to purchase aparticular stock; \nperhaps he is closing the sale of his house or acertificate of deposit is maturing. \nHowever, he would like to buy the stock now, for he feels arally is imminent. He \nmight buy calls at the present time if he had asmall amount of cash available. The \ncall purchases would require an investment much smaller than the stock purchase. \nThen, when he receives the cash that he knew was forthcoming, he could exercise the \ncalls and buy the stock. In this way, he might have participated in arally by the stock \nbefore he actually had the money available to pay for the stock in full.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:120", "doc_id": "ae2f6eaa5836ca17f06579d592227b5f112054489c0150bfda742be5ea336d9f", "chunk_index": 0}
{"text": "Cl,opter 3: Call Buying 97 \nRISK AND REWARD FOR THE CALL BUYER \nThe most important fact for the call buyer to realize is that he will normally win only \nif the stock rises in price. All the worthwhile analysis in the world spent in selecting \nwhich call to buy will not produce profits if the underlying stock declines. However, \nthis fact should not dissuade one from making reasonable analyses in his call buying \nselections. Too often, the call buyer feels that astock will move up, and is correct in \nthat part of his projection, but still loses money on his call purchase because he failed \nto analyze the risk and rewards involved with the various calls available for purchase \nat the time. He bought the wrong call on the right stock. \nSince the best ally that the call buyer has is upward movement in the underly\ning stock, the selection of the underlying stock is the most important choice the call \nbuyer has to make. Since timing is so important when buying calls, the technical fac\ntors of stock selection probably outweigh the fundamentals; even if positive funda\nmentals do exist, one does not know how long it will take in order for them to be \nreflected in the price of the stock. One must be bullish on the underlying stock in \norder to consider buying calls on that stock. Once the stock selection has been made, \nonly then can the call buyer begin to consider other factors, such as which striking \nprice to use and which expiration to buy. The call buyer may have another ally, but \nnot one that he can normally predict: If the stock on which he owns acall becomes \nmore volatile, the call'sprice will rise to reflect that change. \nThe purchase of an out-of-the-money call generally offers both larger potential \nrisk and larger potential reward than does the purchase of an in-the-money call. \nMany call buyers tend to select the out-of-the-money call merely because it is cheap\ner in price. Absolute dollar price should in no way be adeciding factor for the call \nbuyer. If one'sfunds are so limited that he can only afford to buy the cheapest calls, \nhe should not be speculating in this strategy. If the underlying stock increases in price \nsubstantially, the out-of-the-money call will naturally provide the largest rewards. \nHowever, if the stock advances only moderately in price, the in-the-money call may \nactually perform better. \nExample: XYZ is at 65 and the July 60 sells for 7 while the July 70 sells for 3. If the \nstock moves up to 68 relatively slowly, the buyer of the July 70 - the out-of-the\nmoney call - may actually experience aloss, even if the call has not yet expired. \nHowever, the holder of the in-the-money July 60 will definitely have aprofit because \nthe call will sell for at least 8 points, its intrinsic value. The point is that, percentage\nwise, an in-the-rrwney call will offer better rewards for arrwdest stock gain, and an \nout-ofthe-rrwney call is better for larger stock gains.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:121", "doc_id": "3308bf0217a6e9e75f09e2430df2fd06cf720242ded84f04fdc5bfc5c79c70fc", "chunk_index": 0}
{"text": "98 Part II: Call Option Strategies \nWhen risk is considered, the in-the-money call clearly has less probability of \nrisk. In the prior example, the in-the-money call buyer would not lose his entire \ninvestment unless XYZ fell by at least 5 points. However, the buyer of the out-of-the\nmoney July 70 would lose all of his investment unless the stock advanced by more \nthan 5 points by expiration. Obviously, the probability that the in-the-money call will \nexpire worthless is much smaller than that for the out-of-the-money call. \nThe time remaining to expiration is also relevant to the call buyer. If the stock \nis fairly close to the striking price, the near-term call will most closely follow the price \nmovement of the underlying stock, so it has the greatest rewards and also the great\nest risks. The far-term call, because it has alarge amount of time remaining, offers \nthe least risk and least percentage reward. The intermediate-temi call offers amod\nerate amount of each, and is therefore often the most attractive one to buy. Many \ntimes an investor will buy the longer-term call because it only costs apoint or apoint \nand ahalf more than the intermediate-term call. He feels that the extra price is abar\ngain to pay for three extra months of time. This line of thought may prove somewhat \nmisleading, however, because most call buyers don'thold calls for more than 60 or 90 \ndays. Thus, even though it looks attractive to pay the extra point for the long-term \ncall, it may prove to be an unnecessary expense if, as is usually the case, one will be \nselling the call in two or three months. \nCERTAINTY OF TIMING \nThe certainty with which one expects the underlying stock to advance may also help \nto play apart in his selection of which call to buy. If one is fairly sure that the under\nlying stock is about to rise immediately, he should strive for more reward and not be \nas concerned about risk. This would mean buying short-term, slightly out-of-the\nmoney calls. Of course, this is only ageneral rule; one would not normally buy an out\nof-the-money call that has only one week remaining until expiration, in any case. At \nthe opposite end of the spectrum, if one is very uncertain about his timing, he should \nbuy the longest-term call, to moderate his risk in case his timing is wrong by awide \nmargin. This situation could easily result, for example, if one feels that apositive fun\ndamental aspect concerning the company will assert itself and cause the stock to \nincrease in price at an unknown time in the future. Since the buyer does not know \nwhether this positive fundamental will come to light in the next month or six months \nfrom now, he should buy the longer-term call to allow room for error in timing. \nIn many cases, one is not intending to hold the purchased call for any signifi\ncant period of time; he is just looking to capitalize on aquick, short-term movement \nby the underlying stock. In this case, he would want to buy arelatively short-term in\nthe-money call. Although such acall may be more ex-pensive than an out-of-the-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:122", "doc_id": "961efebbe1eba59883b989511f47a103d4d49f113e67a29e1f4ce8963f0f1f41", "chunk_index": 0}
{"text": "Cl,apter 3: Call Buying 99 \nmoney call on the same underlying stock, it will most surely move up on any increase \nin price by the underlying stock. Thus, the short-term trader would profit. \nTHE DELTA \nThe reader should by now be familiar with basic facts concerning call options: The \ntime premium is highest when the stock is at the striking price of the call; it is lowest \ndeep in- or out-of-the-money; option prices do not decay at alinear rate -the time pre\nmium disappears more rapidly as the option approaches expiration. As afurther means \nof review, the option pricing curve introduced in Chapter 1 is reprinted here. Notice \nthat all the facts listed above can be observed from Figure 3-1. The curves are much \nnearer the \"intrinsic value\" line at the ends than they are in the middle, implying that \nthe time value premium is greatest when the stock is at the strike, and is least when \nthe stock moves away from the strike either into- or out-of-the-money. Furthermore, \nthe fact that the curve for the 3-month option lies only about halfway between the \nintrinsic value line and the curve of the 9-month option implies that the rate of decay \nof an at- or near-the-money option is not linear. The reader may also want to refer back \nto the graph of time value premium decay in Chapter 1 (Figure 1-4). \nThere is another property of call options that the buyer should be familiar with, \nthe delta of the option (also called the hedge ratio). Simply stated, the delta of an \noption is the arrwunt by which the call will increase or decrease in price if the under\nlying stock moves by 1 point. \nFIGURE 3-1. \nOption pricing curve; 3-, 6-, and 9-month calls. \nQ) \n0 \n~ \nC: \n0 \na \n0 \n9-Month Curve \n6-Month Curve \n3-Month Curve \n/ \nIntrinsic Value \nStriking Price \nStock Price \nAs expiration date draws \ncloser, the lower curve \nmerges with the intrinsic \nvalue line. The option \nprice then equals its \nintrinsic value.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:123", "doc_id": "07ec28611d465cd9363fa71ceb69012ce905e94b2ee608c6222558b0ca230de1", "chunk_index": 0}
{"text": "100 Part II: Call Option Strategies \nExample: The delta of acall option is close to 1 when the underlying stock is well \nabove the striking price of the call. If XYZ were 60 and the XYZ July 50 call were \n101/s, the call would change in price by nearly 1 point ifXYZ moved by 1 point, either \nup or down. Adeeply out-of-the-money call has adelta of nearly zero. If XYZ were \n40, the July 50 call might be selling at¼ of apoint. The call would change very little \nin price if XYZ moved by one point, to either 41 or 39. When the stock is at the strik\ning price, the delta is usually between one-half of apoint and five-eighths of apoint. \nVery long-term calls may have even larger at-the-money deltas. Thus, if XYZ were 50 \nand the XYZ July 50 call were 5, the call might increase to 5½ if XYZ rose to 51 or \ndecrease to 4½ if XYZ dropped to 49. \nActually, the delta changes each time the underlying stock changes even frac\ntionally in price; it is an exact mathematical derivation that is presented in alater \nchapter. This is most easily seen by the fact that adeep in-the-money option has adelta of 1. However, if the stock should undergo aseries of I-point drops down to the \nstriking price, the delta will be more like½, certainly not 1 any longer. In reality, the \ndelta changed instantaneously all during the price decline by the stock. For those \nwho are geometrically inclined, the preceding option price curve is useful in deter\nmining agraphic representation of the delta. The delta is the slope of the tangent line \nto the price curve. Notice that adeeply in-the-money option lies to the upper right \nside of the curve, very nearly on the intrinsic value line, which has aslope of 1 above \nthe strike. Similarly, adeeply out-of-the-money call lies to the left on the price curve, \nagain near the intrinsic value line, which has aslope of zero below the strike. \nSince it is more common to relate the option'sprice change to afull point \nchange in the underlying stock (rather than to deal in \"instantaneous\" price changes), \nthe concepts of up delta and down delta arise. That is, if the underlying stock moves \nup by 1 full point, acall with adelta of .50 might increase by 5/s. However, should the \nstock fall by one full point, the call might decrease by only 3/s. There is adifferent net \nprice change in the call when the stock moves up by 1 full point as opposed to when \nit falls by apoint. The up delta is observed to be 5/swhile the down delta is 3/s. In the \ntrue mathematical sense, there is only one delta and it measures \"instantaneous\" \nprice change. The concepts of up delta and down delta are practical, rather than the\noretical, concepts that merely illustrate the fact that the true delta changes whenev\ner the stock price changes, even by as little as 1 point. In the following examples and \nin later chapters, only one delta is referred to. \nThe delta is an important piece of information for the call buyer because it can \ntell him how much of an increase or decrease he can expect for short-term moves by \nthe underlying stock. This piece of information may help the buyer decide which call \nto buy.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:124", "doc_id": "b8389d6016a2ed1c43770206fd16032541f3569a8a825f87ec9efef9cfac4380", "chunk_index": 0}
{"text": "Chapter 3: Call Buying 101 \nExample: If XYZ is 4 7½ and the call buyer expects aquick, but possibly limited, rise \nin price in the underlying stock, should he buy the 45 call or the 50 call? The delta \nmay help him decide. He has the following information: \nXYZ: 471/2 XYZ July 45 call: price = 31/2, \nXYZ July 50 call: price = 1, \ndelta = 5/adelta = 1/4 \nIt will make matters easier to make aslightly incorrect, but simplifying, assumption \nthat the deltas remain constant over the short term. Which call is the better buy if \nthe buyer expects the stock to quickly rise to 49? This would represent a 1 ½-point \nincrease in XYZ, which would translate into a 15/16 increase in the July 45 (l½ times \n5/s) or a 3/sincrease in the July 50 (1 ½ times ¼). Consequently, the July 45, if it \nincreased in price by 15/16, would appreciate by 27%. The July 50, if it increased by \n3/a, would appreciate by over 37%. Thus, the July 50 appears to be the better buy in \nthis simple example. Commissions should, of course, be included when making an \nanalysis for actual investment. \nThe investor does not have to bother with computing deltas for himself. Any \ngood call-buying data service will supply the information, and some brokerage hous\nes provide this information free of charge. \nMore advanced applications of deltas are described in many of the succeeding \nchapters, as they apply to avariety of strategies. \nWHICH OPTION TO BUY? \nThere are various trading strategies, some short-term, some long-term (even buy and \nhold). If one decides to use an option to implement atrading strategy, the time hori\nzon of the strategy itself often dictates the general category of option that should be \nbought - in-the-money versus out-of-the-money, near-term versus long-term, etc. \nThis statement is true whether one is referring to stock, index, or futures options. \nThe general rule is this: The shorter-term the strategy, the higher the delta should be \nof the instrument being used to trade the strategy. \nDAY TRADING \nFor example, day trading has become apopular endeavor. Statistics have been pro\nduced that indicate that most day traders lose money. In fact, there are profitable day \ntraders; it simply requires more and harder work than many are willing to invest. \nMany day traders have attempted to use options in their strategies. These day traders", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:125", "doc_id": "9a6f9e3aad008ad55051057009ee65950737efdfac54a5439c1dbe862be7fff3", "chunk_index": 0}
{"text": "102 Part II: Call Option Strategies \napparently are attracted by the leverage available from options, but they often lose \nmoney via option trading as well. \nWhat many of these option-oriented day traders fail to realize is that, for day\ntrading purposes, the instrument with the highest possible delta should be used. That \ninstrument is the underlying, for it has adelta of 1.0. Day trading is hard enough \nwithout complicating it by trying to use options. So of you're day trading Microsoft \n(MSFT), trade the stock, not an option. \nWhat makes options difficult in such ashort-term situation is their relatively \nwide bid-asked spread, as compared to that of the underlying instrument itself. Also, \naday trader is looking to capture only asmall part of the underlying'sdaily move; an \nat-the-money or out-of-the-money option just won'trespond well enough to those \nmovements. That is, if the delta is too low, there just isn'tenough room for the option \nday trader to make money. \nIf aday trader insists on using options, ashort-term, in-the-money should be \nbought, for it has the largest delta available - preferably something approaching .90 \nor higher. This option will respond quickly to small movements by the underlying. \nSHORT-TERM TRADING \nSuppose one employs astrategy whereby he expects to hold the underlying for \napproximately aweek or two. In this case, just as with day trading, ahigh delta is \ndesirable. However, now that the holding period is more than aday, it may be appro\npriate to buy an option as opposed to merely trading the underlying, because the \noption lessens the risk of asurprisingly large downside move. Still, it is the short\nterm, in-the-money option that should be bought, for it has the largest delta, and will \nthus respond most closely to the movement in the underlying stock. Such an option \nhas avery high delta, usually in excess of .80. Part of the reason that the high-delta \noptions make sense in such situations is that one is fairly certain of the timing of day \ntrading or very short-term trading systems. When the system being used for selection \nof which stock to trade has ahigh degree of timing accuracy, then the high-delta \noption is called for. \nINTERMEDIATE-TERM TRADING \nAs the time horizon of one'strading strategy lengthens, it is appropriate to use an \noption with alesser delta. This generally means that the timing of the selection \nprocess is less exact. One might be using atrading system based, for ernmple, on sen\ntiment, which is generally not an exact timing indicator, but rather one that indicates \nageneral trend change at major turning points. The timing of the forthcoming move", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:126", "doc_id": "04b58414c7a7c82ba568f3fc48151cc5476db333eaba9dcd7294004acf68a6ee", "chunk_index": 0}
{"text": "Gapter 3: Call Buying 103 \nis not exact, because it often takes time for an extreme change in sentiment to reflect \nitself in achange of direction by the underlying. \nHence, for astrategy such as this, one would want to use an option with asmall\ner delta. The investor would limit his risk by using such an option, knowing that large \nmoves are possible since the position is going to be held for several weeks or perhaps \neven acouple of months or more. Therefore, an at-the-money option can be used in \nsuch situations. \nI.ONG-TERM TRADING \nIf one'sstrategy is even longer-term, an option with alower delta can be considered. \nSuch strategies would generally have only vague timing qualities, such as selecting astock to buy based on the general fundamental outlook for the company. In the \nextreme, it would even apply to \"buy and hold\" strategies. \nGenerally, buying out-of-the-money options is not recommended; but for very \nlong-term strategies, one might consider something slightly out-of-the-money, or at \nleast afairly long-term at-the-money option. In either case, that option will have alower delta as compared to the options that have been recommended for the other \nstrategies mentioned above. Alternatively, LEAPS options might be appropriate for \nstock strategies of this type. \nADVANCED SELECTION CRITERIA \nThe criteria presented previously represented elementary techniques for selecting \nwhich call to buy. In actual practice, one is not usually bullish on just one stock at atime. In fact, the investor would like to have alist of the \"best\" calls to buy at any \ngiven time. Then, using some method of stock selection, either technical or funda\nmental, he can select three or four calls that appear to offer the best rewards. This \nlist should be ranked in order of the best potential rewards available, but the con\nstruction of the list itself is important. \nCall option rankings for buying purposes must be based on the volatilities of the \nunderlying stocks. This is not easy to do mathematically, and as aresult many pub\nlished rankings of calls are based strictly on percentage change in the underlying \nstock. Such alist is quite misleading and can lead one to the wrong conclusions. \nExample: There are two stocks with listed calls: NVS, which is not volatile, and VVS, \nwhich is quite volatile. Since acall on the volatile stock will be higher-priced than acall on the nonvolatile stock, the following prices might exist:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:127", "doc_id": "c8d0f1a7de710d98293c9d6fd176a271db7dddef8fe810355f272d190a433b1d", "chunk_index": 0}
{"text": "104 Part II: Call Option Strategies \nNVS: 40 VVS: 40 \nNVS July 40 call: 2 VVS July 40 call: 4 \nIf these two calls are ranked for buying purposes, based strictly on apercentage \nchange in the underlying stock, the NVS call will appear to be the better buy. For \nexample, one might see alist such as \"best call buys if the underlying stock advances \nby 10%.\" In this example, if each stock advanced 10% by expiration, both NVS and \nWS would be at 44. Thus, the NVS July 40 would be worth 4, having doubled in \nprice, for a 100% potential profit. Meanwhile, the WS July 40 would be worth 4 also, \nfor a 0% profit to the call buyer. This analysis would lead one to believe that the NVS \nJuly 40 is the better buy. Such aconclusion may be wrong, because an incorrect \nassumption was made in the ranking of the potentials of the two stocks. It is not right \nto assume that both stocks have the same probability of moving 10% by expiration. \nCertainly, the volatile stock has amuch better chance of advancing by 10% ( or more) \nthan the nonvolatile stock does. Any ranking based on equal percentage changes in \nthe underlying stock, without regard for their volatilities, is useless and should be \navoided. \nThe correct method of comparing these two July 40 calls is to utilize the actual \nvolatilities of the underlying stocks. Suppose that it is known that the volatile stock, \nWS, could expect to move 15% in the time to July expiration. The nonvolatile stock, \nNVS, however, could only expect amove of 5% in the same period. Using this infor\nmation, the call buyer can arrive at the conclusion that WS July 40 is the better call \nto buy: \nStock Price in July \nVVS: 46 (up 15%) \nNVS: 42 (up 5%) \nColl Price \nVVS July 40: 6 (up 50%) \nNVS July 40: 2 (unchanged) \nBy assuming that each stock can rise in accordance with its volatility, we can see that \nthe WS July 40 has the better reward potential, despite the fact that it was twice as \nexpensive to begin with. This method of analysis is much more realistic. \nOne more refinement needs to be made in this ranking process. Since most call \npurchases are made for holding periods of from 30 to 90 days, it is not correct to \nassume that the calls will be held to expiration. That is, even if one buys a 6-month \ncall, he will normally liquidate it, to take profits or cut losses, in 1 to 3 months. The \ncall buyer'slist should thus be based on how the call will peiform if held for arealis\ntic time period, such as 90 days.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:128", "doc_id": "ad08cc9200de4dd90aa01a2fa7063ed984828d201059a43c106fbbb9c6270e18", "chunk_index": 0}
{"text": "Chapter 3: Call Buying 105 \nSuppose the volatile stock in our example, WS, has the potential to rise by 12% \nin 90 days, while the less volatile stock, NVS, has the potential of rising only 4% in 90 \ndays. In 90 days, the July 40 calls will not be at parity, because there will be some time \nremaining until July expiration. Thus, it is necessary to attempt to predict what their \nprices will be at the end of the 90-day holding period. Assume that the following \nprices are accurate estimates of what the July 40 calls will be selling for in 90 days, if \nthe underlying stocks advance in relation to their volatilities: \nStock Price in 90 Days \nVVS: 44.8 (up 12%) \nNVS: 41 .6 (up 4%) \nColl Price \nVVS July 40: 6 (up 50%) \nNVS July 40: 21/2 (up 25%) \nWith some time remaining in the calls, they would both have time value premium at \nthe end of 90 days. The bigger time premium would be in the WS call, since the \nunderlying stock is more volatile. Under this method of analysis, the WS call is still \nthe better one to buy. \nThe correct method of ranking potential reward situations for call buyers is as \nfollows: \n1. Assume each underlying stock can advance in accordance with its volatility over \nafixed period (30, 60, or 90 days). \n2. Estimate the call prices after the advance. \n3. Rank all potential call purchases by highest percentage reward opportunity for \naggressive purchases. \n4. Assume each stock can decline in accordance with its volatility. \n5. Estimate the call prices after the decline. \n6. Rank all purchases by reward/risk ratio ( the percentage gain from item 2 divided \nby the percentage loss from item 5). \nThe list from item 3 will generate more aggressive purchases because it incorporates \npotential rewards only. The list from item 6 would be aless speculative one. This \nmethod of analysis automatically incorporates the criteria set forth earlier, such as \nbuying short-term out-of-the-money calls for aggressive purchases and buying \nlonger-term in-the-money calls for amore conservative purchase. The delta is also afunction of the volatility and is essentially incorporated by steps 1 and 4. \nIt is virtually impossible to perform this sort of analysis without acomputer. The \ncall buyer can generally obtain such alist from abrokerage firm or from adata serv\nice. For those individuals who have access to acomputer and would like to generate", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:129", "doc_id": "e9bc2dc53931ca82be69ee46117d3485b9ee2e983b4900b3669405fd75f9224f", "chunk_index": 0}
{"text": "106 Part II: Call Option Strategies \nsuch an analysis for themselves, the details of computing astock'svolatility and pre\ndicting the call prices are provided in Chapter 28 on mathematical techniques. \nOVERPRICED OR UNDERPRICED CALLS \nFormulae exist that are capable of predicting what acall should be selling for, based \non the relationship of the stock price and the striking price, the time remaining to \nexpiration, and the volatility of the underlying stock. These are useful, for example, \nin performing the second step in the foregoing analysis, estimating the call price after \nan advance in the underlying stock. In reality, acall'sactual price may deviate some\nwhat from the price computed by the formula. If the call is actually selling for more \nthan the \"fair\" ( computed) price, the call is said to be overvalued. An undervalued \ncall is one that is actually trading at aprice that is less than the \"fair\" price. \nIf the calls are truly overpriced, there may be astrategy that can help reduce \ntheir cost while still preserving upside profit potential. This strategy, however, \nrequires the addition of aput spread to the call purchase, so it is beyond the scope \nof the subject matter at the current time. It is described in Chapter 23 on spreads \ncombining calls and puts. \nGenerally, the amount by which acall is overvalued or undervalued may be only \nasmall fraction of apoint, such as 10 or 20 cents. In theory, the call buyer who pur\nchases an undervalued call has gained aslight advantage in that the call should return \nto its \"fair\" value. However, in practice, this information is most useful only to mar\nket-makers or firm traders who pay little or no commissions for trading options. The \ngeneral public cannot benefit directly from the knowledge that such asmall discrep\nancy exists, because of commission costs. \nOne should not base his call buying decisions merely on the fact that acall is \nunderpriced. It is small solace to the call buyer to find that he bought a \"cheap\" call \nthat subsequently declined in price. The method of ranking calls for purchase that \nhas been described does, in fact, give some slight benefit to underpriced calls. \nHowever, under the recommended method of analysis, acall will not automatically \nappear as an attractive purchase just because it is slightly undervalued. \nTIME VALUE PREMIUM IS A MISNOMER \nThis is atopic that will be mentioned several times throughout the book, most \nnotably in conjunction with volatility trading. It is introduced here because even the \ninexperienced option trader must understand that the portion of an option'sprice \nthat is not intrinsic value - the part that we routinely call \"time value premium\" - is \nreally composed of much more than just time value. Yes, time will eventually wear", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:130", "doc_id": "1f5f53e7ea02824d6243919a9c1ac67bc5de46bb07898dda06a33ab268b53c2d", "chunk_index": 0}
{"text": "Chpter 3: Call Buying 107 \naway that portion of the option'sprice as expiration approaches. However, when an \noption has aconsiderable amount of time remaining until its expiration, the more \nimportant component of the option value is really volatility. If traders expect the \nunderlying stock to be volatile, the option will be expensive; if they expect the oppo\nsite, the option will be cheap. This expensiveness and cheapness is reflected in the \nportion of the option that is not intrinsic value. For example, asix-month option will \nnot decay much in one day'stime, but aquick change in volatility expectations by \noption traders can heavily affect the price of the option, especially one with agood \ndeal of time remaining. So an option buyer should carefully assess his purchases, not \njust view them as something that will waste away. With careful analysis, option buy\ners can do very well, if they consider what can happen during the life of the option, \nand not merely what will happen at expiration. \nCALL BUYERS' FRUSTRATIONS \nDespite one'sbest efforts, it may often seem that one does not make much money \nwhen afairly volatile stock makes aquick move of 3 or 4 points. The reasons for this \nare somewhat more complex than can be addressed at this time, although they relate \nstrongly to delta, time decay, and the volatility of the underlying stock. They are dis\ncussed in Chapter 36, 'The Basics of Volatility Trading.\" If one plans to conduct aserious call buying strategy, he should read that chapter before embarking on apro\ngram of extensive call buying. \nFOLLOW-UP ACTION \nThe simplest follow-up action that the call buyer can implement when the underly\ning stock drops is to sell his call and cut his losses. There is often anatural tendency \nto hold out hope that the stock can rally back to or above the striking price. Most of \nthe time, the buyer does best by cutting his losses in situations in which the stock is \nperforming poorly. He might use a \"mental\" stop price or could actually place asell \nstop order, depending on the rules of the exchange where the call is traded. In gen\neral, stop orders for options result in poor executions, so using a \"mental\" stop is bet\nter. That is, one should base his exit point on the technical pattern of the underlying \nstock itself. If it should break down below support, for example, then the option \nholder should place amarket (not held) order to sell his call option. \nIf the stock should rise, the buyer should be willing to take profits as well. Most \nbuyers will quite readily take aprofit if, for example, acall that was bought for 5 \npoints had advanced to be worth 10 points. However, the same investor is often", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:131", "doc_id": "a70fb56c03f1a26ac70776b6cf6ee9ce743407728cf58dbd1c46a0e2a6885c77", "chunk_index": 0}
{"text": "108 Part II: Call Option Strategies \nreluctant to sell acall at 2 that he had previously bought for 1 point, because \"I've \nonly made apoint.\" The similarity is clear - both cases resulted in approximately a \n100% profit - and the investor should be as willing to accept the one as he is the \nother. This is not to imply that all calls that are bought at 1 should be sold when and \nif they get to 2, but the same factors that induce one to sell the 10-point call after \ndoubling his money should apply to the 2-point call as well. \nIn fact, taking partial profits after acall holding has increased in value is often \nawise plan. For example, if someone bought anumber of calls at aprice of 3, and \nthey later were worth 5, it might behoove the call holder to sell one-third to one-half \nof his position at 5, thereby taking apartial profit. Having done that, it is often easi\ner to let the profits run on the balance, and letting profits run is generally one of the \nkeys to successful trading. \nIt is rarely to the call buyer'sbenefit to exercise the call if he has to pay com\nmissions. When one exercises acall, he pays astock commission to buy the stock at \nthe striking price. Then when the stock is sold, astock sale commission must also be \npaid. Since option commissions are much smaller, dollarwise, than stock commis\nsions, the call holder will usually realize more net dollars by selling the call in the \noption market than by exercising it. \nLOCKING IN PROFITS \nWhen the call buyer is fortunate enough to see the underlying stock advance rela\ntively quickly, he can implement anumber of strategies to enhance his position. \nThese strategies are often useful to the call buyer who has an unrealized profit but is \ntorn between taking the profit or holding on in an attempt to generate more profits \nif the underlying stock should continue to rise. \nExample: Acall buyer bought an XYZ October 50 call for 3 points when the stock \nwas at 48. Then the stock rises to 58. The buyer might consider selling his October \n50 (which would probably be worth about 9 points) or possibly taking one of several \nactions, some of which might involve the October 60 call, which may be selling for 3 \npoints. Table 3-1 summarizes the situation. At this point, the call buyer might take \none of four basic actions: \n1. Liquidate the position by selling the long call for aprofit. \n2. Sell the October 50 that he is currently long and use part of the proceeds to pur\nchase October 60's. \n3. Create aspread by selling the October 60 call against his long October 50. \n4. Do nothing and remain long the October 50 call.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:132", "doc_id": "f5c30e3058048188407f35107240347e85303c572a346540527e2fdfd954a9a6", "chunk_index": 0}
{"text": "Gapter 3: Call Buying \nTABLE 3-1. \nPresent situation on XYZ October calls. \nOriginal Trade \nXYZ common: 48 \nBought XYZ October 50 at 3 \n109 \nCurrent Prices \nXYZ Common: 58 \nXYZ October 50: 9 \nXYZ October 60: 3 \nEach of these actions would produce different levels of risk and reward from \nthis point forward. If the holder sells the October 50 call, he makes a 6-point profit, \nless commissions, and terminates the position. He can realize no further appreciation \nfrom the call, nor can he lose any of his current profits; he has realized a 6-point gain. \nThis is the least aggressive tactic of the four: If the underlying stock continues to \nadvance and rises above 63, any of the other three strategies will outperform the \ncomplete liquidation of the call. However, if the underlying stock should instead \ndecline below 50 by expiration, this action would have provided the most profit of the \nfour strategies. \nThe other simple tactic, the fourth one listed, is to do nothing. If the call is then \nheld to expiration, this tactic would be the riskiest of the four: It is the only one that \ncould produce aloss at expiration if XYZ fell back below 50. However, if the under\nlying stock continues to rise in price, more profits would accrue on the call. Every call \nbuyer realizes the ramifications of these two tactics - liquidating or doing nothing \nand is generally looking for an alternative that might allow him to reduce some of his \nrisk without cutting off his profit potential completely. The remaining two tactics are \ngeared to this purpose: limiting the total risk while providing the opportunity for fur\nther profits of an amount greater than those that could be realized by liquidating. \nThe strategy in which the holder sells the call that he is currently holding, the \nOctober 50, and uses part of the proceeds to buy the call at the next higher strike is \ncalled rolling up. In this example, he could sell the October 50 at 9, pocket his initial \n3-point investment, and use the remaining proceeds to buy two October 60 calls at 3 \npoints each. Thus, it is sometimes possible for the speculator to recoup his entire \noriginal investment and still increase the number of calls outstanding by rolling up. \nOnce this has been done, the October 60 calls will represent pure profits, whatever \ntheir price. The buyer who \"rolls up\" in this rrwnner is essentially speculating with \nsomeone else'smoney. He has put his own money back in his pocket and is using \naccrued profits to attempt to realize further gains. At expiration, this tactic would \nperform best if XYZ increased by asubstantial amount. This tactic turns out to be the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:133", "doc_id": "c7ad27ab308a6c10880eeb822cddbea3d37c342876350d1425315ed1cd856843", "chunk_index": 0}
{"text": "110 Part II: Call Option Strategies \nworst of the four at expiration if XYZ remains near its current price, staying above 53 \nbut not rising above 63 in this example. \nThe other alternative, the third one listed, is to continue to hold the October 50 \ncall but to sell the October 60 call against it. This would create what is known as abull \nspread, and the tactic can be used only by traders who have amargin account and can \nmeet their firm'sminimum equity requirement for spreading (generally $2,000). This \nspread position has no risk, for the long side of the spread - the October 50 cost 3 \npoints, and the short side of the spread - the October 60 - brought in 3 points via its \nsale. Even if the underlying stock drops below 50 by expiration and all the calls expire \nworthless, the trader cannot lose anything except commissions. On the other hand, the \nmaximum potential of this spread is 10 points, the difference between the striking \nprices of 50 and 60. This maximum potential would be realized if XYZ were anywhere \nabove 60 at expiration, for at that time the October 50 call would be worth 10 points \nmore than the October 60 call, regardless of how far above 60 the underlying stock \nhad risen. This strategy will be the best peiformer of the four if XYZ remains relative\nly unchanged, above the lower strike but not much above the higher strike by expira\ntion. It is interesting to note that this tactic is never the worst peiforrner of the four \ntactics, no matter where the stock is at expiration. For example, if XYZ drops below \n50, this strategy has no risk and is therefore better than the \"do nothing\" strategy. If \nXYZ rises substantially, this spread produces aprofit of 10 points, which is better than \nthe 6 points of profit offered by the \"liquidate\" strategy. \nThere is no definite answer as to which of the four tactics is the best one to \napply in agiven situation. However, if acall can be sold against the currently long call \nto produce abull spread that has little or no risk, it may often be an attractive thing \nto do. It can never tum out to be the worst decision, and it would produce the largest \nprofits if XYZ does not rise substantially or fall substantially from its current levels. \nTables 3-2 and 3-3 summarize the four alternative tactics, when acall holder has an \nunrealized profit. The four tactics, again, are: \n1. \"Do nothing\" - continue to hold the currently long call. \n2. \"Liquidate\" - sell the long call to take profits and do not reinvest. \n3. \"Roll up\" - sell the long call, pocket the original investment, and use the remain\ning proceeds to purchase as many out-of-the-money calls as possible. \n4. \"Spread\" - create abull spread by selling the out-of-the-money call against the \ncurrently profitable long call, preferably taking in at least the original cost of the \nlong call.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:134", "doc_id": "16d44a653d9c27d10e463d6b71eea0255185cdb525ca01a3fef51a731e793fe4", "chunk_index": 0}
{"text": "Cl,apter 3: Call Buying 111 \nTABLE 3-2. \nComparison of the four alternative strategies. \nIf the underlying stock then. . . The best tactic was. . . And the worst tactic was ... \ncontinues to rise dramatic\nally ... \n\"roll up\" \nrises moderately above the do nothing \nnext strike ... \nremains relatively unchanged . .. spread \nfalls back below the original liquidate \nstrike ... \nTABLE 3-3. \nResults at expiration. \nXYZ Price at \"Roll-up\" \"Do Nothing\" \nExpiration Profit Profit \n50 or below $ 0 -$ 300(W) \n53 0(W) 0(W) \n56 0(W) + 300 \n60 0(W) + 700 \n63 + 600(W) + 1,000(B) \n67 + 1,400(B) + 1,400(B) \n70 + 2,000(B) + 1,700 \nliquidate \nliquidate or \"roll up\" \n\"roll up\" \ndo nothing \n\"Spread\" \nProfit \n$ 0 \n+ 300 \n+ 600(B) \n+ 1,000(B) \n+ 1,000(B) \n+ 1,000 \n+ 1,000 \nLiquidating \nProfit \n+$600(B) \n+ 600(B) \n+ 600(B) \n+ 600 \n+ 600(W) \n+ 600(W) \n+ 600(W) \nNote that each of the four tactics proves to be the best tactic in one case or another, \nbut that the spread tactic is never the worst one. Tables 3-2 and 3-3 represent the \nresults from holding until expiration. For those who prefer to see the actual numbers \ninvolved in making these comparisons between the four tactics, Table 3-3 summa\nrizes the potential profits and losses of each of the four tactics using the prices from \nthe example above. 'W\" indicates that the tactic is the worst one at that price, and \n\"B\" indicates that it is the best one. \nThere are, of course, modifications that an investor might make to any of these \ntactics. For example, he might decide to sell out half of his long call position, recov\nering amajor part of his original cost, and continue to hold the remainder of the long \ncalls. This still leaves room for further appreciation.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:135", "doc_id": "50aaaec998dc9d87584ecaaa19c896af79645e66a3d8eab0e2de82a8ade5bedd", "chunk_index": 0}
{"text": "112 Part II: Call Option Strategies \nDEFENSIVE ACTION \nTwo follow-up strategies are sometimes employed by the call buyer when the under\nlying stock declines in price. Both involve spread strategies; that is, being long and \nshort two different calls on the same underlying stock simultaneously. Spreads are \ndiscussed in detail in later chapters. This discussion of spreads applies only to their \nuse by the call buyer. \n·\"Rolling Down.\" If an option holder owns an option at acurrently unreal\nized loss, it may be possible to greatly increase the chances of making alimited \nprofit on arelatively small rebound in the stock price. In certain cases, the \ninvestor may be able to implement such astrategy at little or no increase in risk. \nMany call buyers have encountered asituation such as this: An XYZ October 35 \ncall was originally bought for 3 points in hopes of aquick rise in the stock price. \nHowever, because of downward movements in the stock- to 32, say- the call is now \nat 1 ½ with October expiration nearer. If the call buyer still expects amild rally in the \nstock before expiration, he might either hold the call or possibly \"average down\" (buy \nmore calls at I½). In either case he will need arally to nearly 38 by expiration in \norder to break even. Since this would necessitate at least a 15% upward move by the \nstock before expiration, it cannot be considered very likely. Instead, the buyer should \nconsider implementing the following strategy, which will be explained through the \nuse of an example. \nExample: The investor is long the October 35 call at this time: \nXYZ, 32; \nXYZ October 35 call, 1 ½; and \nXYZ October 30 call, 3. \nOne could sell two October 35'sand, at the same time, buy one October 30 for no \nadditional investment before commissions. That is, the sale of 2 October 35'sat $150 \neach would bring in $300, exactly the cost, before commissions, of buying the \nOctober 30 call. This is the key to implementing the roll-down strategy: that one be \nable to buy the lower strike call and sell two of the higher strike calls for nearly even \nmoney. \nNote that the investor is now short the call that he previously owned, the \nOctober 35. Where he previously owned one October 35, he has now sold two of \nthem. He is also now long one October 30 call. Thus, his position is:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:136", "doc_id": "66cd4162fae33e5507e1155656dabadf03ba02a9c2092969c80144cc6d5b33db", "chunk_index": 0}
{"text": "0.,,., 3: Call Buying \nlong 1 XYZ October 30 call, \n1hort 1 XYZ October 35 call. \n113 \nThis is technically known as abull spread, but the terminology is not important. \nTable 3-4 summarizes the transactions that the buyer has made to acquire this \nspread. The trader now \"owns\" the spread at acost of $300, plus commissions. By \nmaking this trade, he has lowered his break-even point significantly without increas\ning his risk. However, the maximum profit potential has also been limited; he can no \nlonger capitalize on astrong rebound by the underlying stock. \nIn order to see that the break-even point has been lowered, consider what the \nresults are~ is at 33 at October expiration. The October 30 call would be worth \n3 points and the October 35 would expire worthless with XYZ at 33. Thus, the \nOctober 30 call could be sold to bring in $300 at that time, and there would not be \nany expense to buy back the October 35. Consequently, the spread could be liqui\ndated for $300, exactly the amount for which it was \"bought.\" The spread then breaks \neven at 33 at expiration. If the call buyer had not rolled down, his break-even point \nwould be 38 at expiration, for he paid 3 points for the original October 35 call and he \nwould thus need XYZ to be at 38 in order to be able to liquidate the call for 3 points. \nClearly, the stock has abetter chance of recovering to 33 than to 38. Thus, the call \nbuyer significantly lowers his break-even point by utilizing this strategy. \nLowering the break-even point is not the investor'sonly concern. He must also \nbe aware of what has happened to his profit and loss opportunities. The risk remains \nessentially the same the $300 in debits, plus commissions, that has been paid out. \nThe risk has actually increased slightly, by the amount of the commissions spent in \n\"rolling down.\" However, the stock price at which this maximum loss would be real\nized has been lowered. With the original long call, the October 35, the buyer would \nlose the entire $300 investment anywhere below 35 at October expiration. The \nTABLE 3-4. \nTransactions in bull spread. \nOriginal trade \nLater trade \nNet position \nTrade \nBuy 1 October 35 call at 3 \nSell 2 October 35 calls at 1 1/2 \nBuy 1 October 30 call at 3 \nLong 1 October 30 call \nShort 1 October 35 call \nCost before Commissions \n$300 debit \n$300 credit \n$300 debit \n$300 debit", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:137", "doc_id": "cd93535a9c5f83610fa7f21536e7e2a482fc7863a0d4582f3486cff7afd293c7", "chunk_index": 0}
{"text": "114 Part II: Call Option Strategies \nspread strategy, however, would result in atotal loss of $300 only if XYZ were below \n30 at October expiration. With XYZ above 30 in October, the long side of the spread \ncould be liquidated for some value, thereby avoiding atotal loss. The investor has \nreduced the chance of realizing the maximum loss, since the stock price at which that \nloss would occur has been lowered by 5 points. \nAs with most investments, the improvement of risk exposure - lowering the \nbreak-even point and lowering the maximum loss price - necessitates that some \npotential reward be sacrificed. In the original long call position (the October 35), the \nmaximum profit potential was unlimited. In the new position, the potential profit is \nlimited to 2 points if XYZ should rally back to, or anywhere above, 35 by October \nexpiration. To see this, assume XYZ is 35 at expiration. Then the long October 30 call \nwould be worth 5 points, while the October 35 would expire worthless. Thus, the \nspread could be liquidated for 5 points, a 2-point profit over the 3 points paid for the \nspread. This is the limit of profit for the spread, however, since if XYZ is above 35 at \nexpiration, any further profits in the long October 30 call would be offset by acorre\nsponding loss on the short October 35 call. Thus, if XYZ were to rally heavily by expi\nration, the \"rolled down\" position would not realize as large aprofit as the original \nlong call position would have realized. \nTable 3-5 and Figure 3-2 summarize the original and new positions. Note that \nthe new position is better for stock prices between 30 and 40. Below 30, the two posi\ntions are equal, except for the additional commissions spent. If the stock should rally \nback above 40, the original position would have worked out better. The new position \nis an improvement, provided that XYZ does not rally back above 40 by expiration. \nThe chances that XYZ could rally 8 points, or 25%, from 32 to 40 would have to be \nconsidered relatively remote. Rolling the long call down into the spread would thus \nappear to be the correct thing to do in this case. \nThis example is particularly attractive, because no additional money was \nrequired to establish the spread. In many cases, however, one may find that the long \ncall cannot be rolled into the spread at even money. Some debit may be required. \nThis fact should not necessarily preclude making the change, since asmall addition\nal investment may still significantly increase the chance of breaking even or making \naprofit on arebound. \nExample: The following prices now exist, rather than the ones used earlier. Only the \nOctober 30 call price has been altered: \nXYZ, 32; \nXYZ October 35 call, 1 ½; and \nXYZ October 30 call, 4.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:138", "doc_id": "1c6622a2bea117bf7b26e8d715102fe45cedef94c787a69a60d789f6c35674c7", "chunk_index": 0}
{"text": "O.,ter 3: Call Buying \nTABLE 3-5. \nOriginal and spread positions compared. \nStock Price Long Call \nat Expiration Result \n25 -$300 \n30 - 300 \n33 - 300 \n35 - 300 \n38 0 \n40 + 200 \n45 + 700 \nFIGURE 3-2. \nCompanion: original call purchase vs. spread. \n§ \n~ +$200 \n·5.. \n~ \nal \ntJ) \n.3 \n0 \n:1: \nec.. -$300 \nStock Price at Expiration \nSpread \nResult \n-$300 \n- 300 \n0 \n+ 200 \n+ 200 \n+ 200 \n+ 200 \n115 \nWith these prices, a 1-point debit would be required to roll down. That is, selling 2 \nOctober 35 calls would bring in $300 ($150 each), but the cost of buying the October \n30 call is $400. Thus, the transaction would have to be done at acost of $100, plus \ncommissions. With these prices, the break-even point after rolling down would be 34, \nstill well below the original break-even price of 38. The risk has now been increased \nby the additional 1 point spent to roll down. If XYZ should drop below 30 at October \nexpiration, the investor would have atotal loss of 4 points plus commissions. The \nmaximum loss with the original long October 35 call was limited to 3 points plus asmaller amount of commissions. Finally, the maximum amount of money that the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:139", "doc_id": "0c1cc0738a87f5c2e9cf95c4ae8c93cac88db13faf0f96db0938dfc33246ade3", "chunk_index": 0}
{"text": "116 Part II: Call Option Strategies \nspread could make is now $100, less commissions. The alternative in this example is \nnot nearly as attractive as the previous one, but it might still be worthwhile for the \ncall buyer to invoke such aspread if he feels that XYZ has limited rally potential up \nto October expiration. \nOne should not automatically discard the use of this strategy merely because adebit is required to convert the long call to aspread. Note that to \"average down\" by \nbuying an additional October 35 call at 1 ½ would require an additional investment \nof $150. This is more than the $100 required to convert into the spread position in \nthe immediately preceding example. The break-even point on the position that was \n\"averaged down\" would be over 37 at expiration, whereas the break-even point on the \nspread is 34. Admittedly, the averaged-down position has much more profit potential \nthan the spread does, but the conversion to the spread is less expensive than \"aver\naging down\" and also provides alower break-even price. \nIn summary, then, if the call buyer finds himself with an unrealized loss because \nthe stock has declined, and yet is unwilling to sell, he may be able to improve his \nchances of breaking even by \"rolling down\" into aspread. That is, he would sell 2 of \nthe calls that he is currently long - the one that he owns plus another one - and \nsimultaneously buy one call at the next lower striking price. If this transaction of sell\ning 2 calls and buying 1 call can be done for approximately even money, it could def\ninitely be to the buyer'sbenefit to implement this strategy, because the break-even \npoint would be lowered considerably and the buyer would have amuch better \nchance of getting out even or making asmall profit should the underlying stock have \nasmall rebound. \nCreating a Calendar Spread. Adifferent type of defensive spread strategy \nis sometimes used by the call buyer who finds that the underlying stock has declined. \nIn this strategy, the holder of an intermediate- or long-term call sells anear-term call, \nwith the same striking price as the call he already owns. This creates what is known \nas acalendar spread. The idea behind doing this is that if the short-term call expires \nworthless, the overall cost of the long call will be reduced to the buyer. Then, if the \nstock should rally, the call buyer has abetter chance of making aprofit. \nExample: Suppose that an investor bought an XYZ October 35 call for 3 points some\ntime in April. By June the stock has fallen to 32, and it appears that the stock might \nremain depressed for awhile longer. The holder of the October 35 call might con\nsider selling a July 35 call, perhaps for aprice of 1 point. Should XYZ remain below \n35 until July expiration, the short call would expire worthless, earning asmall, 1-point \nprofit. The investor would still own the October 35 call and would then hope for arally by XYZ before October in order to make profits on that call. Even if XYZ does", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:140", "doc_id": "c1459c2708db26a9a1522cc2f11b14219f7fab4fd8b3c572d9468954b2ba7020", "chunk_index": 0}
{"text": "Chpter 3: Call Buying 117 \nnot rally by October, he has decreased his overall loss by the amount received for the \nsale of the July 35 call. \nThis strategy is not as attractive to use as the previous one. If XYZ should rally \nbefore July expiration, the investor might find himself with two losing positions. For \nexample, suppose that XYZ rallied back to 36 in the next week. His short call that he \nsold for 1 point would be selling for something more than that, so he would have an \nunrealized loss on the short July 35. In addition, the October 35 would probably not \nhave appreciated back to its original price of 3, and he would therefore have an unre\nalized loss on that side of the spread as well. \nConsequently, this strategy should be used with great caution, for if the under\nlying stock rallies quickly before the near-term expiration, the spread could be at aloss on both sides. Note that in the former spread strategy, this could not happen. \nEven if XYZ rallied quickly, some profit would be made on the rebound. \nA FURTHER COMMENT ON SPREADS \nAnyone not familiar with the margin requirements for spreads, under both the \nexchange margin rules and the rules of the brokerage firm he is dealing with, should \nnot attempt to utilize aspread transaction. Later chapters on spreads outline the \nmore common requirements for spread transactions. In general, one must have amargin account to establish aspread and must have aminimum amount of equity in \nthe account. Thus, the call buyer who operates in acash account cannot necessarily \nuse these spread strategies. To do so might incur amargin call and possible restric\ntion of one'strading account. Therefore, check on specific requirements before uti\nlizing aspread strategy. Do not assume that along call can automatically be \"rolled\" \ninto any sort of spread.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:141", "doc_id": "20951712284b66851084dd576e98ad721dac104d4ee824a032dcf8111f58b5cf", "chunk_index": 0}
{"text": "Other Call Buying Strategies \nIn this chapter, two additional strategies that utilize the purchase of call options are \ndescribed. Both of these strategies involve buying calls against the short sale of the \nunderlying stock. When listed puts are traded on the underlying stock, these strate\ngies are often less effective than when they are implemented with the use of put \noptions. However, the concept is important, and sometimes these strategies are more \nviable in markets where calls are ve:iy liquid but puts are not. These strategies are \ngenerally known as \"synthetic\" strategies. \nTHE PROTECTED SHORT SALE (OR SYNTHETIC PUT) \nPurchasing acall at the same time that one is short the underlying stock is ameans \nof limiting the risk of the short sale to afixed amount. Since the risk is theoretically \nunlimited in ashort sale, many investors are reluctant to use the strategy. Even for \nthose investors who do sell stock short, it can be rather upsetting if the stock rises in \nprice. One may be forced into an emotional - and perhaps incorrect - decision to \ncover the short sale in order to relieve the psychological pressure. By owning acall \nat the same time he is short, the investor limits the risk to afixed and generally small \namount. \nExample: An investor sells XYZ short at 40 and simultaneously purchases an XYZ \nJuly 40 call for 3 points. If XYZ falls in price, the short seller will make his profit on \nthe short sale, less the 3 points paid for the call, which will expire worthless. Thus, by \nbuying the call for protection, asmall amount of profit potential is sacrificed. \nHowever, the advantage of owning the call is demonstrated when the results are \nexamined for astock rise. IfXYZ should rise to any price above 40 by July expiration, \n118", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:142", "doc_id": "52ad6d859d234412b37582059a6f4cfa8cf0262c284b9c16f5e5254d28dbbd4a", "chunk_index": 0}
{"text": "Cl,apter 4: Other Call Buying Strategies 119 \nthe short seller can cover his short by exercising the long call and buying stock at 40. \nThus, the maximum risk that the short seller can incur in this example is the 3 points \npaid for the call. Table 4-1 and Figure 4-1 depict the results at expiration from uti\nlizing this strategy. Commissions are not included. Note that the break-even point is \n37 in this example. That is, if the stock drops 3 points, the protected short sale posi\ntion will break even because of the 3-point loss on the call. The short seller who did \nnot spend the extra money for the long call would, of course, have a 3-point profit at \n37. To the upside, however, the protected short sale outperforms aregular short sale \nif the stock climbs anywhere above 43. At 43, both types of short sales have $300 loss\nes. But above that level, the loss would continue to grow for aregular short sale, while \nit is fixed for the short seller who also bought acall. In either case, the short seller'srisk is increased slightly by the fact that he is obligated to pay out the dividends on \nthe underlying stock, if any are declared. \nAsimple formula is available for determining the maximum amount of risk \nwhen one protects ashort sale by buying acall option: \nRisk = Striking price of purchased call + Call price - Stock price \nDepending on how much risk the short seller is willing to absorb, he might want to \nbuy an out-of-the-money call as protection rather than an at-the-money call, as was \nshown in the example above. Asmaller dollar amount is spent for the protection \nwhen one buys an out-of-the-money call, so that the short seller does not give away \nas much of his profit potential. However, his risk is larger because the call does not \nstart its protective qualities until the stock goes above the striking price. \nExample: With XYZ at 40, the short seller of XYZ buys the July 45 call at ½ for pro\ntection. His maximum possible loss, if XYZ is above 45 at July expiration, would be \nTABLE 4-1. \nResults at expiration-protected short sale. \nXYZ Price at Profit Call Price at Profit Total \nExpiration on XYZ Expiration on Call Profit \n20 +$2,000 0 -$ 300 +$1,700 \n30 + 1,000 0 - 300 + 700 \n37 + 300 0 - 300 0 \n40 0 0 - 300 300 \n50 - 1,000 10 + 700 300 \n60 - 2,000 20 + 1,700 300", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:143", "doc_id": "eaa9f38668b6d14c79a504ce729da9a425d28782bc90722e9f6f56ec1f56d340", "chunk_index": 0}
{"text": "120 \nFIGURE 4-1. \nProtected short sale. \nC: \n0 .:; \n~ \n'a.. X \nUJ \n1o +$0 en en \n0 \n...J \n0 \n-e \n0.-$300 \n40' \n', \nStock Price at Expiration \n' \nPart II: Call Option Strategies \n43 \n', ', ' ', ' ', \nShort ', \n' Sale 'll \n5½ points - the five points between the current stock price of 40 and the striking \nprice of 45, plus the amount paid for the call. On the other hand, if XYZ declines, the \nprotected short seller will make nearly as much as the short seller who did not pro\ntect, since he only spent ½ point for the long call. \nIf one buys an in-the-nwney call as protection for the short sale, his risk will be \nquite minimal. However, his profit potential will be severely limited. As an example, \nwith XYZ at 40, if one had purchased a July 35 call at 5½, his risk would be limited \nto½ point anywhere above 35 at July expiration. Unfortunately, he would not realize \nany profit on the position until the stock went below 34½, adrop of 5½ points. This \nis too much protection, for it limits the profit so severely that there is only asmall \nhope of making aprofit. \nGenerally, it is best to buy acall that is at-the-nwney or only slightly out-of the\nmoney as the protection for the short sale. It is not of much use to buy adeeply out\nof-the-money call as protection, since it does very little to moderate risk unless the \nstock climbs quite dramatically. Normally, one would cover ashort sale before it went \nheavily against him. Thus, the money spent for such adeeply out-of-the-money call \nis wasted. However, if one wants to give ashort sale plenty of room to \"work\" and", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:144", "doc_id": "2bfc4f52bfbdab9a7fbd34a0a21f91d827eff82033316a5f16fef3c76873ee67", "chunk_index": 0}
{"text": "Cl,opter 4: Other Call Buying Strategies 121 \nfeels ve:ry certain that his bearish view of the stock is the correct view, he might then \nbuy afairly deep out-of-the-money call just as disaster protection, in case the stock \nsuddenly bolted upward in price (if it received atakeover bid, for example). \nMARGIN REQUIREMENTS \nThe newest margin rules now allow one to receive favorable margin treatment when \nashort sale of stock is protected by along call option. The margin required is the \nlower of (1) 10% of the call'sstriking price plus any out-of-the-money amount, or (2) \n30% of the current short stock'smarket value. The position will be marked to market \ndaily, and most brokers will require that the short sale be margined at \"normal\" rates \nif the stock is below the strike price. \nExample: Suppose the following prices exist: \nXYZ Common stock: 47 \nOct 40 call: 8 \nOct 50 call: 3 \nOct 60 call: 1 \nSuppose that one is considering ashort sale of 100 shares of XYZ at 47 and the \npurchase of one of the calls as protection. Here are the margin requirements for the \nvarious strike prices. (Note that the option price, per se, is not part of the margin \nrequirement, but all options must be paid for in full, initially). \nPosition \nShort XYZ, long Oct 40 call \nShort XYZ, long Oct 50 call \nShort XYZ, long Oct 60 call \nl 0% strike + out-of-the-money \n400 + 0 = 400* \n500 + 300 = 800* \n600 + 1,300 = 1,900 \n30% stock price \n1,410 \n1,410 \n1,41 0* \n*Since the margin requirement is the lower of the two figures, the items marked with an asterisk in \nthis table are the margin requirements. \nAgain, remember that the long call would have to be paid for in full, and that most \nbrokers impose amaintenance requirement of at least the value of the short sale itself \nas long as the stock is below the strike price of the long call, in addition to the above \nrequirements.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:145", "doc_id": "7292566373348dab4ace32f0a07247175cfb0145098723b6391ecbb6dd727351", "chunk_index": 0}
{"text": "122 Part II: Call Option Strategies \nFOLLOW-UP ACTION \nThere is little that the protected short seller needs to perform in the way of follow\nup action in this strategy, other than closing out the position. If the underlying stock \nmoves down quickly and it appears that it might rebound, the short sale could be cov\nered without selling the long call. In this manner, one could potentially profit on the \ncall side as well if the stock came back above the original striking price. If the under\nlying stock rises in price, asimilar strategy of taking off only the profitable call side \nof the transaction is not recommended. That is, if XYZ climbed from 40 to 50 and the \nJuly 40 call also rose from 3 to 10, it is not advisable to take the 7-point profit in the \ncall, hoping for adrop in the stock price. The reason for this is that one is entering \ninto ahighly risk-oriented situation by removing his protection when the call is in\nthe-money. Thus, when the stock drops, it is all right - perhaps even desirable - to \ntake the profit, because there is little or no additional risk if the stock continues to \ndrop. However, when the stock rises, it is not an equivalent situation. In that case, if \nthe short seller sells his call for aprofit and the stock subsequently rises even further, \nlarge losses could result. \nIt may often be advisable to close the position if the call is at or near parity, \nin-the-money, by exercising the call. In most strategies, the option holder has no \nadvantage in exercising the call because of the large dollar difference between \nstock commissions and option commissions. However, in the protected short sale \nstrategy, the short seller is eventually going to have to cover the short stock in any \ncase and incur the stock commission by so doing. It may be to his advantage to \nexercise the call and buy his stock at the striking price, thereby buying stock at alower price and perhaps paying aslightly lower commission amount. \nExample: XYZ rises to 50 from the original short sale price of 40, and the XYZ July \n40 call is selling at 10 somewhere close to expiration. The position could be liquidat\ned by either (1) buying the stock back at 50 and selling the call at 10, or (2) exercis\ning the call to buy stock at 40. In the first case, one would pay astock commission at \naprice of $50 per share plus an option commission on a $10 option. In the second \ncase, the only commission would be astock commission at the price of $40 per share. \nSince both actions accomplish the same end result - closing the position entirely for \n40 points plus commissions - clearly the second choice is less costly and therefore \nmore desirable. Of course, if the call has time value premium in it of an amount \ngreater than the commission savings, the first alternative should be used.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:146", "doc_id": "c70108d622cfe3632b70dc7658dfc7ce7110348a248b9eacb089cab5743863a3", "chunk_index": 0}
{"text": "Orapter 4: Other Call Buying Strategies 123 \nTHE REVERSE HEDGE (SIMULATED STRADDLE) \nThere is another strategy involving the purchase of long calls against the short sale of \nstock. In this strategy, one purchases calls on more shares than he has sold short. The \nstrategist can profit if the underlying stock rises far enough or falls far enough dur\ning the life of the calls. This strategy is generally referred to as areverse hedge or sim\nulated straddle. On stocks for which listed puts are traded, this strategy is outmoded; \nthe same results can be better achieved by buying astraddle (acall and aput). \nHence, the name \"simulated straddle\" is applied to the reverse hedge strategy. \nThis strategy has limited loss potential, usually amounting to amoderate per\ncentage of the initial investment, and theoretically unlimited profit potential. When \nproperly selected (selection criteria are described in great detail in Chapter 36, \nwhich deals with volatility trading), the percentage of success can be quite high in \nstraddle or synthetic straddle buying. These features make this an attractive strategy, \nespecially when call premiums are low in comparison to the volatility of underlying \nstock. \nExample: XYZ is at 40 and an investor believes that the stock has the potential to \nmove by arelatively large distance, but he is not sure of the direction the stock will \ntake. This investor could short XYZ at 40 and buy 2 XYZ July 40 calls at 3 each to set \nup areverse hedge. If XYZ moves up by alarge distance, he will incur aloss on his \nshort stock, but the fact that he owns two calls means that the call profits will outdis\ntance the stock loss. If, on the other hand, XYZ drops far enough, the short sale prof\nit will be larger than the loss on the calls, which is limited to 6 points. Table 4-2 and \nFigure 4-2 show the possible outcomes for various stock prices at July expiration. If \nXYZ falls, the stock profits on the short sale will accumulate, but the loss on the two \ncalls is limited to $600 (3 points each) so that, below 34, the reverse hedge can make \never-increasing profits. To the upside, even though the short sale is incurring losses, \nthe call profits grow faster because there are two long calls. For example, at 60 at \nexpiration, there will be a 20-point ($2,000) loss on the short stock, but each XYZ July \n40 call will be worth 20 points with the stock at 60. Thus, the two calls are worth \n$4,000, representing aprofit of $3,400 over the initial cost of $600 for the calls. \nTable 4-2 and Figure 4-2 illustrate another important point: The maximum loss \nwould occur if the stock were exactly at the striking price at expiration of the calls. This \nmaximum loss would occur if XYZ were at 40 at expiration and would amount to $600. \nIn actual practice, since the short seller must pay out any dividends paid by the under\nlying stock, the risk in this strategy is increased by the amount of such dividends.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:147", "doc_id": "ffc968e9e0b54df317161cc1283fd98834d1f4ad49af1d1891e9bb49ac913f26", "chunk_index": 0}
{"text": "124 \nTABLE 4-2. \nReverse hedge at July expiration. \nXYZ Price at Stock \nExpiration Profit \n20 +$2,000 \n25 + 1,500 \n30 + 1,000 \n34 + 600 \n40 0 \n46 600 \n50 - 1,000 \n55 - 1,500 \n60 - 2,000 \nFIGURE 4-2. \nReverse hedge {simulated straddle). \nC: \n0 \n~ \n! \nco \n(/) \n(/) \n.3 \n~-$600 \nea. \nProfit on \n2 Calls \n-$ 600 \n600 \n600 \n600 \n600 \n+ 600 \n+ 1,400 \n+ 2,400 \n+ 3,400 \nStock Price at Expiration \nPart II: Call Option Strategies \nTotal \nProfit \n+$ l ,400 \n+ 900 \n+ 400 \n0 \n600 \n0 \n+ 400 \n+ 900 \n+ 1,400 \nThe net margin required for this strategy is 50% of the underlying stock plus \nthe full purchase price of the calls. In the example above, this would be an initial \ninvestment of $2,000 (50% of the stock price) plus $600 for the calls, or $2,600 total \nplus commissions. The short sale is marked to market, so the collateral requirement \nwould grow if the stock rose. Since the maximum risk, before commissions, is $600, \nthis means that the net percentage risk in this transaction is $600/$2,600, about 23%.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:148", "doc_id": "d348cce81505265f6528bdf1926fac3740770366a10761d6178994a3920e867c", "chunk_index": 0}
{"text": "Cl,opter 4: Other Call Buying Strategies 125 \nThis is arelatively small percentage risk in aposition that could have very large prof\nits. There is also very little chance that the entire maximum loss would ever be real\nized since it occurs only at one specific stock price. One should not be deluded into \nthinking that this strategy is asure money-maker. In general, stocks do not move very \nfar in a 3- or 6-month period. With careful selection, though, one can often find sit\nuations in which the stock will be able to move far enough to reach the break-even \npoints. Even when losses are taken, they are counterbalanced by the fact that signif\nicant gains can be realized when the stock moves by agreat distance. \nIt is obvious from the information above that profits are made if the stock moves \nfar enough in either direction. In fact, one can determine exactly the prices beyond \nwhich the stock would have to move by expiration in order for profits to result. These \nprices are 34 and 46 in the foregoing example. The downside break-even point is 34 \nand the upside break-:even point is 46. These break-even points can easily be com\nputed. First, the maximum risk is computed. Then the break-even points are deter\nmined. \nMaximum risk = Striking price + 2 x Call price - Stock price \nUpside break-even point = Striking price + Maximum risk \nDownside break-even point = Striking price - Maximum risk \nIn the preceding example, the striking price was 40, the stock price was also 40, \nand the call price was 3. Thus, the maximum risk = 40 + 2 x 3 - 40 = 6. This con\nfirms that the maximum risk in the position is 6 points, or $600. The upside break\neven point is then 40 + 6, or 46, and the downside break-even point is 40 - 6, or 34. \nThese also agree with Table 4-2 and Figure 4-2. \nBefore expiration, profits can be made even closer to the striking price, because \nthere will be some time value premium left in the purchased calls. \nExample: IfXYZ moved to 45 in one month, each call might be worth 6. If this hap\npened, the investor would have a 5-point loss on the stock, but would also have a 3-\npoint gain on each of the two options, for anet overall gain of 1 point, or $100. Before \nexpiration, the break-even point is clearly somewhere below 46, because the position \nis at aprofit at 45. \nIdeally, one would like to find relatively underpriced calls on afairly volatile \nstock in order to implement this strategy most effectively. These situations, while not \nprevalent, can be found. Normally, call premiums quite accurately reflect the volatil\nity of the underlying stock. Still, this strategy can be quite viable, because nearly \nevery stock, regardless of its volatility, occasionally experiences astraight-line, fairly \nlarge move. It is during these times that the investor can profit from this strategy.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:149", "doc_id": "87a13c5fdd1201e6c1b50107a6a84b8125cf7c5af1a6acfc2ef035333b2de41f", "chunk_index": 0}
{"text": "126 Part II: Call Option Strategies \nGenerally, the underlying stock selected for the reverse hedge should be \nvolatile. Even though option premiums are larger on these stocks, they can still be \noutdistanced by astraight-line move in avolatile situation. Another advantage of uti\nlizing volatile stocks is that they generally pay little or no dividends. This is desirable \nfor the reverse hedge, because the short seller will not be required to pay out as \nmuch. \nThe technical pattern of the underlying stock can also be useful when selecting \nthe position. One generally would like to have little or no technical support and \nresistance within the loss area. This pattern would facilitate the stock'sability to make \nafairly quick move either up or down. It is sometimes possible to find astock that is \nin awide trading range, frequently swinging from one side of the range to the other. \nIf areverse hedge can be set up that has its loss area well within this trading range, \nthe position may also be attractive. \nExample: The XYZ stock in the previous example is trading in the range 30 to 50, \nperhaps swinging to one end and then the other rather frequently. Now the reverse \nhedge example position, which would make profits above 46 or below 34, would \nappear more attractive. \nFOLLOW-UP ACTION \nSince the reverse hedge has abuilt-in limited loss feature, it is not necessary to take \nany follow-up action to avoid losses. The investor could quite easily put the position \non and take no action at all until expiration. This is often the best method of follow\nup action in this strategy. \nAnother follow-up strategy can be applied, although it has some disadvantages \nassociated with it. This follow-up strategy is sometimes known as trading against the \nstraddle. When the stock moves far enough in either direction, the profit on that side \ncan be taken. Then, if the stock swings back in the opposite direction, aprofit can \nalso be made on the other side. Two examples \\vill show how this type of follow-up \nstrategy works. \nExample 1: The XYZ stock in the previous example quickly moves down to 32. At \nthat time, an 8-point profit could be taken on the short sale. This would leave two \nlong calls. Even if they expired worthless, a 6-point loss is all that would be incurred \non the calls. Thus, the entire strategy would still have produced aprofit of 2 points. \nHowever, if the stock should rally above 40, profits could be made on the calls as well. \nAslight variation would be to sell one of the calls at the same time the stock profit is \ntaken. This would result in aslightly larger realized profit; but if the stock rallied back", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:150", "doc_id": "0d4dd4302e7c4a129d6684339a452ac69bd9550647444cd7714323d4f04b587c", "chunk_index": 0}
{"text": "Cl,apter 4: Other Call Buying Strategies 127 \nabove 40, the resulting profits there would be smaller because the investor would be \nlong only one call instead of two. \nExample 2: XYZ has moved up to aprice at which the calls are each worth 8 points. \nOne of the calls could then be sold, realizing a 5-point profit. The resulting position \nwould be short 100 shares of stock and long one call, aprotected short sale. The pro\ntected short sale has alimited risk, above 40, of 3 points (the stock was sold short at \n40 and the call was purchased for 3 points). Even if XYZ remains above 40 and the \nmaximum 3-point loss has to be taken, the overall reverse hedge would still have \nmade aprofit of 2 points because of the 5-point profit taken on the one call. \nConversely, if XYZ drops below 40, the protected short sale position could add to the \nprofits already taken on the call. \nThere is avariation of this upside protective action. \nExample 3: Instead of selling the one call, one could instead short an additional 100 \nshares of stock at 48. If this was done, the overall position would be short 200 shares \nof stock (100 at 40 and the other 100 at 48) and long two calls - again aprotected \nshort sale. If XYZ remained above 40, there would again be an overall gain of 2 \npoints. To see this, suppose that XYZ was above 40 at expiration and the two calls \nwere exercised to buy 200 shares of stock at 40. This would result in an 8-point prof\nit on the 100 shares sold short at 48, and no gain or loss on the 100 shares sold short \nat 40. The initial call cost of 6 points would be lost. Thus, the overall position would \nprofit by 2 points. This means of follow-up action to the upside is more costly in com\nmissions, but would provide bigger profits if XYZ fell back below 40, because there \nare 200 shares of XYZ short. \nIn theory, if any of the foregoing types of follow-up action were taken and the \nunderlying stock did indeed reverse direction and cross back through the striking \nprice, the original position could again be established. Suppose that, after covering \nthe short stock at 32, XYZ rallied back to 40. Then XYZ could be sold short again, \nreestablishing the original position. If the stock moved outside the break-even points \nagain, further follow-up action could be taken. This process could theoretically be \nrepeated anumber of times. If the stock continued to whipsaw back and forth in atrading range, the repeated follow-up actions could produce potentially large profits \non asmall net change in the stock price. In actual practice, it is unlikely that one \nwould be fortunate enough to find astock that moved that far that quickly. \nThe disadvantage of applying these follow-up strategies is obvious: One can \nnever make alarge profit if he continually cuts his profits off at asmall, limited", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:151", "doc_id": "2b0028aefd716302fc81765e1d80b46277541b42f944f9f095aaac52e569a52b", "chunk_index": 0}
{"text": "128 Part II: Call Option Strategies \namount . .. When XYZ falls to 32, the stock can be covered to ensure an overall profit \nof 2 points on the transaction. However, if XYZ continued to fall to 20, the investor \nwho took no follow-up action would make 14 points while the one who did take fol\nlow-up action would make only 2 points. Recall that it was stated earlier that there is \nahigh probability of realizing limited losses in the reverse hedge strategy, but that \nthis is balanced by the potentially large profits available in the remaining cases. If one \ntakes follow-up action and cuts off these potentially large profits, he is operating at adistinct disadvantage unless he is an extremely adept trader. \nProponents of using the follow-up strategy often counter with the argument \nthat it is frustrating to see the stock fall to 32 and then return back to nearly 40 again. \nIf no follow-up action were taken, the unrealized profit would have dissolved into aloss when the stock rallied. This is true as far as it goes, but it is not an effective \nenough argument to counterbalance the negative effects of cutting off one'sprofits. \nALTERING THE RATIO OF LONG CALLS \nTO SHORT STOCK \nAnother aspect of this strategy should be discussed. One does not have to buy exact\nly two calls against 100 shares of short stock. More bullish positions could be con\nstructed by buying three or four calls against 100 shares short. More bearish positions \ncould be constructed by buying three calls and shorting 200 shares of stock. One \nmight adopt aratio other than 2:1, because he is more bullish or bearish. He also \nmight use adifferent ratio if the stock is between two striking prices, but he still \nwants to create aposition that has break-even points spaced equidistant from the cur\nrent stock price. Afew examples will illustrate these points. \nExample: XYZ is at 40 and the investor is slightly bullish on the stock but still wants \nto employ the reverse hedge strategy, because he feels there is achance the stock \ncould drop sharply. He might then short 100 shares of XYZ at 40 and buy 3 July 40 \ncalls for 3 points apiece. Since he paid 9 points for the calls, his maximum risk is that \n9 points if XYZ were to be at 40 at expiration. This means his downside break-even \nprice is 31, for at 31 he would have a 9-point profit on the short sale to offset the 9-\npoint loss on the calls. To the upside, his break-even is now 44½. IfXYZ were at 44½ \nand the calls at 4½ each at expiration, he would lose 4½ points on the short sale, but \nwould make l ½ on each of the three calls, for atotal call profit of 4½. \nAmore bearish investor might short 200 XYZ at 40 and buy 3 July 40 calls at 3. \nHis break-even points would be 35½ on the downside and 49 on the upside, and his \nmaximum risk would be 9 points. There is ageneral formula that one can always", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:152", "doc_id": "fc0143f0366388b6c95d2c15f115139e4ac36ff9cfc35d346fd8f2286983a9b0", "chunk_index": 0}
{"text": "130 \nExample: The following prices exist: \nXYZ, 37½; \nXYZ July 40 call, 2; and \nXYZ July 35 call, 4. \nPart II: Call Option Strategies \nIf one were to short 100 XYZ at 37½ and to buy one July 40 call for 2 and one July \n35 call for 4, he would have aposition that is similar to areverse hedge except that \nthe maximum risk would be realized anywhere between 35 and 40 at expiration. \nAlthough this risk is over amuch wider range than in the normal reverse hedge, it is \nnow much smaller in dimension. Table 4-3 and Figure 4-3 show the results from this \ntype of position at expiration. The maximum loss is 3½ points ($350), which is asmaller amount than could be realized using any ratio strictly with the July 35 or the \nJuly 40 call. However, this maximum loss is realizable over the entire range, 35 to 40. \nAgain, large potential profits are available if the stock moves far enough either to the \nupside or to the downside. \nThis form of the strategy should only be used when the stock is nearly centered \nbetween two strikes and the strategist wants aneutral positioning of the break-even \npoints. Similar types of follow-up action to those described earlier can be applied to \nthis form of the reverse hedge strategy as well. \nTABLE 4-3. \nReverse hedge using two strikes. \nXYZ Price at Stock July 40 Coll July 35 Coll Total \nExpiration Profit Profit Profit Profit \n25 +$1,250 -$200 -$ 400 +$ 650 \n30 + 750 - 200 400 + 150 \n31 1/2 + 600 - 200 400 0 \n35 + 250 - 200 400 350 \n371/2 0 - 200 150 350 \n40 - 250 - 200 + 100 350 \n431/2 - 600 + 150 + 450 0 \n45 - 750 + 300 + 600 + 150 \n50 - 1,250 + 800 + 1,100 + 650", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:154", "doc_id": "917c6dce2d5ae138f77816d29a3e6d96dbb655207ca5b4d9f906e1e0962ae1fc", "chunk_index": 0}
{"text": "Gapter 4: Other Call Buying Strategies 131 \nFIGURE 4-3. \nReverse hedge using two strikes (simulated combination purchase). \nC: \n~ ·5. \nin \n~ \nl/l \n.3 \n0 \ni.l::-$350 \nea. \nSUMMARY \n40 \nStock Price at Expiration \nThe strategies described in this chapter would not normally be used if the underly\ning stock has listed put options. However, if no puts exist, or the puts are very illiq\nuid, and the strategist feels that avolatile stock could move arelatively large distance \nin either direction during the life of acall option, he should consider using one of the \nforms of the reverse hedge strategy - shorting aquantity of stock and buying calls on \nmore shares than he is short. If the desired movement does develop, potentially large \nprofits could result. In any case, the loss is limited to afixed amount, generally \naround 20 to 30% of the initial investment. Although it is possible to take follow-up \naction to lock in small profits and attempt to gain on areversal by the stock, it is wiser \nto let the position run its course to capitalize on those occasions when the profits \nbecome large. Normally a 2:1 ratio (long 2 calls, short 100 shares of stock) is used in \nthis strategy, but this ratio can be adjusted if the investor wants to be more bullish or \nmore bearish. If the stock is initially between two striking prices, aneutral profit \nrange can be set up by shorting the stock and buying calls at both the next higher \nstrike and the next lower strike.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:155", "doc_id": "590f9c80c03982984d93a5c57d0e4199daf1adf800e3676fb543a7e07ee61fa3", "chunk_index": 0}
{"text": "CHAPTER 5 \nNaked Call Writing \nThe next two chapters will concentrate on various aspects of writing uncovered call \noptions. These strategies have risk ofloss if the underlying stock should rise in price, \nbut they offer profits if the underlying stock declines in price. This chapter on \nnaked, or uncovered, call writing - demonstrates some of the risks and rewards \ninherent in this aggressive strategy. Novice option traders often think that selling \nnaked options is the \"best\" way to make money, because of time decay. In addition, \nthey often assume that market-makers and other professionals sell alot of naked \noptions. In reality, neither is true. Yes, options do eventually lose their premium if \nheld all the way until expiration. However, when an option has agood deal of life \nremaining, its excess value above intrinsic value what we call \"time value premium\" \n- is, in reality, heavily influenced by the volatility estimate of the stock. This is called \nimplied volatility and is discussed at length later in the book. For now, though, it is \nsufficient to understand that alot can go wrong when one writes anaked option, \nbefore it eventually expires. As to professionals selling alot of naked options, the fact \nis that most market-makers and other full-time option traders attempt to reduce their \nexposure to large stock price movements if possible. Hence, they may sell some \noptions naked, but they generally try to hedge them by buying other options or by \nbuying the underlying stock. \nMany novice option traders hold these misconceptions, probably because there \nis ageneral belief that most options expire worthless. Occasionally, one will even hear \nor see astatement to this effect in the mainstream media, but it is not true that most \noptions expire worthless. In fact, studies conducted by McMillan Analysis Corp. in \nboth bull and bear months indicate that about 65% to 70% of all options have some \nvalue (at least half apoint) when they expire. This is not to say that all option buyers \nmake money, either, but it does serve to show that many more options do not expire \nworthless than do. \n132", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:156", "doc_id": "95fbbc1f579a5b8891ef25cd69df7cdb9c3c748ea5e5365a4688e1e6b6716e12", "chunk_index": 0}
{"text": "Qapter 5: Naked Call Writing 133 \nTHE UNCOVERED (NAKED) CALL OPTION \nWhen one sells acall option without owning the underlying stock or any equivalent \nsecurity (convertible stock or bond or another call option), he is considered to have \nwritten an uncovered call option. This strategy has limited profit potential and theo\nretically unlimited loss. For this reason, this strategy is unsuitable for some investors. \nThis fact is not particularly attractive, but since there is no actual cash investment \nrequired to write anaked call ( the position can be financed with collateral loan value \nof marginable securities), the strategy can be operated as an adjunct to many other \ninvestment strategies. \nAsimple example will outline the basic profit and loss potential from naked \nwriting. \nExample: XYZ is selling at 50 and a July 50 call is selling for 5. If one were to sell the \nJuly 50 call naked - that is, without owning XYZ stock, or any security convertible into \nXYZ, or another call option on XYZ - he could make, at most, 5 points of profit. This \nprofit would accrue if XYZ were at or anywhere below 50 at July expiration, as the \ncall would then expire worthless. If XYZ were to rise, however, the naked writer \ncould potentially lose large sums of money. Should the stock climb to 100, say, the \ncall would be at aprice of 50. If the writer then covered (bought back) the call for aprice of 50, he would have aloss of 45 points on the transaction. In theory, this loss \nis unlimited, although in practice the loss is limited by time. The stock cannot rise an \ninfinite amount during the life of the call. Clearly, defensive strategies are important \nin this approach, as one would never want to let aloss run as far as the one here. \nTable 5-1 and Figure 5-1 (solid line) depict the results of this position at July expira\ntion. Note that the break-even point in this example is 55. That is, if XYZ rose 10%, \nor 5 points, at expiration, the naked writer would break even. He could buy the call \nback at parity, 5 points, which is exactly what he sold it for. There is some room for \nerror to the upside. Anaked write will not necessarily lose money if the stock moves \nup. It will only lose if the stock advances by more than the amount of the time value \npremium that was in the call when it was originally written. \nNaked writing is not the same as ashort sale of the underlying stock. While both \nstrategies have large potential risk, the short sale has much higher reward potential, \nbut the naked write will do better if the underlying stock remains relatively \nunchanged. It is possible for the naked writer to make money in situations when the \nshort seller would have lost money. Using the example above, suppose one investor \nhad written the July 50 call naked for 5 points while another investor sold the stock \nshort at 50. If XYZ were at 52 at expiration, the naked writer could buy the call back \nat parity, 2 points, for a 3-point profit. The short seller would have a 2-point loss.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:157", "doc_id": "9848edd0f490464e213a117b8e6a0691bfd91ab716413da370b940ecd815b331", "chunk_index": 0}
{"text": "134 \nTABLE 5-1. \nPosition at July expiration. \nXYZ Price at Call Price at \nExpiration Expiration \n30 0 \n40 0 \n50 0 \n55 5 \n60 10 \n70 20 \n80 30 \nFIGURE 5-1. \nUncovered (naked) call write. \n+$500 \nC \n0 \n~ ·15.. \nXwcu \n(/J \n~ ...I \n0 \nlt, \n.... ...... \n\", Naked Write \n45 SO', \n.... .. .... .. .. Short Sale ,, \n.. .. \nStock Price at Expiration \n.. \nPart II: Call Option Strategies \nProfit on \nNaked Write \n+$ 500 \n+ 500 \n+ 500 \n0 \n500 \n- 1,500 \n- 2,500 \n.. .... .. \n~ \nMoreover, the short seller pays out the dividends on the underlying stock, whereas \nthe naked call writer does not. The naked call will expire, of course, but the short sale \ndoes not. This is asituation in which the naked write outperforms the short sale. \nHowever, ifXYZ were to fall sharply- to 20, say- the naked writer could only make \n5 points while the short seller would make 30 points. The dashed line in Figure 5-1 \nshows how the short sale of XYZ at 50 would compare with the naked write of the \nJuly 50 call. Notice that the two strategies are equal at 45 at expiration; they both", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:158", "doc_id": "a3cadddf6fe2eeeb4e06013e299a2a6701dbdb53ecc3aec3e145842f75a00680", "chunk_index": 0}
{"text": "Cl,apter 5: Naked Call Writing 135 \nmake a 5-point profit there. Above 45, the naked write does better; it has larger prof\nits and smaller losses. Below 45, the short sale does better, and the farther the stock \nfalls, the better the short sale becomes in comparison. As will be seen later, one can \nmore closely simulate ashort sale by writing an in-the-money naked call. \nINVESTMENT REQUIRED \nThe margin requirements for writing anaked call are 20% of the stock price plus the \ncall premium, less the amount by which the stock is below the striking price. If the \nstock is below the striking price, the differential is subtracted from the requirement. \nHowever, aminimum of 10% of the stock price is required for each call, even if the \nC-'Omputation results in asmaller number. Table 5-2 gives four examples of how the ini\ntial margin requirement would be computed for four different stock prices. The 20% \ncollateral figure is the minimum exchange requirement and may vary somewhat among \ndifferent brokerage houses. The call premium may be applied against the requirement. \nIn the first line of Table 5-2, if the XYZ July 50 call were selling for 7 points, the $700 \ncall premium could be applied against the $1,800 margin requirement, reducing the \nactual amount that the investor would have to put up as collateral to $1,100. \nTABLE 5-2. \nInitial collateral requirements for four stock prices. \nColl \nWritten \nXYZ July 50 \nXYZ July 50 \nXYZ July 50 \nXYZ July 50 \nStock Price When \nColl Written \n55 \n50 \n46 \n40 \n*Requirement cannot be less than 10%. \nColl \nPrice \n$700 \n400 \n200 \n100 \n20% of \nStock Price \n$1,100 \n1,000 \n920 \n800 \nOut-of-the\nMoney \nDifferential \n$ 0 \n0 \n400 \n- 1,000 \nTotal Margin \nRequirement \n$1,800 \n1,400 \n720 \n400* \nIn addition to the basic requirements, abrokerage firm may require that for acustomer to participate in uncovered writing, he have aminimum equity in his \naccount. This equity requirement may range from as low as $2,000 to as high as \n$100,000. Since naked call writing is ahigh-risk strategy, some brokerage firms \nrequire that the customer be able to show both financial wherewithal and option", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:159", "doc_id": "a3e2cbc8729448946d23a95f021c20fb5900e21c7e0fcd0f1a6e0bdaa3beab7f", "chunk_index": 0}
{"text": "136 Part II: Call Option Strategies \ntrading experience before the account can be approved for naked call writing. In \naddition, some brokers require that amaintenance requirement be applied against \neach option written naked. This requirement, sometimes called akicker, is usually \nless than $250 per call and is generally used by the broker to ensure that, should the \ncustomer fail to respond to an assignment notice against his naked call, the commis\nsion costs for buying and selling the underlying stock would be defrayed. \nNaked Option Positions Are Marked to the Market Daily. This \nmeans that the collateral requirement for the position is recomputed daily, just as in \nthe short sale of stock. The same margin formula that was described above is applied \nand, if the stock has risen far enough, the customer will be required to deposit addi\ntional collateral or close the position. The need for such amark to market is obvious. \nIf the underlying stock should rise, the brokerage firm must ensure that the customer \nhas enough collateral to cover the eventuality of buying the stock in the open market \nand selling it at the striking price if an assignment notice should be received against \nthe naked call. The mark to market works to the customer'sfavor if the stock falls in \nprice. Excess collateral is then released back into the customer'smargin account, and \nmay be used for other purposes. \nIt is important to realize that, in order to write anaked call, collateral is all that \nis required. No cash need be \"invested\" if one owns securities with sufficient collat\neral loan value. \nExample: An investor owns 100 shares of astock selling at $60 per share. This stock \nis worth $6,000. If the loan rate on stock is 50% of $6,000, this investor has acollat\neral loan value equal to 50% of $6,000, or $3,000. This investor could write any of the \nnaked calls in Table 5-2 without adding cash or securities to his account. Moreover, \nhe would have satisfied aminimum equity requirement of at least $6,000, since his \nstock is equity. \nThis aspect of naked call writing - using collateral value to finance the writing \n- is attractive to many investors, since one is able to write calls and bring in premi\nums without disturbing his existing portfolio. Of course, if the stock underlying the \nnaked call should rise too far in price, additional collateral may be called for by the \nbroker because of the mark to market. Moreover, there is risk whether cash or col\nlateral is used. If one buys in anaked call at aloss, he will then be spending cash, cre\nating adebit in his account. \nRegardless of how one finances anaked option position, it is generally agood \nidea to allow enough collateral so that the stock can move all the way to the point at \nwhich one would cover the option or take follow-up action. For example, suppose a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:160", "doc_id": "993ced8a0dc72494c4bf2e342ebbd7398bc5c6cc19a09b7f6d51c46e17b00a79", "chunk_index": 0}
{"text": "Gapter 5: Naked Call Writing 137 \nstock is trading at 50 and one sells an April 60 call naked, figuring that he will cover \nthe call if the stock rises to 60 ( that is, if the option becomes an in-the-money option). \nHe should set aside enough collateral to margin the position as if the stock were at \n60 (even though the actual margin requirement will be smaller than that). If he \nallows that extra collateral, then he will never be forced into amargin call at astock \nprice prior to (that is, below) where he wanted to take follow-up action. Simply stat\ned, let the market take you out of aposition, not amargin call. \nTHE PHILOSOPHY OF SELLING NAKED OPTIONS \nThe first and foremost question one must address when thinking about selling naked \noptions (or any strategy, for that matter) is: \"Can Ipsychologically handle the thought \nof naked options in my account?\" Notice that the question does not have anything to \ndo with whether one has enough collateral or margin to sell calls (although that, too, \nis important) nor does it ask how much money he will make. First, one must decide \nif he can be comfortable with the risk of the strategy. Selling naked options means \nthat there is theoretically unlimited risk if the underlying instrument should make alarge, sudden, adverse move. It is one'sattitude regarding that fact alone that deter\nmines whether he should consider selling naked options. If one feels that he won'tbe \nable to sleep at night, then he should not sell naked options, regardless of any profit \nprojections that might seem attractive. \nIf one feels that the psychological suitability aspect is not aroadblock, then he \ncan consider whether he has the financial wherewithal to write naked options. On the \nsurface, naked option margin requirements are not large (although in equity and \nindex options, they are larger than they were prior to the crash of 1987). \nIn general, one would prefer to let the naked options expire worthless, if at all \npossible, without disturbing them, unless the underlying instrument makes asignifi\ncant adverse move. So, out-of-the-money options are the usual choice for naked sell\ning. Then, in order to reduce ( or almost eliminate) the chance of amargin call, one \nshould set aside the margin requirement as if the underlying had already rrwved to \nthe strike price of the option sold. By allowing margin as if the underlying were \nalready at the strike, one will almost never experience amargin call before the under\nlying price trades up to the strike price, at which time it is best to close the position \nor to roll the call to another strike. \nThus, for naked equity call options, allow as collateral 20% of the highest naked \nstrike price. In this author'sopinion, the biggest mistake atrader can make is to ini\ntiate trades because of margin or taxes. Thus, by allowing the \"maximum\" margin, \none can make trading decisions based on what'shappening in the market, as opposed \nto reacting to amargin call from his broker.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:163", "doc_id": "bf58d6fe51028d539755c3eeb8e1cb3aa37d4ddb6e3366d6eec5ccf6eddfbc88", "chunk_index": 0}
{"text": "138 Part II: Call Option Strategies \n\"Suitability\" also means not risking nwre nwney than one can afford to lose. If \none allows the \"maximum\" margin, then he won'tbe risking alarge portion of his \nequity unless he is unable to cover when the underlying trades through the strike \nprice of his naked option. Gaps in trading prices would be the culprits that could pre\nvent one from covering. Gaps are common in stocks, less common in futures, and \nalmost nonexistent in indices. Hence, index options are the options of choice when it \ncomes to naked writing. Index options are discussed later in the book. \nFinally, there is one more \"rule\" that anaked option writer must follow: \nSomeone has to be watching the position at all times. Disasters could occur if one \nwere to go on vacation and not pay attention to his naked options. Usually, one'sbro\nker can watch the position, even if the trader has to call him from his vacation site. \nIn sum, then, to write naked options, one needs to be prepared psychological\nly, have sufficient funds, be willing to accept the risk, be able to monitor the position \nevery day, sell options whose implied volatility is extremely high, and cover any naked \noptions that become in-the-money options. \nRISK AND REWARD \nOne can adjust the apparent risks and rewards from naked call writing by his selec\ntion of an in-the-money or out-of-the-money call. Writing an out-of-the-money call \nnaked, especially one quite deeply out-of-the-money, offers ahigh probability of \nachieving asmall profit. Writing an in-the-money call naked has the most profit \npotential, but it also has higher risks. \nExample: XYZ is selling at 40 and the July 50 is selling for½. This call could be sold \nnaked. The probability that XYZ could rise to 50 by expiration has to be considered \nsmall, especially if there is not alarge amount of time remaining in the life of the call. \nIn fact, the stock could rise 25%, or 10 points, by expiration to aprice of 50, and the \ncall would still expire worthless. Thus, this naked writer has agood chance of realiz\ning a $50 profit, less commissions. There could, of course, be substantial risk in terms \nof potential profit versus potential loss if the stock rises substantially in price by expi\nration. Still, this apparent possibility of achieving additional limited income with ahigh probability of success has led many investors to use the collateral value of their \nportfolios to sell deeply out-of-the-money naked calls. \nFor those employing this technique, afavored position is to have astock at or \njust about 15 and then sell the near-term option with striking price 20 naked. This \noption would sell for one-eighth or one-quarter, perhaps, although at times there \nmight not be any bid at all. At this price, the stock would have to rally nearly one-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:164", "doc_id": "152724c842e1b5e125e0b98e8512a16a6f851287a259766dd138112a3f984c90", "chunk_index": 0}
{"text": "C.,,er 5: Naked Call Writing 139 \nthird, or 33%, for the writer to lose money. Although there are not usually many \noptionable stocks selling at or just above $10 per share, these same out-of-the-money \nwriters would also be attracted to selling acall with astriking price 15 when the stock \nis at 10, because a 50% upward move by the stock would be required for aloss to be \nrealized. \nThis strategy of selling deeply out-of-the-money calls has its apparent attraction \nin that the writer is assured of aprofit unless the underlying stock can rally rather \nsubstantially before the call expires. The danger in this strategy is that one or two \nlosses, perhaps amounting to only acouple of points each, could wipe out many peri\nods of profits. The stock market does occasionally rally heavily in ashort period, as \nwitnessed repeatedly throughout history. Thus, the writer who is adopting this strat\negy cannot regard it as asure thing and certainly cannot afford to establish the writes \nand forget them. Close monitoring is required in case the market begins to rally, and \nby no means should losses be allowed to accumulate. \nThe opposite end of the spectrum in naked call writing is the writing of fairly \ndeeply in-the-money calls. Since an in-the-money call would not have much time \nvalue premium in it, this writer does not have much leeway to the upside. If the \nstock rallies at all, the writer of the deeply in-the-money naked call will normally \nexperience aloss. However, should the stock drop in price, this writer will make \nlarger dollar profits than will the writer of the out-of-the-money call. The sale of the \ndeeply in-the-money call simulates the profits that ashort seller could make, at least \nuntil the stock drops close to the striking price, since the delta of adeeply in-the\nmoney call is close to 1. \nExample: XYZ is selling at 60 and the July 50 call is selling for 10½. IfXYZ rises, the \nnaked writer will lose money, because there is only ½ of apoint of time value pre\nmium in the call. If XYZ falls, the writer will make profits on apoint-for-point basis \nuntil the stock falls much closer to 50. That is, if XYZ dropped from 60 to 57, the call \nprice would fall by almost 3 points as well. Thus, for quick declines by the stock, the \ndeeply in-the-money write can provide profits nearly equal to those that the short \nseller could accumulate. Notice that if XYZ falls all the way to 50, the profits on the \nwritten call will be large, but will be accumulating at aslower rate as the time value \npremium builds up with the stock near the striking price. \nIf one is looking to trade astock on the short side for just afew points of nwve\nment, he might use adeeply in-the-nwney naked write instead of shorting the stock. \nHis investment will be smaller - 20% of the stock price for the write as compared to \n50% of the stock price for the short sale - and his return will thus be larger. (The \nrequirement for the in-the-money amount is offset by applying the call'spremium.)", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:165", "doc_id": "2eaef32472703755ce08e811f2feeed5c7201e5113d9518bde5073028c475ab3", "chunk_index": 0}
{"text": "140 Part II: Call Option Strategies \nThe writer should take great caution in ascertaining that the call does have some time \npremium in it. He does not want to receive an assignment notice on the written call. \nIt is easiest to find time premium in the more distant expiration series, so the writer \nwould normally be safest from assignment by writing the longest-term deep in-the\nmoney call if he wants to make abearish trade in the stock. \nExample: An investor thinks that XYZ could fall 3 or 4 points from its current price \nof 60 in aquick downward move, and wants to capitalize on that move by writing anaked call. If the April 40 were the near-term call, he might have the choice of sell\ning the April 40 at 20, the July 40 at 20¼, or the October 40 at 20½. Since all three \ncalls will drop nearly point for point with the stock in amove to 56 or 57, he should \nwrite the October 40, as it has the least risk of being assigned. Atrader utilizing this \nstrategy should limit his losses in much the same way ashort seller would, by cover\ning if the stock rallies, perhaps breaking through overhead technical resistance. \nROLLING FOR CREDITS \nMost writers of naked calls prefer to use one of the two strategies described above. \nThe strategy of writing at-the-money calls, when the stock price is initially close to the \nstriking price of the written call, is not widely utilized. This is because the writer who \nwants to limit risk will write an out-of-the-money call, whereas the writer who wants \nto make larger, quick trading profits will write an in-the-money call. There is, how\never, astrategy that is designed to utilize the at-the-money call. This strategy offers ahigh degree of eventual success, although there may be an accumulation of losses \nbefore the success point is reached. It is astrategy that requires large collateral back\ning, and is therefore only for the largest investors. We call this strategy \"rolling for \ncredits.\" The strategy is described here in full, although it can, at times, resemble a \nMartingale strategy; that is, one that requires \"doubling up\" to succeed, and one that \ncan produce ruin if certain physical limits are reached. The classic Martingale strat\negy is this: Begin by betting one unit; if you lose, double your bet; if you win that bet, \nyou'll have netted aprofit of one unit (you lost one, but won two); if you lost the sec\nond bet, double your bet again. No matter how many times you lose, keep doubling \nyour bet each time. When you eventually win, you will profit by the amount of your \noriginal bet (one unit). Unfortunately, such astrategy cannot be employed in real life. \nFor example, in agambling casino, after enough losses, one would bump up against \nthe table limit and would no longer be able to double his bet. Consequently, the strat\negy would be ruined just when it was at its worst point. While \"rolling for credits\" \ndoesn'texactly call for one to double the number of written calls each time, it does \nrequire that one keep increasing his risk exposure in order to profit by the amount of \nthat original credit sold. In general, Martingale strategies should be avoided.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:166", "doc_id": "1f9296388445e17bd32cc12b6c1d17c311f33fcc7a2e0d27ee0ac982dbf16292", "chunk_index": 0}
{"text": "Cl,apter 5: Naked Call Writing 141 \nIn essence, the writer who is rollingf or credits sells the most time premium that \nhe can at any point in time. This would generally be the longest-term, at-the-money \ncall. If the stock declines, the writer makes the time premium that he sold. However, \nif the stock rises in price, the writer rolls up for acredit. That is, when the stock \nreaches the next higher striking price, the writer buys back the calls that were origi\nnally sold and sells enough long-term calls at the higher strike to generate acredit. \nIn this way, no debits are incurred, although arealized loss is taken on the rolling up. \nIf the stock persists and rises to the next striking price, the process is repeated. \nEventually, the stock will stop rising - they always do - and the last set of written \noptions will expire worthless. At that time, the writer would make an overall profit \nconsisting of an amount equal to all the credits that he had taken in so far. In reality, \nmost of that credit will simply be the initial credit received. The \"rolls\" are done for \neven money or asmall credit. In essence, the increased risk generated by continual\nly rolling up is all geared toward eventually capturing that initial credit. The similar\nity to the Martingale strategy is strongest in this regard: One continually increases his \nrisk, knowing that when he eventually wins (i.e., the last set of options expires worth\nless), he profits by the amount of his original \"bet.\" \nThere are really only two requirements for success in this strategy. The first is \nthat the underlying stock eventually fall back, that it does not rise indefinitely. This is \nhardly arequirement; it is axiomatic that all stocks will eventually undergo acorrec\ntion, so this is asimple requirement to satisfy. The second requirement is that the \ninvestor have enough collateral backing to stay with the strategy even if the stock runs \nup heavily against him. \nThis is amuch harder requirement to satisfy, and may in fact tum out to be \nnearly impossible to satisfy. If the stock were to experience astraight-line upward \nmove, the number of calls written might grow so substantially that they would \nrequire an unrealistically large amount of collateral (margin). At aminimum, this \nstrategy is applicable only for the largest investors. For such well-collateralized \ninvestors, this strategy can be thought of as away to add income to aportfolio. That \nis, alarge stock portfolio'sequity may be used to finance this strategy through its loan \nvalue. There would be no margin interest charges, because all transactions are cred\nit transactions. (No debits are created, as long as the Martingale \"limits\" are not \nreached.) The securities portfolio would not have to be touched unless the strategy \nwere terminated before the last set of calls expired worthless. \nThis is where the danger comes in: If the stock upon which the calls are written \nrises so fast that one completely uses up all of his collateral value to finance the naked \ncalls, and then one is required to roll again, the strategy could result in large losses. \nFor awhile, one could simply continue to roll the same number of calls up for deb\nits, but eventually those debits would mount in size if the stock persisted in rising. At", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:167", "doc_id": "2b1a6e8e8ff4d967742bea96044192d74738fea06bda88df7536475db99394e3", "chunk_index": 0}
{"text": "142 Part II: Call Option Strategies \nthis point, even if the stock did finally decline enough for the last set of calls to expire \nworthless, the overall strategy might still have been operated at aloss. \nExample: The basic strategy in the case of rising stock is shown in Table 5-3. Note \nthat each transaction is acredit and that all ( except the last) involve taking arealized \nloss. \nThis example assumes that the stock rose so quickly that alonger-term call was \nnever available to roll into. That is, the October calls were always utilized. If there \nwere alonger-term call available (the January series, for example), the writer should \nroll up and out as well. In this way, larger credits could be generated. The number of \ncalls written increased from 5 to 15 and the collateral required as backing for the \nwriting of the naked calls also increased heavily. Recall that the collateral require\nment is equal to 20% of the stock price plus the call premium, less the amount by \nwhich the call is out-of-the-money. The premium may be used against the collateral \nrequirements. Using the stock and call prices of the example above, the investment \nis computed in Table 5-4. While the number of written calls has tripled from 5 to 15, \nthe collateral requirement has more than quadrupled from $5,000 to $21,000. This is \nwhy the investor must have ample collateral backing to utilize this strategy. The gen\neral philosophy of the large investors who do apply this strategy is that they hope to \neventually make aprofit and, since they are using the collateral value of large securi\nty positions already held, they are not investing any more money. The strategy does \nnot really \"cost\" these investors anything. All profits represent additional income and \ndo not in any way disturb the underlying security portfolio. Unfortunately, losses \ntaken due to aborting the strategy could seriously affect the portfolio. This is why the \ninvestor must have sufficient collateral to carry through to completion. \nThe sophisticated strategist who implements this strategy will generally do \nmore rolling than that discussed in the simple example above. First, if the stock \ndrops, the calls will be rolled down to the next strike - for acredit - in order to con\nstantly be selling the most time premium, which is always found in the longest-term \nat-the-money call. Furthermore, the strategist may want to roll out to amore distant \nexpiration series whenever the opportunity presents itself. This rolling out, or for\nward, action is only taken when the stock is relatively unchanged from the initial \nprice and there is no need to roll up or down. \nThis strategy seems ve:ry attractive as long as one has enough collateral backing. \nShould one use up all of his available collateral, the strategy could collapse, causing \nsubstantial losses. It may not necessarily generate large rates of return in rising mar\nkets, but in stable or declining markets the generation of additional income can be \nquite substantial. Since the investor is not putting up any additional cash but is uti-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:168", "doc_id": "fda1c43103f94224fa38ca7dfb8e80e9f851ec525dad17f3d961402cfe44cf71", "chunk_index": 0}
{"text": "144 Part II: Call Option Strategies \nsecurity, the strategist should diversify several moderately sized positions throughout \navariety of underlying stocks. If he does this, he will probably never have to exceed \nthe position limit of contracts short in any one security. \nEven with as many precautions as one might take, there is no guarantee that \none would have the collateral available to withstand again of 1000% or more, such \nas is occasionally seen with high-flying tech stocks or new IPOs. One would probably \nbe best served, if he really wants to operate this strategy, to stick with stocks that are \nwell capitalized (some of the biggest in the industry), so that they are less suscepti\nble to such violent upside moves. Even then, though, there is no guarantee that one \nwill not run out of collateral in asharply rising market, because it is impossible to esti\nmate with complete certainty just how far any one stock might advance in aparticu\nlar period of time. \nTIME VALUE PREMIUM IS A MISNOMER \nOnce again, the topic of time value premium is discussed, as it was in Chapter 3. \nMany novice option traders think that if they sell an out-of-the-money option \n(whether covered or naked), all they have to do is sit back and wait to collect the pre\nmium as time wears it away. However, alot of things can happen between the time \nan option is sold and its expiration date. The stock can move agreat deal, or implied \nvolatility can skyrocket. Both are bad for the option seller and both completely coun\nteract any benefit that time decay might be imparting. The option seller must con\nsider what might happen during the life of the option, and not simply view it as astrategy to hold the option until expiration. Naked call writers, especially, should \noperate with that thought in mind, but so should covered call writers, even though \nmost don't. What the covered writer gives away is the upside; and if he constantly \nsells options without regard to the possibilities of volatility or stock price increases, \nhe will be doing himself adisservice. \nSo, while it is still proper to refer to the part of an option'sprice that is not \nintrinsic value as \"time value premium,\" the knowledgeable option trader under\nstands that it is also more heavily influenced by volatility and stock price movement \nthan by time. \nSUMMARY \nIn amajority of cases, naked call writing is applied as adeeply out-of-the-money \nstrategy in which the investor uses the collateral value of his security holdings to par\nticipate in astrategy that offers alarge probability of making avery limited profit. It \nis apoor strategy, because one loss may wipe out many profits. The trader who", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:170", "doc_id": "d39877b21f983407caef722aada8e8107e4eb2229257cf137eafc4655abcbc6b", "chunk_index": 0}
{"text": "Ratio Call Writing \nTwo basic types of call writing have been described in previous chapters: covered call \nwriting, in which one owns the underlying stock and sells acall; and naked call writ\ning. Ratio writing is acombination of these two types of positions. \nTHE RATIO WRITE \nSimply stated, ratio call writing is the strategy in which one owns acertain number \nof shares of the underlying stock and sells calls against more shares than he owns. \nThus, there is aratio of calls written to stock owned. The most common ratio is the \n2:1 ratio, whereby one owns 100 shares of the underlying stock and sells 2 calls. Note \nthat this type of position involves writing anumber of naked call options as well as anumber of covered options. This resulting position has both downside risk, as does acovered write, and unlimited upside risk, as does anaked write. The ratio write gen\nerally wilI provide much larger profits than either covered writing or naked writing if \nthe underlying stock remains relatively unchanged during the life of the calls. \nHowever, the ratio write has two-sided risk, aquality absent from either covered or \nnaked writing. \nGenerally, when an investor establishes aratio write, he attempts to be neutral \nin outlook regarding the underlying stock. This means that he writes the calls with \nstriking prices closest to the current stock price. \nExample: Aratio write is established by buying 100 shares of XYZ at 49 and selling \ntwo XYZ October 50 calls at 6 points each. If XYZ should decline in price and be \nanywhere below 50 at October expiration, the calls will expire worthless and the \nwriter will make 12 points from the sale of the calls. Thus, even if XYZ drops 12 \npoints to aprice of 37, the ratio writer will break even. The stock loss of 12 points \n146", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:172", "doc_id": "e5f2cd84a158fa0bed716452b76f62f07dadcdf27210f20029b9eebfe0893810", "chunk_index": 0}
{"text": "Otapter 6: Ratio Call Writing 147 \nwould be offset by a 12-point gain on the calls. As with any strategy in which calls are \nsold, the maximum profit occurs at the striking price of the written calls at expiration. \nIn this example, if XYZ were at 50 at expiration, the calls would still expire worthless \nfor a 12-point gain and the writer would have a 1-point profit on his stock, which has \nmoved up from 49 to 50, for atotal gain of 13 points. This position therefore has \nample downside protection and arelatively large potential profit. Should XYZ rise \nabove 50 by expiration, the profit will decrease and eventually become aloss if the \nstock rises too far. To see this, suppose XYZ is at 63 at October expiration. The calls \nwill be at 13 points each, representing a 7-point loss on each call, because they were \noriginally sold for 6 points apiece. However, there would be a 14-poirit gain on the \nstock, which has risen from 49 to 63. The overall net is abreak-even situation at 63 -\na 14-point gain on the stock offset by 14 points ofloss on the options (7 points each). \nTable 6-1 and Figure 6-1 summarize the profit and loss potential of this example at \nOctober expiration. The shape of the graph resembles aroof with its peak located at \nthe striking price of the written calls, or 50. It is obvious that the position has both \nlarge upside risk above 63 and large downside risk below 37. Therefore, it is imper\native that the ratio writer plan to take follow-up action if the stock should move out\nside these prices. Follow-up action is discussed later. If the stock remains within the \nrange 37 to 63, some profit will result before commission charges. This range \nbetween the downside break-even point and the upside break-even point is called the \nprofit range. \nThis example represents essentially aneutral position, because the ratio writer \nwill make some profit unless the stock falls by more than 12 points or rises by more \nthan 14 points before the expiration of the calls in October. This is frequently an \nattractive type of strategy to adopt because, normally, stocks do not move very far in \nTABLE 6-1. \nProfit and loss at October expiration. \nXYZ Price at Stock Call Profit Total \nExpiration Profit Price on Calls Profit \n30 -$1,900 0 +$1,200 -$ 700 \n37 - 1,200 0 + 1,200 0 \n45 400 0 + 1,200 + 800 \n50 + 100 0 + 1,200 + 1,300 \n55 + 600 5 + 200 + 800 \n63 + 1,400 13 - 1,400 0 \n70 + 2,100 20 - 2,800 - 700", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:173", "doc_id": "e4b6e7b4f529c6a1166fa27fcbc2587e55a523c47f6e5b923fd9ed29af211503", "chunk_index": 0}
{"text": "148 \nFIGURE 6-1. \nRatio write (2: 1 ). \n+$1,300 \nC \n0 \ne ·5. \nX \nLU \nal \nrn rn \n.3 \n0 \n-ea. \nPart II: Call Option Strategies \nStock Price at Expiration \na 3- or 6-month time period. Consequently, this strategy has arather high probabili\nty of making alimited profit. The profit in this example would, of course, be reduced \nby commission costs and margin interest charges if the stock is bought on margin. \nBefore discussing the specifics of ratio writing, such as investment required, \nselection criteria, and follow-up action, it may be beneficial to counter two fairly \ncommon objections to this strategy. The first objection, although not heard as fre\nquently today as when listed options first began trading, is \"Why bother to buy 100 \nshares of stock and sell 2 calls? You will be naked one call. Why not just sell one \nnaked call?\" The ratio writing strategy and the naked writing strategy have very little \nin common except that both have upside risk. The profit graph for naked writing \n(Figure 5-1) bears no resemblance to the roof-shaped profit graph for aratio write \n(Figure 6-1). Clearly, the two strategies are quite different in profit potential and in \nmany other respects as well. \nThe second objection to ratio writing for the conservative investor is slightly \nmore valid. The conservative investor may not feel comfortable with aposition that \nhas risk if the underlying stock moves up in price. This can be apsychological detri\nment to ratio writing: When stock prices are rising and everyone who owns stocks is \nhappy and making profits, the ratio writer is in danger of losing money. However, in \napurely strategic sense, one should be willing to assume some upside risk in \nexchange for larger profits if the underlying stock does not rise heavily in price. The", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:174", "doc_id": "d8f41eff24037c429904526844860832032a340f004e008a1eee4010df716427", "chunk_index": 0}
{"text": "Chapter 6: Ratio Call Writing 149 \ncovered writer has upside protection all the way to infinity; that is, he has no upside \nrisk at all. This cannot be the mathematically optimum situation, because stocks \nnever rise to infinity. Rather, the ratio writer is engaged in astrategy that makes its \nprofits in aprice range more in line with the way stocks actually behave. In fact, if \none were to try to set up the optimum strategy, he would want it to make its most \nprofits in line with the most probable outcomes for astock'smovement. Ratio writ\ning is such astrategy. \nFigure 6-2 shows asimple probability curve for astock'smovement. It is most \nlikely that astock will remain relatively unchanged and there is very little chance that \nit will rise or fall agreat distance. Now compare the results of the ratio writing strat\negy with the graph of probable stock outcomes. Notice that the ratio write and the \nprobability curve have their \"peaks\" in the same area; that is, the ratio write makes \nits profits in the range of most likely stock prices, because there is only asmall chance \nthat any stock will increase or decrease by alarge amount in afixed period of time. \nThe large losses are at the edges of the graph, where the probability curve gets very \nlow, approaching zero probability. It should be noted that these graphs show the prof\nit and probability at expiration. Prior to expiration, the break-even points are closer \nto the original purchase price of the stock because there will still be some time value \npremium remaining on the options that were sold. \nFIGURE 6-2. \nStock price probability curve overlaid on profit graph of ratio \nwrite. \n+$1,300 Probability \nCurve \nStock Price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:175", "doc_id": "bfbb6b41673cacd64b81bb9dbc1b7bef5a2c736ab598f151747bbff1d95cb38a", "chunk_index": 0}
{"text": "150 Part II: Call Option Strategies \nINVESTMENT REQUIRED \nThe ratio writer has acombination of covered writes and naked writes. The margin \nrequirements for each of these strategies have been described previously, and the \nrequirements for aratio writing strategy are the sum of the requirements for anaked \nwrite and acovered write. Ratio writing is normally done in amargin account, \nalthough one could technically keep the stock in acash account. \nExample: Ignoring commissions, the investment required can be computed as fol\nlows: Buy 100 XYZ at 49 on 50% margin and sell 2 XYZ October 50 calls at 6 points \neach (Table 6-2). The commissions for buying the stock and selling the calls would be \nadded to these requirements. Ashorter formula (Table 6-3) is actually more desirable \nto use. It is merely acombination of the investment requirements listed in Table 6-2. \nIn addition to the basic requirement, there may be minimum equity require\nments and maintenance requirements, since naked calls are involved. As these vary \nfrom one brokerage firm to another, it is best for the ratio writer to check with his \nbroker to determine the equity and maintenance requirements. Again, since naked \ncalls are involved in ratio writing, there will be amark to market of the position. If \nthe stock should rise in price, the investor will have to put up more collateral. \nIt is conceivable that the ratio writer would want to stay with his original posi\ntion as long as the stock did not penetrate the upside break-even point of 63. \nTABLE 6-2. \nInvestment required. \nCovered writing portion (buy 100 XYZ and sell 1 call) \n50% of stock price \nLess premium received \nRequirement for covered portion \nNaked writing portion (sell 1 XYZ call) \n20% of stock price \nLess out-of-the-money amount \nPlus call premium \nLess premium received \nRequirement for naked portion \nTotal requirement for ratio write \n$2,450 \n600 \n$1,850 \n$ 980 \n100 \n+ 600 \n600 \n$ 880 \n$2,730", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:176", "doc_id": "26cd35c180952c209b15d088512c72910b7a3f5995b93d713c858c4482216a04", "chunk_index": 0}
{"text": "Cl,apter 6: Ratio Call Writing \nTABLE 6-3. \nInitial investment required for aratio write. \n70% of stock cost (XYZ = 49) \nPlus naked call premiums \nLess total premiums received \nPlus or minus striking price differential \non naked calls \n$3,430 \n+ 600 \n- 1,200 \n100 \n151 \nTotal requirement $2,730 (plus commissions) \nTABLE 6-4. \nCollateral required with stock at upside break-even point of 63. \nCovered writing requirement $1,850 (see Table 6-2) \n20% of stock price (XYZ = 63) 1,260 \nPlus call premium \nLess initial call premium received \nTotal requirement with XYZ at 63 \n1,400 \n600 \n$3,910 \nTherefore, he should allow for enough collateral to cover the eventuality of amove \nto 63. Assuming the October 50 call is at 14 in this case, he would need $3,910 (see \nTable 6-4). This is the requirement that the ratio writer should be concerned with, \nnot the initial collateral requirement, and he should therefore plan to invest $3,910 \nin this position, not $2,730 ( the initial requirement). Obviously, he only has to put up \n$2,730, but from astrategic point of view, he should allow $3,910 for the position. If \nthe ratio writer does this with all his positions, he would not receive amargin call \neven if all the stocks in his portfolio climbed to their upside break-even points. \nSELECTION CRITERIA \nTo decide whether aratio write is adesirable position, the writer must first determine \nthe break-even points of the position. Once the break-even points are known, the \nwriter can then decide if the position has awide enough profit range to allow for \ndefensive action if it should become necessary. One simple way to determine if the \nprofit range is wide enough is to require that the next higher and lower striking prices \nbe within the profit range.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:177", "doc_id": "15b21ec658e044c0b2708b4bfc97adfa69bb3ab539665eba8ba9f966495369a6", "chunk_index": 0}
{"text": "152 Part II: Call Option Strategies \nExample: The writer is buying 100 XYZ at 49 and selling 2 October 50 calls at 6 \npoints apiece. It was seen, by inspection, that the break-even points in the position \nare 37 on the downside and 63 on the upside. Amathematical formula allows one to \nquickly compute the break-even points for a 2:1 ratio write. \nPoints of maximum profit = Strike price - Stock price + 2 x Call price \nDownside break-even point = Strike price - Points of maximum profit \n= Stock price - 2 x Call price \nUpside break-even point = Strike price + Points of maximum profit \nIn this example, the points of maximum profit are 50 - 49 + 2 x 6, or 13. Thus, \nthe downside break-even point would be 37 (50 - 13) and the upside break-even \npoint would be 63 (50 + 13). These numbers agree with the figures determined ear\nlier by analyzing the position. \nThis profit range is quite clearly wide enough to allow for defensive action \nshould the underlying stock rise to the next highest strikes of 55 or 60, or fall to the \nnext two lower strikes, at 45 and 40. In practice, aratio write is not automatically agood position merely because the profit range extends far enough. Theoretically, \none would want the profit range to be wide in relation to the volatility of the under\nlying stock. If the range is wide in relation to the volatility and the break-even \npoints encompass the next higher and lower striking prices, adesirable position is \navailable. Volatile stocks are the best candidates for ratio writing, since their pre\nmiums will more easily satisfy both these conditions. Anonvolatile stock may, at \ntimes, have relatively large premiums in its calls, but the resulting profit range may \nstill not be wide enough numerically to ensure that follow-up action could be taken. \nSpecific measures for determining volatility may be obtained from many data serv\nices and brokerage firms. Moreover, methods of computing volatility are present\ned later in the chapter on mathematical applications, and probabilities are further \naddressed in the chapters on volatility trading. \nTechnical support and resistance levels are also important in establishing the \nposition. If both support and resistance lie within the profit range, there is abetter \nchance that the stock will remain within the range. Aposition should not necessarily \nbe rejected if there is not support and resistance within the profit range, but the \nwriter is then subjecting himself to apossible undeterred move by the stock in one \ndirection or the other. \nThe ratio writer is generally aneutral strategist. He tries to take in the most \ntime premium that he can to earn the premium erosion while the stock remains rel\natively unchanged. If one is more bullish on aparticular stock, he can set up a 2:1 \nratio write with out-of~the-money calls. This allows more room to the upside than to \nthe downside, and therefore makes the position slightly more bullish. Conversely, if", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:178", "doc_id": "8cc6822a42433ae51efb6718080a3b2c8cf491b95942d73a96d5c56ef3e05c77", "chunk_index": 0}
{"text": "Cl,apter 6: Ratio Call Writing 153 \none is more bearish on the underlying stock, he can write in-the-money calls in a 2:1 \nratio. \nThere is another way to produce aslightly more bullish or bearish ratio write. \nThis is to change the ratio of calls written to stock purchased. This method is also \nused to construct aneutral profit range when the stock is not close to astriking price. \nExample: An investor is slightly bearishly inclined in his outlook for the underlying \nstock, so he might write more than two calls for each 100 shares of stock purchased. \nHis position might be to buy 100 XYZ at 49 and sell 3 XYZ October 50 calls at 6 points \neach. This position breaks even at 31 on the downside, because if the stock dropped \nby 18 points at expiration, the call profits would amount to 18 points and would pro\nduce abreak-even situation. To the upside, the break-even point lies at 59½ for the \nstock at expiration. Each call would be worth 9½ at expiration with the stock at 59½, \nand each call would thus lose 3½ points, for atotal loss of 10½ points on the three \ncalls. However, XYZ would have risen from 49 to 59½ - a 10½-point gain - therefore \nproducing abreak-even situation. Again, aformula is available to aid in determining \nthe break-even point for any ratio. \nMaximum profit= (Striking price - Stock price) x Round lots \npurchased+ Number of calls written x Call price \nD •dbak Striking Maximum profit owns1 ere -even = - ------~~----price Number of round lots purchased \nU .dbak Striking Maximum profit psi ere -even = + price ( Calls written - Round lots purchased) \nNote that in the case of a 2:1 ratio write, where the number of round lots purchased \nequals 1 and the number of calls written equals 2, these formulae reduce to the ones \ngiven earlier for the more common 2:1 ratio write. To verify that the formulae above \nare correct, insert the numbers from the most recent example. \nExample: Three XYZ October 50 calls at aprice of 6 were sold against the purchase \nof 100 XYZ at 49. The number of round lots purchased is 1. \nMaximum profit = (50 - 49) x 1 + 3 x 6 = 19 \nDownside break-even= 50-19/1 = 31 \nUpside break-even= 50 + 19/(3 1) = 59½ \nIn the 2:1 ratio writing example given earlier, the break-even points were 37 and 63. \nThe 3:1 write has lower break-even points of 31 and 59½, reflecting the more bear\nish posture on the underlying stock.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:179", "doc_id": "b2e0deffe3f81151f5a14fd91113bab36de3b314942e6c28d42c78ec7eaac9e3", "chunk_index": 0}
{"text": "154 Part II: Call Option Strategies \nAmore bullish write is constructed by buying 200 shares of the underlying stock \nand writing three calls. To quickly verify that this ratio (3:2) is more bullish, again use \n49 for the stock price and 6 for the call price, and now assume that two round lots \nwere purchased. \nMaximum profit= (50-49) x 2 + 3 x 6 = 20 \nDownside break-even = 50 - 20/2 = 40 \nUpside break-even= 50 + 20/(3 - 2) = 70 \nThus, this ratio of 3 calls against 200 shares of stock has break-even points of 40 and \n70, reflecting amore bullish posture on the underlying stock. \nA 2: 1 ratio may not necessarily be neutral. There is, in fact, amathematically \ncorrect way of determining exactly what aneutral ratio should be. The neutral ratio \nis determined by dividing the delta of the written call into 1. Assume that the delta of \nthe XYZ October 50 call in the previous example is .60. Then the neutral ratio is \n1.0/.60, or 5 to 3. This means that one might buy 300 shares and sell 5 calls. Using \nthe formulae above, the details of this position can be observed: \nMaximum profit= (50 -49) x 3 + 5 x 6 = 33 \nDownside break-even = 50 - 33/3 = 39 \nUpside break-even = 50 + 33/(5 --3) = 66½ \nAccording to the mathematics of the situation, then, this would be aneutral position \ninitially. It is often the case that a 5:3 ratio is approximately neutral for an at-the\nmoney call. \nBy now, the reader should have recognized asimilarity between the ratio writ\ning strategy and the reverse hedge (or simulated straddle) strategy presented in \nChapter 4. The two strategies are the reverse of each other; in fact, this is how the \nreverse hedge strategy acquired its name. The ratio write has aprofit graph that looks \nlike aroof, while the reverse hedge has aprofit graph that looks like atrough - the \nroof upside down. In one strategy the investor buys stock and sells calls, while the \nother strategy is just the opposite - the investor shorts stock and buys calls. Which \none is better? The answer depends on whether the calls are \"cheap\" or \"expensive.\" \nEven though ratio writing has limited profits and potentially large losses, the strate\ngy will result in aprofit in alarge majority of cases, if held to expiration. However, \none may be forced to make adjustments to stock moves that occur prior to expiration. \nThe reverse hedge strategy, with its limited losses and potentially large profits, pro\nvides profits only on large stock moves - aless frequent event. Thus, in stable mar\nkets, the ratio writing strategy is generally superior. However, in times of depressed \noption premiums, the reverse hedge strategy gains adistinct advantage. If calls are", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:180", "doc_id": "9b66a84ef7206be623f1c7ab2efe3ff90b68b60fc44cbd32df14569837156a1e", "chunk_index": 0}
{"text": "Chapter 6: Ratio Call Writing 155 \nunderpriced, the advantage lies with the buyer of calls, and that situation is inherent \nin the reverse hedge strategy. \nThe summaries stated in the above paragraph are rather simplistic ones, refer\nring mostly to what one can expect from the strategies if they are held until expira\ntion, without adjustment. In actual trading situations, it is much more likely that one \nwould have to make adjustments to the ratio write along the way, thus disturbing or \nperhaps even eliminating the profit range. Such travails do not befall the reverse \nhedge (simulated straddle buy). Consequently, when one takes into consideration the \nstock movements that can take place prior to expiration, the ratio write loses some of \nits attractiveness and the reverse hedge gains some. \nTHE VARIABLE RATIO WRITE \nIn ratio writing, one generally likes to establish the position when the stock is trading \nrelatively close to the striking price of the written calls. However, it is sometimes the \ncase that the stock is nearly exactly between two striking prices and neither the in\nthe-money nor the out-of-the-money call offers aneutral profit range. If this is the \ncase, and one still wants to be in a 2:1 ratio of calls written to stock owned, he can \nsometimes write one in-the-money call and one out-of-the-money call against each \n100 shares of common. This strategy, often termed avariable ratio write or trape\nzoidal hedge, serves to establish amore neutral profit range. \nExample: Given the following prices: XYZ common, 65; XYZ October 60 call, 8; and \nXYZ October 70 call, 3. \nIf one were to establish a 2:1 ratio write with only the October 60's, he would \nhave asomewhat bearish position. His profit range would be 49 to 71 at expiration. \nSince the stock is already at 65, this means that he would be allowing room for 16 \npoints of downside movement and only 6 points on the upside. This is certainly not \nneutral. On the other hand, if he were to attempt to utilize only the October 70 calls \nin his ratio write, he would have abullish position. This profit range for the October \n70 ratio write would be 59 to 81 at expiration. In this case, the stock at 65 is too close \nto the downside break-even point in comparison to its distance from the upside \nbreak-even point. \nAmore neutral position can be established by buying 100 XYZ and selling one \nOctober 60 and one October 70. This position has aprofit range that is centered \nabout the current stock price. Moreover, the new position has both an upside and adownside risk, as does amore normal ratio write. However, now the maximum prof\nit can be obtained anywhere between the two strikes at expiration. To see this, note", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:181", "doc_id": "ee6e058801937f1f287be74b00b28239f52e6ab2dfa29455f1eb8eb3c093274f", "chunk_index": 0}
{"text": "156 Part II: Call Option Strategies \nthat if XYZ is anywhere between 60 and 70 at expiration, the stock will be called away \nat 60 against the sale of the October 60 call, and the October 70 call will expire worth\nless. It makes no difference whether the stock is at 61 or at 69; the same result will \noccur. Table 6-5 and Figure 6-3 depict the results from this variable hedge at expira\ntion. In the table, it is assumed that the option is bought back at parity to close the \nposition, but if the stock were called away, the results would be the same. \nNote that the shape of Figure 6-3 is something like atrapezoid. This is the \nsource of the name \"trapezoidal hedge,\" although the strategy is more commonly \nknown as avariable hedge or variable ratio write. The reader should observe that the \nmaximum profit is indeed obtained if the stock is anywhere between the two strikes \nat eiqJiration. The maximum profit potential in this position, $600, is smaller than the \nmaximum profit potential available from writing only the October 60'sor only the \nOctober 70's. However, there is avastly greater probability of realizing the maximum \nprofit in avariable ratio write than there is of realizing the maximum profit in anor\nmal ratio write. \nThe break-even points for avariable ratio write can be computed most quickly \nby first computing the maximum profit potential, which is equal to the time value \nthat the writer takes in. The break-even points are then computed directly by sub\ntracting the points of maximum profit from the lower striking price to get the down\nside break-even point and adding the points of maximum profit to the upper striking \nprice to arrive at the upside break-even point. This is asimilar procedure to that fol\nlowed for anormal ratio write: \nTABLE 6-5. \nResults at expiration of variable hedge. \nXYZ Price at XYZ October 60 October 70 Total \nExpiration Profit Profit Profit Profit \n45 -$2,000 +$ 800 +$ 300 -$900 \n50 - 1,500 + 800 + 300 - 400 \n54 - 1,100 + 800 + 300 0 \n60 500 + 800 + 300 + 600 \n65 0 + 300 + 300 + 600 \n70 + 500 - 200 + 300 + 600 \n76 + 1,100 - 800 300 0 \n80 + 1,500 -$1,200 700 - 400 \n85 + 2,000 -1,700 - 1,200 - 900", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:182", "doc_id": "006397294763cc2b87a57a00f15a70fcabf0c149d61ad0f3c6accd092ed8d819", "chunk_index": 0}
{"text": "Gopter 6: Ratio Call Writing \nFIGURE 6-3. \nVariable ratio write (trapezoidal hedge). \n+$600 \nC: \ni $ \nal \n\"' \"' .3 \n5 \n;t: \ne \n0. \n$0 \nStock Price at Expiration \nPoints of maximum profit = Total option premiums + Lower \nstriking price - Stock price \nDownside break-even point = Lower striking price - Points of \nmaximum profit \nUpside break-even point = Higher striking price + Points of \nmaximum profit \n157 \nSubstituting the numbers from the example above will help to verify the formula. \nThe total points of option premium brought in were 11 (8 for the October 60 and 3 \nfor the October 70). The stock price was 65, and the striking prices involved were 60 \nand 70. \nPoints of maximum profit = 11 + 60 - 65 = 6 \nDownside break-even point= 60- 6 = 54 \nUpside break-even point= 70 + 6 = 76 \nThus, the break-even points as computed by the formula agree with Table 6-5 and \nFigure 6-3. Nate that the formula applies only if the stock is initially between the two \nstriking prices and the ratio is 2:1. If the stock is above both striking prices, the for\nmula is not correct. However, the writer should not be attempting to establish avari\nable ratio write with two in-the-money calls.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:183", "doc_id": "10fba481d5175466ad9373100a82b1280c92526cf0017c85f90a36b458ce10ad", "chunk_index": 0}
{"text": "158 Part II: Call Option Strategies \nFOLLOW-UP ACTION \nAside from closing the position completely, there are three reasonable approaches to \nfollow-up action in aratio writing situation. The first, and most popular, is to roll the \nwritten calls up if the stock rises too far, or to roll down if the stock drops too far. Asecond method uses the delta of the written calls. The third follow-up method is to \nutilize stops on the underlying stock to alter the ratio of the position as the stock \nmoves either up or down. In addition to these types of defensive follow-up action, the \ninvestor must also have aplan in mind for taking profits as the written calls approach \nexpiration. These types of follow-up action are discussed separately. \nROLLING UP OR DOWN AS A DEFENSIVE ACTION \nThe reader should already be familiar with the definition of arolling action: The cur\nrently written calls are bought back and calls at adifferent striking price are written. \nThe ratio writer can use rolling actions to his advantage to readjust his position if the \nunderlying stock moves to the edges of his profit range. \nThe reason one of the selection criteria for aratio write was the availability of \nboth the next higher and next lower striking prices was to facilitate the rolling actions \nthat might become necessary as afollow-up measure. Since an option has its great\nest time premium when the stock price and the striking price are the same, one \nwould normally want to roll exactly at astriking price. \nExample: Aratio writer bought 100 XYZ at 49 and sold two October 50 calls at 6 \npoints each. Subsequently, the stock drops in price and the following prices exist: \nXYZ, 40; XYZ October 50, l; and XYZ October 40, 4. \nOne would roll down to the October 40 calls by buying back the 2 October \n50'sthat he is short and selling 2 October 40's. In so doing, he would reestablish asomewhat neutral position. His profit on the buy-back of the October 50 calls \nwould be 5 points each - they were originally sold for 6 - and he would realize a \n10-point gain on the two calls. This 10-point gain effectively reduces his stock cost \nfrom 49 to 39, so that he now has the equivalent of the following position: long 100 \nXYZ at 39 and short 2 XYZ October 40 calls at 4. This adjusted ratio write has aprofit range of 31 to 49 and is thus anew, neutral position with the stock currently \nat 40. The investor is now in aposition to make profits if XYZ remains near this \nlevel, or to take further defensive action if the stock experiences arelatively large \nchange in price again. \nDefensive action to the upside - rolling up -works in much the same manner.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:184", "doc_id": "a8696384c08f70d8669621651ee499de7a8eb77c3626f72bce99e4f267058af2", "chunk_index": 0}
{"text": "Chapter 6: Ratio Call Writing 159 \nExample: The initial position again consists of buying 100 XYZ at 49 and selling two \nOctober 50 calls at 6. If XYZ then rose to 60, the following prices might exist: XYZ, \n60; XYZ October 50, 11; and XYZ October 60, 6. \nThe ratio writer could thus roll this position up to reestablish aneutral profit \nrange. If he bought back the two October 50 calls, he would take a 5-point loss on \neach one for anet loss on the calls of 10 points. This would effectively raise his stock \ncost by 10 points, to aprice of 59. The rolled-up position would then be long 100 XYZ \nat 59 and short 2 October 60 calls at 6. This new, neutral position has aprofit range \nof 47 to 73 at October expiration. \nIn both of the examples above, the writer could have closed out the ratio write \nat avery small profit of about 1 point before commissions. This would not be advis\nable, because of the relatively large stock commissions, unless he expects the stock to \ncontinue to move dramatically. Either rolling up or rolling down gives the writer afairly wide new profit range to work with, and he could easily expect to make more \nthan 1 point of profit if the underlying stock stabilizes at all. \nHaving to take rolling defensive action immediately after the position is estab\nlished is the most detrimental case. If the stock moves very quickly after having set \nup the position, there will not be much time for time value premium erosion in the \nwritten calls, and this will make for smaller profit ranges after the roll is done. It may \nbe useful to use technical support and resistance levels as keys for when to take \nrolling action if these levels are near the break-even points and/or striking prices. \nIt should be noted that this method of defensive action - rolling at or near strik\ning prices - automatically means that one is buying back little or no time premium \nand is selling the greatest amount of time premium currently available. That is, if the \nstock rises, the call'spremium will consist mostly of intrinsic value and very little of \ntime premium value, since it is substantially in-the-money. Thus, the writer who rolls \nup by buying back this in-the-money call is buying back mostly intrinsic value and is \nselling acall at the next strike. This newly sold call consists mostly of time value. By \ncontinually buying back \"real\" or intrinsic value and by selling \"thin air\" or time value, \nthe writer is taking the optimum neutral action at any given time. \nIf astock undergoes adramatic move in one direction or the other, the ratio \nwriter will not be able to keep pace with the dramatic movement by remaining in the \nsame ratio. \nExample: If XYZ was originally at 49, but then undergoes afairly straight-line move \nto 80 or 90, the ratio writer who maintains a 2:1 ratio will find himself in adeplorable \nsituation. He will have accumulated rather substantial losses on the calls and will not \nbe able to compensate for these losses by the gain in the underlying stock. Asimilar", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:185", "doc_id": "e92e5f28eca9c6d1895b582066ff29e34237eb62d86991cde2c0f8915ea414d1", "chunk_index": 0}
{"text": "160 Part II: Call Option Strategies \nsituation could arise to the downside. If:X'YZ were to plunge from 49 to 20, the ratio \nwriter would make agood deal of profit from the calls by rolling down, but may still \nhave alarger loss in the stock itself than the call profits can compensate for. \nMany ratio writers who are large enough to diversify their positions into anum\nber of stocks will continue to maintain 2:1 ratios on all their positions and will simply \nclose out aposition that has gotten out of hand by running dramatically to the upside \nor to the downside. These traders believe that the chances of such adramatic move \noccurring are small, and that they will take the infrequent losses in such cases in \norder to be basically neutral on the other stocks in their portfolios. \nThere is, however, away to combat this sort of dramatic move. This is done by \naltering the ratio of the covered write as the stock moves either up or down. For \nexample, as the underlying stock moves up dramatically in price, the ratio writer can \ndecrease the number of calls outstanding against his long stock each time he rolls. \nEventually, the ratio might decrease as far as 1:1, which is nothing more than acov\nered writing situation. As long as the stock continues to move in the same upward \ndirection, the ratio writer who is decreasing his ratio of calls outstanding will be giv\ning more and more weight to the stock gains in the ratio write and less and less weight \nto the call losses. It is interesting to note that this decreasing ratio effect can also be \nproduced by buying extra shares of stock at each new striking price as the stock \nmoves up, and simultaneously keeping the number of outstanding calls written con\nstant. In either case, the ratio of calls outstanding to stock owned is reduced. \nWhen the stock moves down dramatically, asimilar action can be taken to \nincrease the number of calls written to stock owned. Normally, as the stock falls, one \nwould sell out some of his long stock and roll the calls down. Eventually, after the \nstock falls far enough, he would be in anaked writing position. The idea is the same \nhere: As the stock falls, more weight is given to the call profits and less weight is given \nto the stock losses that are accumulating. \nThis sort of strategy is more oriented to extremely large investors or to firm \ntraders, market-makers, and the like. Commissions will be exorbitant if frequent rolls \nare to be made, and only those investors who pay very small commissions or who have \nsuch alarge holding that their commissions are quite small on apercentage basis will \nbe able to profit substantially from such astrategy. \nADJUSTING WITH THE DELTA \nThe delta of the written calls can be used to determine the correct ratio to be used in \nthis ratio-adjusting defensive strategy. The basic idea is to use the call'sdelta to \nremain as neutral as possible at all times.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:186", "doc_id": "8a179f923103957625fa1d899a2f6986077d7d3c640871f1e083e433d0cfa22d", "chunk_index": 0}
{"text": "Cl,apter 6: Ratio Call Writing 161 \nExample: An investor initially sets up aneutral 5:3 ratio of XYZ October 50 calls to \nXYZ stock, as was determined previously. The stock is at 49 and the delta is .60. \nFurthermore, suppose the stock rises to 57 and the call now has adelta of .80. The \nneutral ratio would currently be 1/.80 ( = 1.20) or 5:4. The ratio writer could thus buy \nanother 100 shares of the underlying stock. \nAlternatively, he might buy in one of the short calls. In this particular example, \nbuying in one call would produce a 4:3 ratio, which is not absolutely correct. If he \nhad had alarger position initially, it would be easier to adjust to fractional ratios. \nWhen the stock declines, it is necessary to increase the ratio. This can be accom\nplished by either selling more calls or selling out some of the long stock. In theory, \nthese adjustments could be made constantly to keep the position neutral. In practice, \none would allow for afew points of movement by the underlying stock before adjust\ning. If the underlying stock rises too far, it may be logical for the neutral strategist to \nadjust by rolling up. Similarly, he would roll down if the stock fell to or below the next \nlower strike. The neutral ratio in that case is determined by using the delta of the \noption into which he is rolling. \nExample: With XYZ at 57, an investor is contemplating rolling up to the October 60'sfrom his present position of long 300 shares and short 5 XYZ October 50's. If the \nOctober 60 has adelta of .40, the neutral ratio for the October 60'sis 2.5:l (1 + .40). \nSince he is already long 300 shares of stock, he should now be short 7.5 calls (3 x 2.5). \nObviously, he would sell 7 or 8, probably depending on his short-term outlook for the \nstock. \nIf one prefers to adopt an even more sophisticated approach, he can make \nadjustments between striking prices by altering his stock position, and can make \nadjustments by rolling up or down if the stock reaches anew striking price. For those \nwho prefer formulae, the following ones summarize this information: \n1. When establishing anew position or when rolling up or down, at the next strike: \nNbfall t 11 Round lots held long um er ocsose = \nDelta of call to be sold \nNote: When establishing anew position, one must first decide how many shares \nof the underlying stock he can buy before utilizing the formula; 1,000 \nshares would be aworkable amount. \n2. When adjusting between strikes by buying or selling stock:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:187", "doc_id": "5de4a989af3337f0b2c25e55e422dea91b82f3b0b10c3012a8cf2efddf2d3a73", "chunk_index": 0}
{"text": "162 Part II: Call Option Strategies \nNumber of \nround lots = Current delta x Number of short calls - Round lots held long \nto buy \nNote: If anegative number results, stock should be sold, not bought. \nThese formulae can be verified by using the numbers from the examples above. For \nexample, when the delta of the October 50 was .80 with the stock at 57, it was seen \nthat buying 100 shares of stock would reestablish aneutral ratio. \nNumber of round lots to buy= .80 x 5 3 = 4- 3 = 1 \nAlso, if the position was to be rolled up to the October 60 (delta = .40), it was seen \nthat 7.5 October 60'swould theoretically be sold: \nNumber of calls to sell = __l_ = 7.5 .40 \nThere is amore general approach to this problem, one that can be applied to \nany strategy, no matter how complicated. It involves computing whether the position \nis net short or net long. The net position is reduced to an equivalent number of shares \nof common stock and is commonly called the \"equivalent stock position\" (ESP). Here \nis asimple formula for the equivalent stock position of any option position: \nESP = Option quantity x Delta x Shares per option \nExample: Suppose that one is long 10 XYZ July 50 calls, which currently have adelta \nof .45. The option is an option on 100 shares of XYZ. Thus, the ESP can be computed: \nESP = 10 x .45 x 100 = 450 shares \nThis is merely saying that owning 10 of these options is equivalent to owning 450 \nshares of the underlying common stock, XYZ. The reader should already understand \nthis, in that an option with adelta of .45 would appreciate by .45 points if the com\nmon stock moved up 1 dollar. Thus, 10 options would appreciate by 4.5 points, or \n$450. Obviously, 450 shares of common stock would also appreciate by $450 if they \nmoved up by one point. \nNote that there are some options - those that result from astock split- that are \nfor more than 100 shares. The inclusion of the term \"shares per option\" in the for\nmula accounts for the fact that such options are equivalent to adifferent amount of \nstock than most options. \nThe ESP of an entire option and stock position can be computed, even if sev\neral different options are included in the position. The advantage of this simple cal-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:188", "doc_id": "9c69ed14ddd0f0edb192370b2e3335296900c35b0c0f5ae62549c5b2b08eee0e", "chunk_index": 0}
{"text": "Chapter 6: Ratio Call Writing 163 \nculation is that an entire, possibly complex option position can be reduced to one \nnumber. The ESP shows how the position will behave for short-term market move\nments. \nLook again at the previous example of aratio write. The position was long 300 \nshares and short 5 options with acurrent delta of .80 after the stock had risen to 57. \nThe ESP of the 5 October 50'sis short 400 shares (5 x .80 x 100 shares per option). \nThe position is also long 300 shares of stock, so the total ESP of this ratio write is \nshort 100 shares. \nThis figure gives the strategist ameasure of perspective on his position. He now \nknows that he has aposition that is the equivalent of being short 100 shares of XYZ. \nPerhaps he is bearish on XYZ and therefore decides to do nothing. That would be \nfine; at least he knows that his position is short. \nNormally, however, the strategist would want to adjust his position. Again \nreturning to the previous example, he has several choices in reducing the ESP back \nto neutral. An ESP of Ois considered to be aperfectly neutral position. Obviously, \none could buy 100 shares of XYZ to reduce the 100-share delta short. Or, given that \nthe delta of the October 50 call is .80, he could buy in 1.25 of these short calls (obvi\nously he could only buy l; fractional options cannot be purchased). \nLater chapters include more discussions and examples using the ESP. It is avital concept that no strategist who is operating positions involving multiple options \nshould be without. The only requirement for calculating it is to know the delta of the \noptions in one'sposition. Those are easily obtainable from one'sbroker or from anumber of computer services, software programs, or Web sites. \nFor investors who do not have the funds or are not in aposition to utilize such \naratio adjusting strategy, there is aless time-consuming method of taking defensive \naction in aratio write. \nUSING STOP ORDERS AS A DEFENSIVE STRATEGY \nAratio writer can use buy or sell stops on his stock position in order to automatical\nly and unemotionally adjust the ratio of his position. This type of defensive strategy \nis not an aggressive one and will provide some profits unless awhipsaw occurs in the \nunderlying stock. \nAs an example of how the use of stop orders can aid the ratio writer, let us again \nassume that the same basic position was established by buying XYZ at 49 and selling \ntwo October 50 calls at 6 points each. This produces aprofit range of 37 to 63 at expi\nration. If the stock begins to move up too far or to fall too far, the ratio writer can \nadjust the ratio of calls short to stock long automatically, through the use of stop \norders on his stock.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:189", "doc_id": "28c643c546bd2ca12ac168aaf985b6ea668afad48739454f7ffe5e36f7cae665", "chunk_index": 0}
{"text": "164 Part II: Call Option Strategies \nExample: An investor places a \"good until canceled\" stop order to buy 100 shares of \nXYZ at 57 at the same time that he establishes the original position. If XYZ should \nget to 57, the stop would be set off and he would then own 200 shares ofXYZ and be \nshort 2 calls. That is, he would have a 200-share covered write of XYZ October 50 \ncalls. \nTo see how such an action affects his overall profit picture, note that his average \nstock cost is now 53; he paid 49 for the first 100 shares and paid 57 for the second 100 \nshares bought via the stop order. Since he sold the calls at 6 each, he essentially has acovered write in which he bought stock at 53 and sold calls for 6 points. This does not \nrepresent alot of profit potential, but it will ensure some profit unless the stock falls \nback below the new break-even point. This new break-even point is 47 - the stock \ncost, 53, less the 6 points received for the call. He will realize the maximum profit \npotential from the covered write as long as the stock remains above 50 until expira\ntion. Since the stock is already at 57, the probabilities are relatively strong that it will \nremain above 50, and even stronger that it will remain above 47, until the expiration \ndate. If the buy stop order was placed just above atechnical resistance area, this prob\nability is even better. \nHence, the use of abuy stop order on the upside allows the ratio writer to auto\nmatically convert the ratio write into acovered write if the stock moves up too far. \nOnce the stop goes off, he has aposition that will make some profit as long as the \nstock does not experience afairly substantial price reversal. \nDownside protective action using asell stop order works in asimilar manner. \nExample: The investor placed a \"good until canceled\" sell stop for 100 shares of \nstock after establishing the original position. If this sell stop were placed at 41, for \nexample, the position would become anaked call writer'sposition if the stock fell to \n41. At that time, the 100 shares of stock that he owned would be sold, at an 8-point \nloss, but he would have the capability of making 12 points from the sale of his two \ncalls as long as the stock remained below 50 until expiration. In fact, his break-even \npoint after converting into the naked write would actually be 52 at expiration, since \nat that price, the calls could be bought back for 2 points each, or 8 points total prof\nit, to offset the 8-point loss on the stock. This action limits his profit potential, but \nwill allow him to make some profit as long as the stock does not experience astrong \nprice reversal and climb back above 52 by expiration. \nThere are several advantages for inexperienced ratio writers to using this \nmethod of protection. First, the implementation of the protective strategies - buying \nan extra 100 shares of stock if the stock moves up, or selling out the 100 shares that \nare long if the stock moves down - is unemotional if the stop orders are placed at the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:190", "doc_id": "ddaefe0fd5071afd74b4c476d8a211baff73eb4060ae7752124a960b1938ea52", "chunk_index": 0}
{"text": "166 Part II: Call Option Strategies \noption investment, the writer who operates in large size will experience less of acommission charge, percentagewise. That is, the writer who is buying 500 shares \nof stock and selling 10 calls to start with will be able to place his stop points far\nther out than the writer who is buying 100 shares of stock and selling 2 calls. \nTechnical analysis can be helpful in selecting the stop points as well. If there is \nresistance overhead, the buy stop should be placed above that resistance. Similarly, if \nthere is support, the sell stop should be placed beneath the support point. Later, \nwhen straddles are discussed, it will be seen that this type of strategy can be operat\ned at less of anet commission charge, since the purchase and sale of stock will not be \ninvolved. \nCLOSING OUT THE WRITE \nThe methods of follow-up action discussed above deal ,vith the eventuality of pre\nventing losses. However, if all goes well, the ratio write will begin to accrue profits as \nthe stock remains relatively close to the original striking price. To retain these paper \nprofits that have accrued, it is necessary to move the protective action points closer \ntogether. \nExample: XYZ is at 51 after some time has passed, and the calls are at 3 points each. \nThe writer would, at this time, have an unrealized profit of $800 - $200 from the \nstock purchase at 49, and $300 each on the two calls, which were originally sold at 6 \npoints each. Recall that the maximum potential profit from the position, ifXYZ were \nexactly at 50 at expiration, is $1,300. The writer would like to adjust the protective \npoints so that nearly all of the $800 paper profit might be retained while still allow\ning for the profit to grow to the $1,300 maximum. \nAt expiration, $800 profit would be realized ifXYZ were at 45 or at 55. This can \nbe verified by referring again to Table 6-1 and Figure 6-1. The 45 to 55 range is now \nthe area that the writer must be concerned with. The original profit range of 39 to 61 \nhas become meaningless, since the position has performed well to this point in time. \nIf the writer is using the rolling method of protection, he would roll forward to the \nnext expiration series if the stock were to reach 45 or 55. If he is using the stop-out \nmethod of protection, he could either close the position at 45 or 55 or he could roll \nto the next expiration series and readjust his stop points. The neutral strategist using \ndeltas would determine the number of calls to roll forward to by using the delta of \nthe longer-term call. \nBy moving the protective action points closer together, the ratio writer can then \nadjust his position while he still has aprofit; he is attempting to \"lock in\" his profit. \nAs even more time passes and expiration draws nearer, it may be possible to move", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:192", "doc_id": "07c8058425042c19a7b71679d33654599caa3c077a11fdaaa325ca83c6de69a7", "chunk_index": 0}
{"text": "Chapter 6: Ratio Call Writing 167 \nthe protective points even closer together. Thus, as the position continues to improve \nover time, the writer should be constantly \"telescoping\" his action points and finally \nroll out to the next expiration series. This is generally the more prudent move, \nbecause the commissions to sell stock to close the position and then buy another \nstock to establish yet another position may prove to be prohibitive. In summary, then, \nas aratio write nears expiration, the writer should be concerned with an ever-nar\nrowing range within which his profits can grow but outside of which his profits could \ndissipate if he does not take action. \nCOMMENTS ON DELTA-NEUTRAL TRADING \nSince the concept of delta-neutral positions was introduced in this chapter, this is \nan appropriate time to discuss them in ageneral way. Essentially, adelta-neutral \nposition is ahedged position in which at least two securities are used - two or more \ndifferent options, or at least one option plus the underlying. The deltas of the two \nsecurities offset each other so that the position starts out with an \"equivalent stock \nposition\" (ESP) of 0. Another term for ESP is \"position delta.\" Thus, in theory, \nthere is no price risk to begin with; the position is neutral with respect to price \nmovement of the underlying. That definition lasts for about ananosecond. \nAs soon as time passes, or the stock moves, or implied volatility changes, the \ndeltas change and therefore the position is no longer delta-neutral. Many people \nseem to have the feeling that adelta-neutral position is somehow one in which it is \neasy to make money without predicting the price direction of the underlying. That is \nnot true. \nDelta-neutral trading is not \"easy\": Either (1) one assumes some price risk as \nsoon as the stock begins to move, or (2) one keeps constantly adjusting his deltas to \nkeep them neutral. Method 2 is not feasible for public traders because of commis\nsions. It is even difficult for market-makers, who pay no commissions. Most public \npractitioners of delta-neutral trading establish aneutral position, but then refrain \nfrom adjusting it too often. \nAcommon mistake that novice traders make with delta-neutral trading is to \nshort options in aneutral manner, figuring that they have little exposure to price \nchange because the position is delta-neutral. However, asizeable move by the under\nlying (which often happens in ashort period of time) ruins the neutrality of the posi\ntion and inevitably costs the trader alot of money. Asimple example: If one sells anaked straddle (i.e., he sells anaked put and anaked call with both having the same \nstriking price) with the stock initially just below the strike price, that'sadelta-ne~tral", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:193", "doc_id": "84a95aa1c3750c53e57f7cf1bf8ee75c614c72e6d454ec88038a4c29ad1414e2", "chunk_index": 0}
{"text": "168 Part II: Call Option Strategies \nposition. However, the position has naked options on both sides, and therefore has \ntremendous liability. \nIn practice, professionals watch more than just the delta; they also watch other \nmeasures of the risk of aposition. Even then, price and volatility changes can cause \nproblems. Advanced risk concepts are addressed more fully in the chapter on \nAdvanced Concepts. \nSUMMARY \nRatio writing is aviable, neutral strategy that can be employed with differing levels \nof sophistication. The initial ratio of short calls to long stock can be selected simplis\ntically by comparing one'sopinion for the underlying stock with projected break-even \npoints from the position. In amore sophisticated manner, the delta of the written \ncalls can be used to determine the ratio. \nSince the strategy has potentially large losses either to the upside or the down\nside, follow-up action is mandatory. This action can be taken by simple methods such \nas rolling up or down in aconstant ratio, or by placing stop orders on the underlying \nstock. Amore sophisticated technique involves using the delta of the option to either \nadjust the stock position or roll to another call. By using the delta, atheoretically neu\ntral position can be maintained at all times. \nRatio writing is arelatively sophisticated strategy that involves selling naked \ncalls. It is therefore not suitable for all investors. Its attractiveness lies in the fact that \nvast quantities of time value premium are sold and the strategy is profitable for the \nmost probable price outcomes of the underlying stock. It has arelatively large prob\nability of making alimited profit, if the position can be held until expiration without \nfrequent adjustment. \nAN INTRODUCTION TO CALL SPREAD STRATEGIES \nAspread is atransaction in which one simultaneously buys one option and sells \nanother option, with different terms, on the same underlying security. In acall \nspread, the options are all calls. The basic idea behind spreading is that the strategist \nis using the sale of one call to reduce the risk of buying another call. The short call in \naspread is considered covered, for margin purposes, only if the long call has an expi\nration date equal to or longer than the short call. Before delving into the individual \ntypes of spreads, it may be beneficial to cover some general facts that pertain to most \nspread situations.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:194", "doc_id": "9ea22739d591507c49a2eee20f4e2778d8b93c55abfb99c04694109ec3d93738", "chunk_index": 0}
{"text": "Chapter 6: Ratio Call Writing 169 \nAll spreads fall into three broad categories: vertical, horizontal, or diagonal. Avertical spread is one in which the calls involved have the same expiration date but \ndifferent striking prices. An example might be to buy the XYZ October 30 and sell \nthe October 35 simultaneously. Ahorizontal spread is one in which the calls have the \nsame striking price but different expiration dates. This is ahorizontal spread: Sell the \nXYZ January 35 and buy the XYZ April 35. Adiagonal spread is any combination of \nvertical and horizontal and may involve calls that have different expiration dates as \nwell as different striking prices. These three names that classify the spreads can be \nrelated to the way option prices are listed in any newspaper summary of closing \noption prices. Avertical spread involves two options from the same column in anews\npaper listing. Newspaper columns run vertically. Ahorizontal spread involves two \ncalls whose prices are listed in the same row in anewspaper listing; rows are hori\nzontal. This relationship to the listing format in newspapers is not important, but it is \nan easy way to remember what vertical spreads and horizontal spreads are. There are \nmany types of vertical and horizontal spreads, and several of them are discussed in \ndetail in later chapters. \nSPREAD ORDER \nThe term \"spread\" designates not only atype of strategy, but atype of order as well. \nAll spread transactions in which both sides of the spread are opening (initial) trans\nactions must be done in amargin account. This means that the customer must gen\nerally maintain aminimum equity in the account, normally $2,000. Some brokerage \nhouses may also have amaintenance requirement, or \"kicker.\" \nIt is possible to transact aspread in acash account, but one of the sides must be \naclosing transaction. In fact, many of the follow-up actions taken in the covered writ\ning strategy are actually spread transactions. Suppose acovered writer is currently \nshort one XYZ April call against 100 shares of the underlying stock. If he wants to roll \nforward to the July 35 call, he will be buying back the April 35 and selling the July 35 \nsimultaneously. This is aspread transaction, technically, since one call is being bought \nand the other is being sold. However, in this transaction, the buy side is aclosing \ntransaction and the sell side is an opening transaction. This type of spread could be \ndone in acash account. Whenever acovered writer is rolling - up, down, or fmward \nhe should place the order as aspread order to facilitate abetter price execution. \nThe spreads discussed in the following chapters are predominantly spread \nstrategies, ones in which both sides of the spread are opening transactions. These are \ndesigned to have their own profit and risk potentials, and are not merely follow-up \nactions to some previously discussed strategy.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:195", "doc_id": "6c9ee87e470c3a132ffd0d145eb67522bb679a795c1b72d6399b3251216a6a82", "chunk_index": 0}
{"text": "170 Part II: Call Option Strategies \nWhen aspread order is entered, the options being bought and sold must be \nspecified. Two other items must be specified as well: the price at which the spread is \nto be executed, and whether that price is acredit or adebit. If the total price of the \nspread results in acash inflow to the spread strategist, the spread is acredit spread. \nThis merely means that the sell side of the spread brings in ahigher price than is paid \nfor the buy side of the spread. If the reverse is true - that is, there is acash outflow \nfrom the spread transaction - the spread is said to be adebit spread. This means that \nthe buy side of the spread costs more than is received from the sell side. It is also \ncommon to refer to the purchased side of the spread as the long side and to refer to \nthe written side of the spread as the short side. \nThe price at which acertain spread can be executed is generally not the differ\nence between the last sale prices of the two options involved in the spread. \nExample: An investor wants to buy an XYZ October 30 and simultaneously sell an \nXYZ October 35 call. If the last sale price of the October 30 was 4 points and the last \nsale price of the October 35 was 2 points, it does not necessarily mean that the spread \ncould be done for a 2-point debit (the difference in the last sale prices). In fact, the \nonly way to detennine the market price for aspread transaction is to know what the \nbid and asked prices of the options involved are. Suppose the following quotes are \navailable on these two calls: \nOctober 30 call \nOctober 35 call \nBid \n37/s \nF/s \nAsked \n41/s \n2 \nLost Sole \n4 \n2 \nSince the spread in question involves buying the October 30 call and selling the \nOctober 35, the spreader will, at market, have to pay 41/sfor the October 30 ( the asked \nor offering quote) and will receive only F/s (the bid quote) for the October 35. This \nresults in adebit of 2¼ points, significantly more than the 2-point difference in the \nlast sale prices. Of course, one is free to specify any price he wants for any type of \ntransaction. One might enter this spread order at a 21/s-point debit and could have areasonable chance of having the order filled if the floor broker can do better than the \nbid side on the October 35 or better than the offering side on the October 30. \nThe point to be learned here is that one cannot assume that last sale prices are \nindicative of the price at which aspread transaction can be executed. This makes \ncomputer analysis of spread transactions via closing price data somewhat difficult. \nSome computer data services offer (generally at ahigher cost) closing bid and asked \nprices as well as closing sale prices. If astrategist is forced to operate with closing", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:196", "doc_id": "b190abcc3a9c4763096ac729eff6f446603e751b3bc6fd276b9473d0dfe9849a", "chunk_index": 0}
{"text": "O,apter 6: Ratio Call Writing 171 \nprices only, however, he should attempt to build some screens into his output to allow \nfor the fact that last sale prices might not be indicative of the price at which the \nspread can be executed. One simple method for screening is to look only at relative\nly liquid options - that is, those that have traded asubstantial number of contracts \nduring the previous trading day. If an option is experiencing agreat deal of trading \nactivity, there is amuch better chance that the current quote is \"tight,\" meaning that \nthe bid and offering prices are quite close to the last sale price. \nIn the early days of listed options, it was somewhat common practice to \"leg\" \ninto aspread. That is, the strategist would place separate buy and sell orders for the \ntwo transactions comprising his spread. As the listed markets have developed, adding \ndepth and liquidity, it is generally apoor idea to leg into aspread. If the floor broker \nhandling the transaction knows the entire transaction, he has amuch better chance \nof \"splitting aquote,\" buying on the bid, or selling on the offering. Splitting aquote \nmerely means executing at aprice that is between the current bid and asked prices. \nFor example, if the bid is 37/sand the offering is 41/s, atransaction at aprice of 4 \nwould be \"splitting the quote.\" \nThe public customer must be aware that spread transactions may involve sub\nstantially higher commission costs, because there are twice as many calls involved in \nany one transaction. Some brokers offer slightly lower rates for spread transactions, \nbut these are not nearly as low as spreads in commodity trading, for example.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:197", "doc_id": "3d54b1072d35dfb5da9f2648f3bd6eac265335d548634005b49aec7f05bd21e3", "chunk_index": 0}
{"text": "CHAPTER 7 \nBull Spreads \nThe bull spread is one of the most popular forms of spreading. In this type of spread, \none buys acall at acertain striking price and sells acall at ahigher striking price. \nGenerally, both options have the same expiration date. This is avertical spread. Abull \nspread tends to be profitable if the underlying stock rrwves up in price; hence, it is abullish position. The spread has both limited profit potential and limited risk. \nAlthough both can be substantial percentagewise, the risk can never exceed the net \ninvestment. In fact, abull spread requires asmaller dollar investment and therefore \nhas asmaller maximum dollar loss potential than does an outright call purchase of asimilar call. \nExample: The following prices exist: \nXYZ common, 32; \nXYZ October 30 call, 3; and \nXYZ October 35 call, 1. \nAbull spread would be established by buying the October 30 call and simultaneous\nly selling the October 35 call. Assume that this could be done at the indicated 2-point \ndebit. Acall bull spread is always adebit transaction, since the call with the lower \nstriking price must always trade for more than acall with ahigher price, if both have \nthe same expiration date. Table 7-1 and Figure 7-1 depict the results of this transac\ntion at expiration. The indicated call profits or losses would be realized if the calls \nwere liquidated at parity at expiration. Note that the spread has amaximum profit \nand this profit is realized if the stock is anywhere above the higher striking price at \nexpiration. The maxipmm loss is realized if the stock is anywhere below the lower \nstrike at expiration, and is equal to the net investment, 2 points in this example. \n172", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:198", "doc_id": "d7b3340f082dd2371a418011c2100e5b7858f88981c6764a638c8a3436823e4f", "chunk_index": 0}
{"text": "Chapter 7: Bull Spreads 173 \nMoreover, there is abreak-even point that always lies between the two striking prices \nat expiration. In this example, the break-even point is 32. All bull spreads have prof\nit graphs with the same shape as the one shown in Figure 7-1 when the expiration \ndates are the same for both calls. \nThe investor who establishes this position is bullish on the underlying stock, but \nis generally looking for away to hedge himself. If he were rampantly bullish, he \nTABLE 7-1. \nResults at expiration of bull spread. \nXYZ Price of \nExpiration \n25 \n30 \n32 \n35 \n40 \n45 \nFIGURE 7-1. \nBull spread. \nc: +$300 \n.Q \n~ \n-~ \nw \nOctober 30 \nProfit \n-$ 300 \n- 300 \n100 \n+ 200 \n+ 700 \n+ 1,200 \nOctober 35 \nProfit \n+$100 \n+ 100 \n+ 100 \n+ 100 \n- 400 \n- 900 \n,, \n,,,' \n;ff \n,,,' \n,,' \niii \n~ \n,,,,' \n$01---------'----J...__.... _ ___. _____ _ \n30 3:?,,' 35 \n0 ::: -$200 \ne 0..-$300 \n, , \n..------,,,,,' \nCall Purchase \n•-----------,' \nStock Price at Expiration \nTotal \nProfit \n-$200 \n- 200 \n0 \n+ 300 \n+ 300 \n+ 300", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:199", "doc_id": "f0c205fcfdf80003215cb0ce2f4a2ddb833bbdf7a09d232b4b86fad548d316ec", "chunk_index": 0}
{"text": "174 Part II: Call Option Strategies \nwould merely buy the October 30 call outright. However, the sale of the October 35 \ncall against the purchase of the October 30 allows him to take aposition that will out\nperform the outright purchase of the October 30, dollarwise, as long as the stock does \nnot rise above 36 by expiration. This fact is demonstrated by the dashed line in Figure \n7-1. \nTherefore, the strategist establishing the bull spread is bullish, but not overly so. \nTo verify that this comparison is correct, note that if one bought the October 30 call \noutright for 3 points, he would have a 3-point profit at expiration if XYZ were at 36. \nBoth strategies have a 3-point profit at 36 at expiration. Below 36, the bull spread \ndoes better because the sale of the October 35 call brings in the extra point of pre\nmium. Above 36 at expiration, the outright purchase outperforms the bull spread, \nbecause there is no limit on the profits that can occur in an outright purchase situa\ntion. \nThe net investment required for abull spread is the net debit plus commissions. \nSince. the spread must be transacted in amargin account, there will generally be aminimum equity requirement imposed by the brokerage firm. In addition, there may \nbe amaintenance requirement by some brokers. Suppose that one was establishing \n10 spreads at the prices given in the example above. His investment, before com\nmissions, would be $2,000 ($200 per spread), plus commissions. It is asimple matter \nto compute the break-even point and the maximum profit potential of acall bull \nspread: \nBreak-even point= Lower striking price+ Net debit of spread \nMaximum profit _ Higher striking _ Lower striking _ Net debit \npotential - price price of spread \nIn the example above, the net debit was 2 points. Therefore, the break-even \npoint would be 30 + 2, or 32. The maximum profit potential would be 35 - 30 - 2, or \n3 points. These figures agree with Table 7-1 and Figure 7-1. Commissions may rep\nresent asignificant percentage of the profit and net investment, and should therefore \nbe calculated before establishing the position. If these commissions are included in \nthe net debit to establish the spread, they conveniently fit into the preceding formu\nlae. Commission charges can be reduced percentagewise by spreading alarger quan\ntity of calls. For this reason, it is generally advisable to spread at least 5 options at atime.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:200", "doc_id": "5dbbefd8925883c43656acd1de1d2e32f0d44ff0382ad590d0caaa8832347fc9", "chunk_index": 0}
{"text": "Chapter 7: Bull Spreads 175 \nDEGREES OF AGGRESSIVENESS \nAGGRESSIVE BULL SPREAD \nDepending on how the bull spread is constructed, it may be an extremely aggressive \nor more conservative position. The most commonly used bull spread is of the aggres\nsive type; the stock is generally well below the higher striking price when the spread \nis established. This aggressive bull spread generally has the ability to generate sub\nstantial percentage returns if the underlying stock should rise in price far enough by \nexpiration. Aggressive bull spreads are most attractive when the underlying common \nstock is relatively close to the lower striking price at the time the spread is established. \nAbull spread established under these conditions will generally be alow-cost spread \nwith substantial profit potential, even after commissions are included. \nEXTREMELY AGGRESSIVE BULL SPREAD \nAn extremely aggressive type of bull spread is the \"out-of-the-money\" spread. In such \naspread, both calls are out-of-the-money when the spread is established. These \nspreads are extremely inexpensive to establish and have large potential profits if the \nstock should climb to the higher striking price by expiration. However, they are usu\nally quite deceptive in nature. The underlying stock has only arelatively remote \nchance of advancing such agreat deal by expiration, and the spreader could realize a \n100% loss of his investment even if the underlying stock advances moderately, since \nboth calls are out-of-the-money. This spread is akin to buying adeeply out-of-the\nmoney call as an outright speculation. It is not recommended that such astrategy be \npursued with more than avery small percentage of one'sspeculative funds. \nLEAST AGGRESSIVE BULL SPREAD \nAnother type of bull spread can be found occasionally - the \"in-the-money\" spread. \nIn this situation, both calls are in-the-money. This is amuch less aggressive position, \nsince it offers alarge probability of realizing the maximum profit potential, although \nthat profit potential will be substantially smaller than the profit potentials offered by \nthe more aggressive bull spreads. \nExample: XYZ is at 37 some time before expiration, and the October 30 call is at 7 \nwhile the October 35 call is at 4. Both calls are in-the-money and the spread would \ncost 3 points (debit) to establish. The maximum profit potential is 2 points, but it \nwould be realized as long as XYZ were above 35 at expiration. That is, XYZ could fall \nby 2 points and the spreader would still make his maximum profit. This is certainly amore conservative position than the aggressive spread described above. The com-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:201", "doc_id": "4568589eea5ae9b408d10ebc803665bd2879735a747282834e690a1aefea1d4f", "chunk_index": 0}
{"text": "176 Part II: Call Option Strategies \nmission costs in this spread would be substantially larger than those in the spreads \nabove, which involve less expensive options initially, and they should therefore be fig\nured into one'sprofit calculations before entering into the spread transaction. Since \nthis stock would have to decline 7 points to fall below 30 and cause aloss of the entire \ninvestment, it would have to be considered arather low-probability event. This fact \nadds to the less aggressive nature of this type of spread. \nRANKING BULL SPREADS \nTo accurately compare the risk and reward potentials of the many bull spreads that \nare available in agiven day, one has to use acomputer to perform the mass calcula\ntions. It is possible to use astrictly arithmetic method of ranking bull spreads, but \nsuch alist will not be as accurate as the correct method of analysis. In reality, it is \nnecessary to incorporate the volatility of the underlying stock, and possibly the \nexpected return from the spread as well, into one'scalculations. The concept of \nexpected return is described in detail in Chapter 28, where abull spread is used as \nan example. \nThe exact method for using volatility and predicting an option'sprice after an \nupward movement are presented later. Many data services offer such information. \nHowever, if the reader wants to attempt asimpler method of analysis, the following \none may suffice. In any ranking of bull spreads, it is important not to rank the spreads \nby their maximum potential profits at expiration. Such aranking will always give the \nmost weight to deeply out-of-the-money spreads, which can rarely achieve their max\nimum profit potential. It would be better to screen out any spreads whose maximum \nprofit prices are too far away from the current stock price. Asimple method of allow\ning for astock'smovement might be to assume that the stock could, at expiration, \nadvance by an amount equal to twice the time value premium in an at-the-money \ncall. Since more volatile stocks have options with greater time value premium, this is \nasimple attempt to incorporate volatility into the analysis. Also, since longer-term \noptions have more time value premium than do short-term options, this will allow for \nlarger movements during alonger time period. Percentage returns should include \ncommission costs. This simple analysis is not completely correct, but it may prove \nuseful to those traders looking for asimple arithmetic method of analysis that can be \ncomputed quickly. \nFURTHER CONSIDERATIONS \nThe bull spreads described in previous examples utilize the same expiration date for \nboth the short call and the long call. It is sometimes useful to buy acall with alonger", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:202", "doc_id": "29617fbad9eff97bdc0d1994a7edb6a7bce2f71882ed1806071c2dfdd49f42c0", "chunk_index": 0}
{"text": "Chapter 7: Bull Spreads 177 \ntime to maturity than the short call has. Such aposition is known as adiagonal bull \nspread and is discussed in alater chapter. \nExperienced traders often tum to bull spreads when options are expensive. The \nsale of the option at the higher strike partially mitigates the cost of buying an expen\nsive option at the lower strike. However, one should not always use the bull spread \napproach just because the options have alot of time value premium, for he would be \ngiving up alot of upside profit potential in order to have ahedged position. \nWith most types of spreads, it is necessary for some time to pass for the spread \nto become significantly profitable, even if the underlying stock moves in favor of the \nspreader. For this reason, bull spreads are not for traders unless the options involved \nare very short-term in nature. If aspeculator is bullishly oriented for ashort-term \nupward move in an underlying stock, it is generally better for him to buy acall out\nright than to establish abull spread. Since the spread differential changes mainly as \nafunction of time, small movements in price by the underlying stock will not cause \nmuch of ashort-term change in the price of the spread. However, the bull spread has \nadistinct advantage over the purchase of acall if the underlying stock advances mod\nerately by expiration. \nIn the previous example, abull spread was established by buying the XYZ \nOctober 30 call for 3 points and simultaneously selling the October 35 call for 1 point. \nThis spread can be compared to the outright purchase of the XYZ October 30 alone. \nThere is ashort-term advantage in using the outright purchase. \nExample: The underlying stock jumps from 32 to 35 in one day'stime. The October \n30 would be selling for approximately 5½ points if that happened, and the outright \npurchaser would be ahead by 2½ points, less one option commission. The long side \nof the bull spread would do as well, of course, since it utilizes the same option, but \nthe short side, the October 35, would probably be selling for about 2½ points. Thus, \nthe bull spread would be worth 3 points in total (5½ points on the long side, less 2½ \npoints loss on the short side). This represents a 1-point profit to the spreader, less two \noption commissions, since the spread was initially established at adebit of 2 points. \nClearly, then, for the shortest time period one day - the outright purchase outper\nforms the bull spread on aquick rise. \nFor aslightly longer time period, such as 30 days, the outright purchase still has \nthe advantage if the underlying stock moves up quickly. Even if the stock should \nadvance above 35 in 30 days, the bull spread will still have time premium in it and \nthus will not yet have reached its maximum spread potential of 5 points. Recall that \nthe maximum potential of abull spread is always equal to the difference between the \nstriking prices. Clearly, the outright purchaser will do very well if the underlying \nstock should advance that far in 30 days' time. When risk is considered, however, it", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:203", "doc_id": "d952740b6181c459162976b078af34a916c93dcc602c7bbaabb420af074bd2a4", "chunk_index": 0}
{"text": "178 Part II: Call Option Strategies \nmust be pointed out that the bull spread has fewer dollars at risk and, if the under\nlying stock should drop rather than rise, the bull spread will often have asmaller loss \nthan the outright call purchase would. \nThe longer it takes for the underlying stock to advance, the more the advantage \nswings to the spread. Suppose XYZ does not get to 35 until expiration. In this case, \nthe October 30 call would be worth 5 points and the October 35 call would be worth\nless. The outright purchase of the October 30 call would make a 2-point profit less \none commission, but the spread would now have a 3-point profit, less two commis\nsions. Even with the increased commissions, the spreader will make more of aprof\nit, both dollarwise and percentagewise. \nMany traders are disappointed with the low profits available from abull spread \nwhen the stock rises almost immediately after the position is established. One way to \npartially off set the problem with the spread not widening out right away is to use agreater distance between the two strikes. When the distance is great, the spread has \nroom to widen out, even though it won'treach its maximum profit potential right \naway. Still, since the strikes are \"far apart,\" there is more room for the spread to \nwiden even if the underlying stock rises immediately. \nThe conclusion that can be drawn from these examples is that, in general, the \noutright purchase is abetter strategy if one is looking for aquick rise by the under\nlying stock. Overall, the bull spread is aless aggressive strategy than the outright pur\nchase of acall. The spread will not produce as much of aprofit on ashort-term move, \nor on asustained, large upward move. It will, however, outperform the outright pur\nchase of acall if the stock advances slowly and moderately by expiration. Also, the \nspread always involves fewer actual dollars of risk, because it requires asmaller debit \nto establish initially. Table 7-2 summarizes which strategy has the upper hand for var\nious stock movements over differing time periods. \nTABLE 7-2. \nBull spread and outright purchase compared. \nIf the underlying stock ... \nRemains \nRelatively Advonces Advances \nDeclines Unchanged Moderately Substantially \nin ... \n1 week Bull spread Bull spread Outright purchase Outright purchase \n1 month Bull spread Bull spread Outright purchase Outright purchase \nAt expiration Bull spread Bull spread Bull spread Outright purchase", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:204", "doc_id": "02a6e4137082e83519079a2599078ce62ff345c0cd1b424937774e41c50266fd", "chunk_index": 0}
{"text": "Chapter 7: Bull Spreads \nFOLLOW-UP ACTION \n179 \nSince the strategy has both limited profit and limited risk, it is not mandatory for the \nspreader to take any follow-up action prior to expiration. If the underlying stock \nadvances substantially, the spreader should watch the time value premium in the \nshort call closely in order to close the spread if it appears that there is apossibility of \nassignment. This possibility would increase substantially if the time value premium \ndisappeared from the short call. If the stock falls, the trader may want to close the \nspread in order to limit his losses even further. \nWhen the spread is closed, the order should also be entered as aspread trans\naction. If the underlying stock has moved up in price, the order to liquidate would \nbe acredit spread involving two closing transactions. The maximum credit that can \nbe recovered from abull spread is an amount equal to the difference between the \nstriking prices. In the previous example, if XYZ were above 35 at expiration, one \nmight enter an order to liquidate the spread as follows: Buy the October 35 (it is \ncommon practice to specify the buy side of aspread first when placing an order); \nsell the October 30 at a 5-point credit. In reality, because of the difference between \nbids and offers, it is quite difficult to obtain the entire 5-point credit even if expira\ntion is quite near. Generally, one might ask for a 4¼ or 47/scredit. It is possible to \nclose the spread via exercise, although this method is normally advisable only for \ntraders who pay little or no commissions. If the short side of aspread is assigned, \nthe spreader may satisfy the assignment notice by exercising the long side of his \nspread. There is no margin required to do so, but there are stock commissions \ninvolved. Since these stock commissions to apublic customer would be substantial\nly larger than the option commissions involved in closing the spread by liquidating \nthe options, it is recommended that the public customer attempt to liquidate rather \nthan exercise. \nAminor point should be made here. Since the amount of commissions paid to \nliquidate the spread would be larger if higher call prices are involved, the actual net \nmaximum profit point for abull spread is for the stock to be exactly at the higher \nstriking price at expiration. If the stock exceeds the higher striking price by agreat \ndeal, the gross profit will be the same (it was demonstrated earlier that this gross \nprofit is the same anywhere above the higher strike at expiration), but the net profit \nwill be slightly smaller, since the investor will pay more in commissions to liquidate \nthe spread. \nSome spreaders prefer to buy back the short call if the underlying stock drops \nin price, in order to lock in the profit on the short side. They will then hold the long \ncall in hopes of arise in price by the underlying stock, in order to make the long side \nof the spread profitable as well. This amounts to \"legging\" out of the spread, although", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:205", "doc_id": "de753aea40af95e5d206a8f6fef34f58b404703ba01168afadf002452e95e739", "chunk_index": 0}
{"text": "180 Part II: Call Option Strategies \nthe overall increase in risk is small - the amount paid to repurchase the short call. If \nhe attempts to \"leg\" out of the spread in such amanner, the spreader should not \nattempt to buy back the short call at too high aprice. If it can be repurchased at 1/sor 1/16, the spreader will be giving away virtually nothing by buying back the short call. \nHowever, he should not be quick to repurchase it if it still has much more value than \nthat, unless he is closing out the entire spread. At no time should one attempt to \"leg\" \nout after astock price increase, taking the profit on the long side and hoping for astock price decline to make the short side profitable as well. The risk is too great. \nMany traders find themselves in the somewhat perplexing situation of having \nseen the underlying make alarge, quick move, only to find that their spread has not \nwidened out much. They often try to figure out away to perhaps lock in some gains \nin case the underlying subsequently drops in price, but they want to be able to wait \naround for the spread to widen out more toward its maximum profit potential. There \nreally isn'tany hedge that can accomplish all of these things. The only position that \ncan lock in the profits in acall bull spread is to purchase the accompanying put bear \nspread. This strategy is discussed in Chapter 23, Spreads Combining Calls and Puts. \nOTHER USES OF BULL SPREADS \nSuperficially, the bull spread is one of the simplest forms of spreading. However, it \ncan be an extremely useful tool in awide variety of situations. Two such situations \nwere described in Chapter 3. If the outright purchaser of acall finds himself with an \nunrealized loss, he may be able to substantially improve his chances of getting out \neven by \"rolling down\" into abull spread. If, however, he has an unrealized profit, he \nmay be able to sell acall at the next higher strike, creating abull spread, in an attempt \nto lock in some of his profit. \nIn asomewhat similar manner, acommon stockholder who is faced with an \nunrealized loss may be able to utilize abull spread to lower the price at which he \ncan break even. He may often have asignificantly better chance of breaking even or \nmaking aprofit by using options. The following example illustrates the stockholder'sstrategy. \nExample: An investor buys 100 shares of XYZ at 48, and later finds himself with an \nunrealized loss with the stock at 42. A 6-point rally in the stock would be necessary \nin order to break even. However, if XYZ has listed options trading, he may be able to \nsignificantly reduce his break-even price. The prices are:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:206", "doc_id": "65385a00491a8410310b9effca7be0aa74fd3119c10a7e14dedfbbbc5109eded", "chunk_index": 0}
{"text": "Chapter 7: Bull Spreads \nXYZ common, 42; \nXYZ October 40, 4; and \nXYZ October 45, 2. \n181 \nThe stock owner could enhance his overall position by buying one October 40 call \nand selling two October 45 calls. Note that no extra money, except commissions, is \nrequired for this transaction, because the credit received from selling two October \n45'sis $400 and is equal to the cost of buying the October 40 call. However, mainte\nnance and equity requirements still apply, because aspread has been established. \nThe resulting position does not have an uncovered, or naked, option in it. One \nof the October 45 calls that was sold is covered by the underlying stock itself. The \nother is part of abull spread with the October 40 call. It is not particularly important \nthat the resulting position is acombination of both abull spread and acovered write. \nWhat is important is the profit characteristic of this new total position. \nIf XYZ should continue to decline in price and be below 40 at October expira\ntion, all the calls will expire worthless, and the resulting loss to the stock owner will \nbe the same (except for the option commissions spent) as if he had merely held onto \nhis stock without having done any option trading. \nSince both acovered write and abull spread are strategies with limited profit \npotential, this new position obviously must have alimited profit. If XYZ is anywhere \nabove 45 at October expiration, the maximum profit will be realized. To determine \nthe size of the maximum profit, assume that XYZ is at exactly 45 at expiration. In that \ncase, the two short October 45'swould expire worthless and the long October 40 call \nwould be worth 5 points. The option trades would have resulted in a $400 profit on \nthe short side ($200 from each October 45 call) plus a $100 profit on the long side, \nfor atotal profit of $500 from the option trades. Since the stock was originally bought \nat 48 in this example, the stock portion of the position is a $300 loss with XYZ at 45 \nat expiration. The overall profit of the position is thus $500 less $300, or $200. \nFor stock prices between 40 and 45 at expiration, the results are shown in \nTable 7-3 and Figure 7-2. Figure 7-2 depicts the two columns from the table labeled \n\"Profit on Stock\" and \"Total Profit,\" so that one can visualize how the new total posi\ntion compares with the original stockholder'sprofit. Several points should be noted \nfrom either the graph or the table. First, the break-even point is lowered from 48 to \n44. The new total position breaks even at 44, so that only a 2-point rally by the stock \nby expiration is necessary in order to break even. The two strategies are equal at 50 \nat expiration. That is, the stock would have to rally more than 8 points, from 42 to \n50, by expiration for the original stockholder'sposition to outperform the new posi-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:207", "doc_id": "6104ef7aa34a2a456bafaa704eb936495a09da0524821ed201f0261d70a48a53", "chunk_index": 0}
{"text": "182 Part II: Call Option Strategies \nTABLE 7-3. \nLowering the break-even price on common stock. \nXYZ Price at Profit on Profit on Short Profit on long Total \nExpiration Stock October 45's October 40 Profit \n35 -$1,300 +$400 -$400 -$1,300 \n38 - 1,000 + 400 - 400 - 1,000 \n40 800 + 400 - 400 800 \n42 600 + 400 - 200 400 \n43 500 + 400 - 100 200 \n44 400 + 400 0 0 \n45 300 + 400 + 100 + 200 \n48 0 - 200 + 400 + 200 \n50 + 200 - 600 + 600 + 200 \ntion. Below 40, the two strategies produce the same result. Finally, between 40 and \n50, the new position outperforms the original stockholder'sposition. \nIn summary, then, the stockholder stands to gain much and gives away very lit\ntle by adding the indicated options to his stock position. If the stock stabilizes at all -\nanywhere between 40 and 50 in the example above - the new position would be an \nimprovement. Moreover, the investor can break even or make profits on asmall rally. \nIf the stock continues to drop heavily, nothing additional will be lost except for option \ncommissions. Only if the stock rallies very sharply will the stock position outperform \nthe total position. \nThis strategy- combining acovered write and abull spread - is sometimes used \nas an initial ( opening) trade as well. That is, an investor who is considering buying \nXYZ at 42 might decide to buy the October 40 and sell two October 45's (for even \nmoney) at the outset. The resulting position would not be inferior to the outright pur\nchase of XYZ stock, in terms of profit potential, unless XYZ rose above 46 by October \nexpiration. \nBull spreads may also be used as a \"substitute\" for covered writing. Recall from \nChapter 2 that writing against warrants can be useful because of the smaller invest\nment required, especially if the warrant was in-the-money and was not selling at \nmuch of apremium. The same thinking applies to call options. If there is an in-the\nmoney call with little or no time premium remaining in it, its purchase may be used \nas asubstitute for buying the stock itself Of course, the call will expire, whereas the \nstock will not; but the profit potential of owning adeeply in-the-money call can be", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:208", "doc_id": "0c786d9936abb85e6064aaf2f0ae5c145d79964accb71a6d6d9d5ada398521ea", "chunk_index": 0}
{"text": "Chapter 7: Bull Spreads \nFIGURE 7-2. \nLowering the break-even price on common stock. \nC: \n0 \nI +$200 \niii \n(/) \n$0 (/) \n.:l \n0 \ni5 \ne \nQ. \n-$800 \n40 \nProfit with Options \n, \n,,,' , , \n,,,' \n50 \nStock Price at Expiration \n183 \n;f ,, \nvery similar to owning the stock. Since such acall costs less to purchase than the stock \nitself would, the buyer is getting essentially the same profit or loss potential with asmaller investment. It is natural, then, to think that one might write another call -\none closer to the money- against the deeply in-the-money purchased call. This posi\ntion would have profit characteristics much like acovered write, since the long call \n\"simulates\" the purchase of stock This position really is, of course, abull spread, in \nwhich the purchased call is well in-the-money and the written call is closer to the \nmoney. Clearly, one would not want to put all of his money into such astrategy and \nforsake covered writing, since, with bull spreads, he could be entirely wiped out in amoderate market decline. In acovered writing strategy, one still owns the stocks even \nafter asevere market decline. However, one may achieve something of acompromise \nby investing amuch smaller amount of money in bull spreads than he might have \ninvested in covered writes. He can still retain the same profit potential. The balance \nof the investor'sfunds could then be placed in interest-bearing securities.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:209", "doc_id": "189c5e5e988a4c392a94c2b8dc5f8c0afb028122dc31e5357fe0161b4aace5f3", "chunk_index": 0}
{"text": "184 \nExample: The following prices exist: \nXYZ common, 49; \nXYZ April 50 call, 3; and \nXYZ April 35 call, 14. \nPart II: Call Option Strategies \nSince the deeply in-the-money call has no time premium, its purchase will perform \nmuch like the purchase of the stock until April expiration. Table 7-4 summarizes the \nprofit potential from the covered write or the bull spread. The profit potentials are \nthe same from acash covered write or the bull spread. Both would yield a $400 prof\nit before commissions if XYZ were above 50 at April expiration. However, since the \nbull spread requires amuch smaller investment, the spreader could put $3,500 into \ninterest-bearing securities. This interest could be considered the equivalent of \nreceiving the dividends on the stock. In any case, the spreader can lose only $1,100, \neven if the stock declines substantially. The covered writer could have alarger unre\nalized loss than that if XYZ were below 35 at expiration. Also, in the bull spread sit\nuation, the writer can \"roll down\" the April 50 call if the stock declines in price, just \nas he might do in acovered writing situation. \nTABLE 7-4. \nResults for covered write and bull spread compared. \nMaximum profit potential \n(stock over 50 in April) \nBreak-even point \nInvestment \nCovered Write: \nBuy XYZ and Sell \nApril 50 Coll \n$ 400 \n46 \n$4,600 \nBull Spread: \nBuy XYZ April 35 Call and \nSell April 50 Coll \n$ 400 \n46 \n$1,100 \nThus, the bull spread offers the same dollar rewards, the same break-even \npoint, smaller commission costs, less potential risk, and interest income from the \nfixed-income portion of the investment. While it is not always possible to find adeeply in-the-money call to use as a \"substitute\" for buying the stock, when one does \nexist, the strategist should consider using the bull spread instead of the covered write.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:210", "doc_id": "c8df897524d0089395a51f8488b6f7abc9977bc4b2dc6ab87c516cfa5e4302e6", "chunk_index": 0}
{"text": "Bear Spreads \nUsing Call Options \nOptions are versatile investment vehicles. For every type of bullish position that can \nbe established, there is normally acorresponding bearish type of strategy. For every \nneutral strategy, there is an aggressive strategy for the investor with an opposite opin\nion. One such case has already been explored in some detail; the straddle buy or \nreverse hedge strategy is the opposite side of the spectrum. For many of the strate\ngies to be described from this point on, there is acorresponding strategy designed for \nthe strategist with the opposite point of view. In this vein, abear spread is the oppo\nsite of abull spread. \nTHE BEAR SPREAD \nIn acall bear spread, one buys acall at acertain striking price and sells acall at alower striking price. This is avertical spread, as was the bull spread. The bear spread \ntends to be profitable if the underlying stock declines in price. Llke the bull spread, \nit has limited profit and loss potential. However, unlike the bull spread, the bear \nspread is acredit spread when the spread is set up with call options. Since one is sell\ning the call with the lower strike, and acall at alower strike always trades at ahigh\ner price than acall at ahigher strike with the same expiration, the bear spread must \nbe acredit position. It should be pointed out that most bearish strategies that can be \nestablished with call options may be more advantageously constructed using put \noptions. Many of these same strategies are therefore discussed again in Part III. \n186", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:212", "doc_id": "3df5b8c9c34075491021c664d0f7711349ad974a3d52235616a427ab1dea2f44", "chunk_index": 0}
{"text": "Chapter 8: Bear Spreads Using Call Options 187 \nExample: An investor is bearish on XYZ. Using the same prices that were used for \nthe examples in Chapter 7, an example of abear spread can be constructed for: \nXYZ common, 32; \nXYZ October 30 call, 3; and \nXYZ October 35 call, 1. \nAbear spread would be established by buying the October 35 call and selling the \nOctober 30 call. This would be done for a 2-point credit, before commissions. In abear spread situation, the strategist is hoping that the stock will drop in price and that \nboth options will expire worthless. If this happens, he will not have to pay anything \nto close his spread; he will profit by the entire amount of the original credit taken in. \nIn this example, then, the maximum profit potential is 2 points, since that is the \namount of the initial credit. This profit would be realized if XYZ were anywhere \nbelow 30 at expiration, because both options would expire worthless in that case. \nIf the spread expands in price, rather than contracts, the bear spreader will be \nlosing money. This expansion would occur in arising market. The maximum amount \nthat this spread could expand to is 5 points - the difference between the striking \nprices. Hence, the most that the bear spreader would have to pay to buy back this \nspread would be 5 points, resulting in amaximum potential loss of 3 points. This loss \nwould be realized if XYZ were anywhere above 35 at October expiration. Table 8-1 \nand Figure 8-1 depict the actual profit and loss potential of this example at expiration \n(commissions are not included). The astute reader will note that the figures in the \ntable are exactly the reverse of those shown for the bull spread example in Chapter \n7. Also, the profit graph of the bear spread looks like abull spread profit graph that \nhas been turned upside down. All bear spreads have aprofit graph with the same \nshape at expiration as the graph shown in Figure 8-1. \nTABLE 8-1. \nBear spread. \nXYZ Price at October 30 October 35 Total \nExpiration Profit Profit Profit \n25 +$300 -$100 +$200 \n30 + 300 - 100 + 200 \n32 + 100 - 100 0 \n35 - 200 - 100 - 300 \n40 - 700 + 400 - 300", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:213", "doc_id": "3f4afe0e548572fd8faaad3b13527d83e3234ba6efd034c90efa5fc73d7f3eb3", "chunk_index": 0}
{"text": "188 \nFIGURE 8-1. \nBear spread • \n. § +$200 \n\"it! -~ \nw \nCJ) 30 ig \n..J \n0 \n:!: \nea. -$300 \nPart II: Call Option Strategies \nStock Price at Expiration \nThe break-even point, maximum profit potential, and investment required are \nall quite simple computations for abear spread. \nMaximum profit potential== Net credit received \nBreak-even point== Lower striking price + Amount of credit \nMaximum Collateral investment = = risk required \nDifference in \nstriking prices \nCredit + Commissions received \nIn the example above, the net credit received from the sale of the October 30 \ncall at 3 and the purchase of the October 35 call at 1 was two points. This is the max\nimum profit potential. The break-even point is then easily computed as the lower \nstriking price, 30, plus the amount of the credit, 2, or 32. The risk is equal to the \ninvestment. It is the difference between the striking prices - 5 points - less the net \ncredit received - 2 points - for atotal investment of 3 points plus commissions. Since \nthis spread involves acall that is not \"covered\" by along call with astriking price \nequal to or lower than that of the short call, some brokerage firms may require ahigher maintenance requirement per spread than would be required for abull \nspread. Again, since aspread must be done in amargin account, most brokerage \nfirms require that aminimum amount of equity be in the account as well. \nSince this is acredit spread, the investor does not really \"spend\" any dollars to \nestablish the spread. The investment is really areduction in the buying power of the \ncustomer'smargin account, but it does not actually require dollars to be spent when \nthe transaction is initiated.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:214", "doc_id": "571e01f90f00e2b7ce2f577cca1261162939cdcba750b8f1680b4f7eab9aa58f", "chunk_index": 0}
{"text": "Chapter 8: Bear Spreads Using Call Options \nSELECTING A BEAR SPREAD \n189 \nDepending on where the underlying stock is trading with respect to the two striking \nprices, the bear spread may be very aggressive, with ahigh profit potential, or it may \nbe less aggressive, with alow profit potential. If alarge credit is initially taken in, \nthere is obviously the potential for agood deal of profit. However, for the spread to \ntake in alarge credit, the underlying stock must be well above the lower striking \nprice. This means that arelatively substantial downward move would be necessary in \norder for the maximum profit potential to be realized. Thus, alarge credit bear \nspread is usually an aggressive position; the spreader needs asubstantial move by the \nunderlying stock in order to make his maximum profit. The probabilities of this \noccurring cannot be considered large. \nAless aggressive type of bear spread is one in which the underlying stock is \nactually below the lower striking price when the spread is established. The credit \nreceived from establishing abear spread in such asituation would be small, but the \nspreader would realize his maximum profit even if the underlying stock remained \nunchanged or actually rose slightly in price by expiration. \nExample: XYZ is trading at aprice of 25. The October 30 call might be sold for 1 ½ \npoints and the October 35 call bought for½ point with the stock at 29. While the net \ncredit, and hence the maximum profit potential, is asmall dollar amount, 1 point, it \nwill be realized even if XYZ rises slightly by expiration, as long as it does not rise \nabove 30. \nIt is not always clear which type of spread is better, the large credit bear spread \nor the small credit bear spread. One has asmall probability of making alarge profit \nand the other has amuch larger probability of making amuch smaller profit. In gen\neral, bear spreads established when the underlying stock is closer to the lower strik\ning price will be the best ones. To see this, note that if abear spread is initiated when \nthe stock is at the higher striking price, the spreader is selling acall that has mostly \nintrinsic value and little time value premium (since it is in-the-money), and is buying \nacall that is nearly all time value. This is just the opposite of what the option strate\ngist should be attempting to do. The basic philosophy of option strategy is to sell time \nvalue and buy intrinsic value. For this reason, the large credit bear spread is not an \noptimum strategy. It will be interesting to observe later that bear spreads with puts \nare more attractive when the underlying stock is at the higher striking price! \nAbear spread will not collapse right away, even if the underlying stock drops in \nprice. This is somewhat similar to the effect that was observed with the call bull \nspreads in Chapter 7. They, too, do not accelerate to their maximum profit potential \nright away. Of course, as time winds down and expiration approaches, then the spread", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:215", "doc_id": "c84e13b0d354e28bdb9f54d6fc6e980e22f7088ea7cdfc1417c018a9ae5caa0a", "chunk_index": 0}
{"text": "190 Part II: Call Option Strategies \nwill approach its maximum profit potential. This is important to understand because, \nif one is expecting aquick move down by the underlying stock, he might need to use \nacall bear spread in which the lower strike is actually somewhat deeply in-the\nmoney, while the upper strike is out-of-the-money. In this case, the in-the-money call \nwill decline in value as the stock moves down, even if that downward move happens \nimmediately. Meanwhile, the out-of-the-money long call protects against adisastrous \nupside breakout by the stock. This type of bear spread is really akin to selling adeep \nin-the-money call for its raw downside profit potential and buying an out-of-the\nmoney call merely as disaster insurance. \nFOLLOW-UP ACTION \nFollow-up strategies are not difficult, in general, for bear spreads. The major thing \nthat the strategist must be aware of is impending assignment of the short call. If the \nshort side of the spread is in-the-money and has no time premium remaining, the \nspread should be closed regardless of how much time remains until expiration. This \ndisappearance of time value premium could be caused either by the stock being \nsignificantly above the striking price of the stock call, or by an impending dividend \npayment. In either case, the spread should be closed to avoid assignment and the \nresultant large commission costs on stock transactions. Note that the large credit \nbear spread (one established with the stock well above the lower striking price) is \ndangerous from the viewpoint of early assignment, since the time value premium \nin the call will be small to begin with. \nSUMMARY \nThe call bear spread is abearishly oriented strategy. Since the spread is acredit \nspread, requiring only areduction in buying power but no actual layout of cash to \nestablish, it is amoderately popular strategy. The bear spread using calls may not be \nthe optimum type of bearish spread that is available; abear spread using put options \nmaybe.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:216", "doc_id": "ab1ca4bf7b44769cf4a634de7a8c207fd63a7290f86d3c29d3a876cce3611747", "chunk_index": 0}
{"text": "Calendar Spreads \nAcalendar spread, also frequently called atime spread, involves the sale of one \noption and the simultaneous purchase of amore distant option, both with the same \nstriking price. In the broad definition, the calendar spread is ahorizontal spread. The \nneutral philosophy for using calendar spreads is that time will erode the value of the \nnear-term option at afaster rate than it will the far-term option. If this happens, the \nspread will widen and aprofit may result at near-term expiration. With call options, \none may construct amore aggressive, bullish calendar spread. Both types of spreads \nare discussed. \nExample: The following prices exist sometime in late January: \nXYZ:50 \nApril 50 Call \n(3-month call) \n5 \nJuly 50 Call \n(6-month call) \n8 \nOctober 50 Call \n(9-month call) \n10 \nIf one sells the April 50 call and buys the July 50 at the same time, he will pay adebit \nof 3 points - the difference in the call prices plus commissions. That is, his invest\nment is the net debit of the spread plus commissions. Furthermore, suppose that in 3 \nmonths, at April expiration, XYZ is unchanged at 50. Then the 3-month call should \nbe worth 5 points, and the 6-month call should be worth 8 points, as they were pre\nviously, all other factors being equal. \nXYZ:50 \nApril 50 Call \n(Expiring) \n0 \nJuly 50 Call \n(3-month call) \n5 \nOctober 50 Call \n(6-month call) \n8 \n191", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:217", "doc_id": "3de83bc8643a08b4d4d48702797d14ea9c72f78a7341533d1509f8582fbfd350", "chunk_index": 0}
{"text": "192 Part II: Call Option Strategies \nThe spread between the April 50 and the July 50 has now widened to 5 points. Since \nthe spread cost 3 points originally, this widening effect has produced a 2-point prof\nit. The spread could be closed at this time in order to realize the profit, or the spread\ner may decide to continue to hold the July 50 call that he is long. By continuing to \nhold the July 50 call, he is risking the profits that have accrued to date, but he could \nprofit handsomely if the underlying stock rises in price over the next 3 months, \nbefore July expiration. \nIt is not necessary for the underlying stock to be exactly at the striking price of \nthe options at near-term expiration for aprofit to result. In fact, some profit can be \nmade in arange that extends both below and above the striking price. The risk in this \ntype of position is that the stock will drop agreat deal or rise agreat deal, in which \ncase the spread between the two options will shrink and the spreader will lose money. \nSince the spread between two calls at the same strike cannot shrink to less than zero, \nhowever, the risk is limited to the amount of the original debit spent to establish the \nspread, plus commissions. \nTHE NEUTRAL CALENDAR SPREAD \nAs mentioned earlier, the calendar spreader can either have aneutral outlook on the \nstock or he can construct the spread for an aggressively bullish outlook. The neutral \noutlook is described first. The calendar spread that is established when the underly\ning stock is at or near the striking price of the options used is aneutral spread. The \nstrategist is interested in selling time and not in predicting the direction of the under\nlying stock. If the stock is relatively unchanged when the near-term option expires, \nthe neutral spread will make aprofit. In aneutral spread, one should initially have \nthe intent of closing the spread by the time the near-tenn option expires. \nLet us again tum to our example calendar spread described earlier in order to \nmore accurately demonstrate the potential risks and rewards from that spread when \nthe near-term, April, call expires. To do this, it is necessary to estimate the price of the \nJuly 50 call at that time. Notice that, with XYZ at 50 at expiration, the results agree \nwith the less detailed example presented earlier. The graph shown in Figure 9-1 is the \n\"total profit\" from Table 9-1. The graph is acurved rather than straight line, since the \nJuly 50 call still has time premium. There is aslightly bullish bias to this graph: The \nprofit range extends slightly farther above the striking price than it does below the \nstriking price. This is due to the fact that the spread is acall spread. If puts had been \nused, the profit range would have abearish bias. The total width of the profit range is \nafunction of the volatility of the underlying stock, since that will determine the price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:218", "doc_id": "3253832275aff70116433578c00e216656baf5dd03466db657ecc2a037f20d02", "chunk_index": 0}
{"text": "Chapter 9: Calendar Spreads \nFIGURE 9-1. \nCalendar spread at near-term expiration. \nC: \ni +$200 \n$ \n1i:i \n~ \n0 \n~ o. -$300 \nStock Price at Expiration \nTABLE 9-1. \nEstimated profit or losses at April expiration. \nXYZ Stock April 50 April 50 July 50 \nPrice Price Profit Price \n40 0 +$500 1/2 \n45 0 + 500 21/2 \n48 0 + 500 4 \n50 0 + 500 5 \n52 2 + 300 6 \n55 5 0 8 \n60 10 - 500 l 01/2 \n193 \nJuly 50 Total \nProfit Profit \n-$750 -$250 \n- 550 - 50 \n- 400 + 100 \n- 300 + 200 \n- 200 + 100 \n0 0 \n+ 250 - 250 \nof the remaining long call at expiration, as well as afunction of the time remaining to \nnear-term expiration. \nTable 9-1 and Figure 9-1 clearly depict several of the more significant aspects \nof the calendar spread. There is arange within which the spread is profitable at near\nterm expiration. That range would appear to be about 46 to 55 in the example. \nOutside that range, losses can occur, but they are limited to the amount of the initial \ndebit. Notice in the example that the stock would have to be well below 40 or well", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:219", "doc_id": "dd155c36a147835dc82da3ecb74077bdca58eb1fdd95e0d1a1196bdf9299ea37", "chunk_index": 0}
{"text": "194 Part II: Call Option Strategies \nabove 60 for the maximum loss to occur. Even if the stock is at 40 or 60, there is some \ntime premium left in the longer-term option, and the loss is not quite as large as the \nmaximum possible loss of $300. \nThis type of calendar spread has limited profits and relatively large commission \ncosts. It is generally best to establish such aspread 8 to 12 weeks before the near\nterm option expires. If this is done, one is capitalizing on the maximum rate of decay \nof the near-term option with respect to the longer-term option. That is, when acall \nhas less than 8 weeks of life, the rate of decay of its time value premium increases \nsubstantially with respect to the longer-term options on the same stock. \nTHE EFFECT OF VOLATILITY \nThe implied volatility of the options (and hence the actual volatility of the underly\ning stock) will have an effect on the calendar spread. As volatility increases, the \nspread widens; as volatility contracts, the spread shrinks. This is important to know. \nIn effect, buying acalendar spread is an antivolatility strategy: One wants the under\nlying to remain somewhat unchanged. Sometimes, calendar spreads look especially \nattractive when the underlying stock is volatile. However, this can be misleading for \ntwo reasons. First of all, since the stock is volatile, there is agreater chance that it will \nmove outside of the profit area. Second, if the stock does stabilize and trades in arange near the striking price, the spread will lose value because of the decrease in \nvolatility. That loss may be greater than the gain from time decay! \nFOLLOW-UP ACTION \nIdeally, the spreader would like to have the stock be just below the striking price \nwhen the near-term call expires. If this happens, he can close the spread with only \none commission cost, that of selling out the long call. If the calls are in-the-money at \nthe expiration date, he will, of course, have to pay two commissions to close the \nspread. As with all spread positions, the order to close the spread should be placed \nas asingle order. \"Legging\" out of aspread is highly risky and is not recommended. \nPrior to expiration, the spreader should close the spread if the near-term short \ncall is trading at parity. He does this to avoid assignment. Being called out of spread \nposition is devastating from the viewpoint of the stock commissions involved for the \npublic customer. The near-term call would not normally be trading at parity until \nquite close to the last day of trading, unless the stock has undergone asubstantial rise \nin price. \nIn the case of an early downside breakout by the underlying stock, the spread\ner has several choices. He could immediately close the spread and take asmall loss", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:220", "doc_id": "d03d2fe1ce789d2c43449acbb1f42a435bd120834178246112231378e7c60cce", "chunk_index": 0}
{"text": "Chapter 9: Calendar Spreads 195 \non the position. Another choice is to leave the spread alone until the near-term call \nexpires and then to hope for apartial recovery from the stock in order to be able to \nrecover some value from the long side of the spread. Such aholding action is often \nbetter than the immediate close-out, because the expense of buying back the short \ncall can be quite large percentagewise. Ariskier downside defensive action is to sell \nout the long call if the stock begins to break down heavily. In this way, the spreader \nrecovers something from the long side of his spread immediately, and then looks for \nthe stock to remain depressed so that the short side of the spread will expire worth\nless. This action requires that one have enough collateral available to margin the \nresulting naked call, often an amount substantially in excess of the original debit paid \nfor the spread. Moreover, if the underlying stock should reverse direction and rally \nback to or above the striking price, the short side of the spread is naked and could \nproduce substantial losses. The risk assumed by such afollow-up violates the initial \nneutral premise of the spread, and should therefore be avoided. Of these three types \nof downside defensive action, the easiest and rrwst conservative one is to do nothing \nat all, letting the short call expire worthless and then hoping for arecovery by the \nunderlying stock. If this tack is taken, the risk remains fixed at the original debit paid \nfor the spread, and occasionally arally may produce large profits on the long call. \nAlthough this rally is anonfrequent event, it generally costs the spreader very little \nto allow himself the opportunity to take advantage of such arally if it should occur. \nIn fact, the strategist can employ aslight modification of this sort of action, even \nif the spread is not at alarge loss. If the underlying stock is moderately below the \nstriking price at near-term expiration, the short option will expire worthless and the \nspreader will be left holding the long option. He could sell the long side immediate\nly and perhaps take asmall gain or loss. However, it is often areasonable strategy to \nsell out aportion of the long side - recovering all or asubstantial portion of the ini\ntial investment - and hold the remainder. If the stock rises, the remaining long posi\ntion may appreciate substantially. Although this sort of action deviates from the true \nnature of the time spread, it is not overly risky. \nAn early breakout to the upside by the underlying stock is generally handled in \nmuch the same way as adownside breakout. Doing nothing is often the best course \nof action. If the underlying stock rallies shortly after the spread is established, the \nspread will shrink by asmall amount, but not substantially, because both options will \nhold premium in arally. If the spreader were to rush in to close the position, he \nwould be paying commissions on two rather expensive options. He will usually do \nbetter to wait and give himself as much of achance for areversal as possible. In fact, \neven at near-term expiration, there will normally be some time premium left in the \nlong option so that the maximum loss would not have to be realized. Ahighly risk\noriented upside defensive action is to cover the short call on atechnical breakout and", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:221", "doc_id": "80196a9161d1d715013865dccf349ec396934808366ab9bb0fc54fcc8abe5f69", "chunk_index": 0}
{"text": "196 Part II: Call Option Strategies \ncontinue to hold the long call. This can become disastrous if the breakout fails and \nthe stock drops, possibly resulting in losses far in excess of the original debit. \nTherefore, this action cannot be considered anything but extremely aggressive and \nillogical for the neutral strategist. \nIf abreakout does not occur, the spreader will normally be making unrealized \nprofits as time passes. Should this be the case, he may want to set some mental stop\nout points for himself. For example, if the underlying stock is quite close to the strik\ning price with only two weeks to go, there will be some more profit potential left in \nthe spread, but the spreader should be ready to close the position quickly if the stock \nbegins to get too far away from the striking price. In this manner, he can leave room \nfor more profits to accrue, but he is also attempting to protect the profits that have \nalready built up. This is somewhat similar to the action that the ratio writer takes \nwhen he narrows the range of his action points as more and more time passes. \nTHE BULLISH CALENDAR SPREAD \nAless neutral and more bullish type of calendar spread is preferred by the more \naggressive investor. In abullish calendar spread, one sells the near-term call and buys \nalonger-term call, but he does this when the underlying stock is some distance below \nthe striking price of the calls. This type of position has the attractive features of low \ndollar investment and large potential profits. Of course, there is risk involved as well. \nExample: One might set up abullish calendar spread in the following manner: \nXYZ common, 45; \nsell the XYZ April 50 for l; and \nbuy the XYZ July 50 for 1 ½. \nThis investor ideally wants two things to happen. First, he would like the near\nterm call to expire worthless. That is why the bullish calendar spread is established \nwith out-of-the-money calls: to increase the chances of the short call expiring worth\nless. If this happens, the investor will then own the longer-term call at anet cost of \nhis original debit. In this example, his original debit was only ½ of apoint to create \nthe spread. If the April 50 call expires worthless, the investor will own the July 50 call \nat anet cost of ½ point, plus commissions. \nThe investor now needs asecond criterion to be fulfilled: The stock must rise in \nprice by the time the July 50 call expires. In this example, even if XYZ were to rally \nto only 52 between April and July, the July 50 call could be sold for at least 2 points. \nThis represents asubstantial percentage gain, because the cost of the call has been", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:222", "doc_id": "6a106e94b0de9d0378c8447a53be3e59de785bc601d0a5ae4fb82f344c8e2afc", "chunk_index": 0}
{"text": "Chapter 9: Calendar Spreads 197 \nreduced to ¼ point. Thus, there is the potential for large profits in bullish calendar \nspreads if the underlying stock rallies above the striking price before the longer-term \ncall expires, provided that the short-term call has already expired worthless. \nWhat chance does the investor have that both ideal conditions will occur? There \nis areasonably good chance that the written call will expire worthless, since it is ashort-term call and the stock is below the striking price to start with. If the stock falls, \nor even rises alittle - up to, but not above, the striking price the first condition will \nhave been met. It is the second condition, arally above the striking price by the \nunderlying stock before the longer-term expiration date, that normally presents the \nbiggest problem. The chances of this happening are usually small, but the rewards \ncan be large when it does happen. Thus, this strategy offers asmall probability of \nmaking alarge profit. In fact, one large profit can easily offset several losses, because \nthe losses are small, dollarwise. Even if the stock remains depressed and the July 50 \ncall in the example expires worthless, the loss is limited to the initial debit of¼ point. \nOf course, this loss represents 100% of the initial investment, so one cannot put all \nhis money into bullish calendar spreads. \nThis strategy is areasonable way to speculate, provided that the spreader \nadheres to the following criteria when establishing the spread: \n1. Select underlying stocks that are volatile enough to move above the striking price \nwithin the allotted time. Bullish calendar spreads may appear to be very \"cheap\" \non nonvolatile stocks that are well below the striking price. But if alarge stock \nmove, say 20%, is required in only afew months, the spread is not worthwhile for \nanonvolatile stock. \n2. Do not use options more than one striking price above the current market. For \nexample, if XYZ were 26, use the 30 strike, not the 35 strike, since the chances \nof arally to 30 are many times greater than the chances of arally to 35. \n3. Do not invest alarge percentage of available trading capital in bullish calendar \nspreads. Since these are such low-cost spreads, one should be able to follow this \nrule easily and still diversify into several positions. \nFOLLOW-UP ACTION \nIf the underlying stock should rally before the near-term call expires, the bullish cal\nendar spreader must never consider \"legging\" out of the spread, or consider cover\ning the short call at aloss and attempting to ride the long call. Either action could \nturn the initial small, limited loss into adisastrous loss. Since the strategy hinges on", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:223", "doc_id": "67309f67b9c9cd889fc9966a03e59192d4ce438b8be74203fe7c1e07e81cd5a0", "chunk_index": 0}
{"text": "198 Part II: Call Option Strategies \nthe fact that all the losses will be small and the infrequent large profits will be able \nto overcome these small losses, one should do nothing to jeopardize the strategy and \npossibly generate alarge loss. \nThe only reasonable sort of follow-up action that the bullish calendar spreader \ncan take in advance of expiration is to close the spread if the underlying stock has \nmoved up in price and the spread has widened to become profitable. This might \noccur if the stock moves up to the striking price after some time has passed. In the \nexample above, if XYZ moved up to 50 with amonth or so of life left in the April 50 \ncall, the call might be selling for I½ while the July 50 call might be selling for 3 \npoints. Thus, the spread could be closed at I½ points, representing a I-point gain \nover the initial debit of 1/2 point. Two commissions would have to be paid to close \nthe spread, of course, but there would still be anet profit in the spread. \nUSING ALL THREE EXPIRATION SERIES \nIn either the neutral calendar spread or the bullish calendar spread, the investor has \nthree choices of which months to use. He could sell the nearest-term call and buy the \nintermediate-term call. This is usually the most common way to set up these spreads. \nHowever, there is no rule that prevents him from selling the intermediate-term and \nbuying the longest-term, or possibly selling the near-term and buying the long-term. \nAny of these situations would still be calendar spreads. \nSome proponents of calendar spreads prefer initially to sell the near-term and \nbuy the long-term call. Then, if the near-term call expires worthless, they have an \nopportunity to sell the intermediate-term call if they so desire. \nExample: An investor establishes acalendar spread by selling the April 50 call and \nbuying the October 50 call. The April call would have less than 3 months remaining \nand the October call would be the long-term call. At April expiration, if XYZ is below \n50, the April call will expire worthless. At that time, the July 50 call could be sold \nagainst the October 50 that is held long, thereby creating another calendar spread \nwith no additional commission cost on the long side. \nThe advantage of this type of strategy is that it is possible for the two sales (April \n50 and July 50 in this example) to actually bring in more credits than were spent for \nthe one purchase (October 50). Thus, the spreader might be able to create aposition \nin which he has aguaranteed profit. That is, if the sum of his transactions is actually \nacredit, he cannot lose money in the spread (provided that he does not attempt to \n\"leg\" out of the spread). The disadvantage of using the long-term call in the calendar \nspread is that the initial debit is larger, and therefore more dollars are initially at risk.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:224", "doc_id": "15f36a2a23e1c0c180a973a1477b789687fdd103c0556ddb24282a0bb069bf0f", "chunk_index": 0}
{"text": "Chapter 9: Calendar Spreads 199 \nIf the underlying stock moves substantially up or down in the first 3 months, the \nspreader could realize alarger dollar loss with the October/ April spread because his \nloss will approach the initial debit. \nThe remaining combination of the expiration series is to initially buy the \nlongest-term call and sell the intermediate-term call against it. This combination will \ngenerally require the smallest initial debit, but there is not much profit potential in \nthe spread until the intermediate-term expiration date draws near. Thus, there is alot of time for the underlying stock to move some distance away from the initial strik\ning price. For this reason, this is generally an inferior approach to calendar spread\ning. \nSUMMARY \nCalendar spreading is alow-dollar-cost strategy that is anonaggressive approach, pro\nvided that the spreader does not invest alarge percentage of his trading capital in the \nstrategy, and provided that he does not attempt to \"leg\" into or out of the spreads. \nThe neutral calendar spread is one in which the strategist is mainly selling time; he \nis attempting to capitalize on the known fact that the near-term call will lose time pre\nmium more rapidly than will alonger-term call. Amore aggressive approach is the \nbullish calendar spread, in which the speculator is essentially trying to reduce the net \ncost of alonger-term call by the amount of credits taken in from the sale of anearer\nterm call. This bullish strategy requires that the near-term call expire worthless and \nthen that the underlying stock rise in price. In either strategy, the most common \napproach is to sell the nearest-term call and buy the intermediate-term call. \nHowever, it may sometimes prove advantageous to sell the near-term and buy the \nlongest-term initially, with the intention of letting the near-term expire and then pos\nsibly writing against the longer-term call asecond time.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:225", "doc_id": "adeb4f717f519785a3e3aa0a723989ca6c4e6fbb90ed4f983eefa053b03dc811", "chunk_index": 0}
{"text": ". CHAPTER 10 \nThe Butterfly Spread \nThe recipient of one of the more exotic names given to spread positions, the butter\nfly spread is aneutral position that is acombination of both abull spread and abear \nspread. This spread is for the neutral strategist, one who thinks the underlying stock \nwill not experience much of anet rise or decline by expiration. It generally requires \nonly asmall investment and has limited risk. Although profits are limited as well, they \nare larger than the potential risk. For this reason, the butterfly spread is aviable strat\negy. However, it is costly in terms of commissions. In this chapter, the strategy is \nexplained using only calls. The strategy can also be implemented using acombination \nof puts and calls, or with puts only, as will be demonstrated later. \nThere are three striking prices involved in abutterfiy spread. Using only calls, \nthe butterfly spread consists of buying one call at the lowest striking price, selling two \ncalls at the middle striking price, and buying one call at the highest striking price. The \nfollowing example will demonstrate how the butterfly spread works. \nExample: Abutterfly spread is established by buying a July 50 call for 12, selling 2 \nJuly 60 calls for 6 each, and buying a July 70 call for 3. The spread requires arela\ntively low debit of $300 (Table 10-1), although there are four option commissions \ninvolved and these may represent asubstantial percentage of the net investment. As \nusual, the maximum amount of profit is realized at the striking price of the written \ncalls. With most types of spreads, this is auseful fact to remember, for it can aid in \nquick computation of the potential of the spread. In this example, if the stock were \nat the striking price of the written options at expiration (60), the two July 60'sthat are \nshort would expire worthless for a $1,200 gain. The long July 70 call would expire \nworthless for a $300 loss, and the long July 50 call would be worth 10 points, for a \n$200 loss on that call. The sum of the gains and losses would thus be a $700 gain, less \ncommissions. This is the maximum profit potential of the spread. \n200", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:226", "doc_id": "927f95cc67a7a4c3327a9168400ac65babfa21b8a20aa82264a0dc55dacd4c68", "chunk_index": 0}
{"text": "Chapter 10: The Butterfly Spread \nTABLE 10-1. \nButterfly spread example. \nCurrent prices: \nXYZ common: \nXYZ July 50 call: \nXYZ July 60 call: \nXYZ July 70 call: \nButterfly spread: \nBuy 1 July 50 call \nSell 2 July 60 calls \nBuy 1 July 70 call \nNet debit \n60 \n12 \n6 \n3 \n$1 ,200 debit \n$1,200 credit \n$300 debit \n$300 (plus commissions) \n201 \nThe risk is limited in abutterfly spread, both to the upside and to the downside, \nand is equal to the amount of the net debit required to establish the spread. In the \nexample above, the risk is limited to $300 plus commissions. \nTable 10-2 and Figure 10-1 depict the results of this butterfly spread at various \nprices at expiration. The profit graph resembles that of aratio write, except that the \nloss is limited on both the upside and the downside. There is aprofit range within \nwhich the butterfly spread makes money - 53 to 67 in the example, before commis\nsions are included. Outside this profit range, losses will occur at expiration, but these \nlosses are limited to the amount of the original debit plus commissions. \nIn accordance with more lenient margin requirements passed in 2000, the \ninvestment required for abutterfly spread is equal to the net debit expended, which \nis the risk in the spread. When the options expire in the same month and the strik\ning prices are evenly spaced (the spacing is 10 points in this example), the following \nformulae can be used to quickly compute the important details of the butterfly \nspread: \nNet investment= Net debit of the spread \nMaximum profit = Distance between strikes - Net debit \nDownside break-even= Lowest strike+ Net debit \nUpside break-even= Highest strike - Net debit \nIn the example, the distance between strikes is 10 points, the net debit is 3 \npoints (before commissions), the lowest strike used is 50, and the highest strike is 70. \nThese formulae would then yield the following results for this example spread.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:227", "doc_id": "f43292bc6b57c3779fa0c7a26c0ea97787f2d2bd325dc7b56e0b3d5b9b846a1f", "chunk_index": 0}
{"text": "Chapter 10: The Butterfly Spread 203 \nNote that all of these answers agree with the results that were previously obtained by \nanalyzing the example spread in detail. \nIn this example, the maximum profit potential is $700, the maximum risk is \n$300, and the investment required is also $300, commissions excluded. In percent\nage terms, this means that the butterfly spread has aloss limited to about 100% of \ncapital invested and could make profits of nearly 133% in this case. These represent \nan attractive risk/reward relationship. This is, however, just an example, and two fac\ntors that exist in the actual marketplace may greatly affect these numbers. First, com\nmissions are large; it is possible that eight commissions might have to be paid to \nestablish and liquidate the spread. Second, depending on the level of premiums to \nbe found in the market at any point in time, it may not be possible to establish aspread for adebit as low as 3 points when the strikes are 10 points apart. \nSELECTING THE SPREAD \nIdeally, one would want to establish abutterfly spread at as small of adebit as pos\nsible in order to limit his risk to asmall amount, although that risk is still equal to \n100% of the dollars invested in the spread. One would also like to have the stock be \nnear the middle striking price to begin with, because he will then be in his maximum \nprofit area if the stock remains relatively unchanged. Unfortunately, it is difficult to \nsatisfy both conditions simultaneously. \nThe smallest-debit butterfly spreads are those in which the stock is some dis\ntance away from the middle striking price. To see this, note that if the stock were \nwell above the middle strike and all the options were at parity, the net debit would \nbe zero. Although no one would attempt to establish abutterfly spread with parity \noptions because of the risk of early assignment, it may be somewhat useful to try to \nobtain asmall debit by taking an opinion on the underlying stock. For example, if \nthe stock is close to the higher striking price, the debit would be small normally, but \nthe investor would have to be somewhat bearish on the underlying stock in order to \nmaximize his profit; that is, the stock would have to decline in price from the upper \nstriking price to the middle striking price for the maximum profit to be realized. An \nanalogous situation exists when the underlying stock is originally close to the lower \nstriking price. The investor could establish the spread for asmall debit in this case \nalso, but he would now have to be somewhat bullish on the underlying stock in order \nto attempt to realize his maximum profit. \nExample: XYZ is at 70. One may be able to establish alow-debit butterfly spread \nwith the 50's, 60's, and 70'sif the following prices exist:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:229", "doc_id": "6b76702e26fa86fd3fbbcbf86c24c7a56f136f38e29fad814b3dc333a640e0f9", "chunk_index": 0}
{"text": "204 \nXYZ common, 70; \nXYZ July 50, 20; \nXYZ July 60, 12; and \nXYZ July 70, 5. \nPart II: Call Option Strategies \nThe butterfly spread would require adebit of only $100 plus commissions to estab\nlish, because the cost of the calls at the higher and lower strike is 25 points, and a 24-\npoint credit would be obtained by selling two calls at the middle strike. This is indeed \nalow-cost butterfly spread, but the stock will have to move down in price for much \nof aprofit to be realized. The maximum profit of $900 less commissions would be \nrealized at 60 at expiration. The strategist would have to be bearish on XYZ to want \nto establish such aspread. \nWithout the aid of an example, the reader should be able to determine that if \nXYZ were originally at 50, alow-cost butterfly spread could be established by buying \nthe 50, selling two 60's, and buying a 70. In this case, however, the investor would \nhave to be bullish on the stock, because he would want it to move up to 60 by expi\nration in order for the maximum profit to be realized. \nIn general, then, if the butterfly spread is to be established at an extremely low \ndebit, the spreader will have to make adecision as to whether he wants to be bullish \nor bearish on the underlying stock. Many strategists prefer to remain as neutral as \npossible on the underlying stock at all times in any strategy. This philosophy would \nlead to slightly higher debits, such as the $300 debit in the example at the beginning \nof this chapter, but would theoretically have abetter chance of making money \nbecause there would be aprofit if the stock remained relatively unchanged, the most \nprobable occurrence. \nIn either philosophy, there are other considerations for the butterfly spread. \nThe best butterfly spreads are generally found on the more expensive and/or more \nvolatile stocks that have striking prices spaced 10 or 20 points apart. In these situa\ntions, the maximum profit is large enough to overcome the weight of the commission \ncosts involved in the butterfly spread. When one establishes butterfly spreads on \nlower-priced stocks whose striking prices are only 5 points apart, he is normally put\nting himself at adisadvantage unless the debit is extremely small. One exception to \nthis rule is that attractive situations are often found on higher-priced stocks with \nstriking prices 5 points apart (50, 55, and 60, for example). They do exist from time \nto time. \nIn analyzing butterfly spreads, one commonly works with closing prices. It was \nmentioned earlier that using closing prices for analysis can prove somewhat mislead\ning, since the actual execution will have to be done at bid and asked prices, and these", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:230", "doc_id": "01f326b2cb2e48b1fca9887cff2730f2e63f8363b21828a7dc96f550d1b9daf6", "chunk_index": 0}
{"text": "Chapter 10: The Butterfly Spread 205 \nmay differ somewhat from closing prices. Normally, this difference is small, but since \nthere are three different calls involved in abutterfly spread, the difference could be \nsubstantial. Therefore, it is usually necessary to check the appropriate bid and asked \nprice for each call before entering the spread, in order to be able to place areason\nable debit on the order. As with other types of spreads, the butterfly spread order can \nbe placed as one order. \nBefore moving on to discuss follow-up action, it may be worthwhile to describe \natactic for stocks with 5 points between striking prices. For example, the butterfly \nspreader might work with strikes of 45, 50, and 60. If he sets up the usual type of but\nterfly spread, he would end up with aposition that has too much risk near 60 and very \nlittle or none at all near 45. If this is what he wants, fine; but if he wants to remain \nneutral, the standard type of butterfly spread will have to be modified slightly. \nExample: The following prices exist: \nXYZ common, 50; \nJuly 45 call, 7; \nJuly 50 call, 5; and \nJuly 60 call, 2. \nThe normal type of butterfly spread- buying one 45, selling two 50's, and buying one \n60 - can actually be done for acredit of 1 point. However, the profitability is no \nlonger symmetric about the middle striking price. In this example, the investor can\nnot lose to the downside because, even if the stock collapses and all the calls expire \nworthless, he will still make his I-point credit. However, to the upside, there is risk: \nIf XYZ is anywhere above 60 at expiration, the risk is 4 points. This is no longer aneu\ntral position. The fact that the lower strike is only 5 points from the middle strike \nwhile the higher strike is 10 points away has made this asomewhat bearish position. \nIf the spreader wants to be neutral and still use these striking prices, he will have to \nput on two bull spreads and only one bear spread. That is, he should: \nBuy 2 July 45's: \nSell 3 July 50's: \nBuy 1 July 60: \n$1,400 debit \n$1,500 credit \n$200 debit \nThis position now has anet debit of $100 but has abetter balance of risk at either \nend. If XYZ drops and is below 45 at expiration, the spreader will lose his $100 ini\ntial debit. But now, if XYZ is at or above 60 at expiration, he will lose $100 in that \nrange also. Thus, by establishing two bull spreads with a 5-point difference between", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:231", "doc_id": "a518181700826f6390786040203617059569557441d6ad5286e70cdd03d82b2d", "chunk_index": 0}
{"text": "206 Part II: Call Option Strategies \nstrikes versus one bear spread with a IO-point difference between strikes, the risk has \nbeen balanced at both ends. When one uses strike prices that are not evenly spaced \napart, his margin requirement increases substantially. In such acase, one has to mar\ngin the individual component spreads separately. Therefore, in this example, he \nwould have to pay for the two bull spreads ( $200 each, for atotal of $400) and then \nmargin the additional call bear spread ($700: the $1,000 difference in the strikes, less \nthe $300 credit taken in for that portion of the spread). Hence, in this example, the \nmargin requirement would be $1,100, even though the risk is only $100. Technically, \nof that $1,100 requirement, the spread trader pays out only $100 in cash (the actual \ndebit of the spread), and the rest of the requirement can be satisfied with excess \nequity in his account. \nThe same analysis obviously applies whenever 5-point striking price intervals \nexist. There are numerous combinations that could be worked out for lower-priced \nstocks by merely skipping over astriking price ( using the 25's, 30's, and 40's, for exam\nple). Although there are not normally many stocks trading over $100 per share, the \nsame analysis is applicable using 130's, 140's, and 160's, for example. \nFOLLOW-UP ACTION \nSince the butterfly spread has limited risk by its construction, there is usually little \nthat the spreader has to do in the way of follow-up action other than avoiding early \nexercise or possibly dosing out the position early to take profits or limit losses even \nfurther. The only part of the spread that is subject to assignment is the call at the mid\ndle strike. If this call trades at or near parity, in-the-money, the spread should be \nclosed. This may happen before expiration if the underlying stock is about to go ex\ndividend. It should be noted that accepting assignment will not increase the risk of \nthe spread (because any short calls assigned would still be protected by the remain\ning long calls). However, the margin requirement would change substantially, since \none would now have asynthetic put (long calls, short stock) in place. Plus, there may \nbe more onerous commissions for trading stock. Therefore, it is usually wise to avoid \nassignment in abutterfly spread, or in any spread, for that matter. \nIf the stock is near the middle strike after areasonable amount of time has \npassed, an unrealized profit will begin to accrue to the spreader. If one feels that the \nunderlying stock is about to move away from the middle striking price and thereby \njeopardize these profits, it may be advantageous to close the spread to take the avail\nable profit. Be certain to include commission costs when determining if an unreal\nized profit exists. As ageneral rule of thumb, if one is doing 10 spreads at atime, he", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:232", "doc_id": "b5cdbbfba0bc4173637e03ce13582b01443898fa828bf8dcba0782ea01e54756", "chunk_index": 0}
{"text": "Chapter 10: Tire Butterfly Spread 207 \ncan estimate that the commission cost for each option is about 1/spoint. That is, if one \nhas 10 butterfly spreads and the spread is currently at 6 points, he could figure that \nhe would net about 5½ points after commissions to close the spread. This 1/sestimate \nis only valid if the spreader has at least 10 options at each strike involved in aspread. \nNormally, one would not close the spread early to limit losses, since these loss\nes are limited to the original net debit in any case. However, if the original debit was \nlarge and the stock is beginning to break out above the higher strike or to break down \nbelow the lower strike, the spreader may want to close the spread to limit losses even \nfurther. \nIt has been repeatedly stated that one should not attempt to ''leg\" out of aspread because of the risk that is incurred if one is wrong. However, there is amethod of legging out of abutterfly spread that is acceptable and may even be pru\ndent. Since the spread consists of both abull spread and abear spread, it may often \nbe the case that the stock experiences arelatively substantial move in one direction \nor the other during the life of the butterfly spread, and that the bull spread portion \nor the bear spread portion could be closed out near their maximum profit potentials. \nIf this situation arises, the spreader may want to take advantage of it in order to be \nable to profit more if the underlying stock reverses direction and comes back into the \nprofit range. \nExampk: This strategy can be explained by using the initial example from this chap\nter and then assuming that the stock falls from 60 to 45. Recall that this spread was \ninitially established with a 3-point debit and amaximum profit potential of 7 points. \nThe profit range was 53 to 67 at July expiration. However, arather unpleasant situa\ntion has occurred: The stock has fallen quickly and is below the profit range. If the \nspreader does nothing and keeps the spread on, he will lose 3 points at most if the \nstock remains below 50 until July expiration. However, by increasing his risk slightly, \nhe may be able to improve his position. Notice in Table 10-3 that the bear spread por\ntion of the overall spread - short July 60, long July 70 - has very nearly reached its \nmaximum potential. The bear spread could be bought back for ½ point total (pay 1 \npoint to buy back the July 60 and receive½ point from selling out the July 70). Thus, \nthe spreader could convert the butterfly spread to abull spread by spending ½ point. \nWhat would such an action do to his overall position? First, his risk would be \nincreased by the ½ point spent to close the bear spread. That is, if XYZ continues to \nremain below 50 until July expiration, he would now lose 3½ rather than 3 points, \nplus commissions in either case. He has, however, potentially helped his chances of \nrealizing something close to the maximum profit available from the original butterfly \nspread.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:233", "doc_id": "03031b54b2e61a2dc13905fe9c8a2470fe1e586c565ffe1e4adace9264274a4b", "chunk_index": 0}
{"text": "208 Part II: Call Option Strategies \nTABLE 10-3. \nInitial spread and current prices. \nInitial Spread Current Prices \nXYZ common: 60 XYZ common: 45 \nJuly 50 call: 12 July 50 call: 2 \nJuly 60 call: 6 July 60 call: 1 \nJuly 70 call: 3 July 70 call: 1/2 \nAfter buying back the bear spread, he is left with the following bull spread: \nLong July 50 call _ Ntdb·t 3u, . thlall ee 1 ,2 pom s Sort Ju y 60 c \nHe has abull spread at the total cost paid to date - 3½ points. From the earlier dis\ncussion of bull spreads, the reader should know that the break-even point for this \nposition is 53½ at expiration, and it could make a 6½ point profit if XYZ is anywhere \nover 60 at July expiration. Hence, the break-even point for the position was raised \nfrom 53 to 53½ by the expense of the ½ point to buy back the bear spread. However, \nif the stock should rally back above 60, the strategist will be making aprofit nearly \nequal to the original maximum profit that he was aiming for (7 points). Moreover, this \nprofit is now available anywhere over 60, not just exactly at 60 as it was in the origi\nnal position. Although the chances of such arally cannot be considered great, it does \nnot cost the spreader much to restructure himself into aposition with amuch broad\ner maximum profit area. \nAsimilar situation is available if the underlying stock moves up in price. In that \ncase, the bull spread may be able to be removed at nearly its maximum profit poten\ntial, thereby leaving abear spread. Again, suppose that the same initial spread was \nestablished but that XYZ has risen to 75. When the underlying stock advances sub\nstantially, the bull spread portion of the butterfly spread may expand to near its max\nimum potential. Since the strikes are 10 points apart in this bull spread, the widest it \ncan grow to is 10 points. At the prices shown in Table 10-4, the bull spread - long \nJuly 50 and short July 60 - has grown to 9½ points. Thus, the bull spread position \ncould be removed within ½ point of its maximum profit potential and the original \nbutterfly spread would become abear spread. Note that the closing of the bull spread \nportion generates a 9½ point credit: The July 50 is sold at 25½ and the July 60 is \nbought back at 16. The original butterfly spread was established at a 3-point debit, so \nthe net position is the remaining position:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:234", "doc_id": "b7e527c271a395372b6b32d8cadc53f48c7fceaaef2a58f249b649e162613c0f", "chunk_index": 0}
{"text": "Chapter 10: The BatterRy Spread 209 \nLong July 70 call . \nShort July 60 call - Net credit 6½ points \nThis bear spread has amaximum profit potential of 6½ points anywhere below 60 at \nJuly expiration. The maximum risk is 3½ points anywhere above 70 at expiration. \nThus, the original butterfly spread was again converted into aposition such that astock price reversal to any price below 60 could produce something close to the max\nimum profit. Moreover, the risk was only increased by an additional ½ point. \nTABLE 10-4. \nInitial spread and new current prices. \nInitiol Spread \nXYZ common: 60 \nXYZ July 50 call: 12 \nJuly 60 call: 6 \nJuly 70 call: 3 \nSUMMARY \nCurrent Prices \nXYZ common: \nJuly 50 call: \nJuly 60 call: \nJuly 70 call: \n75 \n251/2 \n16 \n7 \nThe butterfly spread is aviable, low-cost strategy with both limited profit potential \nand limited risk. It is actually acombination of abull spread and abear spread, and \ninvolves using three striking prices. The risk is limited should the underlying stock \nfall below the lowest strike or rise above the highest strike. The maximum profit is \nobtained at the middle strike. One can keep his initial debits to aminimum by ini\ntially assuming abullish or bearish posture on the underlying stock. If he would \nrather remain neutral, he will normally have to pay aslightly larger debit to establish \nthe spread, but may have abetter chance of making money. If the underlying stock \nexperiences alarge move in one direction or the other prior to expiration, the spread\ner may want to close the profitable side of his butterfly spread near its maximum \nprofit potential in order to be able to capitalize on astock price reversal, should one \noccur.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:235", "doc_id": "ec233f600d84b0e4323a551d862a828c5945a4d3d67e04a4b69f4e9da531dbd9", "chunk_index": 0}
{"text": "Ratio Call Spreads \nAratio call spread is aneutral strategy in which one buys anumber of calls at alower \nstrike and sells more calls at ahigher strike. It is somewhat similar to aratio write in \nconcept, although the spread has less downside risk and normally requires asmaller \ninvestment than does aratio write. The ratio spread and ratio write are similar in that \nboth involve uncovered calls, and both have profit ranges within which aprofit can \nbe made at expiration. Other comparisons are demonstrated throughout the chapter. \nExample: The following prices exist: \nXYZ common, 44; \nXYZ April 40 call, 5; and \nXYZ April 45 call, 3. \nA 2:1 ratio call spread could be established by buying one April 40 call and simulta\nneously selling two April 45's. This spread would be done for acredit of 1 point - the \nsale of the two April 45'sbringing in 6 points and the purchase of the April 40 cost\ning 5 points. This spread can be entered as one spread order, specifying the net cred\nit or debit for the position. In this case, the spread would be entered at anet credit \nof 1 point. \nRatio spreads, unlike ratio writes, have arelatively small, limited downside risk. \nIn fact, if the spread is established at an initial credit, there is no downside risk at all. \nIn aratio spread, the profit or loss at expiration is constant below the lower striking \nprice, because both options would be worthless in that area. In the example above, if \nXYZ is below 40 at April expiration, all the options would expire worthless and the \nspreader would have made aprofit of his initial I-point credit, less commissions. This \nI-point gain would occur anywhere below 40 at expiration; it is aconstant. \n210", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:236", "doc_id": "46ec23ac6414a3e4e5f783fff594023b162ff1c71f8edbf23d2265668a33e38f", "chunk_index": 0}
{"text": "Chapter 11: Ratio Call Spreads 211 \nThe maximum profit at expiration for aratio spread occurs if the stock is exact\nly at the striking price of the written options. This is true for nearly all types of strate\ngies involving written options. In the example, if XYZ were at 45 at April expiration, \nthe April 45 calls would expire worthless for again of $600 on the two of them, and \nthe April 40 call would be worth 5 points, resulting in no gain or loss on that call. \nThus, the total profit would be $600 less commissions. \nThe greatest risk in aratio call spread lies to the upside, where the loss may the\noretically be unlimited. The upside break-even point in this example is 51, as shown \nin Table 11-1. The table and Figure 11-1 illustrate the statements made in the pre\nceding paragraphs. \nIn a 2:1 ratio spread, two calls are sold for each one purchased. The maximum \nprofit amount and the upside break-even point can easily be computed by using the \nfollowing formulae: \nPoints of maximum profit = Initial credit + Difference between strikes or \n= Difference between strikes - Initial debit \nUpside break-even point= Higher strike price+ Points of maximum profit \nIn the preceding example, the initial credit was 1 point, so the points of maxi\nmum profit = 1 + 5 = 6, or $600. The upside break-even point is then 45 + 6, or 51. \nThis agrees with the results determined earlier. Note that if the spread is established \nat adebit rather than acredit, the debit is subtracted from the striking price differ\nential to determine the points of maximum profit. \nMany neutral investors prefer ratio spreads over ratio writes for two reasons: \nTABLE 11-1. \nRatio call spread. \nXYZ Price of April 40 Coll April 45 Coll Total \nExpiration Profits Profits Profits \n35 -$ 500 +$ 600 +$100 \n40 - 500 + 600 + 100 \n42 - 300 + 600 + 300 \n45 0 + 600 + 600 \n48 + 300 0 + 300 \n51 + 600 - 600 0 \n55 +1,000 -1,400 - 400 \n60 + 1,500 -2,400 - 900", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:237", "doc_id": "24fcf0ae6f7a3eb03676ee7576f5604870e4e1d111f7411ae5c185e137390ac3", "chunk_index": 0}
{"text": "212 Part II: Call Option Strategies \nFIGURE 11 • 1. \nRatio call spread (2: 1 ). \nStock Price at Expiration \n1. The downside risk or gain is predetermined in the ratio spread at expiration, and \ntherefore the position does not require much monitoring on the downside. \n2. The margin investment required for aratio spread is normally smaller than that \nrequired for aratio write, since on the long side one is buying acall rather than \nbuying the common stock itself. \nFor margin purposes, aratio spread is really the combination of abull spread \nand anaked call write. There is no margin requirement for abull spread other than \nthe net debit to establish the bull spread. The net investment for the ratio spread is \nthus equal to the collateral required for the naked calls in the spread plus or minus \nthe net debit or credit of the spread. In the example above, there is one naked call. \nThe requirement for the naked call is 20% of the stock price plus the call premium, \nless the out-of-the-money amount. So the requirement in the example would be 20% \nof 44, or $880, plus the call premium of $300, less the one point that the stock is \nbelow the striking price - a $1,080 requirement for the naked call. Since the spread \nwas established at acredit of one point, this credit can also be applied against the ini\ntial requirement, thereby reducing that requirement to $980. Since there is anaked \ncall in this spread, there will be amark to market if the stock moves up. Just as was \nrecommended for the ratio write, it is recommended that the ratio spreader allow at \nleast enough collateral to reach the upside break-even point. Since the upside break\neven point is 51 in this example, the spreader should allow 20% of 51, or $1,020, plus", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:238", "doc_id": "e8fd3fd090b189cc03400a90085fa6c1082fc5f11c7cff6745c1d2464f9a84c6", "chunk_index": 0}
{"text": "Chapter 11: Ratio Call Spreads 213 \nthe 6 points that the call would be worth less the 1-point initial net credit - atotal of \n$1,520 for this spread ($1,020 + $600 - $100). \nDIFFERING PHILOSOPHIES \nFor many strategies, there is more than one philosophy of how to implement the \nstrategy. Ratio spreads are no exception, with three philosophies being predominant. \nOne philosophy holds that ratio spreading is quite similar to ratio writing - that one \nshould be looking for opportunities to purchase an in-the-money call with little or no \ntime premium in it so that the ratio spread simulates the profit opportunities from \nthe ratio write as closely as possible with asmaller investment. The ratio spreads \nestablished under this philosophy may have rather large debits if the purchased call \nis substantially in-the-money. Another philosophy of ratio spreading is that spreads \nshould be established for credits so that there is no chance of losing money on the \ndownside. Both philosophies have merit and both are described. Athird philosophy, \ncalled the \"delta spread,\" is more concerned with neutrality, regardless of the initial \ndebit or credit. It is also described. \nRATIO SPREAD AS RATIO WRITE \nThere are several spread strategies similar to strategies that involve common stock. In \nthis case, the ratio spread is similar to the ratio write. Whenever such asimilarity \nexists, it may be possible for the strategist to buy an in-the-money call with little or no \ntime premium as asubstitute for buying the common stock. This was seen earlier in \nthe covered call writing strategy, where it was shown that the purchase of in-the\nmoney calls or warrants might be aviable substitute for the purchase of stock. If one \nis able to buy an in-the-rrwney call as asubstitute for the stock, he will not affect his \nprofit potential substantially. When comparing aratio spread to aratio write, the max\nimum profit potential and the profit range are reduced by the time value premium \npaid for the long call. If this call is at parity (the time value premium is thus zero), the \nratio spread and the ratio write have exactly the same profit potential. Moreover, the \nnet investment is reduced and there is less downside risk should the stock fall in price \nbelow the striking price of the purchased call. The spread also involves smaller com\nmission costs than does the ratio write, which involves astock purchase. The ratio \nwriter does receive stock dividends, if any are paid, whereas the spreader does not. \nExample: XYZ is at 50, and an XYZ July 40 call is selling for 11 while an XYZ July 50 \ncall is selling for 5. Table 11-2 compares the important points between the ratio write \nand the ratio spread.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:239", "doc_id": "cb42f74f206af8835da065fceca70f45845f6de7ed7fc1b74099ba5c1daba8fc", "chunk_index": 0}
{"text": "214 \nTABLE 11-2. \nRatio write and ratio spread compared. \nProfit range \nMaximum profit \nDownside risk \nUpside risk \nInitial investment \nRatio Write: \nBuy XYZ of 50 and \nSell 2 July SO'sat 5 \n40 to 60 \n10 points \n40 points \n40 points \n$3,000 \nPart II: Call Option Strategies \nRatio Spread: \nBuy 1 July 40 of 11 and \nSell 2 July SO'sat 5 \n41 to 59 \n9 points \n1 point \nUnlimited \n$1,600 \nIn Chapter 6, it was pointed out that ratio writing was one of the better strate\ngies from aprobability of profit viewpoint. That is, the profit potential conforms well \nto the expected movement of the underlying stock. The same statement holds true \nfor ratio spreads as substitutes for ratio writes. In fact, the ratio spread may often be \nabetter position than the ratio write itself, when the long call can be purchased with \nlittle or no time value premium in it. \nRATIO SPREAD FOR CREDITS \nThe second philosophy of ratio spreads is to establish them only for credits. \nStrategists who follow this philosophy generally want asecond criterion fulfilled also: \nthat the underlying stock be below the striking price of the written calls when the \nspread is established. In fact, the farther the stock is below the strike, the more \nattractive the spread would be. This type of ratio spread has no downside risk \nbecause, even if the stock collapses, the spreader will still make aprofit equal to the \ninitial credit received. This application of the ratio spread strategy is actually asub\ncase of the application discussed above. That is, it may be possible both to buy along \ncall for little or no time premium, thereby simulating aratio write, and also to be able \nto set up the position for acredit. \nSince the underlying stock is generally below the maximum profit point when \none establishes aratio spread for acredit, this is actually amildly bullish position. \nThe investor would want the stock to move up slightly in order for his maximum prof\nit potential to be realized. Of course, the position does have unlimited upside risk, so \nit is not an overly bullish strategy.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:240", "doc_id": "f894baf3fef6b3adfbf764e78fe86aed5a536fae62cb1140e1bee09b87f11e71", "chunk_index": 0}
{"text": "Chapter 11: Ratio Call Spreads 215 \nThese two philosophies are not mutually exclusive. The strategist who uses ratio \nspreads without regard for whether they are debit or credit spreads will generally \nhave abroader array of spreads to choose from and will also be able to assume amore \nneutral posture on the stock. The spreader who insists on generating credits only will \nbe forced to establish spreads on which his return will be slightly smaller if the under\nlying stock remains relatively unchanged. However, he will not have to worry about \ndownside defensive action, since he has no risk to the downside. The third philoso\nphy, the \"delta spread,\" is described after the next section, in which the uses of ratios \nother than 2: 1 are described. \nALTERING THE RATIO \nUnder either of the two philosophies discussed above, the strategist may find that a \n3:1 ratio or a 3:2 ratio better suits his purposes than the 2:1 ratio. It is not common \nto write in aratio of greater than 4: 1 because of the large increase in upside risk at \nsuch high ratios. The higher the ratio that is used, the higher will be the credits of \nthe spread. This means that the profits to the downside will be greater if the stock \ncollapses. The lower the ratio that is used, the higher the upside break-even point will \nbe, thereby reducing upside risk. \nExample: If the same prices are used as in the initial example in this chapter, it will \nbe possible to demonstrate these facts using three different ratios (Table 11-3): \nXYZ common, 44; \nXYZ April 40 call, 5; and \nXYZ April 45 call, 3. \nTABLE 11-3. \nComparison of three ratios. \nPrice of spread \n(downside risk) \nUpside break-even \nDownside break-even \nMaximum profit \n3:2 Ratio: \nBuy 2 April 40's \nSell 3 April 45's \n1 debit \n54 \n401/2 \n9 \n2:1 Ratio: 3:1 Ratio: \nBy 1 April 40 Buy 1 April 40 \nSell 2 April 45's Sell 3 April 45's \n1 credit 4 credit \n51 49½ \nNone None \n6 9", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:241", "doc_id": "7c0482ae00c76868b9d2ee00cea96e2f10a0b82b2d33675d72101bfb22a148e0", "chunk_index": 0}
{"text": "216 Part II: Call Option Strategies \nIn Chapter 6 on ratio writing, it was seen that it was possible to alter the ratio \nto adjust the position to one'soutlook for the underlying stock The altering of the \nratio in aratio spread accomplishes the same objective. In fact, as will be pointed out \nlater in the chapter, the ratio may be adjusted continuously to achieve what is con\nsidered to be a \"neutral spread.\" Asimilar tactic, using the option'sdelta, was \ndescribed for ratio writes. \nThe following formulae allow one to determine the maximum profit potential \nand upside break~even point for any ratio: \nPoints of maximum = Net credit+ Number oflong calls xprofit Difference in striking prices or \n= Number of long calls X Difference in \nstriking prices - Net debit \nUpside break-even = Points of maximum profit ff ht \"ki . \npoint Number of naked calls + ig er snng pnce \nThese formulae can easily be verified by checking the numbers in Table 11-3. \nTHE \"DELTA SPREAD\" \nThe third philosophy of ratio spreading is amore sophisticated approach that is often \nreferred to as the delta spread, because the deltas of the options are used to estab\nlish and monitor the spread. Recall that the delta of acall option is the amount by \nwhich the option is expected to increase in price if the underlying stock should rise \nby one point. Delta spreads are neutral spreads in that one uses the deltas of the two \ncalls to set up aposition that is initially neutral. \nExample: The deltas of the two calls that appeared in the previous examples were \n.80 and .50 for the April 40 and April 45, respectively. If one were to buy 5 of the \nApril 40'sand simultaneously sell 8 of the April 45's, he would have adelta-neutral \nspread. That is, if XYZ moved up by one point, the 5 April 40 calls would appreciate \nby .80 point each, for anet gain of 4 points. Similarly, the 8 April 45 calls that he is \nshort would each appreciate by .50 point for anet loss of 4 points on the short side. \nThus, the spread is initially neutral - the long side and the short side will offset each \nother. The idea of setting up this type of neutral spread is to be able to capture the \ntime value premium decay in the preponderance of short calls without subjecting the \nspread to an inordinate amount of market risk. The actual credit or debit of the \nspread is not adetermining factor.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:242", "doc_id": "140adeed213b5dc90de7dfc9ce209bbd15f061e4f81f4255ccf5c62aef34c98e", "chunk_index": 0}
{"text": "Chapter 11: Ratio Call Spreads 217 \nIt is afairly simple matter to determine the correct ratio to use in the delta \nspread: Merely divide the delta of the purchased call by the delta of the written call. \nIn the example, this implies that the neutral ratio is .80 divided by .50, or 1.6:1. \nObviously, one cannot sell 1.6 calls, so it is common practice to express that ratio as \n16:10. Thus, the neutral spread would consist of buying 10 April 40'sand selling 16 \nApril 45's. This is the same as an 8:5 ratio. Notice that this calculation does not \ninclude anything about debits or credits involved in the spread. In this example, an \n8:5 ratio would involve asmall debit of one point (5 April 40'scost 25 points and 8 \nApril 45'sbring in 24 points). Generally, reasonably selected delta spreads involve \nsmall debits. \nCertain selection criteria can be offered to help the spreader eliminate some of \nthe myriad possibilities of delta spreads on aday-to-day basis. First, one does not \nwant the ratio of the spread to be too large. An absolute limit, such as 4:1, can be \nplaced on all spread candidates. Also, if one eliminates any options selling for less \nthan ½ point as candidates for the short side of the spread, the higher ratios will be \neliminated. Second, one does not want the ratio to be too small. If the delta-neutral \nratio is less than 1.2:1 (6:5), the spread should probably be rejected. Finally, if one is \nconcerned with downside risk, he might want to limit the total debit outlay. This \nmight be done with asimple parameter, such as not paying adebit of more than 1 \npoint per long option. Thus, in aspread involving 10 long calls, the total debit must \nbe 10 points or less. These screens are easily applied, especially with the aid of acom\nputer analysis. One merely uses the deltas to determine the neutral ratio. Then, if it \nis too small or too large, or if it requires the outlay of too large adebit, the spread is \nrejected from consideration. If not, it is apotential candidate for investment. \nFOLLOW-UP ACTION \nDepending on the initial credit or debit of the spread, it may not be necessary to take \nany downside defensive action at all. If the initial debit was large, the writer may roll \ndown the written calls as in aratio write. \nExample: An investor has established the ratio write by buying an XYZ July 40 call \nand selling two July 60 calls with the stock near 60. He might have done this because \nthe July 40 was selling at parity. If the underlying stock declines, this spreader could \nroll down to the 50'sand then to the 45's, in the same manner as he would with aratio \nwrite. On the other hand, if the spread was initially set up with contiguous striking \nprices, the lower strike being just below the higher strike, no rolling-down action \nwould be necessary.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:243", "doc_id": "d0ac096e5d067faba00dc54893c3c7413cac1262ae4ceb76fc13b8cc1aa4291d", "chunk_index": 0}
{"text": "218 Part II: Call Option Strategies \nREDUCING THE RATIO \nUpside fallow-up action does not normally consist of rolling up as it does in aratio \nwrite. Rather, one should usually buy some more long calls to reduce the ratio in the \nspread. Eventually, he would want to reduce the spread to 1:1, or anormal bull \nspread. An example may help to illustrate this concept. \nExample: In the initial example, one April 40 call was bought and two April 45'swere \nsold, for anet credit of one point. Assume that the spreader is going to buy one more \nApril 40 as ameans of upside defensive action if he has to. When and if he buys this \nsecond long call, his total position will be anormal bull spread - long 2 April 40'sand \nshort 2 April 45's. The liquidating value of this bull spread would be 10 points if XYZ \nwere above 45 at April expiration, since each of the two bull spreads would widen to \nits maximum potential (5 points) with the stock above 45 in April. The ratio spread\ner originally brought in aone-point credit for the 2:1 spread. If he were later to pay \n11 points to buy the additional long April 40 call, his total outlay would have been 10 \npoints. This would represent abreak-even situation at April expiration if XYZ were \nabove 45 at that time, since it was just shown that the spread could be liquidated for \n10 points in that case. So the ratio spreader could wait to take defensive action until \nthe April call was selling for 11 points. This is adynamic type of follow-up action, one \nthat is dependent on the options' price, not the stock price per se. \nThis outlay of 11 points for the April 40 would leave abreak-even situation as \nlong as the stock did not reverse and fall in price below 45 after the call was bought. \nThe spreader may decide that he would rather leave some room for upside profit \nrather than merely trying to break even if the stock rallies too far. He might thus \ndecide to buy the additional long call at 9 or 10 points rather than waiting for it to get \nto 11. Of course, this might increase the chances of awhipsaw occurring, but it would \nleave some room for upside profits if the stock continues to rise. \nWhere ratios other than 2:1 are involved initially, the same thinking can be \napplied. In fact, the purchase of the additional long calls might take place in atwo\nstep process. \nExample: If the spread was initially long 5 calls and short 10 calls, the spreader \nwould not necessarily have to wait until the April 40'swere selling at 11 and then buy \nall 5 needed to make the spread anormal bull spread. He might decide to buy 2 or \n3 at alower price, thereby reducing his ratio somewhat. Then, if the stock rallied \neven further, he could buy the needed long calls. By buying afew at acheaper price, \nthe spreader gives himself the leeway to wait considerably longer to the upside. In \nessence, all 5 additional long calls in this spread would have to be bought at an aver\nage price of 11 or lower in order for the spread to break even. However, if the first 2", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:244", "doc_id": "737a6f5d05d5bb15833c3af628d987e8611fa515ba4aa763bf23e0fda965f4ee", "chunk_index": 0}
{"text": "Chapter 11: Ratio Call Spreads 219 \nof them are bought for 8 points, the spreader would not have to buy the remaining 3 \nuntil they were selling around 13. Thus, he could wait longer to the upside before \nreducing the spread ratio to 1:1 (abull spread). Aformula can be applied to deter\nmine the price one would have to pay for the additional long calls, to convert the ratio \nspread into abull spread. If the calls are bought, such abull spread would break even \nwith the stock above the higher striking price at expiration: \nBreak-even cost of Number of short calls x Difference in strikes -Total debit to date \nlong calls - Number of naked calls \nIn the simple 2: 1 example, the number of short calls was 2, the difference in the \nstrikes was 5, the total debit was minus one (-1) (since it was actually a 1.:.point cred\nit), and the number of naked calls is 1. Thus, the break-even cost of the additional \nlong call is [2 x 5- (-1)(1)]/l = 11. As another verification of the formula, consider \nthe 10:5 spread at the same prices. The initial credit of this spread would be 5 points, \nand the break-even cost of the five additional long calls is 11 points each. Assume that \nthe spreader bought two additional April 40'sfor 8 points each (16 debit). This would \nmake the total debit to date of the spread equal to 11 points, and reduce the number \nof naked calls to 3. The break-even cost of the remaining 3 long calls that would need \nto be purchased if the stock continued to rally would be (10 x 5 - 11)/3 = 13. This \nagrees with the observation made earlier. This formula can be used before actual fol\nlow-up action is implemented. For example, in the 10:5 spread, if the April 40'swere \n. selling for 8, the spreader might ask: \"To what would Iraise the purchase price of the \nremaining long calls if Ibuy 2 April 40'sfor 8 right now?\" By using the formula, he \ncould easily see that the answer would be 13. \nADJUSTING WITH THE DELTA \nThe theoretically-oriented spreader can use the delta-neutral ratio to monitor his \nspreads as well as to establish them. If the underlying stock moves up in price too far \nor down in price too far, the delta-neutral ratio of the spread will change. The spread\ner can then readjust his spread to aneutral status by buying some additional long calls \non an upside movement by the stock, or by selling some additional short calls on adownward movement by the stock Either action will serve to make the spread delta\nneutral again. The public customer who is employing the delta-neutral adjustment \nmethod of follow-up action should be careful not to overadjust, because the com\nmission costs would become prohibitive. Amore detailed description of the use of \ndeltas as ameans of follow-up action is contained in Chapter 28 on mathematical \napplications, under the heading \"Facilitation or Institutional Block Positioning.\" The \ngeneral concept, however, is the same as that shown earlier for ratio writing.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:245", "doc_id": "e2868328f2ff6468237472af5f5ad5d684a4571533227539dc04b369188616df", "chunk_index": 0}
{"text": "220 Part II: Call Option Strategies \nExample: Early in this chapter, when selection criteria were described, aneutral \nratio was determined to be 16:10, with XYZ at 44. Suppose, after establishing the \nspread, that the common rallied to 4 7. One could use the current deltas to adjust. \nThis information is summarized in Table 11-4. The current neutral ratio is approxi\nmately 14:10. Thus, two of the short April 45'scould be bought closing. In practice, \none usually decreases his ratio by adding to the long side. Consequently, one would \nbuy two April 40's, decreasing his overall ratio to 16:12, which is 1.33 and is close to \nthe actual neutral ratio of 1.38. The position would therefore be delta-neutral once \nmore. \nAn alternative way of looking at this is to use the equivalent stock position \n(ESP), which, for any option, is the multiple of the quantity times the delta times the \nshares per option. The last three lines of Table 11-4 show the ESP for each call and \nfor the position as awhole. Initially, the position has an ESP of 0, indicating that it is \nperfectly delta-neutral. In the current situation, however, the position is delta short \n140 shares. Thus, one could adjust the position to be delta-neutral by buying 140 \nshares of XYZ. If he wanted to use the options rather than the stock, he could buy \ntwo April 45's, which would add adelta long of 130 ESP (2 x .65 x 100), leaving the \nposition delta short 10 shares, which is very near neutral. As pointed out in the above \nparagraph, the spreader probably should buy the call with the most intrinsic value -\nthe April 40. Each one of these has an ESP of 90 (1 x .9 x 100). Thus, if one were \nbought, the position would be delta short 50 shares; if two were bought, the total \nposition would be delta long 40 shares. It would be amatter of individual preference \nwhether the spreader wanted to be long or short the \"odd lot\" of 40 or 50 shares, \nrespectively. \nTABLE 11-4. \nOriginal and current prices and deltas. \nXYZ common \nApril 40 call \nApril 45 call \nApril 40 delta \nApril 45 delta \nNeutral ratio \nApril 40 ESP \nApril 45 ESP \nTotal ESP \nOriginal Situation \n44 \n5 \n3 \n.80 \n.50 \n16:10 (.80/.50) \n800 long (l Ox .8 x 100) \n800 shrt ( 16 x .5 xl 00) \n0 (neutral) \nCurrent Situation \n47 \n8 \n5 \n.90 \n.65 \n14:10 (.90/.65 = 1.38) \n900 long (10 x .9 x 100) \nl ,040 shrt ( 16 x .65 xl 00) \n140 shrt", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:246", "doc_id": "956387567680f2d8fd975b97e660601a7316ab87efe194e493a30442cb0bec3d", "chunk_index": 0}
{"text": "Chapter 11: Ratio Call Spreads 221 \nThe ESP method is merely aconfirmation of the other method. Either one \nworks well. The spreader should become familiar with the ESP method because, in \naposition with many different options, it reduces the exposure of the entire position \nto asingle number. \nTAKING PROFITS \nIn addition to defensive action, the spreader may find that he can close the spread \nearly to take aprofit or to limit losses. If enough time has passed and the underlying \nstock is close to the maximum profit point - the higher striking price - the spreader \nmay want to consider closing the spread and taking his profit. Similarly, if the under\nlying stock is somewhere between the two strikes as expiration draws near, the writer \nwill normally find himself with aprofit as the long call retains some intrinsic value \nand the short calls are nearly worthless. If at this time one feels that there is little to \ngain (aprice decline might wipe out the long call value), he should close the spread \nand take his profit. \nSUMMARY \nRatio spreads can be an attractive strategy, similar in some ways to ratio writing. Both \nstrategies offer alarge probability of making alimited profit. The ratio spread has \nlimited downside risk, or possibly no downside risk at all. In addition, if the long \ncall(s) in the spread can be bought with little or no time value premium in them, the \nratio spread becomes asuperior strategy to the ratio write. One can adjust the ratio \nused to reflect his opinion of the underlying stock or to make aneutral profit range \nif desired. The ratio adjustment can be accomplished by using the deltas of the \noptions. In abroad sense, this is one of the more attractive forms of spreading, since \nthe strategist is buying mostly intrinsic value and is selling arelatively large amount \nof time value.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:247", "doc_id": "31848f080f82e64bf46d8944050a5b6d6459a437bc2e230f41d89802ad33c7ce", "chunk_index": 0}
{"text": "Cotnbining Calendar \nand Ratio Spreads \nThe previous chapters on spreading introduced the basic types of spreads. The sim\nplest forms of bull spreads, bear spreads, or calendar spreads can often be combined \nto produce aposition with amore attractive potential. The butterfly spread, which is \nacombination of abull spread and abear spread, is an example of such acombina\ntion. The next three chapters are devoted to describing other combinations of \nspreads, wherein the strategist not only mixes basic strategies ..:... bull, bear, and calen\ndar - but uses varying expiration dates as well. Although they may seem overly com\nplicated at first glance, these combinations are often employed by professionals in the \nfield. \nRATIO CALENDAR SPREAD \nThe ratio cdendar spread is acombination of the techniques used in the calendar \nand ratio spreads. Recall that one philosophy of the calendar spread strategy was to \nsell the near-term call and buy alonger-term call, with both being out-of-the-money. \nThis is abullish calendar spread. If the underlying stock never advances, the spread\ner loses the entire amount of the relatively small debit that he paid for the spread. \nHowever, if the stock advances after the near-term call expires worthless, large prof\nits are possible. It was stated that this bullish calendar spread philosophy had asmall \nprobability of attaining large profits, and that the few profits could easily exceed the \npreponderance of small losses. \nThe ratio calendar spread is an attempt to raise the probabilities while allowing \nfor large potential profits. In the ratio calendar spread, one sells anumber of near-\n222", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:248", "doc_id": "8fbeb55790bba703afece1d85600ed3f97cbce392e2399483c03619b18ec2d81", "chunk_index": 0}
{"text": "Chapter 12: Combining Calendar and Ratio Spreads 223 \nterm calls while buyingfewer of the intermediate-term or long-term calls. Since more \ncalls are being sold than are being bought, naked options are involved. It is often pos\nsible to set up aratio calendar spread for acredit, meaning that if the underlying \nstock never rallies above the strike, the strategist will still make money. However, \nsince naked calls are involved, the collateral requirements for participating in this \nstrategy may be large. \nExample: As in the bullish calendar spreads described in Chapter 9, the prices are: \nXYZ common, 45; \nXYZ April 50 call, l; and \nXYZ July 50 call, l½. \nIn the bullish calendar spread strategy, one July 50 is bought for each April 50 sold. \nThis means that the spread is established for adebit of½ point and that the invest\nment is $50 per spread, plus commissions. The strategist using the ratio calendar \n/ spread has essentially the same philosophy as the bullish calendar spreader: The \nstock will remain below 50 until April expiration and may then rally. The ratio calen\ndar spread might be set up as follows: \nBuy 1 XYZ July 50 call at l½ \nSell 2 XYZ April 50 calls at 1 each \nNet \nl½ debit \n2 credit \n½ credit \nAlthough there is no cash involved in setting up the ratio spread since it is done for \nacredit, there is acollateral requirement for the naked April 50 call. \nIf the stock remains below 50 until April expiration, the long call - the July 50 \n- will be owned free. After that, no matter what happens to the underlying stock, the \nspread cannot lose money. In fact, if the underlying stock advances dramatically after \nnear-term expiration, large profits will accrue as the July 50 call increases in value. Of \ncourse, this is entirely dependent on the near-term call expiring worthless. If the \nunderlying stock should rally above 50 before the April calls expire, the ratio calen\ndar spread is in danger of losing alarge amount of money because of the naked calls, \nand defensive action must be taken. Follow-up actions are described later. \nThe collateral required for the ratio calendar spread is equal to the amount of \ncollateral required for the naked calls less the credit taken in for the spread. Since \nnaked calls will be marked to market as the stock moves up, it is always best to allow \nenough collateral to get to adefensive action point. In the example above, suppose \nthat one felt he would definitely be taking defensive action if the stock rallied to 53", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:249", "doc_id": "ffb1cc04b763f58789133adc97d5b2c8ab0203818c86d572143ce80d8fc234c0", "chunk_index": 0}
{"text": "224 Part II: Call Option Strategies \nbefore April expiration. He should then figure his collateral requirement as if the \nstock were at 53, regardless of what the collateral requirement is at the current time. \nThis is aprudent tactic whenever naked options are involved, since the strategist will \nnever be forced into an unwanted close-out before his defensive action point is \nreached. The collateral required for this example would then be as follows, assuming \nthe call is trading at 3½: \n20% of 53 \nCall premium \nLess initial credit \nTotal collateral to set aside \n$1,060 \n+ 350 \n-___fill \n$1,360 \nThe strategist is not really \"investing\" anything in this strategy, because his require\nment is in the form of collateral, not cash. That is, his current portfolio assets need \nnot be disturbed to set up this spread, although losses would, of course, create deb\nits in the account. Many naked option strategies are similar in this respect, and the \nstrategist may earn additional money from the collateral value of his portfolio with\nout disturbing the portfolio itself. However, he should take care to operate such \nstrategies in aconservative manner, since any income earned is \"free,\" but losses may \nforce him to disturb his portfolio. In light of this fact, it is always difficult to compute \nreturns on investment in astrategy that requires only collateral to operate. One can, \nof course, compute the return on the maximum collateral required during the life of \nthe position. The large investor participating in such astrategy should be satisfied \nwith any sort of positive return. \nReturning to the example above, the strategist would make his $50 credit, less \ncommissions, if the underlying stock remained below 50 until July expiration. It is not \npossible to determine the results to the upside so definitively. If the April 50 calls \nexpire worthless and then the stock rallies, the potential profits are limited only by \ntime. The case in which the stock rallies before April expiration is of the most con\ncern. If the stock rallies immediately, the spread will undoubtedly show aloss. If the \nstock rallies to 50 more slowly, but still before April expiration, it is possible that the \nspread will not have changed much. Using the same example, suppose that XYZ ral\nlies to 50 with only afew weeks of life remaining in the April 50 calls. Then the April \n50 calls might be selling at l ½ while the July 50 call might be selling at 3. The ratio \nspread could be closed for even money at that point; the cost of buying back the 2 \nApril 50'swould equal the credit received from selling the one July 50. He would thus \nmake½ point, less commissions, on the entire spread transaction. Finally, at the expi\nration date of the April 50 calls, one can estimate where he would break even. \nSuppose one estimated that the July 50 call would be selling for 5½ points if XYZ \nwere at 53 at April expiration. Since the April 50 calls would be selling for 3 at that", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:250", "doc_id": "ab6a4a48d089531bab758edb85d620479d943306fd3aaa82af413ae3e23d917a", "chunk_index": 0}
{"text": "Chapter 12: Combining Calendar and Ratio Spreads 225 \ntime (they would be at parity), there would be adebit of½ point to close the ratio \nspread. The two April 50 calls would be bought for 6 points and the July 50 call sold \nfor 5½ - a ½ debit. The entire spread transaction would thus have broken even, less \ncommissions, at 53 at April expiration, since the spread was put on for a ½ credit and \nwas taken off for a ½ debit. The risk to the upside depends clearly, then, on how \nquickly the stock rallies above 50 before April expiration. \nCHOOSING THE SPREAD \nSome of the same criteria used in setting up abullish calendar spread apply here as \nwell. Select astock that is volatile enough to move above the striking price in the \nallotted time - after the near-term expires, but before the long call expires. Do not \nuse calls that are so far out-of-the-money that it would be virtually impossible for the \nstock to reach the striking price. Always set up the spread for acredit, commissions \nincluded. This will assure that aprofit will be made even if the stock goes nowhere. \nHowever, if the credit has to be generated by using an extremely large ratio - greater \nthan 3 short calls to every long one - one should probably reject that choice, since \nthe potential losses in an immediate rally would be large. \nThe upside break-even point prior to April expiration should be determined \nusing apricing model. Such amodel, or the output from one, can generally be \nobtained from adata service or from some brokerage firms. It is useful to the strate\ngist to know exactly how much room he has to the upside if the stock begins to rally. \nThis will allow him to take defensive action in the form of closing out the spread \nbefore his break-even point is reached. Since apricing model can estimate acall \nprice for any length of time, the strategist can compute his break-even points at \nApril expiration, 1 month before April expiration, 6 weeks before, and so on. When \nthe long option in aspread expires at adifferent time from the short option, the \nbreak-even point is dynamic. That is, it changes with time. Table 12-1 shows how \nthis information might be accumulated for the example spread used above. Since \nthis example spread was established for a ½-point credit with the stock at 45, the \nbreak-even points would be at stock prices where the spread could be removed for \na ½-point debit. Suppose the spread was initiated with 95 days remaining until April \nexpiration. In each line of the table, the cost for buying 2 April 50'sis ½ point more \nthan the price of the July 50. That is, there would be a ½-point debit involved in \nclosing the spread at those prices. Notice that the break-even price increases as time \npasses. Initially, the spread would show aloss if the stock moved up at all. This is to \nbe expected, since an immediate move would not allow for any erosion in the time \nvalue premium of the near-term calls. As more and more time passes, time weighs", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:251", "doc_id": "25ec8c986a2250f8b8c5653febf5000d27b39f6636c0406cc255ab49a05f999e", "chunk_index": 0}
{"text": "226 Part II: Call Option Strategies \nmore heavily on the near-term April calls than on the longer-term July call. Once the \nstrategist has this information, he might then look at achart of the underlying stock. \nIf there is resistance for XYZ below 53, his eventual break-even point at April expi\nration, he could then feel more confident about this spread. \nFOLLOW-UP ACTION \nThe main purpose of defensive action in this strategy is to limit losses if the stock \nshould rally before April e:xJ)iration. The strategist should be quick to close out the \nspread before any serious losses accrue. The long call quite adequately compen\nsates for the losses on the short calls up to acertain point, afact demonstrated in \nTable 12-1. However, the stock cannot be allowed to run. Arule of thumb that is \noften useful is to close the spread if the stock breaks out above technical resistance \nor if it breaks above the eventual break-even point at expiration. In the example \nabove, the strategist would close the spread if, at any time, XYZ rose above 53 \n(before April expiration, of course). \nIf asignificant amount of time has passed, the strategist might act even more \nquickly in closing the spread. As was shown earlier, if the stock rallies to 50 with only \nafew weeks of time remaining, the spread may actually be at aslight profit at that \ntime. It is often the best course of action to take the small profit, if the stock rises \nabove the striking price. \nTABLE 12-1. \nBreak-even points changing over time. \nEstimated Estimated \nDays Remaining until Break-Even Point April 50 July 50 \nApril Expiration (Stock Price) Price Price \n90 45 11/2 \n60 48 Jl/2 21/2 \n30 51 21/2 4 1/2 \n0 53 3 51/2 \nTHE PROBABILITIES ARE GOOD \nThis is astrategy with arather large probability of profit, provided that the defensive \naction described above is adhered to. The spread will make money if the stock never \nrallies above the striking price, since the spread is established for acredit. This in", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:252", "doc_id": "33f4a8bdb2ece59b9569844aca0e224c6f78cae7094122f2e8e896efc039c8a1", "chunk_index": 0}
{"text": "Chapter 12: Combining Calendar and Ratio Spreads 227 \nitself is arather high-probability event, because the stock is initially below the strik\ning price. In addition, the spread can make large potential profits if the stock rallies \nafter the near-term calls expire. Although this is amuch less probable event, the prof\nits that can accrue add to the expected return of the spread. The only time the spread \nloses is when the stock rallies quickly, and the strategist should close out the spread \nin that case to limit losses. \nAlthough Table 12-2 is not mathematically definitive, it can be seen that this \nstrategy has apositive expected return. Small profits occur more frequently than \nsmall losses do, and sometimes large profits can occur. These expected outcomes, \nwhen coupled with the fact that the strategist may utilize collateral such as stocks, \nbonds, or government securities to set up these spreads, demonstrate that this is aviable strategy for the advanced investor. \nTABLE 12-2. \nProfitability of ratio calendar spreading. \nEvent \nStock never rallies above \nstrike \nStock rallies above strike in ashort time \nStock rallies above strike after \nnear-term call expires \nOutcome \nSmall profit. \nSmall loss if defensive \naction employed \nLarge potential profit \nDELTA-NEUTRAL CALENDAR SPREADS \nProbability \nLarge probability \nSmall probability \nSmall probability \nThe preceding discussion dealt with aspecific kind of ratio calendar spread, the out\nof-the-money call spread. Amore accurate ratio can be constructed using the deltas \nof the calls involved, similar to the ratio spreads in Chapter 11. The spread can be \ncreated with either out-of-the-money calls or in-the-money calls. The former has \nnaked calls, while the latter has extra long calls. Both types of ratio calendars are \ndescribed. \nIn either case, the number of calls to sell for each one purchased is determined \nby dividing the delta of the long call by the delta of the short call. This is the same \nfor any ratio spread, not just calendars. \nExample: Suppose XYZ is trading at 45 and one is considering using the July 50 call \nand the April 50 call to establish aratio calendar spread. This is the same situation", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:253", "doc_id": "adf0d319464e0f8eb1cca234427cc9d41ccba1e333b009c13eee6222ef400973", "chunk_index": 0}
{"text": "228 Part II: Call Option Strategies \nthat was described earlier in this chapter. Furthermore, assume that the deltas of the \ncalls in question are .25 for the July and .15 for the April. Given that information, one \ncan compute the neutral ratio to be 1.667 to 1 (.25/.15). That is, one would sell 1.667 \ncalls for each one he bought; restated, he would sell 5 for each 3 bought. \nThis out-of-the-money neutral calendar is typical. One normally sells more calls \nthan he buys to establish aneutral calendar when the calls are out-of-the-money. The \nramifications of this strategy have already been described in this chapter. Follow-up \nstrategy is slightly different, though, and is described later. \nTHE IN-THE-MONEY CALENDAR SPREAD \nWhen the calls are in-the-money, the neutral spread has adistinctly different look. \nAn example will help in describing the situation. \nExample: XYZ is trading at 49, and one wants to establish aneutral calendar spread \nusing the July 45 and April 45 calls. The deltas of these in-the-money calls are .8 for \nthe April and .7 for the July. Note that for in-the-rrwney calls, ashorter-term call has \nahigher delta than alonger-term call. \nThe neutral ratio for this in-the-money spread would be .875 to 1 (.7/.8). This \nmeans that .875 calls would be sold for each one bought; restated, 7 calls would be \nsold and 8 bought. Thus, the spreader is buying more calls than he is selling when \nestablishing an in-the-money neutral calendar. In some sense, one is establishing \nsome \"regular'' calendar spreads (seven of them, in this example) and simultaneous\nly buying afew extra long calls to go along with them ( one extra long call, in this \nexample). \nThis type of position can be quite attractive. First of all, there is no risk to the \nupside as there is with the out-of-the-money calendar; the in-the-money calendar \nwould make money, because there are extra long calls in the position. Thus, if there \nwere to be alarge gap to the upside in XYZ perhaps caused by atakeover attempt \n- the in-the-money calendar would make money. If, on the other hand, XYZ stays in \nthe same area, then the regular calendar spread portion of the strategy will make \nmoney. Even though the extra call would probably lose some time value premium in \nthat event, the other seven spreads would make alarge enough profit to easily com\npensate for the loss on the one long call. The least desirable result would be for XYZ \nto drop precipitously. However, in that case, the loss is limited to the amount of the \ninitial debit of the spread. Even in the case of XYZ dropping, though, follow-up \naction can be taken. There are no naked calls to margin with this strategy, making it \nattractive to many smaller investors. In the above example, one would need to pay for \nthe entire debit of the position, but there would be no further requirements.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:254", "doc_id": "1d0ba41fae905e3043f9dd9007e28ec6fe43da86b8e9727a684a8053e4fb564d", "chunk_index": 0}
{"text": "Chapter 12: Combining Calendar and Ratio Spreads \nFOLLOW-UP ACTION \n229 \nIf one decides to preserve aneutral strategy with follow-up action in either type of \nratio call calendar, he would merely need to look at the deltas of the calls and keep \nthe ratio neutral. Doing so might mean that one would switch from one type of cal\nendar spread to the other, from the out-of-the-money with naked calls to the in-the\nmoney with extra long calls, or vice versa. For example, if XYZ started at 45, as in the \nfirst example, one would have sold more calls than he bought. If XYZ then rallied \nabove 50, he would have to move his position into the in-the-money ratio and get \nlong more calls than he is short. \nWhile such follow-up action is strategically correct maintaining the neutral \nratio - it might not make sense practically, especially if the size of the original spread \nwere small. If one had originally sold 5 and bought 3, he would be better to adhere \nto the follow-up strategy outlined earlier in this chapter. The spread is not large \nenough to dictate adjusting via the delta-neutral ratios. If, however, alarge trader had \noriginally sold 500 calls and bought 300, then he has enough profitability in the \nspread to make several adjustments along the way. \nIn asimilar manner, the spreader who had established asmall in-the-money cal\nendar might decide not to bother rationing the spread if the stock dropped below the \nstrike. He knows his risk is limited to his initial debit, and that would be small for asmall spread. He might not want to introduce naked options into the position if XYZ \ndeclines. However, if the same spread were established by alarge trader, it should be \nadjusted because of the greater tolerance of the spread to being adjusted, merely \nbecause of its size.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:255", "doc_id": "4a5318e9cad14da980574ee843579deac9040a7b20388de6a82b84e1a99f24f3", "chunk_index": 0}
{"text": "Reverse Spreads \nIn general, when astrategy has the term \"reverse\" in its name, the strategy is the \nopposite of amore commonly used strategy. The reader should be familiar with this \nnomenclature from the earlier discussions comparing ratio writing (buying stock and \nselling calls) with reverse hedging (shorting stock and buying calls). If the reverse \nstrategy is sufficiently well-known, it usually acquires aname of its own. For exam\nple, the bear spread is really the reverse of the bull spread, but the bear spread is apopular enough strategy in its own right to have acquired ashorter, unique name. \nREVERSE CALENDAR SPREAD \nThe reverse calendar spread is an infrequently used strategy, at least for public cus\ntomers trading stock or index options, because of the margin requirements. However, \neven then, it does have aplace in the arsenal of the option strategist. Meanwhile, pro\nfessionals and futures option traders use the strategy with more frequency because \nthe margin treatment is more favorable for them. \nAs its name implies, the reverse calendar spread is aposition that is just the \nopposite of a \"normal\" calendar spread. In the reverse calendar spread, one sells along-term call option and simultaneously buys ashorter-term call option. The spread \ncan be constructed with puts as well, as will be shown in alater chapter. Both calls \nhave the same striking price. \nThis strategy will make money if one of two things happens: Either (1) the stock \nprice moves away from the striking price by agreat deal, or (2) the inplied volatility \nof the options involved in the spread shrinks. For readers familiar with the \"normal\" \ncalendar spread strategy, the first way to profit should be obvious, because a \"normal\" \n230", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:256", "doc_id": "574b2f8e60b386a7ae4d3983006e4771a73cefd64a9c5d3cfaf114076c22e7c2", "chunk_index": 0}
{"text": "Chapter 13: Reverse Spreads 231 \ncalendar spread makes the most money if the stock is right at the strike price at expi\nration, and it loses money if the stock rises or falls too far. \nAs with any spread involving options expiring in differing months, it is common \npractice to look at the profitability of the position at or before the near-term expira\ntion. An example will show how this strategy can profit. \nExample: Suppose the current month is April and that XYZ is trading at 80. \nFurthermore, suppose that XYZ'soptions are quite expensive, and one believes the \nunderlying stock will be volatile. Areverse calendar spread would be away to profit \nfrom these assumptions. The following prices exist: \nXYZ December 80 call: 12 \nXYZ July 80 call: 7 \nAreverse calendar spread is established by selling the December 80 call for 12 \npoints, and buying the July 80 call for 7, anet credit of 5 points for the spread. \nIf, later, XYZ falls dramatically, both call options will be nearly worthless and the \nspread could be bought back for aprice well below 5. For example, if XYZ were to \nfall to 50 in amonth or so, the July 80 call would be nearly worthless and the \nDecember 80 call could be bought back for about apoint. Thus, the spread would \nhave shrunk from its initial price of 5 to aprice of about 1, aprofit of 4 points. \nThe other way to make money would be for implied volatility to decrease. \nSuppose implied volatility dropped after amonth had passed. Then the spread might \nbe worth something like 4 points - an unrealized profit of about 1 point, since it was \nsold for aprice of 5 initially. \nThe profit graph in Figure 13-1 shows the profitability of the reverse calendar. \nThere are two lines on the graph, both of which depict the results at the expiration \nof the near-term option (the July 80 call in the above example). The lower line shows \nwhere profits and losses would occur if implied volatility remained unchanged. You \ncan see that the position could profit if XYZ were to rise above 98 or fall below 70. \nIn addition, the higher curve on the graph shows where profits would lie if implied \nvolatility fell prior to expiration of the near-term options. In that case, additional prof\nits would accrue, as depicted on the graph. \nSo there are two ways to make money with this strategy, and it is therefore best \nto establish it when implied volatility is high and the underlying has atendency to be \nvolatile. \nThe problem with this spread, for stock and index option traders, is that the call \nthat is sold is considered to be naked. This is preposterous, of course, since the short\nterm call is aperfectly valid hedge until it expires. Yet the margin requirements \nremain onerous. When they were overhauled recently, this glaring inefficiency was", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:257", "doc_id": "be9b7b3272053279857888d964318ea33ee3609ebc488585c72b5a8b0d8455ad", "chunk_index": 0}
{"text": "232 Part II: Call Option Strategies \nFigure 13-1 • \nCalendar spread sale at near-term expiration. \n$400 \n$300 \nImplied Volatility \nLower \n$200 \\ \nf/) \n$100 f/) \n0 \n~ \n$0 50 60 110 120 \na. -$100 \n-$200 \n-$300 \nImplied Volatility \n-$400 Remains High \n-$500 \nUnderlying Price \nallowed to stand because none of the member firms cared about changing it. Still, if \none has excess collateral - perhaps from alarge stock portfolio - and is interested in \ngenerating excess income in ahedged manner, then the strategy might be applicable \nfor him as well. Futures option traders receive more favorable margin requirements, \nand it thus might be amore economical strategy for them. \nREVERSE RATIO SPREAD (BACKSPREAD) \nAmore popular reverse strategy is the reverse ratio call spread, which is comrrwnly \nknown as abackspread. In this type of spread, one would sell acall at one striking \nprice and then would buy several calls at ahigher striking price. This is exactly the \nopposite of the ratio spread described in Chapter 11. Some traders refer to any \nspread with unlimited profit potential on at least one side as abackspread. Thus, in \nmost backspreading strategies, the spreader wants the stock to rrwve dramatically. He \ndoes not generally care whether it moves up or down. Recall that in the reverse \nhedge strategy (similar to astraddle buy) described in Chapter 4, the strategist had \nthe potential for large profits if the stock moved either up or down by agreat deal. \nIn the backspread strategy discussed here, large potential profits exist if the stock \nmoves up dramatically, but there is limited profit potential to the downside. \nExample: XYZ is selling for 43 and the July 40 call is at 4, with the July 45 call at l. \nAreverse ratio spread would be established as follows: ·", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:258", "doc_id": "5af87a8abca7014eb0b6455bd778d00d2bbe069fcbec9d50a69a9a485b0c21ad", "chunk_index": 0}
{"text": "Chapter 13: Reverse Spreads \nBuy 2 July 45 calls at 1 each \nSell 1 July 40 call at 4 \nNet \n2 debit \n4 credit \n2 credit \n233 \nThese spreads are generally established for credits. In fact, if the spread cannot \nbe initiated at acredit, it is usually not attractive. If the underlying stock drops in \nprice and is below 40 at July expiration, all the calls will expire worthless and the \nstrategist will make aprofit equal to his initial credit. The maximum downside poten\ntial of the reverse ratio spread is equal to the initial credit received. On the other \nhand, if the stock rallies substantially, the potential upside profits are unlimited, since \nthe spreader owns more calls than he is short. Simplistically, the investor is bullish \nand is buying out-of the-money calls but is simultaneously hedging himself by selling \nanother call. He can profit if the stock rises in price, as he thought it would, but he \nalso profits if the stock collapses and all the calls expire worthless. \nThis strategy has limited risk. With most spreads, the maximum loss is attained \nat expiration at the striking price of the purchased call. This is atrue statement for \nbackspreads. \nExample: IfXYZ is at exactly 45 at July expiration, the July 45 calls will expire worth\nless for aloss of $200 and the July 40 call will have to be bought back for 5 points, a \n$100 loss on that call. The total loss would thus be $300, and this is the most that can \nbe lost in this example. If the underlying stock should rally dramatically, this strategy \nhas unlimited profit potential, since there are two long calls for each short one. In \nfact, one can always compute the upside break-even point at expiration. That break\neven point happens to be 48 in this example. At 48 at July expiration, each July 45 \ncall would be worth 3 points, for anet gain of $400 on the two of them. The July 40 \ncall would be worth 8 with the stock at 48 at expiration, representing a $400 loss on \nthat call. Thus, the gain and the loss are offsetting and the spread breaks even, except \nfor commissions, at 48 at expiration. If the stock is higher than 48 at July expiration, \nprofits will result. \nTable 13-1 and Figure 13-2 depict the potential profits and losses from this \nexample of areverse ratio spread. Note that the profit graph is exactly like the prof\nit graph of aratio spread that has been rotated around the stock price axis. Refer to \nFigure 11-1 for agraph of the ratio spread. There is actually arange outside of which \nprofits can be made - below 42 or above 48 in this example. The maximum loss \noccurs at the striking price of the purchased calls, or 45, at expiration. \nThere are no naked calls in this strategy, so the investment is relatively small. \nThe strategy is actually along call added to abear spread. In this example, the bear", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:259", "doc_id": "c588b16dbf280c9c159ccac68628c0ec076989395359aeb6d1588dfcc638b36a", "chunk_index": 0}
{"text": "234 Part II: Call Option Strategies \nTABLE 13·1. \nProfits and losses for reverse ratio spread. \nXYZ Price at Profit on Profit on Total \nJuly Expiration 1 July 40 2 July 45's Profit \n35 +$ 400 -$ 200 +$ 200 \n40 + 400 200 + 200 \n42 + 200 200 0 \n45 100 200 300 \n48 400 + 400 0 \n55 - 1,100 + 1,800 + 700 \n70 - 2,600 + 4,800 + 2,200 \nspread portion is long the July 45 and short the July 40. This requires a $500 collat\neral requirement, because there are 5 points difference in the striking prices. The \ncredit of $200 received for the entire spread can be applied against the initial \nrequirement, so that the total requirement would be $300 plus commissions. There \nis no increase or decrease in this requirement, since there are no naked calls. \nNotice that the concept of adelta-neutral spread can be utilized in this strate\ngy, in much the same way that it was used for the ratio call spread. The number of \ncalls to buy and sell can be computed mathematically by using the deltas of the \noptions involved. \nExample: The neutral ratio is determined by dividing the delta of the July 45 into the \ndelta of the July 40. \nPrices \nXYZ common: = 43 \nXYZ July 40 call: 4 \nXYZ July 45 call: \nDelta \n.80 \n.35 \nIn this case, that would be aratio of 2.29:1 (.80/.35). That is, if one sold 5 July 40's, \nhe would buy 11 July 45's (or if he sold 10, he would then buy 23). By beginning with \naneutral ratio, the spreader should be able to make money on aquick move by the \nstock in either direction. \nThe neutral ratio can also help the spreader to avoid being too bearish or too \nbullish to begin with. For example, aspreader would not be bullish enough if he", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:260", "doc_id": "037b96dda2288d2cce571eb1b87005e57e30268932781237bb0c895ec381a76c", "chunk_index": 0}
{"text": "Chapter 13: Reverse Spreads \nFIGURE 13-2. \nReverse ratio spread (backspread). \nC: \n~ +$200 \n;% \n:!:: \nea. -$300 \nStock Price at Expiration \n235 \nmerely used a 2:1 ratio for convenience, instead of using the 2.3:lratio. If anything, \none might normally establish the spread with an extra bullish emphasis, since the \nlargest profits are to the upside. There is little reason for the spreader to have too lit\ntle bullishness in this strategy. Thus, if the deltas are correct, the neutral ratio can aid \nthe spreader in the determination of amore accurate initial ratio. \nThe strategist must be alert to the possibility of early exercise in this type of \nspread, since he has sold acall that is in-the-money. Aside from watching for this pos\nsibility, there is little in the way of defensive follow-up action that needs to be imple\nmented, since the risk is limited by the nature of the position. He might take profits \nby closing the spread if the stock rallies before expiration. \nThis strategy presents areasonable method of attempting to capitalize on alarge stock movement with little tie-up of collateral. Generally, the strategist would \nseek out volatile stocks for implementation of this strategy, because he would want as \nmuch potential movement as possible by the time the calls expire. In Chapter 14, it \nwill be shown that this strategy can become more attractive by buying calls with alonger maturity than the calls sold.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:261", "doc_id": "25b33bda6b518644d85c32d3ed85feb4e95d08ac289d373bdcc4b1d533193c9b", "chunk_index": 0}
{"text": "CH.APTER 14 \nDiagonalizing a Spread \nWhen one uses both different striking prices and different expiration dates in aspread, it is adiagonal spread. Generally, the long side of the spread would expire \nlater than the short side of the spread. Note that this is within the definition of aspread for margin purposes: The long side must have amaturity equal to or longer \nthan the maturity of the short side. With the exception of calendar spreads, all the \nprevious chapters on spreads have described ones in which the expiration dates of the \nshort call and the long call were the same. However, any of these spreads can be diag\nonalized; one can replace the long call in any spread with one expiring at alater date. \nIn general, diagonalizing aspread in this manner makes it slightly rrwre bear\nish at near-term expiration. This can be seen by observing what would happen if the \nstock fell or rose substantially. If the stock falls, the long side of the spread will retain \nsome value because of its longer maturity. Thus, adiagonal spread will generally do \nbetter to the downside than will aregular spread. If the stock rises substantially, all \ncalls will come to parity. Thus, there is no advantage in the long-term call; it will be \nselling for approximately the same price as the purchased call in anormal spread. \nHowever, since the strategist had to pay more originally for the longer-term call, his \nupside profits would not be as great. \nAdiagonalized position has an advantage in that one can reestablish the posi\ntion if the written calls expire worthless in the spread. Thus, the increased cost of \nbuying alonger-term call initially may prove to be asavings if one can write against \nit twice. These tactics are described for various spread strategies. \nTHE DIAGONAL BULL SPREAD \nAvertical call bull spread consists of buying acall at alower striking price and sell\ning acall at ahigher striking price, both with the same expiration date. The diagonal \n236", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:262", "doc_id": "46b19de316842cb379132901ed28fa935ca51b13cd4076577afdcc71918f80cb", "chunk_index": 0}
{"text": "Chapter 14: Diagonalizing a Spread 231 \nbull spread would be similar except that one would buy alonger-tenn call at the lower \nstrike and would sell anear-tenn call at the higher strike. The number of calls long \nand short would still be the same. By diagonalizing the spread, the position is hedged \nsomewhat on the downside in case the stock does not advance by near-term expira\ntion. Moreover, once the near-term option expires, the spread can often be reestab\nlished by selling the call with the next maturity. \nExample: The following prices exist: \nStrike April Ju~ October Stock Price \nXYZ 30 3 4 5 32 \nXYZ 35 11/2 2 32 \nAvertical bull spread could be established in any of the expiration series by buying \nthe call with 30 strike and selling the call with 35 strike. Adiagonal bull spread would \nconsist of buying the July 30 or October 30 and selling the April 35. To compare avertical bull spread with adiagonal spread, the following two spreads will be used: \nVertical bull spread: buy the April 30 call, sell the April 35 - 2 debit \nDiagonal bull spread: buy the July 30 call, sell the April 35 3 debit \nThe vertical bull spread has a 3-point potential profit if XYZ is above 35 at April expi\nration. The maximum risk in the normal bull spread is 2 points (the original debit) if \nXYZ is anywhere below 30 at April expiration. By diagonalizing the spread, the strate\ngist lowers his potential profit slightly at April expiration, but also lowers the proba\nbility of losing 2 points in the position. Table 14-1 compares the two types of spreads \nat April expiration. The price of the July 30 call is estimated in order to derive the \nestimated profits or losses from the diagonal bull spread at that time. If the underly\ning stock drops too far - to 20, for example - both spreads will experience nearly atotal loss at April expiration. However, the diagonal spread will not lose its entire \nvalue if XYZ is much above 24 at expiration, according to Table 14-1. The diagonal \nspread actually has asmaller dollar loss than the normal spread between 27 and 32 \nat expiration, despite the fact that the diagonal spread was more expensive to estab\nlish. On apercentage basis, the diagonal spread has an even larger advantage in this \nrange. If the stock rallies aboye 35 by expiration, the normal spread will provide alarger profit. There is an interesting characteristic of the diagonal spread that is \nshown in Table 14-1. If the stock advances substantially and all the calls come to par\nity, the profit on the diagonal spread is limited to 2 points. However, if the stock is \nnear 35 at April expiration, the long call will have some time premium in it and the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:263", "doc_id": "97bd20731deb744ae4a42c6d98d94034767c08588e39673a67411676ce50e3a5", "chunk_index": 0}
{"text": "238 Part II: Call Option Strategies \nTABLE 14-1. \nComparison of spreads at expiration. \nVertical Bull \nXYZ Price at April 30 April 35 July 30 Spread Diagonal \nApril Expiration Price Price Price Profit Spread Profit \n20 0 0 0 -$200 -$300 \n24 0 0 1/2 - 200 - 250 \n27 0 0 1 - 200 - 200 \n30 0 0 2 - 200 - 100 \n32 2 0 3 0 0 \n35 5 0 51/2 + 300 + 250 \n40 10 5 10 + 300 + 200 \n45 15 10 15 + 300 + 200 \nspread will actually widen to more than 5 points. Thus, the maximum area of profit \nat April expiration for the diagonal spread is to have the stock near the striking price \nof the written call. The figures demonstrate that the diagonal spread gives up asmall \nportion of potential upside profits to provide ahedge to the downside. \nOnce the April 35 call expires, the diagonal spread can be closed. However, if \nthe stock is below 35 at that time, it may be more prudent to then sell the July 35 call \nagainst the July 30 call that is held long. This would establish anormal bull spread for \nthe 3 months remaining until July expiration. Note that ifXYZ were still at 32 at April \nexpiration, the July 35 call might be sold for 1 point if the stock'svolatility was about \nthe same. This should be true, since the April 35 call was worth 1 point with the stock \nat 32 three months before expiration. Consequently, the strategist who had pursued \nthis course of action would end up with anormal July bull spread for anet debit of 2 \npoints: He originally paid 4 for the July 30 call, but then sold the April 35 for 1 point \nand subsequently sold the July 35 for 1 point. By looking at the table of prices for the \nfirst example in this chapter, the reader can see that it would have cost 2½ points to \nset up the normal July bull spread originally. Thus, by diagonalizing and having the \nnear-term call expire worthless, the strategist is able to acquire the normal July bull \nspread at acheaper cost than he could have originally. This is aspecific example of \nhow the diagonalizing effect can prove beneficial if the writer is able to write against \nthe same long call two times, or three times if he originally purchased the longest\nterm call. In this example, if XYZ were anywhere between 30 and 35 at April expira\ntion, the spread would be converted to anormal July bull spread. If the stock were \nabove 35, the spread should be closed to take the profit. Below 30, the July 30 call \nwould probably be closed or left outright long.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:264", "doc_id": "38ab386557e28e1616dd8e1f2b4de5bb1b74d50bf971c371dfae5668648e2e04", "chunk_index": 0}
{"text": "Chapter 14: Diagonalizing a Spread 239 \nIn summary, the diagonal bull spread may often be an improvement over the \nnormal bull spread. The diagonal spread is an improvement when the stock remains \nrelatively unchanged or falls, up until the near-term written call expires. At that time, \nthe spread can be converted to anormal bull spread if the stock is at afavorable price. \nOf course, if at any time the underlying stock rises above the higher striking price at \nan expiration date, the diagonal spread will be profitable. \nOWNING A CALL FOR \"FREE\" \nDiagonalization can be used in other spread strategies to accomplish much the same \npurposes already described; but in addition, it may also be possible for the spreader \nto wind up owning along call at asubstantially reduced cost, possibly even for free. \nThe easiest w~yto see this would be to consider adiagonal bear spread. \nExample: XYZ is at 32 and the near-term April 30 call is selling for 3 points while the \nlonger-term July 35 call is selling for 1 ½ points. Adiagonal bear spread could be \nestablished by selling the April 30 and buying the July 35. This is still abear spread, \nbecause acall with alower striking price is being sold while acall at ahigher strike \nis being purchased. However, since the purchased call has alonger maturity date \nthan the written call, the spread is diagonalized. \nThis diagonal bear spread will make money ifXYZ falls in price before the near\nterm April call expires. For example, ifXYZ is at 29 at expiration, the written call will \nexpire worthless and the July 35 will still have some value, perhaps ½. Thus, the prof\nit would be 3 points on the April 30, less a 1-point loss on the July 35, for an overall \nprofit of 2 points. The risk in the position lies to the upside, just as in aregular bear \nspread. If XYZ should advance by agreat deal, both options would be at parity and \nthe spread would have widened to 5 points. Since the initial credit was 1 ½ points, the \nloss would be 5 minus 1 ½, or 3½ points in that case. As in all diagonal spreads, the \nspread will do slightly better to the downside because the long call will hold some \nvalue, but it will do slightly worse to the upside if the underlying stock advances sub\nstantially. \nThe reason that astrategist might attempt adiagonal bear spread would not be \nfor the slight downside advantage that the diagonalizing effect produces. Rather it \nwould be because he has achance of owning the July 35 call - the longer-term call -\nfor asubstantially reduced cost. In the example, the cost of the July 35 call was 1 ½ \npoints and the premium received from the sale of the April 30 call was 3 points. If \nthe spreader can make 1 ½ points from the sale of the April 30 call, he will have com\npletely covered the cost of his July option. He can then sit back and hope for arally", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:265", "doc_id": "be5c860e104692d163bafad332bb657616508e5e855a3bf60f1826fffcf652d2", "chunk_index": 0}
{"text": "240 Part II: Call Option Strategies \nby the underlying stock. If such arally occurred, he could make unlimited profits on \nthe long side. If it did not, he loses nothing. \nExample: Assume that the same spread was established as in the last example. Then, \nif XYZ is at or below 31 ½ at April expiration, the April 30 call can be purchased for \n1 ½ points or less. Since the call was originally sold for 3, this would represent aprof\nit of at least 1 ½ points on the April 30 call. This profit on the near-term option cov\ners the entire cost of the July 35. Consequently, the strategist owns the July 35 for \nfree. If XYZ never rallies above 35, he would make nothing from the overall trade. \nHowever, if XYZ were to rally above 35 after April expiration (but before July expi\nration, of course), he could make potentially large profits. Thus, when one establish\nes adiagonal spread for acredit, there is always the potential that he could own acall \nfor free. That is, the profits from the sale of the near-term call could equal or exceed \nthe original cost of the long call. This is, of course, adesirable position to be in, for if \nthe underlying stock should rally substantially after profits are realized on the short \nside, large profits could accrue. \nDIAGONAL BACKSPREADS \nIn an analogous strategy, one might buy more than one longer-term call against the \nshort-term call that is sold. Using the foregoing prices, one might sell the April 30 for \n3 points and buy 2 July 35'sat 1 ½ points each. This would be an even money spread. \n. The credits equal the debits when the position is established. If the April 30 call \nexpires worthless, which would happen if the stock was below 30 in April, the spread\ner would own 2 July 35 calls for free. Even if the April 30 does not expire totally \nworthless, but if some profit can be made on the sale of it, the July 35'swill be owned \nat areduced cost. In Chapter 13, when reverse spreads were discussed, the strategy \nin which one sells acall with alower strike and then buys more calls at ahigher strike \nwas termed areverse ratio spread, or backspread. The strategy just described is \nmerely the diagonalizing of abackspread. This is astrategy that is favored by some \nprofessionals, because the short call reduces the risk of owning the longer-term calls \nif the underlying stock declines. Moreover, if the underlying stock advances, the pre\nponderance of long calls with alonger maturity will certainly outdistance the losses \non the written call. The worst situation that could result would be for the underlying \nstock to rise very slightly by near-term expiration. If this happened, it might be pos\nsible to lose money on both sides of the spread. This would have to be considered arather low-probability event, though, and would still represent alimited loss, so it \ndoes not substantially offset the positive aspects of the strategy.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:266", "doc_id": "de5fceb78f7fd534421908b8c6d8a44bf073e78b08ffd4d62e85e60d4ae73038", "chunk_index": 0}
{"text": "0.,ter 14: Diagonalizing a Spread 241 \nAny type of spread may be diagonalized. There are some who prefer to diago\nnalize even butterfly spreads, figuring that the extra time to maturity in the purchased \ncalls will be of benefit. Overall, the benefits of diagonalizing can be generalized by \nrecalling the way in which the decay of the time value premium of acall takes place. \nRecall that it was determined that acall loses most of its time value premium in the \nlast stages of its life. When it is avery long-term option, the rate of decay is small. \nKnowing this fact, it makes sense that one would want to sell options with ashort life \nremaining, so that the maximum benefit of the decay could be obtained. \nCorrespondingly, the purchase of alonger-term call would mean that the buyer is not \nsubjecting himself to asubstantial loss in time value premium, at least over the first \nthree months of ownership. Adiagonal spread encompasses both of these features -\nselling ashort-term call to try to obtain the maximum rate of time decay, while buy\ning alonger-term call to try to lessen the effect of time decay on the long side. \nCALL OPTION SUMMARY \nThis concludes the description of strategies that utilize only call options. The call \noption has been seen to be avehicle that the astute strategist can use to set up awide \nvariety of positions. He can be bullish or bearish, aggressive or conservative. In addi\ntion, he can attempt to be neutral, trying to capitalize on the probability that astock \nwill not move very far in ashort time period. \nThe investor who is not familiar with options should generally begin with asim\nple strategy, such as covered call writing or outright call purchases. The simplest \ntypes of spreads are the bull spread, the bear spread, and the calendar spread. The \nmore sophisticated investor might consider using ratios in his call strategies - ratio \nwriting against stock or ratio spreading using only calls. \nOnce the strategist feels that he understands the risk and reward relationships \nbetween longer-term and short-term calls, between in-the-money and out-of-the\nmoney calls, and between long calls and short calls, he could then consider utilizing \nthe most advanced types of strategies. This might include reverse ratio spreads, diag\nonal spreads, and more advanced types of ratios, such as the ratio calendar spread. \nAgreat deal of information, some of it rather technical in detail, has been pre\nsented in preceding chapters. The best pattern for an investor to follow would be to \nattempt only strategies that he fully comprehends. This does not mean that he mere\nly understands the profitability aspects (especially the risk) of the strategy. One must \nalso be able to readily understand the potential effects of early assignments, large div\nidend payments, striking price adjustments, and the like, if he is going to operate \nadvanced strategies. Without afull understanding of how these things might affect \none'sposition, one cannot operate an advanced strategy correctly.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:267", "doc_id": "b018abbba25b6fbcafc8abd66a14959bdf1a57b51a81b351a2e5f23e2441df6b", "chunk_index": 0}
{"text": "INTRODUCTION \nAput option gives the holder the right to sell the underlying security at the striking \nprice at any time until the expiration date of the option. Listed put options are \nslightly newer than listed call options, having been introduced on June 3, 1977. The \nintroduction of listed puts has provided amuch wider range of strategies for both \nconservative and aggressive investors. The call option is least effective in strategies \nin which downward price movement by the underlying stock is concerned. The put \noption is auseful tool in that case. \nAll stocks with listed call options have listed put options as well. The use of puts \nor the combination of puts and calls can provide more versatility to the strategist. \nWhen listed put options exist, it is no longer necessary to implement strategies \ninvolving long calls and short stock. Listed put options can be used more efficiently \nin such situations. There are many similarities between call strategies and put \nstrategies. For example, put spread strategies and call spread strategies employ sim\nilar tactics, although there are technical differences, of course. In certain strategies, \nthe tactics for puts may appear largely to be arepetition of those used for calls, but \nthey are nevertheless spelled out in detail here. The strategies that involve the use \nof both puts and calls together - straddles and combinations - have techniques of \ntheir own, but even in these cases the reader will recognize certain similarities to \nstrategies previously discussed. Thus, the introduction of put options not only \nwidens the realm of potential strategies, but also makes more efficient some of the \nstrategies previously described. \n244", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:270", "doc_id": "8ff1556391e07d17d25ef82d3bde39647450d7100d590651a6fcfb0554902547", "chunk_index": 0}
{"text": "CH.APTER 15 \nPut Option Basics \nMuch of the same terminology that is applied to call options also pertains to put \noptions. Underlying security, striking price, and expiration date are all terms that \nhave the same meaning for puts as they do for calls. The expiration dates of listed put \noptions agree with the expiration dates of the calls on the same underlying stock. In \naddition, puts and calls have the same striking prices. This means that if there are \noptions at acertain strike, say on aparticular underlying stock that has both listed \nputs and calls, both calls at 50 and puts at 50 will be trading, regardless of the price \nof the underlying stock. Note that it is no longer sufficient to describe an option as \nan \"XYZ July 50.\" It must also be stated whether the option is aput or acall, for an \nXYZ July 50 call and an XYZ July 50 put are two different securities. \nIn many respects, the put option and its associated strategies will be very near\nly the opposite of corresponding call-oriented strategies. However, it is not correct to \nsay that the put is exactly the opposite of acall. In this introductory section on puts, \nthe characteristics of puts are described in an attempt to show how they are similar \nto calls and how they are not. \nPUT STRATEGIES \nIn the simplest terms, the outright buyer of aput is hoping for astock price decline \nin order for his put to become more valuable. If the stock were to decline well below \nthe striking price of the put option, the put holder could make aprofit. The holder \nof the put could buy stock in the open market and then exercise his put to sell that \nstock for aprofit at the striking price, which is higher. \nExample: If XYZ stock is at 40, an XYZ July 50 put would be worth at least 10 points, \nfor the put grants the holder the right to sell XYZ at 50 - 10 points above its current \n245", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:271", "doc_id": "6584daefa0cfe0611b4ffe0d8acb1e1f8add3bd8ce1382ceae0fdaeae9ef7b97", "chunk_index": 0}
{"text": "CHAPTER 15 \nPut Option Basics \nMuch of the same terminology that is applied to call options also pertains to put \noptions. Underlying security, striking price, and expiration date are all terms that \nhave the same meaning for puts as they do for calls. The expiration dates of listed put \noptions agree with the expiration dates of the calls on the same underlying stock. In \naddition, puts and calls have the same striking prices. This means that if there are \noptions at acertain strike, say on aparticular underlying stock that has both listed \nputs and calls, both calls at 50 and puts at 50 will be trading, regardless of the price \nof the underlying stock. Note that it is no longer sufficient to describe an option as \nan \"XYZ July 50.\" It must also be stated whether the option is aput or acall, for an \nXYZ July 50 call and an XYZ July 50 put are two different securities. \nIn many respects, the put option and its associated strategies will be very near\nly the opposite of corresponding call-oriented strategies. However, it is not correct to \nsay that the put is exactly the opposite of acall. In this introductory section on puts, \nthe characteristics of puts are described in an attempt to show how they are similar \nto calls and how they are not. \nPUT STRATEGIES \nIn the simplest terms, the outright buyer of aput is hopingfor astock price decline \nin order for his put to become more valuable. If the stock were to decline well below \nthe striking price of the put option, the put holder could make aprofit. The holder \nof the put could buy stock in the open market and then exercise his put to sell that \nstock for aprofit at the striking price, which is higher. \nExample: If XYZ stock is at 40, an XYZ July 50 put would be worth at least 10 points, \nfor the put grants the holder the right to sell XYZ at 50 10 points above its current \n245", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:273", "doc_id": "7791cb614cc9226ca96c543e2b967a4f4102b7eab9e257d21601669f0f56bb6b", "chunk_index": 0}
{"text": "246 Part Ill: Put Option Strategies \nprice. On the other hand, if the stock price were above the striking price of the put \noption at expiration, the put would be worthless. No one would logically want to exer\ncise aput option to sell stock at the striking price when he could merely go to the \nopen market and sell the stock for ahigher price. Thus, as the price of the underly\ning stock declines, the put becomes more valuable. This is, of course, the opposite of \nacall option'sprice action. \nThe meaning of in-the-money and out-of-the-money are altered when one is \nspeaking of put options. Aput is considered to be in-the-money when the underlying \nstock is below the striking price of the put option; it is out-of the-money when the \nstock is above the striking price. This, again, is the opposite of the call option. IfXYZ \nis at 45, the XYZ July 50 put is in-the-money and the XYZ July 50 call is out-of-the\nmoney. However, ifXYZ were at 55, the July 50 put would be out-of-the-money while \nthe July 50 call would be in-the-money. The broad definition of an in-the-money \noption as \"an option that has intrinsic value\" would cover the situation for both puts \nand calls. Note that aput option has intrinsic value when the underlying stock is \nbelow the striking price of the put. That is, the put has some \"real\" value when the \nstock is below the striking price. \nThe intrinsic value of an in-the-money put is merely the difference between \nthe striking price and the stock price. Since the put is an option (to sell), it will gen\nerally sell for more than its intrinsic value when there is time remaining until the \nexpiration date. This excess value over its intrinsic value is referred to as the time \nvalue premium, just as is the case with calls. \nExample: XYZ is at 47 and the XYZ July 50 put is selling for 5, the intrinsic value is \n3 points (50- 47), so the time value premium must be 2 points. The time value pre\nmium of an in-the-money put option can always be quickly computed by the follow\ning formula: \nTime value premium p . Sk · St \"ki · • ) == ut option + toe pnce - nng pnce (m-the-money put \nThis is not the same formula that was applied to in-the-money call options, although \nit is always true that the time value premium of an option is the excess value over \nintrinsic value. \nTime value premium Call ti S ·ki · St k · . all == op on + tn ng pnce - oc pnce (m-the-money c ) \nIf the put is out-of-the-money, the entire premium of the put is composed of time \nvalue premium, for the intrinsic value of an out-of-the-money option is always zero.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:274", "doc_id": "d66b7c7d2980120e4a31bc73375f639a46984851abf20b06d3729d511cbd3f4b", "chunk_index": 0}
{"text": "O.,,ter 15: Put Option Basks 247 \nThe time value premium of aput is largest when the stock is at the striking price of \nthe put. As the option becomes deeply in-the-money or deeply out-of-the-money, the \ntime value premium will shrink substantially. These statements on the magnitude of \nthe time value premium are true for both puts and calls. Table 15-1 will help to illus\ntrate the relationship of stock price and option price for both puts and calls. The \nreader may want to refer to Table 1-1, which described the time value premium rela\ntionship for calls. Table 15-1 describes the prices of an XYZ July 50 call option and \nan XYZ July 50 put option. \nTable 15-1 demonstrates several basic facts. As the stock drops, the actual price \nof acall option decreases while the value of the put option increases. Conversely, as \nthe stock rises, the call option increases in value and the put option decreases in \nvalue. Both the put and the call have their maximum time value premium when the \nstock is exactly at the striking price. However, the call will generally sell for rrwre than \nthe put when the stock is at the strike. Notice in Table 15-1 that, with XYZ at 50, the \ncall is worth 5 points while the put is worth only 4 points. This is true in general, \nexcept in the case of astock that pays alarge dividend. This phenomenon has to do \nwith the cost of carrying stock. More will be said about this effect later. Table 15-1 \nalso describes an effect of put options that normally holds true: An in-the-rrwney put \n( stock is below strike) loses time value premium rrwre quickly than an in-the-rrwney \ncall does. Notice that with XYZ at 43 in Table 15-1, the put is 7 points in-the-money \nand has lost all its time value premium. But when the call is 7 points in-the-money, \nXYZ at 57, the call still has 2 points of time value premium. Again, this is aphenom\nenon that could be affected by the dividend payout of the underlying stock, but is \ntrue in general. \nPRICING PUT OPTIONS \nThe same factors that determine the price of the call option also determine the price \nof the put option: price of the underlying stock, striking price of the option, time \nremaining until expiration, volatility of the underlying stock, dividend rate of the \nunderlying stock, and the current risk-free interest rate (Treasury bill rate, for exam\nple). Market dynamics - supply, demand, and investor psychology - play apart as \nwell. \nWithout going into as much detail as was shown in Chapter 1, the pricing curve \nof the put option can be developed. Certain facts remain true for the put option as \nthey did for the call option. The rate of decay of the put option is not linear; that is, \nthe time value premium will decay more rapidly in the weeks immediately preced\ning expiration. The more volatile the underlying stock, the higher will be the price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:275", "doc_id": "7147c211b9d1f0d1c83e3664484181bd8f5b285b32196a9e8de809f3b951eecb", "chunk_index": 0}
{"text": "248 Part Ill: Put Option Strategies \nTABLE 15-1. \nCall and put options compared. \nXYZ XYZ Coll Coll XYZ Put Put \nStock July 50 Intrinsic Time Value July 50 Intrinsic Time Value \nPrice Coll Price Value Premium Put Price Value Premium \n40 1/2 0 1/2 93/4 10 -1/4* \n43 1 0 1 7 7 0 \n45 2 0 2 6 5 \n47 3 0 3 5 3 2 \n50 5 0 5 4 0 4 \n53 7 3 4 3 0 3 \n55 8 5 3 2 0 2 \n57 9 7 2 0 \n60 101/2 10 1/2 1/2 0 l/2 \n70 193/4 20 -1/4 * 1/4 0 1/4 \n* Adeeply in-the-money option may actually trade at adiscount from intrinsic value in advance of \nexpiration. \nof its options, both puts and calls. Moreover, the marketplace may at any time value \noptions at ahigher or lower volatility than the underlying stock actually exhibits. \nThis is called implied volatility, as distinguished from actual volatility. Also, the put \noption is usually worth at least its intrinsic value at any time, and should be worth \nexactly its intrinsic value on the day that it expires. Figure 15-1 shows where one \nmight expect the XYZ July 50 put to sell, for any stock price, if there are 6 months \nremaining until expiration. Compare this with the similar pricing curve for the call \noption (Figure 15-2). Note that the intrinsic value line for the put option faces in \nthe opposite direction from the intrinsic value line for call options; that is, it gains \nvalue as the stock falls below the striking price. This put option pricing curve \ndemonstrates the effect mentioned earlier, that aput option loses time value pre\nmium more quickly when it is in-the-money, and also shows that an out-of-the\nmoney put holds agreat deal of time value premium. \nTHE EFFECT OF DIVIDENDS ON PUT OPTION PREMIUMS \nThe dividend of the underlying stock is anegative factor on the price of its call \noptions. The opposite is true for puts. The larger the dividend, the nwre valuable the \nputs will be. This is true because, as the stock goes ex-dividend, it will be reduced in", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:276", "doc_id": "42feb734cad8b51e72322b1fa49d2ca38e3cb691ef5518b0a26506b8a3877905", "chunk_index": 0}
{"text": "Cl,opter 15: Put Option Basics \nFIGURE 1 5-1. \nPut option price curve. \n~ \nit \nC: \n.Qa. \n0 \nFIGURE 1 5-2. \nCall option price curve. \n~ \nct \nC: \n0 \n11 \n10 \n9 \n8 \n7 \n6 \na 5 \nStriking \nPrice (50) \nGreatest \nValue for \nTime Value \nStock Price \n0 4 ----------------------\n3 \n2 \n1 \n0 \n40 45 \nrepresents the option'stime value premium. ________ L ________ _ \n50\\ 55 60 Stock Price Intrinsic value \nremains at zero \nuntil striking price \nis passed. \n249 \nprice by the amount of the dividend. That is, the stock will decrease in price and \ntherefore the put will become more valuable. Consequently, the buyer of the put will \nbe willing to pay ahigher price for the put and the seller of the put will also demand \nahigher price. As with listed calls, listed puts are not adjusted for the payment of cash \ndividends on the underlying stock. However, the price of the option itself will reflect \nthe dividend payments on the stock.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:277", "doc_id": "ff25a47b14503a8f6d0eeef3536cba6de499da8705d386402bb3054e7b047a77", "chunk_index": 0}
{"text": "250 Part Ill: Put Option Strategies \nExample: XYZ is selling for $25 per share and will pay $1 in dividends over the next \n6 months. Then a 6-month put option with strike 25 should automatically be worth \nat least $1, regardless of any other factor concerning the underlying stock. During the \nnext 6 months, the stock will be reduced in price by the amount of its dividends- $1 \n- and if everything else remained the same, the stock would then be at 24. With the \nstock at 24, the put would be 1 point in-the-money and would thus be worth at least \nits intrinsic value of 1 point. Thus, in advance, this large dividend payout of the \nunderlying stock will help to increase the price of the put options on this stock. \nOn the day before astock goes ex-dividend, the time value premium of an in\nthe-money put should be at least as large as the impending cash dividend payment. \nThat is, if XYZ is 40 and is about to pay a $.50 dividend, an XYZ January 50 put should \nsell for at least l 0½. This is true because the stock will be reduced in price by the \namount of its dividend on the day of the ex-dividend. \nEXERCISE AND ASSIGNMENT \nWhen the holder of aput option exercises his option, he sells stock at the striking \nprice. He may exercise this right at any time during the life of the put option. When \nthis happens, the writer of aput option with the same terms is assigned an obligation \nto buy stock at the striking price. It is important to notice the difference between \nputs and calls in this case. The call holder exercises to buy stock and the call writer is \nobligated to sell stock. The reverse is true for the put holder and writer. \nThe methods of assignment via the OCC and the brokerage firm are the same \nfor puts and calls; any fair method of random or first-in/first-out assignment is \nallowed. Stock commissions are charged on both the purchase and sale of the stock \nvia the assignment and exercise. \nWhen the holder of aput option exercises his right to sell stock, he may be sell\ning stock that he currently holds in his portfolio. Second, he may simultaneously go \ninto the open market and buy stock for sale via the put exercise. Finally, he may want \nto sell the stock in his short stock account; that is, he may short the underlying stock \nby exercising his put option. He would have to be able to borrow stock and supply \nthe margin collateral for ashort sale of stock if he chose this third course of action. \nThe writer of the put option also has several choices in how he wants to handle \nthe stock purchase that he is required to make. The put writer who is assigned must \nreceive stock. (The call writer who is assigned delivers stock.) The put writer may cur\nrently be short the underlying stock, in which case he will merely use the receipt of \nstock from the assignment to cover his short sale. He may also decide to immediate-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:278", "doc_id": "f1acf3c6eb1123529183ce63230da0bde00f4172d18f76dca32b34836815210a", "chunk_index": 0}
{"text": "0.,ter 15: Put Option Basics 251 \nly sell stock in the open market to offset the purchase that he is forced to make via \nthe put assignment. Finally, he may decide to retain the stock that is delivered to him; \nhe merely keeps the stock in his portfolio. He would, of course, have to pay for ( or \nmargin) the stock if he decides to keep it. \nThe mechanics as to how the put holder wants to deliver the stock and how the \nput writer wants to receive the stock are relatively simple. Each one merely notifies \nhis brokerage firm of the way in which he wants to operate and, provided that he can \nmeet the margin requirements, the exercise or assignment will be made in the \ndesired manner. \nANTICIPATING ASSIGNMENT \nThe writer of aput option can anticipate assignment in the same way that the writer \nof acall can. When the time value premium of an in-the-money put option disappears, \nthere is arisk of assignment, regardless of the time remaining until expiration. In \nChapter 1, aform of arbitrage was described in which market-makers or firm traders, \nwho pay little or no commissions, can take advantage of an in-the-money call selling \nat adiscount to parity. Similarly, there is amethod for these traders to take advantage \nof an in-the-money put selling at adiscount to parity. \nExample: XYZ is at 40 and an XYZ July 50 put is selling for 9¾ a ¼ discount from \nparity. That is, the option is selling for ¼ point below its intrinsic value. The arbi\ntrageur could take advantage of this situation through the following actions: \n1. Buy the July put at 9¾. \n2. Buy XYZ common stock at 40. \n3. Exercise the put to sell XYZ at 50. \nThe arbitrageur makes 10 points on the stock portion of the transaction, buying the \ncommon at 40 and selling it at 50 via exercise of his put. He paid 9¾ for the put \noption and he loses this entire amount upon exercise. However, his overall profit is \nthus ¼ point, the amount of the original discount from parity. Since his commission \ncosts are minimal, he can actually make anet profit on this transaction. \nAs was the case with deeply in-the-money calls, this type of arbitrage with \ndeeply in-the-money puts provides asecondary market that might not otherwise \nexist. It allows the public holder of an in-the-money put to sell his option at aprice \nnear its intrinsic value. Without these arbitrageurs, there might not be areasonable \nsecondary market in which public put holders could liquidate.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:279", "doc_id": "e5254328a33f93ff6a765e3e9e96e3afc11dac76e63f6ab51589b23dc2f516ae", "chunk_index": 0}
{"text": "252 Part Ill: Put Option Strategies \nDividend payment dates may also have an effect on the frequency of assign\nment. For call options, the writer might expect to receive an assignment on the day \nthe stock goes ex-dividend. The holder of the call is able to collect the dividend by \nso exercising. Things are slightly different for the writer of puts. He might expect \nto receive an assignment on the day after the ex-dividend date of the underlying \nstock. Since the writer of the put is obligated to buy stock, it is unlikely that any\none would put the stock to him until after the dividend has been paid. In any case, \nthe writer of the put can use arelatively simple gauge to anticipate assignment near \nthe ex-dividend date. If the time value premium of an in-the-money put is less than \nthe amount of the dividend to be paid, the writer may often anticipate that he will \nbe assigned immediately after the ex-dividend of the stock. An example will show \nwhy this is true. \nExample: XYZ is at 45 and it will pay a $.50 dividend. Furthermore, the XYZ July 50 \nput is selling at 5¼. Note that the time value premium of the July 50 put is ¼ point \n- less than the amount of the dividend, which is ½ point. An arbitrageur could take \nthe following actions: \n1. Buy XYZ at 45. \n2. Buy the July 50 put at 5¼. \n3. Collect the ½-point dividend (he must hold the stock until the ex-date to collect \nthe dividend). \n4. Exercise his put to sell XYZ at 50 ( writer would receive assignment on the day \nafter the ex-date). \nThe arbitrageur makes 5 points on the stock trades, buying XYZ at 45 and selling it \nat 50 via exercise of the put. He also collects the ½-point dividend, making his total \nintake equal to 5½ points. He loses the 5¼ points that he paid for the put but still \nhas anet profit of ¼ point. Thus, as the ex-dividend date of astock approaches, the \ntime value premium of all in-the-money puts on that stock will tend to equal or exceed \nthe amount of the dividend payment. \nThis is quite different from the call option. It was shown in Chapter 1 that the \ncall writer only needs to observe whether the call was trading at or below parity, \nregardless of the amount of the dividend, as the ex-dividend date approaches. The \nput writer must determine if the time value premium of the put exceeds the amount \nof the dividend to be paid. If it does, there is amuch smaller chance of assignment \nbecause of the dividend. In any case, the put writer can anticipate the assignment if \nhe carefully monitors his position.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:280", "doc_id": "ad2e31a5fd2388ce7a596aa7af45a0f3c3634afeae14904be9327ebd89e13e36", "chunk_index": 0}
{"text": "O.,ter 15: Put Option Basics \nPOSITION LIMITS \n253 \nRecall that the position limit rule states that one cannot have aposition of more than \nthe limit of options on the same side of the market in the same underlying security. \nThe limit varies depending on the trading activity and volatility of the underlying stock \nand is set by the exchange on which the options are traded. The actual limits are \n13,500, 22,500, 31,500, 60,000, or 75,000 contracts, depending on these factors. One \ncannot have more than 75,000 option contracts on the bullish side of the market - long \ncalls and/or short puts - nor can he have more than 75,000 contracts on the bearish \nside of the market - short calls and/or long puts. He may, however, have 75,000 con\ntracts on each side of the market; he could simultaneously be long 75,000 calls and \nlong 75,000 puts. \nFor the following examples, assume that one is concerned with an underlying \nstock whose position limit is 75,000 contracts. \nLong 75,000 calls, long 75,000 puts - no violation; 75,000 contracts bullish (long \ncalls) and 75,000 contracts bearish (long puts). \nLong 38,000 calls, short 37,000 puts - no violation; total of 75,000 contracts bullish. \nLong 38,000 calls, short 38,000 puts - violation; total of 76,000 contracts bullish. \nMoney managers should be aware that these position limits apply to all \"related\" \naccounts, so that someone managing several accounts must total all the accounts' \npositions when considering the position limit rule. \nCONVERSION \nMany of the relationships between call prices and put prices relate to aprocess \nknown as aconversion. This term dates back to the over-the-counter option days \nwhen adealer who owned aput ( or could buy one) was able to satisfy the needs of apotential call buyer by \"converting\" the put to acall. This terminology is somewhat \nconfusing, and the actual position that the dealer would take is little more than an \narbitrage position. In the listed market, arbitrageurs and firm traders can set up the \nsame position that the converter did. \nThe actual details of the conversion process, which must include the carrying \ncost of owning stock and the inclusion of all dividends to be paid by the stock during \nthe time the position is held, are described later. However, it is important for the put \noption trader to understand what the arbitrageur is attempting to do in order for him \nto fully understand the relationship between put and call prices in the listed option \nmarket.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:281", "doc_id": "c7d30e5827f28b858c9fce67296603cf05b4a258c77df3bcec219c89276baf65", "chunk_index": 0}
{"text": "254 Part Ill: Put Option Strategies \nAconversion position has no risk. The arbitrageur will do three things: \n1. Buy 100 shares of the underlying stock. \n2. Buy 1 put option at acertain striking price. \n3. Sell lcall option at the same striking price. \nThe arbitrageur has no risk in this position. If the underlying stock drops, he can \nalways exercise his long put to sell the stock at ahigher price. If the underlying stock \nrises, his long stock offsets the loss on his short call. Of course, the prices that the \narbitrageur pays for the individual securities determine whether or not aconversion \nwill be profitable. At times, apublic customer may look at prices in the newspaper \nand see that he could establish aposition similar to the foregoing one for aprofit, \neven after commissions. However, unless prices are out of line, the public customer \nwould not normally be able to make abetter return than he could by putting his \nmoney into abank or a Treasury bill, because of the commission costs he would pay. \nWithout needing to understand, at this time, exactly what prices would make an \nattractive conversion, it is possible to see that it would not always be possible for the \narbitrageur to do aconversion. The mere action of many arbitrageurs doing the same \nconversion would force the prices into line. The stock price would rise because arbi\ntrageurs are buying the stock, as would the put price; and the call price would drop \nbecause of the preponderance of sellers. \nWhen this happens, another arbitrage, known as areversal ( or reverse conver\nsion), is possible. In this case, the arbitrageur does the opposite: He shorts the under\nlying stock, sells 1 put, and buys 1 call. Again, this is aposition with no risk. If the \nstock rises, he can always exercise his call to buy stock at alower price and cover his \nshort sale. If the stock falls, his short stock will offset any losses on his short put. \nThe point of introducing this information, which is relatively complicated, at \nthis place in the text is to demonstrate that there is arelationship between put and \ncall prices, when both have the same striking price and expiration date. They are not \nindependent of one another. If the put becomes \"cheap\" with respect to the call, arbi\ntrageurs will move in to do conversions and force the prices back in line. On the other \nhand, if the put becomes expensive with relationship to the call, arbitrageurs will do \nreversals until the prices move back into line. \nBecause of the way in which the carrying cost of the stock and the dividend rate \nof the stock are involved in doing these conversions or reversals, two facts come to \nlight regarding the relationship of put prices and call prices. Both of these facts have \nto do with the carrying costs incurred during the conversion. First, aput option will \ngenerally sell for less than acall option when the underlying stock is exactly at the \nstriking price, unless the stock pays alarge dividend. In the older over-the-counter", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:282", "doc_id": "18b6cf2d635bb5f1a9ffb49426aae643d613befd6b5f6f0d25e81add2e2423af", "chunk_index": 0}
{"text": "a,,pter 15: Put Option Basics 255 \noption market, it was often stated that the reason for this relationship was that the \ndemand for calls was larger than the demand for puts. This may have been partially \ntrue, but certainly it is no longer true in the listed option targets, where alarge sup\nply of both listed puts and calls is available through the OCC. Arbitrageurs again \nserve auseful function in increasing supply and demand where it might not other\nwise exist. The second fact concerning the relationship of puts and calls is that aput \noption will lose its time value premium much more quickly in-the-money than acall \noption will (and, conversely, aput option will generally hold out-of-the-money time \nvalue premium better than acall option will). Again, the conversion and reversal \nprocesses play alarge role in this price action phenomenon of puts and calls. Both of \nthese facts have to do with the carrying costs involved in the conversion. \nIn the chapter on Arbitrage, exact details of conversions and reversals will be \nspelled out, with specific reasons why these procedures affect the relationship of put \nand call prices as stated above. However, at this time, it is sufficient for the reader to \nunderstand that there is an arbitrage process that is quite widely practiced that will, \nin fact, make true the foregoing relationships between puts and calls.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:283", "doc_id": "2c65c03a8208cca2e6f3c6bb6daa5c0ad9784f797fa447b179f79923fb5dcae2", "chunk_index": 0}
{"text": "Put Option Buying \nThe purchase of aput option provides leverage in the case of adownward move by \nthe underlying stock. In this manner, it is an alternative to the short sale of stock, \nmuch as the purchase of acall option is aleveraged alternative to the purchase of \nstock. \nPUT BUYING VERSUS SHORT SALE \nIn the simplest case, when an investor expects astock to decline in price, he may \neither short the underlying stock or buy aput option on the stock. Suppose that XYZ \nis at 50 and that an XYZ July 50 put option is trading at 5. If the underlying stock \ndeclines substantially, the buyer of the put could make profits considerably in excess \nof his initial investment. However, if the underlying stock rises in price, the put buyer \nhas limited risk; he can lose only the amount of money that he originally paid for the \nput option. In this example, the most that the put buyer could lose would be 5 points, \nwhich is equal to his entire initial investment. Table 16-1 and Figure 16-1 depict the \nresults, at expiration, of this simple purchase of the put option. \nThe put buyer has limited profit potential, since astock can never drop in price \nbelow zero dollars per share. However, his potential profits can be huge, percent\nagewise. His loss, which normally would occur if the stock rises in price, is limited to \nthe amount of his initial investment. The simplest use of aput purchase is for specu\nlative purposes when expecting aprice decline in the underlying stock. \nThese results for the profit or loss of the put option purchases can be compared \nto asimilar short sale of XYZ at 50 in order to observe the benefits of leverage and \nlimited risk that the put option buyer achieves. In order to sell short 100 XYZ at 50, \nassume that the trader would have to use $2,500 in margin. Several points can be ver-\n256", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:284", "doc_id": "a2636d04acfb63f3320fcac039cae75f9a50e0a3a9b6b973ccbd87d5e4cd3e09", "chunk_index": 0}
{"text": "258 Part Ill: Put Option Strategies \nchase can achieve. If the underlying stock remains relatively unchanged, the short \nseller would do better because he does not risk losing his entire investment in alim\nited amount of time if the underlying stock changes only slightly in price. However, \nif the underlying stock should rise dramatically, the short seller can actually lose more \nthan his initial investment. The short sale of stock has theoretically unlimited risk. \nSuch is not true of the put option purchase, whereby the risk is limited to the amount \nof the initial investment. One other point should be made when comparing the pur\nchase of aput and the short sale of stock: The short seller of stock is obligated to pay \nthe dividends on the stock, but the put option holder has no such obligation. This is \nan additional advantage to the holder of the put. \nTABLE 16-2. \nResults of selling short. \nXYZ Price at Put Option \nExpiration Short Sale Purchase \n20 + $3,000 (+ 120%) +$2,500 (+ 500%) \n30 + 2,000 (+ 80%) + 1,500 (+ 300%) \n40 + 1,000 (+ 40%) + 500 (+ 100%) \n45 + 500(+ 20%) 0( 0%) \n48 + 200(+ 80%) 300 (- 60%) \n50 0( 0%) 500 (- 100%) \n60 - 1,000 (- 40%) 500 (- 100%) \n75 - 2,500 (- 100%) 500 (- 100%) \n100 - 5,000 (- 200%) 500 (- 100%) \nSELECTING WHICH PUT TO BUY \nMany of the same types of analyses that the call buyer goes through in deciding which \ncall to buy can be used by the prospective put buyer as well. First, when approach\ning put buying as aspeculative strategy, one should not place more than 15% of his \nrisk capital in the strategy. Some investors participate in put buying to add some \namount of downside protection to their basically bullishly-oriented common stock \nportfolios. More is said in Chapter 17 about buying puts on stocks that one actually \nowns. \nThe out-ofthe-nwney put offers both higher reward potentials and higher risk \npotentials than does the in-the-nwney put. If the underlying stock drops substantial-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:286", "doc_id": "1a4bd1571d7c408648e176455a0e3d8f99c8d437cca107d03d7877feda9c7c86", "chunk_index": 0}
{"text": "G,pter 16: Put Option Buying 259 \nly, the percentage returns from having purchased acheaper, out-of-the-money put \nwill be greater. However, should the underlying stock decline only moderately in \nprice, the in-the-rrwney put will often prove to be the better choice. In fact, since aput option tends to lose its time value premium quickly as it becomes an in-the\nmoney option, there is an even greater advantage to the purchase of the in-the\nmoney put. \nExample: XYZ is at 49 and the following prices exist: \nXYZ, 49; \nXYZ July 45 put, l; and \nXYZ July 50 put, 3. \nIf the underlying stock were to drop to 40 by expiration, the July 45 put would be \nworth 5 points, a 400% profit. The July 50 put would be worth 10 points, a 233% \nprofit over its initial purchase price of 3. Thus, in asubstantial downward move, the \nout-of-the-money put purchase provides higher reward potential. However, if the \nunderlying stock drops only moderately, say to t:15, the purchaser of the July 45 put \nwould lose his entire investment, since the put would be worthless at expiration. The \npurchaser of the in-the-money July 50 put would have a 2-point profit with XYZ at \n45 at expiration. \nThe preceding analysis is based on holding the put until expiration. For the \noption buyer, this is generally an erroneous form of analysis, because the buyer \ngenerally tends to liquidate his option purchase in advance of expiration. When \nconsidering what happens to the put option in advance of expiration, it is helpful to \nremember that an in-the-money put tends to lose its time premium rather quickly. \nIn the example above, the July 45 put is completely composed of time value pre\nmium. If the underlying stock begins to drop below 45, the price of the put will not \nincrease as rapidly as would the price of acall that is going into-the-money. \nExample: If XYZ fell by 5 points to 44, definitely amove in the put buyer'sfavor, he \nmay fmd that the July 45 put has increased in value only to 2 or 2½ points. This is \nsomewhat disappointing because, with call options, one would expect to do signifi\ncantly better on a 5-point stock movement in his favor. Thus, when purchasing put \noptions for speculation, it is generally best to concentrate on in-the-rrwney puts unless \navery substantial decline in the price of the underlying stock is anticipated. \nOnce the put option is in-the-money, the time value premium will decrease \neven in the longer-term series. Since this time premium is small in all series, the put", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:287", "doc_id": "54382b45306e2512123257d54efde720c49fc943b0ad912c6dc0e08525304fb8", "chunk_index": 0}
{"text": "260 Part Ill: Put Option Strategies \nbuyer can often purchase alonger-term option for very little extra money, thus gain\ning more time to work with. Call option buyers are generally forced to avoid the \nlonger-term series because the extra cost is not worth the risk involved, especially in \natrading situation. However, the put buyer does not necessarily have this disadvan\ntage. If he can purchase the longer-term put for nearly the same price as the near\nterm put, he should do so in case the underlying stock takes longer to drop than he \nhad originally anticipated it would. \nIt is not uncommon to see such prices as the following: \nXYZ common, 46: \nXYZ April 50 put, 4; \nXYZ July 50 put, 4½; and \nXYZ October 50 put, 5. \nNone of these three puts have much time value premium in their prices. Thus, the \nbuyer might be willing to spend the extra 1 point and buy the longest-term put. If the \nunderlying stock should drop in price immediately, he will profit, but not as much as \nif he had bought one of the less expensive puts. However, should the underlying stock \nrise in price, he will own the longest-term put and will therefore suffer less of aloss, \npercentagewise. If the underlying stock rises in price, some amount of time value \npremium will come back into the various puts, and the longest-term put will have the \nlargest amount of time premium. For example, if the stock rises back to 50, the fol\nlowing prices might exist: \nXYZ common, 50; \nXYZ April 50 put, l; \nXYZ July 50 put, 2½; and \nXYZ October 50 put, 3½. \nThe purchase of the longer-term October 50 put would have suffered the least loss, \npercentagewise, in this event. Consequently, when one is purchasing an in-the\nmoney put, he may often want to consider buying the longest-term put if the time \nvalue premium is small when compared to the time premium in the nearer-term \nputs. \nIn Chapter 3, the delta of an option was described as the amount by which one \nmight expect the option will increase or decrease in price if the underlying stock \nmoves by afixed amount (generally considered to be one point, for simplicity). Thus, \nif XYZ is at 49 and acall option is priced at 3 with adelta of ½, one would expect the \ncall to sell for 3½ with XYZ at 50 and to sell at 2¼ with XYZ at 48. In reality, the delta", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:288", "doc_id": "af95ef8e525783f14b0faf5eee6ec23e0c558310a8642e9be80cd8f60767160c", "chunk_index": 0}
{"text": "O.,ter 16: Put Option Buying 261 \nchanges even on afractional move in the underlying stock, but one generally assumes \nthat it will hold true for a 1-point move. Obviously, put options have deltas as well. The \ndelta of aput is anegative number, reflecting the fact that the put price and the stock \nprice are inversely related. As an approximation, one could say that the delta of the \nctill option minus the delta of the put option with the same terms is equal to 1. That is, \nDelta of put = Delta of call - 1. \nThis is an approximation and is accurate unless the put is deeply in-the-money. It has \nalready been pointed out that the time value premium behavior of puts and calls is \ndifferent, so it is inaccurate to assume that this formula holds true exactly for all \ncases. \nThe delta of aput ranges between Oand minus 1. If a July 50 put has adelta of \n-½, and the underlying stock rises by 1 point, the put will lose ½ point. The delta of \nadeeply out-of-the-money put is close to zero. The put'sdelta would decrease slow\nly at first as the stock declined in value, then would begin to decrease much more \nrapidly as the stock fell through the striking price, and would reach avalue of minus \n1 (the minimum) as the stock fell only moderately below the striking price. This is \nreflective of the fact that an out-of-the-money put tends to hold time premium quite \nwell and an in-the-money put comes to parity rather quickly. \nRANKING PROSPECTIVE PUT PURCHASES \nIn Chapter 3, amethod of ranking prospective call purchases was developed that \nencompassed certain factors, such as the volatility of the underlying stock and the \nexpected holding period of the purchased option. The same sort of analysis should be \napplied to put option purchases. \nThe steps are summarized below. The reader may refer to the section titled \n\"Advanced Selection Criteria\" in Chapter 3 for amore detailed description of why \nthis method of ranking is superior. \n1. Assume that each underlying stock can decrease in price in accordance with its \nvolatility over afixed holding period (30, 60, or 90 days). \n2. Estimate the put option prices after the decrease. \n3. Rank all potential put purchases by the highest reward opportunity for aggressive \npurchases. \n4. Estimate how much would be lost if the underlying stock instead rose in accor\ndance with its volatility, and rank all potential put purchases by best risk/reward \nratio for amore conservative list of put purchases.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:289", "doc_id": "c1fa82c52a3be6797e69831bcdd0f5df4191e0269bedb62d031f1df93cbc42a7", "chunk_index": 0}
{"text": "262 Part Ill: Put Option Strategies \nAs was stated earlier, it is necessary to have acomputer to make an accurate analysis \nof all listed options. The average customer is forced to obtain such data from abro\nkerage firm or data service. He should be sure that the list he is using conforms to \nthe above-mentioned criteria. If the data service is ranking option purchases by how \nwell the puts would do if each underlying stock fell by afixed percentage (such as 5% \nor 10%), the list should be rejected because it is not incorporating the volatility of the \nunderlying stock into its analysis. Also, if the list is based on holding the put purchase \nuntil expiration, the list should be rejected as well, because this is not arealistic \nassumption. There are enough reliable and sophisticated data services that one \nshould not have to work with inferior analyses in today'soption market. \nFor those readers who are more mathematically advanced and have the com\nputer capability to construct their own analyses, the details of implementing an analy\nsis similar to the one described above are presented in Chapter 28, Mathematical \nApplications. An application of put purchases, combined with fixed-income securi\nties, is described in Chapter 26, Buying Options and Treasury Bills. \nFOLLOW-UP ACTION \nThe put buyer can take advantage of strategies that are very similar to those the call \nbuyer uses for follow-up action, either to lock in profits or to attempt to improve alosing situation. Before discussing these specific strategies, it should be stated again \nthat it is rarely to the option buyer'sbenefit to exercise the option in order to liqui\ndate. This precludes, of course, those situations in which the call buyer actually wants \nto own the stock or the put buyer actually wants to sell the stock. If, however, the \noption holder is merely looking to liquidate his position, the cost of stock commis\nsions makes exercising aprohibitive move. This is true even ifhe has to accept aprice \nthat is aslight discount from parity when he sells his option. \nLOCKING IN PROFITS \nThe reader may recall that there were four strategies (perhaps \"tactics\" is abetter \nword) for the call buyer with an unrealized profit. These same four tactics can be \nused with only slight variations by the put option buyer. Additionally, afifth strategy \ncan be employed when astock has both listed puts and calls. \nAfter an underlying stock has moved down and the put buyer has arelatively \nsubstantial unrealized gain, he might consider taking one of the following actions: \n1. Sell the put and liquidate the position for aprofit. \n2. Do nothing and continue to hold the put.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:290", "doc_id": "40d4f8ac2f7f96a657677cb251c1acced95ceb3c8b278a7003c86cdb2ab31775", "chunk_index": 0}
{"text": "O.,,er 16: Put Option Buying 263 \n3, Sell the in-the-money long put and use part of the proceeds to purchase out-of\nthe-money puts. \n4. Create aspread by selling an out-of-the-money put against the one he currently \nholds. \nThese are the same four tactics that were discussed earlier with respect to call buy\ning. In the fifth tactic, the holder of alisted put who has an unrealized profit might \nconsider buying alisted call to protect his position. \nExample: Aspeculator originally purchased an XYZ October 50 put for 2 points when \nthe stock was 52. If the stock has now fallen to 45, the put might be worth 6 points, \nrepresenting an unrealized gain of 4 points and placing the put buyer in aposition to \nimplement one of these five tactics. After some time has passed, with the stock at 45, \nan at-the-money October 45 put might be selling for 2 points. Table 16-3 summarizes \nthe situation. If the trader merely liquidates his position by selling out the October 50 \nput, he would realize aprofit of 4 points. Since he is terminating the position, he can \nmake neither more nor less than 4 points. This is the most conservative of the tactics, \nallowing no additional room for appreciation, but also eliminating any chance of los\ning the accumulated profits. \nTABLE 16-3. \nBackground table for profit alternatives. \nOriginal Trade Current Prices \nXYZ common: 52 XYZ common: 45 \nBought XYZ October 50 put at 2 XYZ October 50 put: 6 \nXYZ October 45 put: 2 \nIf the trader does nothing, merely continuing to hold the October 50 put, he is \ntaking an aggressive action. If the stock should reverse and rise back above 50 by \nexpiration, he would lose everything. However, if the stock continues to fall, he could \nbuild up substantially larger profits. This is the only tactic that could eventually result \nin aloss at expiration. \nThese two simple strategies - liquidating or doing nothing are the easiest \nalternatives. The remaining strategies allow one to attempt to achieve abalance \nbetween retaining built-up profits and generating even more profits. The third tactic \nthat the speculator could use would be to sell the put that he is currently holding and", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:291", "doc_id": "20c27a9e82df982d8384add6bbc3e8677fc789acc6c9dd2312a85e7ef803589a", "chunk_index": 0}
{"text": "264 Part Ill: Put Option Strategies \nuse some of the proceeds to purchase the October 45 put. The general idea in this \ntactic is to pull one'sinitial investment out of the market and then to increase the \nnumber of option contracts held by buying the out-of-the-money option. \nExample: The trader would receive 6 points from the sale of the October 50 put. He \nshould take 2 points of this amount and put it back into his pocket, thus covering his \ninitial investment. Then he could buy 2 October 45 puts at 2 points each with the \nremaining portion of the proceeds from the sale. He has no risk at expiration with this \nstrategy, since he has recovered his initial investment. Moreover, if the underlying \nstock should continue to fall rapidly, he could profit handsomely because he has \nincreased the number of put contracts that he holds. \nThe fourth choice that the put holder has is to create aspread by selling the \nOctober 45 put against the October 50 that he currently holds. This would create abear spread, technically. This type of spread is described in more detail later. For the \ntime being, it is sufficient to understand what happens to the trader'srisks and \nrewards by creating this spread. The sale of the October 45 put brings in 2 points, \nwhich covers the initial 2-point purchase cost of the October 50 put. Thus, his \"cost\" \nfor this spread is nothing; he has no risk, except for commissions. If the underlying \nstock should rise above 50 by expiration, all the puts would expire worthless. (Aput \nexpires worthless when the underlying stock is above the striking price at expiration.) \nThis would represent the worst case; he would recover nothing from the spread. If \nthe stock should be below 45 at expiration, he would realize the maximum potential \nof the spread, which is 5 points. That is, no matter how far XYZ is below 45 at expi\nration, the October 50 put will be worth 5 points more than the October 45 put, and \nthe spread could thus be liquidated for 5 points. His maximum profit potential in the \nspread situation is 5 points. This tactic would be the best one if the underlying stock \nstabilized near 45 until expiration. \nTo analyze the fifth strategy that the put holder could use, it is necessary to \nintroduce acall option into the picture. \nExample: With XYZ at 45, there is an October 45 call selling for 3 points. The put \nholder could buy this call in order to limit his risk and still retain the potential for \nlarge future profits. If the trader buys the call, he will have the following position: \nLong l October 50 put Cb' dt 5 . tl Ob 5 all - om me cos : porn s Long cto er 4 c \nThe total combined cost of this put and call combination is 5 points - 2 points were \noriginally paid for the put, and now 3 points have been paid for the call. No matter \nwhere the underlying stock is at expiration, this combination will be worth at least 5", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:292", "doc_id": "3bc2090aeaeb10cfd29050368d6d3adcbd02699d65e51d37c7710f2ff9b384e9", "chunk_index": 0}
{"text": "Gapter 16: Put Option Buying 265 \npoints. For example, if XYZ is at 46 at expiration, the put will be worth 4 and the call \nworth l; or if XYZ is at 48, the put will be worth 2 and the call worth 3. If the stock \nis above 50 or below 45 at expiration, the combination will be worth more than 5 \npoints. Thus, the trader has no risk in this combination, since he has paid 5 points for \nit and will be able to sell it for at least 5 points at expiration. In fact, if the underly\ning stock continues to drop, the put will become more valuable and he could build \nup substantial profits. Moreover, if the underlying stock should reverse direction and \nclimb substantially, he could still profit, because the call will then become valuable. \nThis tactic is the best one to use if the underlying stock does not stabilize near 45, \nbut instead makes arelatively dramatic move either up or down by expiration. The \nstrategy of simultaneously owning both aput and acall is discussed in much greater \ndetail in Chapter 23. It is introduced here merely for the purposes of the put buyer \nwanting to obtain protection of his unrealized profits. \nEach of these five strategies may work out to be the best one under adifferent \nset of circumstances. The ultimate result of each tactic is dependent on the direction \nthat XYZ moves in the future. As was the case with call options, the spread tactic \nnever turns out to be the worst tactic, although it is the best one only if the underly\ning stock stabilizes. Tables 16-4 and 16-5 summarize the results the speculator could \nexpect from invoking each of these five tactics. The tactics are: \n1. Liquidate - sell the long put for aprofit and do not reinvest. \n2. Do nothing - continue to hold the long put. \n3. \"Roll down\" - sell the long put, pocket the initial investment, and invest the \nremaining proceeds in out-of-the-money puts at alower strike. \n4. \"Spread\" - create aspread by selling the out-of-the-money put against the put \nalready held. \n5. \"Combine\" create acombination by buying acall at alower strike while con\ntinuing to hold the put. \nTABLE 16-4. \nComparison of the five tactics. \nBy expiration, if XYZ ... \nContinues to fall dramatically \nFalls moderately further \nRemains relatively unchanged \nRises moderately \nRises substantially \nthe best strategy was ... \n\"Roll down\" \nDo nothing \nSpread \nLiquidate \nCombine \nand the worst \nstrategy was ... \nLiquidate \nCombine \nCombine or \"roll down\" \n\"Roll down\" or do nothing \nDo nothing", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:293", "doc_id": "473262da11edacf45254218a96f11da5900029349bd7bcb5be82852ea899eb2b", "chunk_index": 0}
{"text": "266 Part Ill: Put Option Strategies \nTABLE 16-5. \nResults of adopting each of the five tactics. \nXYZ Price at \"Roll Down\" Do-Nothing Spread Liquidate Combine \nExpiration Profit Profit Profit Profit Profit \n30 + $3,000 (8) +$1,800 +$500 +$400 (W) +$1,500 \n35 + 2,000 (8) + 1,300 + 500 + 400 (W) + 1,000 \n41 + 800 (8) + 700 + 500 + 400 (W) + 400 \n42 + 600 (8) + 600 (8) + 500 + 400 + 300 (W) \n43 + 400 + 500 (8) + 500 (8) + 400 + 200 (W) \n45 0(W) + 300 + 500 (8) + 400 0(W) \n46 0(W) + 200 + 400 (8) + 400 (8) O(W) \n48 0(W) 0(W) + 200 + 400 (8) 0(W) \n50 0 200 (W) 0 + 400 (8) 0 \n54 0 200 (W) 0 + 400 (8) + 400 (8) \n60 0 200 (W) 0 + 400 + 1,000 (8) \nNote that each tactic is the best one under one of the scenarios, but that the spread \ntactic is never the worst of the five. The actual results of each tactic, using the figures \nfrom the example above, are depicted in Table 16-5, where Bdenotes best tactic and \nWdenotes worst one. \nAll the strategies are profitable if the underlying stock continues to fall dramat\nically, although the \"roll down,\" \"do nothing,\" and combinations work out best, \nbecause they continue to accrue profits if the stock continues to fall. If the underly\ning stock rises instead, only the combination outdistances the simplest tactic of all, \nliquidation. \nIf the underlying stock stabilizes, the \"do-nothing\" and \"spread\" tactics work out \nbest. It would generally appear that the combination tactic or the \"roll-down\" tactic \nwould be the most attractive, since neither one has any risk and both could generate \nlarge profits if the stock moved substantially. The advantage for the spread was sub\nstantial in call options, but in the case of puts, the premium received for the out-of\nthe-money put is not as large, and therefore the spread strategy loses some of its \nattractiveness. Finally, any of these tactics could be applied partially; for example, one \ncould sell out half of aprofitable long position in order to take some profits, and con\ntinue to hold the remainder.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:294", "doc_id": "8e34525c6239d02ae8ec0ce031acbf54429d9d1e3a88e2c051a59c8469177f8f", "chunk_index": 0}
{"text": "Cl,opter 16:PutOptionBuying \nLOSS-LIMITING ACTIONS \n267 \nThe foregoing discussion concentrated on how the put holder could retain or \nincrease his profit. However, it is often the case in option buying that the holder of \nthe option is faced with an unrealized loss. The put holder may also have several \nchoices of action to take in this case. His first, and simplest, course of action would \nbe to sell the put and take his loss. Although this is advisable in certain cases, espe\ncially when the underlying stock seems to have assumed adistinctly bullish stance, it \nis not always the wisest thing to do. The put holder who has aloss may also consider \neither \"rolling up\" to create abearish spread or entering into acalendar spread. \nEither of these actions could help him recover part or all of his loss. \nTHE \"ROLLING-UP\" STRATEGY \nThe reader may recall that asimilar action to \"rolling up,\" termed \"rolling down,\" was \navailable for call options held at aloss and was described in Chapter 3. The put buyer \nwho owns aput at aloss may be able to create aspread that allows him to break even \nat amore favorable price at expiration. Such action will inevitably limit his profit \npotential, but is generally useful in recovering something from aput that might oth\nerwise expire totally worthless. \nExample: An investor initially purchases an XYZ October 45 put for 3 points when \nthe underlying stock is at 45. However, the stock rises to 48 at alater date and the \nput that was originally bought for 3 points is now selling for 1 ¼ points. It is not \nunusual, by the way, for aput to retain this much of its value even though the stock \nhas moved up and some amount of time has passed, since out-of-the-money puts \ntend to hold time value premium rather well. With XYZ at 48, an October 50 put \nmight be selling for 3 points. The put holder could create aposition designed to per\nmit recovery of some of his losses by selling two of the puts that he is long - October \n45's - and simultaneously buying one October 50 put. The net cost for this transac\ntion would be only commissions, since he receives $300 from selling two puts at 1 ¼ \neach, which completely covers the $300 cost of buying the October 50 put. The \ntransactions are summarized in Table 16-6. \nBy selling 2 of the October 45 puts, the investor is now short an October 45 put. \nSince he also purchased an October 50 put, he has aspread ( technically, abear \nspread). He has spent no additional money, except commissions, to set up this spread, \nsince the sale of the October 45'scovered the purchase of the October 50 put. This \nstrategy is most attractive when the debit involved to create the spread is small. In \nthis example, the debit is zero.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:295", "doc_id": "e1ca91dc79ff2ffb18aa233787233ee9d4139630937d648362210a703783c16c", "chunk_index": 0}
{"text": "268 \nTABLE 16-6. \nSummary of rolling-up transactions. \nOriginal trade: \nLater: \nNet position: \nBuy 1 October 45 put for 3 \nwith XYZ at 45 \nWith XYZ at 48, sell 2 \nOctober 45'sfor 11/2 each \nand buy l October 50 put for 3 \nLong 1 October 50 put \nShort 1 October 45 put \nPart Ill: Put Option Strategies \n$300 debit \n$300 credit \n$300 debit \n$300 debit \nThe effect of creating this spread is that the investor has not increased his risk \nat all, but has raised the break-even point for his position. That is, if XYZ merely falls \nasmall distance, he will be able to get out even. Without the effect of creating the \nspread, the put holder would need XYZ to fall back to 42 at expiration in order for \nhim to break even, since he originally paid 3 points for the October 45 put. His orig\ninal risk was $300. IfXYZ continues to rise in price and the puts in the spread expire \nworthless, the net loss will still be only $300 plus additional commissions. Admittedly, \nthe commissions for the spread will increase the loss slightly, but they are small in \ncomparison to the debit of the position ($300). On the other hand, if the stock should \nfall back only slightly, to 47 by expiration, the spread will break even. At expiration, \nwith XYZ at 47, the in-the-money October 50 put will be worth 3 points and the out\nof-the-money October 45 put will expire worthless. Thus, the investor will recover his \n$300 cost, except for commissions, with XYZ at 47 at expiration. His break-even point \nis raised from 42 to 47, asubstantial improvement of his chances for recovery. \nThe implementation of this spread strategy reduces the profit potential of the \nposition, however. The maximum potential of the spread is 2 points. If XYZ is any\nwhere below 45 at expiration, the spread will be worth 5 points, since the October 50 \nput will sell for 5 points more than the October 45 put. The investor has limited his \npotential profit to 2 points - the 5-point maximum width of the spread, less the 3 \npoints that he paid to get into the position. He can no longer gain substantially on alarge drop in price by the underlying stock. This is normally of little concern to the \nput holder faced with an unrealized loss and the potential for atotal loss. He gener\nally would be appreciative of getting out even or of making asmall profit. The cre\nation of the spread accomplishes this objective for him. \nIt should also be pointed out that he does not incur the maximum loss of his \nentire debit plus commissions, unless XYZ closes above 50 at expiration. If XYZ is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:296", "doc_id": "d43bca4c3d4a43ac863d839c5f1cc1d5362ec4830146e14f8d63d5c58eefe33e", "chunk_index": 0}
{"text": "O,apter 16: Put Option Buying 269 \nanywhere below 50, the October 50 will have some value and the investor will be able \nto recover something from the position. This is distinctly different from the original \nput holding of the October 45, whereby the maximum loss would be incurred unless \nthe stock were below 45 at expiration. Thus, the introduction of the spread also \nreduces the chances of having to realize the maximum loss. \nIn summary, the put holder faced with an unrealized loss may be able to create \naspread by selling twice the number of puts that he is currently long and simultane\nously buying the put at the next higher strike. This action should be used only if the \nspread can be transacted at asmall debit or, preferably, at even money (zero debit). \nThe spread position offers amuch better chance of breaking even and also reduces \nthe possibility of having to realize the maximum loss in the position. However, the \nintroduction of these loss-limiting measures reduces the maximum potential of the \nposition if the underlying stock should subsequently decline in price by asignificant \namount. Using this spread strategy for puts would require amargin account, just as \ncalls do. \nTHE CALENDAR SPREAD STRATEGY \nAnother strategy is sometimes available to the put holder who has an unrealized loss. \nIf the put that he is holding has an intermediate-term or long-term expiration date, \nhe might be able to create acalendar spread by selling the near-term put against the \nput that he currently holds. \nExample: An investor bought an XYZ October 45 put for 3 points when the stock was \nat 45. The stock rises to 48, moving in the wrong direction for the put buyer, and his \nput falls in value to 1 ½. He might, at that time, consider selling the near-term July \n45 put for 1 point. The ideal situation would be for the July 45 put to expire worth\nless, reducing the cost of his long put by 1 point. Then, if the underlying stock \ndeclined below 45, he could profit after July expiration. \nThe major drawback to this strategy is that little or no profit will be made - in \nfact, aloss is quite possible - if the underlying stock falls back to 45 or below before \nthe near-term July option expires. Puts display different qualities in their time value \npremiums than calls do, as has been noted before. With the stock at 45, the differ\nential between the July 45 put and the October 45 put might not widen much at all. \nThis would mean that the spread has not gained anything, and the spreader has aloss \nequal to his commissions plus the initial unrealized loss. In the example above, ifXYZ \ndropped quickly back to 45, the July 45 might be worth 1 ½ and the October worth \n2½. At this point, the spreader would have aloss on both sides of his spread: He sold \nthe July 45 put for 1 and it is now 1 ½; he bought the October 45 for 3 and it is now", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:297", "doc_id": "952c5d7eee37b90c945f29ab78a4fcdd9f96f94d6f85601aeaa9b86e486ed550", "chunk_index": 0}
{"text": "270 Part Ill: Put Option Strategies \n2½; plus he has spent two commissions to date and would have to spend two more \nto liquidate the position. \nAt this point, the strategist may decide to do nothing and take his chances that \nthe stock will subsequently rally so that the July 45 put will expire worthless. \nHowever, if the stock continues to decline below 45, the spread will most certainly \nbecome more of aloss as both puts come closer to parity. \nThis type of spread strategy is not as attractive as the \"rolling-up\" strategy. In \nthe \"rolling-up\" strategy, one is not subjected to aloss if the stock declines after the \nspread is established, although he does limit his profits. The fact that the calendar \nspread strategy can lead to aloss even if the stock declines makes it aless desirable \nalternative. \nEQUIVALENT POSITIONS \nBefore considering other put-oriented strategies, the reader should understand the \ndefinition of an equivalent position. Two strategies, or positions, are equivalent when \nthey have the same profit potential. They may have different collateral or investment \nrequirements, but they have similar profit potentials. Many of the call-oriented \nstrategies that were discussed in Part II of the book have an equivalent put strategy. \nOne such case has already been described: The \"protected short sale,\" or shorting the \ncommon stock and buying acall, is equivalent to the purchase of aput. That is, both \nhave alimited risk above the striking price of the option and relatively large profit \npotential to the downside. An easy way to tell if two strategies are equivalent is to see \nif their profit graphs have the same shape. The put purchase and the \"protected short \nsale\" have profit graphs with exactly the same shape (Figures 16-1 and 4-1, respec\ntively). As more put strategies are discussed, it will always be mentioned if the put \nstrategy is equivalent to apreviously described call strategy. This may help to clarify \nthe put strategies, which understandably may seem complex to the reader who is not \nfamiliar with put options.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:298", "doc_id": "1133245b91fd5752a5d65500f045577be67f805817b922266f875edf0d0e10fa", "chunk_index": 0}
{"text": "Put Buying in Conjunction \nwith Com.m.on Stock \nOwnership \nAnother useful feature of put options, in addition to their speculative leverage in adownward move by the underlying stock, is that the put purchase can be used to limit \ndownside loss in astock that is owned. When one simultaneously owns both the com\nmon stock and aput on that same stock, he has aposition with limited downside risk \nduring the life of the put. This position is also called asynthetic long call, because the \nprofit graph is the same shape as along call's. \nExample: An investor owns XYZ stock, which is at 52, and purchases an XYZ October \n50 put for 2. The put gives him the right to sell XYZ at 50, so the most that the stock\nholder can lose on his stock is 2 points. Since he pays 2 points for the put protection, his \nmaximum potential loss until October expiration is 4 points, no matter how far XYZ \nmight decline up until that time. If, on the other hand, the price of the stock should \nmove up by October, the investor would realize any gain in the stock, less the 2 points \nthat he paid for the put protection. The put functions much like an insurance policy with \nafinite life. Table 17-1 and Figure 17-1 depict the results at October expiration for this \nposition: buying the October 50 put for 2 points to protect aholding in XYZ common \nstock, which is selling at 52. The dashed line on the graph represents the profit poten\ntial of the common stock ownership by itself. Notice that if the stock were below 48 in \nOctober, the common stock owner would have been better off buying the put. However, \nwith XYZ above 48 at expiration, the put purchase was aburden that cost asmall por\ntion of potential profits. This strategy, however, is not necessarily geared to maximizing \n211", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:299", "doc_id": "1eef398a750b3ea19c67d0439bd78802476156b5050d1a5a64c82fadc1fe8a44", "chunk_index": 0}
{"text": "272 Part Ill: Put Option Strategies \nTABLE 17-1. \nResults at expiration on aprotected stock holding. \nXYZ Price at Stock Put \nExpiration Profit Profit \n30 -$2,200 +$1,800 \n40 - 1,200 + 800 \n50 200 200 \n54 + 200 200 \n60 + 800 200 \n70 + 1,800 200 \n80 + 2,800 200 \nFIGURE 17-1. \nlong common stock and long put. \nC: \n0 \ne ·5. \nXw \n1i'i $0 Cf) \nCf) \n0 ..Jc5 \ne \n0. \n-$400 \n, \n, , , \nLong ,' \nStock ,, \n,, ,, \n, , , \n48 50 ,'52 \n, ,, , \n,, , \n, \n, ,, , \n, , ,, \nStock Price at Expiration \n,, ,, \n,, ,, \n, , \nTotal \nProfit \n-$ 400 \n400 \n400 \n0 \n+ 600 \n+ 1,600 \n+ 2,600 \none'sprofit potential on the common stock, but rather provides the stock owner with \nprotection, eliminating the possibility of any devastating loss on the stock holding during \nthe life of the put. In all the put buying strategies discussed in this chapter and Chapter \n18, the put must be paid for in full. That is the only increase in investment. \nAlthough any common stockholder may use this strategy, two general classes of \nstock owners find it particularly attractive: First, the long-term holder of the stock \nwho is not considering selling the stock may utilize the put protection to limit losses \nover ashort-term horizon. Second, the buyer of common stock who wants some \n\"insurance\" in case he is wrong may also find the put protection attractive.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:300", "doc_id": "2058a56f82470e8df0022e6d65accd2d1e4ba7f74a344c2c637d602baffc6b66", "chunk_index": 0}
{"text": "Cl,apter 17: Put Buying in Conjunction with Common Stock Ownership 273 \nThe long-term holder who strongly feels that his stock will drop should proba\nbly sell that stock. However, his cost basis may make the capital gains tax on the sale \nprohibitive. He also may not be entirely sure that the stock will decline - and may \nwant to continue to hold the stock in case it does go up. In either case, the purchase \nof aput will limit the stockholder'sdownside risk while still allowing room for upside \nappreciation. Alarge number of individual and institutional investors have holdings \nthat they might find difficult to sell for one reason or another. The purchase of alow\ncost put can often reduce the negative effects of abear market on their holdings. \nThe second general class of put buyers for protection includes the investor who \nis establishing aposition in the stock. He might want to buy aput at the same time \nthat he buys the stock, thereby creating aposition with profitability as depicted in the \nprevious profit graph. He immediately starts out with aposition that has limited \ndownside risk with large potential profits if the stock moves up. In this way, he can \nfeel free to hold the stock during the life of the put without worrying about when to \nsell it if it should experience atemporary setback. Some fairly aggressive stock traders \nuse this technique because it eliminates the necessity of having to place astop loss \norder on the stock. It is often frustrating to see astock fall and touch off one'sstop \nloss limit order, only to subsequently rise in price.' The stock owner who has aput for \nprotection need not overreact to adownward move. He can afford to sit back and \nwait during the life of the put, since he has built-in protection. \nWHICH PUT TO BUY \nThe selection of which put the stock owner purchases will determine how much of \nhis profit potential he is giving up and how much risk he is limiting. An out-of-the\nmoney put will cost very little. Therefore, it will be less of ahindrance on profit \npotential if the underlying stock rises in price. Unfortunately, the put'sprotective fea\nture is small until the stock falls to the striking price of the put. Therefore, the pur\nchase of the out-ofthe-rrwney put will not provide as much downside protection as \nan at- or in-the-money put would. The purchase of adeeply out-of-the-money put as \nprotection is more like \"disaster insurance\": It will prevent astock owner from expe\nriencing adisaster in terms of adownside loss during the life of the put, but will not \nprovide much protection in the case of alimited stock decline. \nExample: XYZ is at 40 and the October 35 put is selling for ½. The purchase of this \nput as protection for the common stock would not reduce upside potential much at \nall, only by ½ point. However, the stock owner could lose 5½ points if XYZ fell to 35 \nor below. That is his maximum possible loss, for if XYZ were below 35 at October expi\nration, he could exercise his put to sell the stock at 35, losing 5 points on the stock, and \nhe would have paid ½ point for the put, bringing his total loss to 5½ points.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:301", "doc_id": "2d424fa819ba72d3a4952bb41b1844e1239fba25733ffaaa2793b77b55716269", "chunk_index": 0}
{"text": "274 Part Ill: Put Option Strategies \nAt the opposite end of the spectrum, the stock owner might buy an in-the\nmoney put as protection. This would quite severely limit his profit potential, since the \nunderlying stock would have to rise above the strike and more for him to make aprofit. However, the in-the-money put provides vast quantities of downside protec\ntion, limiting his loss to avery small amount. \nExample: XYZ is again at 40 and there is an October 45 put selling for 5½. The stock \nowner who purchases the October 45 put would have amaximum risk of½ point, for \nhe could always exercise the put to sell stock at 45, giving him a 5-point gain on the \nstock, but he paid 5½ points for the put, thereby giving him an overall maximum loss \nof ½ point. He would have difficulty making any profit during the life of the put, \nhowever. XYZ would have to rise by more than 5½ points (the cost of the put) for \nhim to make any total profit on the position by October expiration. \nThe deep in-the-money put purchase is overly conservative and is usually not agood strategy. On the other hand, it is not wise to purchase aput that is too deeply \nout-of-the-money as protection. Generally, one should purchase aslightly out-ofthe\nmoney put as protection. This helps to achieve abalance between the positive feature \nof protection for the common stock and the negative feature of limiting profits. \nThe reader may find it interesting to know that he has actually gone through this \nanalysis, back in Chapter 3. Glance again at the profit graph for this strategy of using \nthe put purchase to protect acommon stock holding (Figure 17-1). It has exactly the \nsame shape as the profit graph of asimple call purchase. Therefore, the call purchase \nand the long put/long stock strategies are equivalent. Again, by equivalent it is meant \nthat they have similar profit potentials. Obviously, the ownership of acall differs sub\nstantially from the ownership of common stock and aput. The stock owner continues \nto maintain his position for an indefinite period of time, while the call holder does not. \nAlso, the stockholder is forced to pay substantially more for his position than is the call \nholder, and he also receives dividends whereas the call holder does not. Therefore, \n\"equivalent\" does not mean exactly the same when comparing call-oriented and put\noriented strategies, but rather denotes that they have similar profit potentials. \nIn Chapter 3, it was determined that the slightly in-the-money call often offers \nthe best ratio between risk and reward. When the call is slightly in-the-money, the \nstock is above the striking price. Similarly, the slightly out-of-the-money put often \noffers the best ratio between risk and reward for the common stockholder who is buy\ning the put for protection. Again, the stock is slightly above the striking price. Actually, \nsince the two positions are equivalent, the same conclusions should be arrived at; that \nis why it was stated that the reader has been through this analysis previously.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:302", "doc_id": "e650ac1076dc382d84db7ecc2d3b4732bb4cfa561c8ffff2b981546fcc17f395", "chunk_index": 0}
{"text": "G,pter 17: Put Buying in Conjunction with Common Stock Ownership \nTAX CONSIDERATIONS \n275 \nAlthough tax considerations are covered in detail in alater chapter, an important tax \nlaw concerning the purchase of puts against acommon stock holding should be men\ntioned at this time. If the stock owner is already along-term holder of the stock at the \ntime that he buys the put, the put purchase has no effect on his tax status. Similarly, \nif the stock buyer buys the stock at the time that he buys the put and identifies the \nposition as ahedge, there is no effect on the tax status of his stock. However, if one \nIs currently ashort-tenn holder of the common stock at the time that he buys aput, \nhe eliminates any accrued holding period on his common stock. Moreover, the hold\ning period for that stock does not begin again until the put is sold. \nExample: Assume the long-term holding period is 6 months. That is, astock owner \nmust own the stock for 6 months before it can be considered along-term capital gain. \nAn investor who bought the stock and held it for 5 months and then purchased aput \nwould wipe out his entire holding period of 5 months. Suppose he then held the put \nand the stock simultaneously for 6 months, liquidating the put at the end of 6 months. \nHis holding period would start all over again for that common stock. Even though he \nhas owned the stock for 11 months - 5 months prior to the put purchase and 6 \nmonths more while he simultaneously owned the put - his holding period for tax pur\nposes is considered to be zero! \nThis law could have important tax ramifications, and one should consult atax advisor \nif he is in doubt as to the effect that aput purchase might have on the taxability of \nhis common stock holdings. \nPUT BUYING AS PROTECTION FOR THE COVERED CALL WRITER \nSince put purchases afford protection to the owner of common stock, some investors \nnaturally feel that the same protective feature could be used to limit their downside \nrisk in the covered call writing strategy. Recall that the covered call writing strategy \ninvolves the purchase of stock and the sale of acall option against that stock. The cov\nered write has limited upside profit potential and offers protection to the downside in \nthe amount of the call premium. The covered writer will make money if the stock falls \nalittle, remains unchanged, or rises by expiration. The covered writer can actually lose \nmoney only if the stock falls by more than the call premium received. He has poten\ntially large downside losses. This strategy is known as aprotective collar or, more sim\nply, a \"collar.\" (It is also called a \"hedge wrapper,\" although that is an outdated term.)", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:303", "doc_id": "792bab5dae04ba9a0398d876ef7c2bdb2ee0b1fac905e7362f9e0e63b76371e9", "chunk_index": 0}
{"text": "274 Part Ill: Put Option Strategies \nAt the opposite end of the spectrum, the stock owner might buy an in-the\nmoney put as protection. This would quite severely limit his profit potential, since the \nunderlying stock would have to rise above the stiike and more for him to make aprofit. However, the in-the-money put provides vast quantities of downside protec\ntion, limiting his loss to avery small amount. \nExample: XYZ is again at 40 and there is an October 45 put selling for 5½. The stock \nowner who purchases the October 45 put would have amaximum risk of½ point, for \nhe could always exercise the put to sell stock at 45, giving him a 5-point gain on the \nstock, but he paid 5½ points for the put, thereby giving him an overall maximum loss \nof ½ point. He would have difficulty making any profit during the life of the put, \nhowever. XYZ would have to rise by more than 5½ points (the cost of the put) for \nhim to make any total profit on the position by October expiration. \nThe deep in-the-money put purchase is overly conservative and is usually not agood strategy. On the other hand, it is not wise to purchase aput that is too deeply \nout-of-the-money as protection. Generally, one should purchase aslightly out-ofthe\nnwney put as protection. This helps to achieve abalance between the positive feature \nof protection for the common stock and the negative feature of limiting profits. \nThe reader may find it interesting to know that he has actually gone through this \nanalysis, back in Chapter 3. Glance again at the profit graph for this strategy of using \nthe put purchase to protect acommon stock holding (Figure 17-1). It has exactly the \nsame shape as the profit graph of asimple call purchase. Therefore, the call purchase \nand the long put/long stock strategies are equivalent. Again, by equivalent it is meant \nthat they have similar profit potentials. Obviously, the ovvnership of acall differs sub\nstantially from the ownership of common stock and aput. The stock owner continues \nto maintain his position for an indefinite period of time, while the call holder does not. \nAlso, the stockholder is forced to pay substantially more for his position than is the call \nholder, and he also receives dividends whereas the call holder does not. Therefore, \n\"equivalent\" does not mean exactly the same when comparing call-oriented and put\noriented strategies, but rather denotes that they have similar profit potentials. \nIn Chapter 3, it was determined that the slightly in-the-money call often offers \nthe best ratio between 1isk and reward. When the call is slightly in-the-money, the \nstock is above the striking price. Similarly, the slightly out-of-the-money put often \noffers the best ratio between risk and reward for the common stockholder who is buy\ning the put for protection. Again, the stock is slightly above the striking price. Actually, \nsince the two positions are equivalent, the same conclusions should be arrived at; that \nis why it was stated that the reader has been through this analysis previously.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:304", "doc_id": "f45d2e63d5cfbf957bca7b07953d9e70ad8f0558923f82822bc80ed0019ede59", "chunk_index": 0}
{"text": "0.,,,,, I 7: Put Buying in Conjundion with Common Stock Ownership \nJAX CONSIDERATIONS \n275 \nAlthough tax considerations are covered in detail in alater chapter, an important tax \nlaw concerning the purchase of puts against acommon stock holding should be men\ntioned at this time. If the stock owner is already along-term holder of the stock at the \ntime that he buys the put, the put purchase has no effect on his tax status. Similarly, \nif the stock buyer buys the stock at the time that he buys the put and identifies the \nposition as ahedge, there is no effect on the tax status of his stock. However, if one \nis currently ashort-term holder of the comrrwn stock at the time that he buys aput, \nhe eliminates any accrued holding period on his comrrwn stock. Moreover, the hold\ning period for that stock does not begin again until the put is sold. \nExample: Assume the long-term holding period is 6 months. That is, astock owner \nmust own the stock for 6 months before it can be considered along-term capital gain. \nAn investor who bought the stock and held it for 5 months and then purchased aput \nwould wipe out his entire holding period of 5 months. Suppose he then held the put \nand the stock simultaneously for 6 months, liquidating the put at the end of 6 months. \nHis holding period would start all over again for that common stock. Even though he \nhas owned the stock for 11 months - 5 months prior to the put purchase and 6 \nmonths more while he simultaneously owned the put - his holding period for tax pur\nposes is considered to be zero! \nThis law could have important tax ramifications, and one should consult atax advisor \nif he is in doubt as to the effect that aput purchase might have on the taxability of \nhis common stock holdings. \nPUT BUYING AS PROTECTION FOR THE COVERED CALL WRITER \nSince put purchases afford protection to the owner of common stock, some investors \nnaturally feel that the same protective feature could be used to limit their downside \nrisk in the covered call writing strategy. Recall that the covered call writing strategy \ninvolves the purchase of stock and the sale of acall option against that stock. The cov\nered write has limited upside profit potential and offers protection to the downside in \nthe amount of the call premium. The covered writer will make money if the stock falls \nalittle, remains unchanged, or rises by expiration. The covered writer can actually lose \nmoney only if the stock falls by more than the call premium received. He has poten\ntially large downside losses. This strategy is known as aprotective collar or, more sim\nply, a \"collar.\" (It is also called a \"hedge wrapper,\" although that is an outdated term.)", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:305", "doc_id": "16ef5bf416f2696907db04bc2a6668d16e1cc6933e0387269fb76fcae529170b", "chunk_index": 0}
{"text": "276 Part Ill: Put Option Strategies \nThe purchase of an out-of the-money put option can eliminate the risk of large \npotential losses for the covered write, although the money spent for the put purchase \nwill reduce the overall return from the covered write. One must therefore include \nthe put cost in his initial calculations to determine if it is worthwhile to buy the put. \nExample: X'YZ is at 39 and there is an XYZ October 40 call selling for 3 points and an \nXYZ October 35 put selling for ½ point. Acovered write could be established by buy\ning the common at 39 and selling the October 40 call for 3. This covered write would \nhave amaximum profit potential of 4 points if XYZ were anywhere above 40 at expi\nration. The write would lose money if XYZ were anywhere below 36, the break-even \npoint, at October expiration. By also purchasing the October 35 put at the time the \ncovered write is initiated, the covered writer will limit his profit potential slightly, but \nwill also greatly reduce his risk potential. If the put purchase is added to the covered \nwrite, the maximum profit potential is reduced to 3½ points at October expiration. The \nbreak-even point moves up to 36½, and the writer will experience some loss if XYZ is \nbelow 36½ at expiration. However, the most that the writer could lose would be 1 ¼ \npoints if XYZ were below 35 at expiration. The purchase of the put option produces \nthis loss-limiting effect. Table 17-2 and Figure 17-2 depict the profitability of both the \nregular covered write and the covered write that is protected by the put purchase. \nCommissions should be carefully included in the covered writer'sreturn calcula\ntions, as well as the cost of the put. It was demonstrated in Chapter 2 that the covered \nwriter must include all commissions and margin interest expenses as well as all divi\ndends received in order to produce an accurate \"total return\" picture of the covered \nwrite. Figure 17-2 shows that the break-even point is raised slightly and the overall prof\nit potential is reduced by the purchase of the put. However, the maximum risk is quite \nsmall and the writer need never be forced to roll down in adisadvantageous situation. \nRecall that the covered writer who does not have the protective put in place is \nforced to roll down in order to gain increased downside protection. Rolling down \nmerely means that he buys back the call that is currently written and writes another \ncall, with alower striking price, in its place. This rolling-down action can be helpful \nif the stock stabilizes after falling; but if the stock reverses and climbs upward in price \nagain, the covered writer who rolled down would have limited his gains. In fact, he \nmay even have \"locked in\" aloss. The writer who has the protective put need not be \nbothered with such things. He never has to roll down, for he has alimited maximum \nloss. Therefore, he should never get into a \"locked-in\" loss situation. This can be agreat advantage, especially from an emotional viewpoint, because the writer is never \nforced to make adecision as to the future price of the stock in the middle of the \nstock'sdecline. With the put in place, he can feel free to take no action at all, since \nhis overall loss is limited. If the stock should rally upward later, he will still be in aposition to make his maximum profit.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:306", "doc_id": "5a0b0b5a6baea058a6a28567be20217f04d64840484a5474227f81cb4e6eaf9e", "chunk_index": 0}
{"text": "Chapter 17: Put Buying in Conjundion with Common Stock Ownership \nTABLE 17·2. \nComparison of regular and protected covered writes. \nXYZ Price at Stock October 40 October 35 \nExpiration Profit Call Profit Put Profit \n25 -$1,400 +$300 +$950 \n30 900 + 300 + 450 \n35 400 + 300 - 50 \n36.50 250 + 300 - 50 \n38 100 + 300 - 50 \n40 + 100 + 300 - 50 \n45 + 600 - 200 - 50 \n50 + 1,100 - 700 - 50 \nFIGURE 17-2. \nCovered call write protected by aput purchase. \nC \n0 \ne ·5. \nX \nLU \nco $0 CJ) \nCJ) \n0 .J \n0 \n~ -$150 a.. \n,, \n},.,,' \n; \n,, \nRegular \nCovered ,,' \nWrite/ \n36 / , , \n;\n,,' \n+$400 \n,----------➔ ,,,' _____ ...,.. \n, +$350 \n,,,' \n40 \nStock Price at Expiration \n277 \nTotal \nProfit \n-$150 \n- 150 \n- 150 \n0 \n+ 150 \n+ 350 \n+ 350 \n+ 350 \nThe longer-term effects of buying puts in combination with covered writes are \nnot easily definable, but it would appear that the writer reduces his overall rate of \nreturn slightly by buying the puts. This is because he gives something away if the \nstock falls slightly, remains unchanged, or rises in price. He only \"gains\" something if \nthe stock falls heavily. Since the odds of astock falling heavily are small in compari\nson to the other events (falling slightly, remaining unchanged, or rising), the writer \nwill be gaining something in only asmall percentage of cases. However, the put buy\ning strategy may still prove useful in that it removes the emotional uncertainty of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:307", "doc_id": "d3f31c754f9f8399554c3b5fc50c78ee93efe9cd5bd07480c769b37e2cf6308b", "chunk_index": 0}
{"text": "278 Part Ill: Put Option Strategies \nlarge losses. The covered writer who buys puts may often find it easier to operate in \namore rational manner when he has the protective put in place. \nThis strategy is equivalent to one that has been described before, the bull \nspread. Notice that the profit graph in Figure 17-2 has the same shape as the bull \nspread profit graph (Figure 7-1). This means that the two strategies are equivalent. \nIn fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con\nsidered a \"substitute\" for covered writing. Actually, the bull spread is more akin to \nthis strategy - the covered write protected by aput purchase. There are, of course, \ndifferences between the strategies. They are equivalent in profit and loss potential, \nbut the covered writer could never lose all his investment in ashort period of time, \nalthough the spreader could. In order to actually use bull spreads as substitutes for \ncovered writes, one would invest only asmall portion of his available funds in the \nspread and would place the remainder of his funds in fixed-income securities. That \nstrategy was discussed in more depth in Chapter 7. \nNO-COST COLLARS \nThe \"collar\" strategy is often arrived at in another manner: astockholder begins \nto worry about the downside potential of the stock market and decides to buy puts \non his stock as protection. However, he is dismayed by the cost of the puts and so he \nalso considers the sale of calls. If he buys an out-of-the-money put, it is quite possi\nble that he might be able to sell an out-of-the-money call whose proceeds complete\nly cover the cost of the put. Thus, he has established aprotective collar at no cost -\nat least no debit. His \"cost\" is the fact that he has forsaken the upside profit poten\ntial on his stock, above the striking price of the written call. \nIn fact, certain large institutional traders are able to transact collars through \nlarge over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley. \nThey might even give the broker instructions such as this: \"Iown XYZ and Iwant to \nbuy aput 10 percent out of the money that expires in ayear. What would the strik\ning price of aone-year call have to be in order to create ano-cost collar?\" The bro\nker might then tell him that such acall would have to be struck 30 percent out of the \nmoney. The actual strike price of the call would depend on the volatility estimate for \nthe underlying stock, as well as interest rates and dividends. These types of transac\ntions occur with afair amount of frequency. \nSome very interesting situations can be created with long-term options. One of \nthe most interesting occurred in 1999, when acompany that owned 5 million shares \nof Cisco ( CSCO) decided it would like to hedge them by creating ano-cost collar \nover the next three years. At the time, CSCO was trading at about 130, and its volatil\nity was about 50%. It turns out that athree-year put struck at 130 sells for about the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:308", "doc_id": "53d77667277f351c9db7d1653c81a07ddf5edfd1c90669f198f85ca1a2517c62", "chunk_index": 0}
{"text": "278 Part Ill: Put Option Strategies \nlarge losses. The covered writer who buys puts may often find it easier to operate in \namore rational manner when he has the protective put in place. \nThis strategy is equivalent to one that has been described before, the bull \nspread. Notice that the profit graph in Figure 17-2 has the same shape as the bull \nspread profit graph (Figure 7-1). This means that the two strategies are equivalent. \nIn fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con\nsidered a \"substitute\" for covered writing. Actually, the bull spread is more akin to \nthis strategy- the covered write protected by aput purchase. There are, of course, \ndifferences between the strategies. They are equivalent in profit and loss potential, \nbut the covered writer could never lose all his investment in ashort period of time, \nalthough the spreader could. In order to actually use bull spreads as substitutes for \ncovered writes, one would invest only asmall portion of his available funds in the \nspread and would place the remainder of his funds in fixed-income securities. That \nstrategy was discussed in more depth in Chapter 7. \nNO-COST COLLARS \nThe \"collar\" strategy is often arrived at in another manner: astockholder begins \nto worry about the downside potential of the stock market and decides to buy puts \non his stock as protection. However, he is dismayed by the cost of the puts and so he \nalso considers the sale of calls. If he buys an out-of-the-money put, it is quite possi\nble that he might be able to sell an out-of-the-money call whose proceeds complete\nly cover the cost of the put. Thus, he has established aprotective collar at no cost -\nat least no debit. His \"cost\" is the fact that he has forsaken the upside profit poten\ntial on his stock, above the striking price of the written call. \nIn fact, certain large institutional traders are able to transact collars through \nlarge over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley. \nThey might even give the broker instructions such as this: \"Iown XYZ and Iwant to \nbuy aput 10 percent out of the money that e.:\\.J)ires in ayear. What would the strik\ning price of aone-year call have to be in order to create ano-cost collar?\" The bro\nker might then tell him that such acall would have to be struck 30 percent out of the \nmoney. The actual strike price of the call would depend on the volatility estimate for \nthe underlying stock, as well as interest rates and dividends. These types of transac\ntions occur with afair amount of frequency. \nSome very interesting situations can be created with long-term options. One of \nthe most interesting occurred in 1999, when acompany that owned 5 million shares \nof Cisco (CSCO) decided it would like to hedge them by creating ano-cost collar \nover the next three years. At the time, CSCO was trading at about 130, and its volatil\nity was about 50%. It turns out that athree-year put struck at 130 sells for about the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:309", "doc_id": "889dcb9f794ae9981394fd4632ded02114586c6be714421f2592d756ec1d41c3", "chunk_index": 0}
{"text": "278 Part Ill: Put Option Strategies \nlarge losses. The covered writer who buys puts may often find it easier to operate in \namore rational manner when he has the protective put in place. \nThis strategy is equivalent to one that has been described before, the bull \nspread. Notice that the profit graph in Figure 17-2 has the same shape as the bull \nspread profit graph (Figure 7-1). This means that the two strategies are equivalent. \nIn fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con\nsidered a \"substitute\" for covered writing. Actually, the bull spread is more akin to \nthis strategy - the covered write protected by aput purchase. There are, of course, \ndifferences between the strategies. They are equivalent in profit and loss potential, \nbut the covered writer could never lose all his investment in ashort period of time, \nalthough the spreader could. In order to actually use bull spreads as substitutes for \ncovered ,vrites, one would invest only asmall portion of his available funds in the \nspread and would place the remainder of his funds in fixed-income securities. That \nstrategy was discussed in more depth in Chapter 7. \nNO-COST COLLARS \nThe \"collar\" strategy is often arrived at in another manner: astockholder begins \nto worry about the downside potential of the stock market and decides to buy puts \non his stock as protection. However, he is dismayed by the cost of the puts and so he \nalso considers the sale of calls. If he buys an out-of-the-money put, it is quite possi\nble that he might be able to sell an out-of-the-money call whose proceeds complete\nly cover the cost of the put. Thus, he has established aprotective collar at no cost -\nat least no debit. His \"cost\" is the fact that he has forsaken the upside profit poten\ntial on his stock, above the striking price of the written call. \nIn fact, certain large institutional traders are able to transact collars through \nlarge over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley. \nThey might even give the broker instructions such as this: \"Iown XYZ and Iwant to \nbuy aput 10 percent out of the money that expires in ayear. What would the strik\ning p1ice of aone-year call have to be in order to create ano-cost collar?\" The bro\nker might then tell him that such acall would have to be struck 30 percent out of the \nmoney. The actual strike price of the call would depend on the volatility estimate for \nthe underlying stock, as well as interest rates and dividends. These types of transac\ntions occur with afair amount of frequency. \nSome very interesting situations can be created with long-term options. One of \nthe most interesting occurred in 1999, when acompany that owned 5 million shares \nof Cisco ( CSCO) decided it would like to hedge them by creating ano-cost collar \nover the next three years. At the time, CSCO was trading at about 130, and its volatil\nity was about 50%. It turns out that athree-year put struck at 130 sells for about the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:310", "doc_id": "441928822423311eb9578741b392f91a6ca4ef010f86f29cbd3fc0f894f554f6", "chunk_index": 0}
{"text": "Cltapter 17: Put Buying in Conjunction with Common Stock Ownership \nTABLE 17-3. \nHighest Call Strike That Pays for an At-the-Money Put \n(Assuming 2.5 years to expiration) \nVolatility Coll Strike \n30% \n40% \n50% \n70% \n100% \nof Underlying \n30% out of money \n35% out of money \n40% out of money \n50% out of money \n70% out of money \n279 \nsame price as athree-year call struck at 200! That may seem illogical, but the figures \ncan be checked out with the aid of an option-pricing model. Thus, this company was \nable to hedge all of its CSCO stock, with no downside risk ( the striking price of the \nputs was the same as the current stock price) and still had profit potential of over 50% \nto the upside over the next three years. \nThus, one should consider using LEAPS options when he establishes acollar -\neven ifhe is not an institutional trader - because the striking price of the calls can be \nquite high in comparison to that of the put' sstrike or in comparison to the price of \nthe underlying stock. Table 17-3 shows how far out-of-the-money awritten call could \nbe that still covers the cost of buying an at-the-money put. The time to expiration in \nthis table is 2.5 years - the longest term listed option that currently exists as a LEAPS \noption. \nUSING LOWER STRIKES AS A PARTIAL COVERED WRITE \nIt should also be pointed out that one does not necessarily have to forsake all of \nthe profit potential from his stock. He might buy the puts, as usual, and then sell calls \nwith asomewhat lower strike than needed for alow-cost collar, but the quantity of \ncalls sold would be less than that of stock owned. In that way, there would be unlim\nited profit potential on some of the shares of the underlying stock. \nExample: Suppose that the following prices exist: \nXYZ:61 \nApr 55 put: 1 \nApr 65 call: 2 \nFurthermore, suppose that one owns 1000 shares of XYZ. Thus, the purchase \nof 10 Apr 55 puts at 1 point apiece would protect the downside. In order to cover the \ncost of those puts ($1000), one need only sell five of the Apr 65 calls at 2 points", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:311", "doc_id": "c8e40b7ee34049dcb7cc5f65f0354ba02396d0e47243438b912521578fe2694c", "chunk_index": 0}
{"text": "280 Part Ill: Put Option Strategies \napiece. Thus, the protection would have cost nothing and there would still be unlim\nited profit potential on 500 of the shares of XYZ, since only five calls were sold against \nthe 1000 shares that are owned. \nIn this manner, one could get quite creative in constructing collars - deciding \nwhat call strike to use in order to strike abalance between paying for the puts and \nallowing upside profit potential. The lower the strike he uses for the written calls, the \nfewer calls he will have to write; the higher the strike of the written calls, the more \ncalls will be necessary to cover the cost of the purchased puts. The tradeoff is that alower call strike allows for more eventual upside profit potential, but it limits what \nhas been written against to alower price. \nUsing the above example once again, these facts can be demonstrated: \nExample (continued): As before, the same prices exist, but now one more call will \nbe brought into the picture: \nXYZ: 61 \nApr55 put: l \nApr 65 call: 2 \nApr 70 call: l \nAs before one could sell five of the Apr 65 calls to cover the cost of ten puts, or \nas an alternative he could sell ten of the Apr 70 calls. If he sells the five, he has unlim\nited profit potential on 500 shares, but the other 500 shares will be called away at 65. \nIn the alternative strategy, he has limited upside profit potential, but nothing will be \ncalled away until the stock reaches 70. Which is \"better?\" It'snot easy to say. In the \nformer strategy, if the stock climbs all the way to 75, it results in the same profit as if \nthe stock is called away at 70 in the latter strategy. This is true because 500 shares \nwould be worth 75, but the other 500 would have been called away at 65 - making \nfor an average of 70. Hence, the former strategy only outperforms the latter if the \nstock actually climbs above 75 - arather unlikely event, one would have to surmise. \nStill, many investors prefer the former strategy because it gives them protection with\nout asking them to surrender all of their upside profit potential. \nIn summary, one can often be quite creative with the \"collar\" strategy. One thing \nto keep in mind: if one sells options against stock that he has no intention of selling, he \nis actually writing naked calls in his ovm mind. That is, if one owns stock that \"can't\" \nbe sold - perhaps the capital gains would be devastating or the stock has been \"in the \nfamily\" for along time - then he should not sell covered calls against it, because he will \nbe forced into treating the calls as naked (if he refuses to sell the stock). This can cause \nquite abit of consternation if the underlying stock rises significantly in price, that could \nhave easily been avoided by not writing calls against the stock in the first place.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:312", "doc_id": "41578798aa8860491383b82c027a69476cb6a988b1ee0db095c2146fb46ba8ff", "chunk_index": 0}
{"text": "CHAPCIJER 18 \nBuying Puts in Conjunction \nwith Call Purchases \nThere are several ways in which the purchases of both puts and calls can be used to \nthe speculator'sadvantage. One simple method is actually afollow-up strategy for the \ncall buyer. If the stock has advanced and the call buyer has aprofit, he might con\nsider buying aput as ameans of locking in his call profits while still allowing for more \npotential upside appreciation. In Chapter 3, four basic alternatives were listed for the \ncall buyer who had aprofit: He could liquidate the call and take his profit; he could \ndo nothing; he could \"roll up\" by selling the call for aprofit and using part of the pro\nceeds to purchase more out-of-the-money calls; or he could create abull spread by \nselling the out-of-the-money call against the profitable call that he holds. If the \nunderlying stock has listed puts, he has another alternative: He could buy aput. This \nput purchase would serve to lock in some of the profits on the call and would still \nallow room for further appreciation if the stock should continue to rise in price. \nExample: An investor initially purchased an XYZ October 50 call for 3 points when \nthe stock was at 48. Sometime later, after the stock had risen to 58, the call would be \nworth about 9 points. If there was an October 60 put, it might be selling for 4 points, \nand the call holder could buy this put to lock in some of his profits. His position, after \npurchasing the put, would be: \nLong l October 50 call at 3 points Ntt 7 • t - ecos: pom s Long l October 60 put at 4 points \nHe would own a \"strangle\" - any position consisting of both aput and acall with dif\nfering terms - that is always worth at least 10 points. The combination will be worth \nexactly 10 points at expiration if XYZ is anywhere between 50 and 60. For example, \n281", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:313", "doc_id": "1b1dc9e9868acffd17b1b96140031c569c0cb93a7fb11dacc6bbf47d8314b35b", "chunk_index": 0}
{"text": "282 Part Ill: Put Option Strategies \nif xyz is at 52 at expiration, the call will be worth 2 points and the put will be wort Ii \n8 points. Alternatively, if the stock is at 58 at expiration, the put will be worth 2 points \nand the call worth 8 points. Should xyz be above 60 at expiration, the combination'svalue will be equal to the call'svalue, since the put will expire worthless with XYZ \nabove 60. The call would have to be worth more than 10 points in that case, since it \nhas astriking price of 50. Similarly, if xyz were below 50 at expiration, the combi\nnation would be worth more than 10 points, since the put would be more than 10 \npoints in-the-money and the call would be worthless. \nThe speculator has thus created aposition in which he cannot lose money, \nbecause he paid only 7 points for the combination (3 points for the call and 4 points \nfor the put). No matter what happens, the combination will be worth at least 10 \npoints at e:x-piration, and a 3-point profit is thus locked in. If xyz should continue to \nclimb in price, the speculator could make more than 3 points of profit whenever xyz \nis above 60 at expiration. Moreover, if xyz should suddenly collapse in price, the \nspeculator could make more than 3 points of profit if the stock was below 50 by expi\nration. The reader must realize that such aposition can never be created as an initial \nposition. This desirable situation arose only because the call had built up asubstan\ntial profit before the put was purchased. The similar strategy for the put buyer who \nmight buy acall to protect his unrealized put profits was described in Chapter 16. \nSTRADDLE BUYING \nAstraddle purchase consists of buying both aput and acall with the same terms -\nsarne underlying stock, striking price, and expiration date. The straddle purchase \nallows the buyer to make large potential profits if the stock moves far enough in \neither direction. The buyer has apredetermined maximum loss, equal to the amount \nof his initial investment. \nExample: The following prices exist: \nxyz common, 50; \nXYZ July 50 call, 3; and \nXYZ July 50 put, 2. \nIf one purchased both the July 50 call and the July 50 put, he would be buying astraddle. This would cost 5 points plus commissions. The investment required to \npurchase astraddle is the net debit. If the underlying stock is exactly at 50 at expi\nration, the buyer would lose all his investment, since both the put and the call would \nexpire worthless. If the stock were above .55 at expiration, the call portion of the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:314", "doc_id": "124ad7d87bbd13bc381ec45b2d008377db57cf0148fa078d3bdb96ea65a91dca", "chunk_index": 0}
{"text": "18: Buying Puts in Conjundion with Call Purchases 283 \ndle would be worth more than 5 points and the straddle buyer would make \ny, even though his put expired worthless. To the downside, asimilar situation \nMists. If XYZ were below 45 at expiration, the put would be worth more than 5 \npoints and he would have aprofit despite the fact that the call expired worthless. \nTable 18-1 and Figure 18-1 depict the results of this example straddle purchase at \nexpiration. The straddle buyer can immediately determine his break-even points at \nexpiration - 45 and 55 in this example. He will lose money if the underlying stock is \nbetween those break-even points at expiration. He has potentially large profits if \nXYZ should move agreat distance away from 50 by expiration. \nOne would normally purchase astraddle on arelatively volatile stock that has \nthe potential to move far enough to make the straddle profitable in the allotted time. \nThis strategy is particularly attractive when option premiums are low, since low pre\nmiums will mean acheaper straddle cost. Although losses may occur in arelatively \nlarge percentage of cases that are held all the way until their expiration date, there is \nactually only aminute probability of losing one'sentire investment. Even if XYZ \nshould be at 50 at expiration, there would still be the opportunity to sell the straddle \nfor asmall amount on the final day of trading. \nTABLE 18-1. \nResults of straddle purchase at expiration. \nXYZ Price at Total Straddle \nExpiration Coll Profit Put Profit Profit \n30 -$ 300 +$1,800 + $1,500 \n40 300 + 800 + 500 \n45 300 + 300 0 \n50 300 200 500 \n55 + 200 200 0 \n60 + 700 200 + 500 \n70 + 1,700 200 + 1,500 \nEQUIVALENCES \nStraddle buying is equivalent to the reverse hedge, astrategy described in Chapter 4 \nin which one sells the underlying stock short and purchases two calls on the under\nlying stock. Both strategies have similar profit characteristics: alimited loss that \nwould occur at the striking price of the options involved, and potentially large prof\nits if the underlying stock should rise or fall far enough in price. The straddle pur-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:315", "doc_id": "b4a37089247ff22fe89f9a2ca17c04943fc009ccd04805afeaec6f23161cbc1a", "chunk_index": 0}
{"text": "284 \nFIGURE 18-1. \nStraddle purchase. \nC: \n.Q \nI!! ·a. \nXwro $0 en en 0 \n..J \n0 \n-ea.. \n-$500 \nPart Ill: Put Option Strategies \nStock Price at Expiration \nchase is superior to the reverse hedge, however, and where listed puts exist on astock, \nthe reverse hedge strategy becomes obsolete. The reasons that the straddle purchase \nis superior are that dividends are not paid by the holder and that commission costs \nare much smaller in the straddle situation. \nREVERSE HEDGE WITH PUTS \nAthird strategy is equivalent to both the straddle purchase and the reverse hedge. \nIt consists of buying the underlying stock and buying two put options. If the stock \nrises substantially in price, large profits will accrue, for the stock profit will more \nthan offset the fixed loss on the purchase of two put options. If the stock declines in \nprice by alarge amount, profits will also be generated. In adecline, the profits gen\nerated by 2 long puts will more than offset the loss on 100 shares of long stock. This \nform of the straddle purchase has limited risk as well. The worst case would occur \nif the stock were exactly at the striking price of the puts at their expiration date - the \nputs would both expire worthless. The risk is limited, percentagevvise and dollar\nwise, since the cost of two put options would normally be arelatively small per\ncentage of the total cost of buying the stock. Furthermore, the investor may receive \nsome dividends if the underlying stock is adividend-paying stock. Buying stock and \nbuying two puts is superior to the reverse hedge strategy, but is still inferior to the \nstraddle purchase.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:316", "doc_id": "5b1be73786a9eea135eefda3872d4040602f1536c373fa6bb820b540191f78f6", "chunk_index": 0}
{"text": "ter 18: Buying Puts in Conjunction with Call Purchases \nIILECTING A STRADDLE BUY \n285 \nIn theory, one could find the best straddle purchases by applying the analyses for best \ncall purchases and best put purchases simultaneously. Then, if both the puts and calls \non aparticular stock showed attractive opportunity, the straddle could be bought. \nThe straddle should be viewed as an entire position. Asimilar sort of analysis to that \nproposed for either put or call purchases could be used for straddles as well. First, \none would assume the stock would move up or down in accordance with its volatili\nty within afixed time period, such as 60 or 90 days. Then, the prices of both the put \nand the call could be predicted for this stock movement. The straddles that off er the \nbest reward opportunity under this analysis would be the most attractive ones to buy. \nTo demonstrate this sort of analysis, the previous example can be utilized again. \nExample: XYZ is at 50 and the July 50 call is selling for 3 while the July 50 put is sell\ning for 2 points. If the strategist is able to determine that XYZ has a 25% chance of \nbeing above 54 in 90 days and also has a 25% chance of being below 46 in 90 days, \nhe can then predict the option prices. Arigorous method for determining what per\ncentage chance astock has of making apredetermined price movement is presented \nin Chapter 28 on mathematical applications. For now, ageneral procedure of analy\nsis is more important than its actual implementation. If XYZ were at 54 in 90 days, it \nmight be reasonable to assume that the call would be worth 5½ and the put would \nbe worth 1 point. The straddle would therefore be worth 6½ points. Similarly, if the \nstock were at 46 in 90 days, the put might be worth 4½ points, and the call worth 1 \npoint, making the entire straddle worth 5½ points. It is fairly common for the strad\ndle to be higher-priced when it is afixed distance in-the-money on the call side (such \nas 4 points) than when it is in-the-money on the put side by that same distance. In \nthis example, the strategist has now determined that there is a 25% chance that the \nstraddle will be worth 6½ points in 90 days on an upside movement, and there is a \n25% chance that the straddle will be worth 5½ points on adownside movement. The \naverage price of these two expectations is 6 points. Since the straddle is currently sell\ning for 5 points, this would represent a 20% profit. If all potential straddles are \nranked in the same manner - allowing for a 25% chance of upside and downside \nmovement by each underlying stock - the straddle buyer will have acommon basis \nfor comparing various straddle opportunities. \nFOLLOW-UP ACTION \nIt has been mentioned frequently that there is agood chance that astock will remain \nrelatively unchanged over ashort time period. This does not mean that the stock will", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:317", "doc_id": "aef5bab199f0135728878d7dfa479e22769636b19844cb0a8f980974d64a756f", "chunk_index": 0}
{"text": "286 Part Ill: Put Option Strategies \nnever move much one way or the other, but that its net movement over the time peri\nod will generally be small. \nExample: If XYZ is currently at 50, one might say that its chances of being over .5.5 \nat the end of 90 days are fairly small, perhaps 30%. This may even be supported by \nmathematical analysis based on the volatility of the underlying stock. This does not \nimply, however, that the stock has only a 30% chance of ever reaching 55 during the \n90-day period. Rather, it implies that it has only a 30% chance of being over 55 at the \nend of the 90-day period. These are two distinctly different events, with different \nprobabilities of occurrence. Even though the probability of being over 55 at the end \nof 90 days might be only 30%, the probability of ever being over 55 during the 90-\nday period could be amazingly high, perhaps as high as 80%. It is important for the \nstraddle buyer to understand the differences between these events occurring, for he \nmight often be able to take follow-up action to improve his position. \nMany times, after astraddle is bought, the underlying stock will begin to move \nstrongly, making it appear that the straddle is immediately going to become prof\nitable. However, just as things are going well, the stock reverses and begins to change \ndirection, perhaps so quickly that it would now appear that the straddle will become \nprofitable on the other side. These volatile stock movements often result in little net \nchange, however, and at expiration the straddle buyer may have aloss. One might \nthink that he would take profits on the call side when they became available in aquick upward movement, and then hope for adownward reversal so that he could \ntake profits on the put side as well. Taking small profits, however, is apoor strategy. \nStraddle buying has limited losses and potentially unlimited profits. One might have \nto suffer through asubstantial number of small losses before hitting abig winner, but \nthe magnitude of the gain on that one large stock movement can offset many small \nlosses. By taking small profits, the straddle buyer is immediately cutting off his \nchances for asubstantial gain; that is why it is apoor strategy to limit the profits. \nThis is one of those statements that sounds easier in theory than it is in practice. \nIt is emotionally distressing to watch the straddle gain 2 or 3 points in ashort time \nperiod, only to lose that and more when the stock fails to follow through. By using adifferent example, it is possible to demonstrate the types of follow-up action that the \nstraddle buyer might take. \nExample: One had initially bought an XYZ January 40 straddle for 6 points when the \nstock was 40. After afairly short time, the stock jumps up to 45 and the following \nprices exist:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:318", "doc_id": "6df7b25cf3366814d72ae7006d60b1eb1475b93e71ec39e2136b0db7843a4e48", "chunk_index": 0}
{"text": "Cl,apter 18: Buying Puts in Conjunction with Call Purchases \nXYZ common, 45: \nXYZ January 40 call, 7; \nXYZ January 40 put, l; and \nXYZ January 45 put, 3. \n287 \nThe straddle itself is now worth 8 points. The January 45 put price is included \nbecause it will be part of one of the follow-up strategies. What could the straddle \nbuyer do at this time? First, he might do nothing, preferring to let the straddle run \nits course, at least for three months or so. Assuming that he is not content to sit tight, \nhowever, he might sell the call, taking his profit, and hope for the stock to then drop \nin price. This is an inferior course of action, since he would be cutting off potential \nlarge profits to the upside. \nIn the older, over-the-counter option market, one might have tried atechnique \nknown as trading against the straddle. Since there was no secondary market for \nover-the-counter options, straddle buyers often traded the stock itself against the \nstraddle that they owned. This type of follow-up action dictated that, if the stock \nrose enough to make the straddle profitable to the upside, one would sell short the \nunderlying stock. This involved no extra risk, since if the stock continued up, the \nstraddle holder could always exercise his call to cover the short sale for aprofit. \nConversely, if the underlying stock fell at the outset, making the straddle profitable \nto the downside, one would buy the underlying stock. Again, this involved no extra \nrisk if the stock continued down, since the put could always be exercised to sell the \nstock at aprofit. The idea was to be able to capitalize on large stock price reversals \nwith the addition of the stock position to the straddle. This strategy worked best for \nthe brokers, who made numerous commissions as the trader tried to gauge the \nwhipsaws in the market. In the listed options market, the same strategic effect can \nbe realized ( without as large acommission expense) by merely selling out the long \ncall on an upward move, and using part of the proceeds to buy asecond put similar \nto the one already held. On adownside move, one could sell out the long put for aprofit and buy asecond call similar to the one he already owns. In the example \nabove, the call would be sold for 7 points and asecond January 40 put purchased for \n1 point. This would allow the straddle buyer to recover his initial 6-point cost and \nwould allow for large downside profit potential. This strategy is not recommended, \nhowever, since the straddle buyer is limiting his profit in the direction that the stock \nis moving. Once the stock has moved from 40 to 45, as in this example, it would be \nmore reasonable to expect that it could continue up rather than experience adrop \nof more than 5 points.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:319", "doc_id": "1a2fa184a587f02bcd007d468c4b83156f82f484ee7397478751838494c9d833", "chunk_index": 0}
{"text": "288 Part Ill: Put Option Strategies \nArrwre desirable sort off allow-up action would be one whereby the straddle \nbuyer could retain much of the profit already built up without limiting further poten\ntial profits if the stock continues to run. In the example above, the straddle buyer \ncould use the January 45 put - the one at the higher price - for this purpose. \nExample: Suppose that when the stock got to 45, he sold the put that he owned, the \nJanuary 40, for 1 point, and simultaneously bought the January 45 put for 3 points. \nThis transaction would cost 2 points, and would leave him in the following position: \nLong 1 January 40 call Cb· dt 8 . t - om me cos : porn s Long 1 January 45 put \nHe now owns acombination at acost of 8 points. However, no matter where the \nunderlying stock is at expiration, this combination will be worth at least 5 points, \nsince the put has astriking price 5 points higher than the call'sstriking price. In fact, \nif the stock is above 45 at expiration or is below 40 at expiration, the straddle will be \nworth more than 5 points. This follow-up action has not limited the potential profits. \nIf the stock continues to rise in price, the call will become more and more valuable. \nOn the other hand, if the stock reverses and falls dramatically, the put will become \nquite valuable. In either case, the opportunity for large potential profits remains. \nMoreover, the investor has improved his risk exposure. The most that the new posi\ntion can lose at expiration is 3 points, since the combination cost 8 points originally, \nand can be sold for 5 points at worst. \nTo summarize, if the underlying stock moves up to the ne:t\"tstrike, the straddle \nbuyer should consider rolling his put up, selling the one that he is long and buying \nthe one at the next higher striking price. Conversely, if the stock starts out with adownward move, he should consider rolling the call down, selling the one that he is \nlong and buying the one at the next lower strike. In either case, he reduces his risk \nexposure without limiting his profit potential - exactly the type of follow-up result \nthat the straddle buyer should be aiming for. \nBUYING A STRANGLE \nAstrangle is aposition that consists of both aput and acall, which generally have the \nsame expiration date, but different striking prices. The fallowing example depicts astrangle. \nExample: One might buy astrangle consisting of an XYZ January 45 put and an XYZ \nJanuary 50 call. Buying such astrangle is quite similar to buying astraddle, although", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:320", "doc_id": "4a90be58e0f3bec21208c4ca9be9c70b3a793d062b2da983ae8794a4460070f4", "chunk_index": 0}
{"text": "O.,,ter 18: Buying Puts in Conjunction with Call Purchases 289 \nthere are some differences, as the following discussion will demonstrate. Suppose the \nfollowing prices exist: \nXYZ common, 47; \nXYZ January 45 put, 2; and \nXYZ January 50 call, 2. \nIn this example, both options are out-of-the-money when purchased. This, again, is \nthe most normal application of the strangle purchase. If XYZ is still between 45 and \n50 at January expiration, both options will expire worthless and the strangle buyer \nwill lose his entire investment. This investment - $400 in the example - is generally \nsmaller than that required to buy astraddle on XYZ. If XYZ moves in either direc\ntion, rising above 50 or falling below 45, the strangle will have some value at expira\ntion. In this example, ifXYZ is above 54 at expiration, the call will be worth more than \n4 points (the put will expire worthless) and the buyer will make aprofit. In asimilar \nmanner, if XYZ is below 41 at expiration, the put will have avalue greater than 4 \npoints and the buyer would make aprofit in that case as well. The potential profits \nare quite large if the underlying stock should nwve agreat deal before the options \nexpire. Table 18-2 and Figure 18-2 depict the potential profits or losses from this \nposition at January expiration. The maximum loss is possible over amuch wider range \nthan that of astraddle. The straddle achieves its maximum loss only if the stock is \nexactly at the striking price of the options at expiration. However, the strangle has its \nmaximum loss anywhere between the two strikes at expiration. The actual amount of \nthe loss is smaller for the strangle, and that is acompensating factor. The potential \nprofits are large for both strategies. \nThe example above is one in which both options are out-of-the money. It is also \npossible to construct avery similar position by utilizing in-the-money options. \nExample: With XYZ at 47 as before, the in-the-money options might have the fol\nlowing prices: XYZ January 45 call, 4; and XYZ January 50 put, 4. If one purchased \nthis in-the-rrwney strangle, he would pay atotal cost of 8 points. However, the value \nof this strangle will always be at least 5 points, since the striking price of the put is 5 \npoints higher than that of the call. The reader has seen this sort of position before, \nwhen protective follow-up strategies for straddle buying and for call or put buying \nwere described. Because the strangle will always be worth at least 5 points, the most \nthat the in-the-money strangle buyer can lose is 3 points in this example. His poten\ntial profits are still unlimited should the underlying stock move alarge distance. \nThus, even though it requires alarger initial investment, the in-the-rrwney strangle \nmay often be asuperior strategy to the out-of the-rrwney strangle, from abuyer's", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:321", "doc_id": "0f6a9d259edd71fc5131d09d575b2b9c431e64eab782cdfe9a62184a6f9c50cc", "chunk_index": 0}
{"text": "290 \nTABLE 18-2. \nResults at expiration of astrangle purchase. \nXYZ Price at \nExpiration \n25 \n35 \n41 \n43 \n45 \n47 \n50 \n54 \n60 \n70 \nFIGURE 18-2. \nStrangle purchase. \nC: \n0 \n~ ·c. \nXw \n1ii \n(/) $0 (/) \n0 \n..J \n6 \nil= -$400 ea. \nPut Call \nProfit Profit \n+$1,800 -$ 200 \n+ 800 200 \n+ 200 200 \n0 200 \n200 200 \n200 200 \n200 200 \n200 + 200 \n200 + 800 \n200 + 1,800 \nStock Price at Expiration \nPart Ill: Put Option Strategies \nTotal \nProfit \n+$1,600 \n+ 600 \n0 \n200 \n400 \n400 \n400 \n0 \n+ 600 \n+ 1,600 \nviewpoint. The in-the-money strangle purchase certainly involves less percentage \nrisk: The buyer can never lose all his investment, since he can always get back 5 \npoints, even in the worst case (when XYZ is behveen 45 and 50 at expiration). His \npercentage profits are lower with the in-the-money strangle purchase, since he paid \nmore for the strangle to begin with. These observations should come as no surprise,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:322", "doc_id": "12d8ac9b98e3d4cb300a3061c6d3987cd5e77313ccea6e06426b1d703faba3d6", "chunk_index": 0}
{"text": "\\O.,ter 18: Buying Puts in Conjunction with Call Purchases 291 \nsince when the outright purchase of acall was discussed, it was shown that the \npurchase of an in-the-money call was more conservative than the purchase of an out\nof-the-money call, in general. The same was true for the outright purchase of puts, \nperhaps even more so, because of the smaller time value of an in-the-money put. \nTherefore, the strangle created by the two an in-the-money call and an in-the\nmoney put - should be more conservative than the out-of-the-money strangle. \nIf the underlying stock moves quickly in either direction, the strangle buyer \nmay sometimes be able to take action to protect some of his profits. He would do so \nin amanner similar to that described for the straddle buyer. For example, if the stock \nmoved up quickly, he could sell the put that he originally bought and buy the put at \nthe next higher striking price in its place. If he had started from an out-of-the-money \nstrangle position, this would then place him in astraddle. The strategist should not \nblindly take this sort of follow-up action, however. It may be overly expensive to \"roll \nup\" the put in such amanner, depending on the amount of time that has passed and \nthe actual option prices involved. Therefore, it is best to analyze each situation on acase-by-case basis to see whether it is logical to take any follow-up action at all. \nAs afinal point, the out-of-the-money strangles may appear deceptively cheap, \nboth options selling for fractions of apoint as expiration nears. However, the proba\nbility of realizing the maximum loss equal to one'sinitial investment is fairly large \nwith strangles. This is distinctly different from straddle purchases, whereby the prob\nability of losing the entire investment is small. The aggressive speculator should not \nplace alarge portion of his funds in out-of-the-money strangle purchases. The per\ncentage risk is smaller with the in-the-money strangle, being equal to the amount of \ntime value premium paid for the options initially, but commission costs will be some\nwhat larger. In either case, the underlying stock still needs to move by arelatively \nlarge amount in order for the buyer to profit.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:323", "doc_id": "9ceb374391df590c28aee0161fb41b020e2883096a855543d62d8e5ffe23d9ca", "chunk_index": 0}
{"text": "CH.APTER 19 \nThe Sale of a Put \nThe buyer of aput stands to profit if the underlying stock drops in price. As might \nthen be expected, the seller of aput will make money if the underlying stock increas\nes in price. The uncovered sale of aput is amore common strategy than the covered \nsale of aput, and is therefore described first. It is abullishly-oriented strategy. \nTHE UNCOVERED PUT SALE \nSince the buyer of aput has aright to sell stock at the striking price, the writer of aput is obligating himself to buy that stock at the striking price. For assuming this obli\ngation, he receives the put option premium. If the underlying stock advances and the \nput expires worthless, the put writer will not be assigned and he could make amaxi\nmum profit equal to the premium received. He has large downside risk, since the \nstock could fall substantially, thereby increasing the value of the written put and caus\ning large losses to occur. An example will aid in explaining these general statements \nabout risk and reward. \nExample: XYZ is at 50 and a 6-month put is selling for 4 points. The naked put writer \nhas afixed potential profit to the upside - $400 in this example and alarge poten\ntial loss to the downside (Table 19-1 and Figure 19-1). This downside loss is limited \nonly by the fact that astock cannot go below zero. \nThe collateral requirement for writing naked puts is the same as that for writ\ning naked calls. The requirement is equal to 20% of the current stock price plus the \nput premium minus any out-of-the-money amount. \nExample: If XYZ is at 50, the collateral requirement for writing a 4-point put with astriking price of 50 would be $1,000 (20% of 5,000) plus $400 for the put premium \n292", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:324", "doc_id": "c9f462dd8669dedeb3e598d2f761d6fc8a57202130ceef2ca89c63c3eff15840", "chunk_index": 0}
{"text": "Cl,opter 19: The Sale of a Put \nTABLE 19-1. \nResults from the sale of an uncovered put. \nXYZ Price at Put Price at \nExpiration Expiration (Parity) \n30 20 \n40 10 \n46 4 \n50 0 \n60 0 \n70 0 \nf IGURE 19-1. \nUncovered sale of aput. \n$400 \nC \n0 \n~ ·5. \nXw \n'lii \n(/l $0 (/l \n.3 50 \n0 \n~ a. \nStock Price at Expiration \n293 \nPut Sale \nProfit \n-$1,600 \n600 \n0 \n+ 400 \n+ 400 \n+ 400 \nfor atotal of $1,400. If the stock were above the striking price, the striking price dif\nforential would be subtracted from the requirement. The minimum requirement is \nI 0% of the put' sstriking price, plus the put premium, even if the computation above \nyields asmaller result. \nThe uncovered put writing strategy is similar in many ways to the covered call \nwriting strategy. Note that the profit graphs have the same shape; this means that the \ntwo strategies are equivalent. It may be helpful to the reader to describe the aspects \nof naked put writing by comparing them to similar aspects of covered call writing.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:325", "doc_id": "b25a98525d6795f92699e4b6b1db07fa4a94133e06c4b2ccacee96230ef26dd8", "chunk_index": 0}
{"text": "294 Part Ill: Put Option Strategies \nIn either strategy, one needs to be somewhat bullish, or at least neutral, on the \nunderlying stock. If the underlying stock moves upward, the uncovered put writer \nwill make aprofit, possibly the entire amount of the premium received. If the under\nlying stock should be unchanged at expiration - aneutral situation - the put writer \nwill profit by the amount of the time value premium received when he initially wrote \nthe put. This could represent the maximum profit if the put was out-of-the-money \ninitially, since that would mean that the entire put premium was composed of time \nvalue premium. For an in-the-money put, however, the time value premium would \nrepresent something less than the entire value of the option. These are similar qual\nities to those inherent in covered call writing. If the stock moves up, the covered call \nwriter can make his maximum profit. However, if the stock is unchanged at expira\ntion, he will make his maximum profit only if the stock is above the call'sstriking \nprice. So, in either strategy, if the position is established with the stock above the \nstriking price, there is agreater probability of achieving the maximum profit. This \nrepresents the less aggressive application: writing an out-of-the-money put initially, \nwhich is equivalent to the covered write of an in-the-money call. \nThe more aggressive application of naked put writing is to write an in-the\nmoney put initially. The writer will receive alarger amount of premium dollars for \nthe in-the-money put and, if the underlying stock advances far enough, he will thus \nmake alarge profit. By increasing his profit potential in this manner, he assumes \nmore risk. If the underlying stock should fall, the in-the-money put writer will lose \nmoney more quickly than one who initially wrote an out-of-the-money put. Again, \nthese facts were demonstrated much earlier with covered call writing. An in-the\nmoney covered call write affords more downside protection but less profit potential \nthan does an out-of-the-money covered call write. \nIt is fairly easy to summarize all of this by noting that in either the naked put \nwriting strategy or the covered call writing strategy, aless aggressive position is estab\nlished when the stock is higher than the striking price of the written option. If the \nstock is below the striking price initially, amore aggressive position is created. \nThere are, of course, some basic differences between covered call writing and \nnaked put writing. First, the naked put write will generally require asmaller invest\nment, since one is only collateralizing 20% of the stock price plus the put premium, \nas opposed to 50% for the covered call write on margin. Also, the naked put writer is \nnot actually investing cash; collateral is used, so he may finance his naked put writing \nthrough the value of his present portfolio, whether it be stocks, bonds, or government \nsecurities. However, any losses would create adebit and might therefore cause him \nto disturb aportion of this portfolio. It should be pointed out that one can, ifhe wish\nes, write naked puts in acash account by depositing cash or cash equivalents equal to \nthe striking price of the put. This is called \"cash-based put writing.\" The covered call", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:326", "doc_id": "c10fbed49f7052b06ec8915b64f1c8c3954b1c0d6b47896c5a686c02e54db34c", "chunk_index": 0}
{"text": "O.,,ter 19: The Sale of a Put 295 \nwriter receives the dividends on the underlying stock, but the naked put writer does \nnot. In certain cases, this may be asubstantial amount, but it should also be pointed \nout that the puts on ahigh-yielding stock will have more value and the naked put \nwriter will thus be taking in ahigher premium initially. From strictly arate of return \nviewpoint, naked put writing is superior to covered call writing. Basically, there is adifferent psychology involved in writing naked puts than that required for covered call \nwriting. The covered call write is acomfortable strategy for most investors, since it \ninvolves common stock ownership. Writing naked options, however, is amore foreign \nconcept to the average investor, even if the strategies are equivalent. Therefore, it is \nrelatively unlikely that the same investor would be aparticipant in both strategies. \nFOLLOW-UP ACTION \nThe naked put writer would take protective follow-up action if the underlying stock \ndrops in price. His simplest form of follow-up action is to close the position at asmall \nloss if the stock drops. Since in-the-money puts tend to lose time value premium rap\nidly, he may find that his loss is often quite small if the stock goes against him. In the \nexample above, XYZ was at 50 with the put at 4. If the stock falls to 45, the writer \nmay be able to quite easily repurchase the put for 5½ or 6 points, thereby incurring \nafairly small loss. \nIn the covered call writing strategy, it was recommended that the strategist roll \ndown wherever possible. One reason for doing so, rather than closing the covered call \nposition, is that stock commissions are quite large and one cannot generally afford to \nbe moving in and out of stocks all the time. It is more advantageous to try to preserve \nthe stock position and roll the calls down. This commission disadvantage does not \nexist with naked put writing. When one closes the naked put position, he merely buys \nin the put. Therefore, rolling down is not as advantageous for the naked put writer. \nFor example, in the paragraph above, the put writer buys in the put for 5½ or 6 \npoints. He could roll down by selling aput with striking price 45 at that time. \nHowever, there may be better put writing situations in other stocks, and there should \nbe no reason for him to continue to preserve aposition in XYZ stock \nIn fact, this same reasoning can be applied to any sort of rolling action for the \nnaked put writer. It is extremely advantageous for the covered call writer to roll for\nward; that is, to buy back the call when it has little or no time value premium remain\ning in it and sell alonger-term call at the same striking price. By doing so, he takes in \nadditional premium without having to disturb his stock position at all. However, the \nnaked put writer has little advantage in rolling forward. He can also take in addition\nal premium, but when he closes the initial uncovered put, he should then evaluate", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:327", "doc_id": "76c03cb5c0db2ce84e5a21d25f7d8f3c6ac63200ba99f66b04f54e987daf7ed8", "chunk_index": 0}
{"text": "296 Part Ill: Put Option Strategies \nother available put writing positions before deciding to write another put on the sam<' \nunderlying stock. His commission costs are the same if he remains in XYZ stock or if \nhe goes on to aput writing position in adifferent stock. \nEVALUATING A NAKED PUT WRITE \nThe computation of potential returns from anaked put write is not as straightforward \nas were the computations for covered call writing. The reason for this is that the col\nlateral requirement changes as the stock moves up or down, since any naked option \nposition is marked to the market. The most conservative approach is to allow enough \ncollateral in the position in case the underlying stock should fall, thus increasing the \nrequirement. In this way, the naked put writer would not be forced to prematurely \nclose aposition because he cannot maintain the margin required. \nExample: XYZ is at 50 and the October 50 put is selling for 4 points. The initial col\nlateral requirement is 20% of 50 plus $400, or $1,400. There is no additional require\nment, since the stock is exactly at the striking price of the put. Furthermore, let us \nassume that the writer is going to close the position should the underlying stock fall \nto 43. To maintain his put write, he should therefore allow enough margin to collat\neralize the position if the stock were at 43. The requirement at that stock price would \nbe $1,560 (20% of 43 plus at least 7 points for the in-the-money amount). Thus, the \nput writer who is establishing this position should allow $1,560 of collateral value for \neach put written. Of course, this collateral requirement can be reduced by the \namount of the proceeds received from the put sale, $400 per put less commissions in \nthis example. If we assume that the writer sells 5 puts, his gross premium inflow \nwould be $2,000 and his commission expense would be about $75, for anet premi\num of $1,925. \nOnce this information has been determined, it is asimple matter to determine \nthe maximum potential return and also the downside break-even point. To achieve \nthe maximum potential return, the put would expire worthless with the underlying \nstock above the striking price. Therefore, the maximum potential profit is equal to \nthe net premium received. The return is merely that profit divided by the collateral \nused. In the example above, the maximum potential profit is $1,925. The collateral \nrequired is $1,560 per put (allowing for the stock to drop to 43) or $7,800 for 5 puts, \nreduced by the $1,925 premium received, for atotal requirement of $5,875. The \npotential return is then $1,925 divided by $5,875, or 32.8%. Table 19-2 summarizes \nthese calculations.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:328", "doc_id": "08b6838c6e830135ca23f34cbad848cdb0e6fa9a7aec66674ec1a1516541c9fd", "chunk_index": 0}
{"text": "t,r 19: The Sale of a Put \nILE 19-2. \n297 \nlculation of the potential return of uncovered put writing. \n50 \n4 \nless commissions \nPotential maximum profit (premium received) \nStriking price \nLess premium per put ($1,925/5) \nBreak-even stock price \nCollateral required (allowing for stock to drop to 43): \n20% of 43 \nPlus put premium \nRequirement for 5 puts \nLess premium received \nNet collateral \nPotential return: \nPremium divided by net collateral \n$2,000 \n75 \n$1,925 \n$50.00 \n3.85 \n46.15 \n$ 860 \n+ 700 \n$1,560 \nX 5 \n$7,800 \n- 1,925 \n$5,875 \n$1,925/$5,875 = 32.8% \nThere are differences of opinion on how to compute the potential returns from \nnaked put writing. The method presented above is amore conservative one in that it \ntakes into consideration alarger collateral requirement than the initial requirement. \nOf course, since one is not really investing cash, but is merely using the collateral \nvalue of his present portfolio, it may even be correct to claim that one has no invest\nment at all in such aposition. This may be true, but it would be impossible to com\npare various put writing opportunities without having areturn computation available. \nOne other important feature of return computations is the return if unchanged. \nIf the put is initially out-of-the-money, the return if unchanged is the same as the \nmaximum potential return. However, if the put is initially in-the-money, the compu\ntation must take into consideration what the writer would have to pay to buy back the \nput when it expires.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:329", "doc_id": "4969a6adcf4d92922a65bb9e45e96458636a73b260e9ff370d3fb0ba84f954be", "chunk_index": 0}
{"text": "298 Part Ill: Put Option Strategies \nExample: XYZ is 48 and the XYZ January 50 put is selling for 5 points. The profit \nthat could be made if the stock were unchanged at expiration would be only 3 points, \nless commissions, since the put would have to be repurchased for 2 points with XYZ \nat 48 at expiration. Commissions for the buy-back should be included as well, to \nmake the computation as accurate as possible. \nAs was the case with covered call writing, one can create several rankings of \nnaked put writes. One list might be the highest potential returns. Another list could \nbe the put writes that provide the rrwst downside protection; that is, the ones that \nhave the least chance of losing money. Both lists need some screening applied to \nthem, however. When considering the maximum potential returns, one should take \ncare to ensure at least some room for downside movement. \nExample: If XYZ were at 50, the XYZ January 100 put would be selling at 50 also and \nwould most assuredly have atremendously large maximum potential return. \nHowever, there is no room for downside movement at all, and one would surely not \nwrite such aput. One simple way of allowing for such cases would be to reject any \nput that did not offer at least 5% downside protection. Alternatively, one could also \nreject situations in which the return if unchanged is below 5%. \nThe other list, involving maximum downside protection, also must have some \nscreens applied to it. \nExample: With XYZ at 70, the XYZ January 50 put would be selling for½ at most. \nThus, it is extremely unlikely that one would lose money in this situation; the stock \nwould have to fall 20 points for aloss to occur. However, there is practically nothing \nto be made from this position, and one would most likely not ever write such adeeply \nout-of-the-money put. \nAminimum acceptable level of return must accompany the items on this list of \nput writes. For example, one might decide that the return would have to be at least \n12% on an annualized basis in order for the put write to be on the list of positions \noffering the most downside protection. Such arequirement would preclude an \nextreme situation like that shown above. Once these screens have been applied, the \nlists can then be ranked in anormal manner. The put writes offering the highest \nreturns would be at the top of the more aggressive list, and those offering the high\nest percentage of downside protection would be at the top of the more conservative \nlist. In the strictest sense, amore advanced technique to incorporate the volatility of \nthe underlying stock should rightfully be employed. As mentioned previously, that \ntechnique is presented in Chapter 28 on mathematical applications.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:330", "doc_id": "0016363cf9a21495cbf577184b6c1e7d77ed2854da18e4835b015558fde4de32", "chunk_index": 0}
{"text": "19: The Sale of a Put 299 \nYING STOCK BELOW ITS MARKET PRICE \naddition to viewing naked put writing as astrategy unto itself, as was the case in \nprevious discussion, some investors who actually want to acquire stock will often \nte naked puts as well. \nbmple: XYZ is a $60 stock and an investor feels it would be agood buy at 55. He \nplaces an open buy order with alimit of 55. Three months later, XYZ has drifted \ndown to 57 but no lower. It then turns and rises heavily, but the buy limit was never \nreached, and the investor misses out on the advance. \nThis hypothetical investor could have used anaked put to his advantage. \nSuppose that when XYZ was originally at 60, this investor wrote anaked three-month \nput for 5 points instead of placing an open buy limit order. Then, if XYZ is anywhere \nbelow 60 at expiration, he will have stock put to him at 60. That is, he will have to buy \nstock at 60. However, since he received 5 points for the put sale, his net cost for the \nstock is 55. Thus, even ifXYZ is at 57 at expiration and has never been any lower, the \ninvestor can still buy XYZ for anet cost of 55. \nOf course, if XYZ rose right away and was above 60 at expiration, the put would \nnot be assigned and the investor would not own XYZ. However, he would still have \nmade $500 from selling the put, which is now worthless. The put writer thus assumes \namore active role in his investments by acting rather than waiting. He receives at \nleast some compensation for his efforts, even though he did not get to buy the stock. \nIf, instead of rising, XYZ fell considerably, say to 40 by expiration, the investor \nwould be forced to purchase stock at anet cost of 55, thereby giving himself an \nimmediate paper loss. He was, however, going to buy stock at 55 in any case, so the \nput writer and the investor using abuy limit have the same result in this case. Critics \nmay point out that any buy order for common stock may be canceled if one'sopinion \nchanges about purchasing the stock. The put writer, of course, may do the same thing \nby closing out his obligation through aclosing purchase of the put. \nThis technique is useful to many types of investors who are oriented toward \neventually owning the stock. Large portfolio managers as well as individual investors \nmay find the sale of puts useful for this purpose. It is amethod of attempting to accu\nmulate astock position at prices lower than today'smarket price. If the stock rises \nand the stock is not bought, the investor will at least have received the put premium \nas compensation for his efforts. \nSOME CAUTION IS REQUIRED \nDespite the seemingly benign nature of naked put writing, it can be ahighly dan\ngerous strategy for two reasons: (1) Large losses are possible if the underlying stock", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:331", "doc_id": "d43ad8726295be1ad3c32fa3d725167d7e210fb0ee4c35b2e43bb37866c5fb92", "chunk_index": 0}
{"text": "300 Part Ill: Put Option Strategies \ntakes anasty fall, and (2) collateral requirements are small, so it is possible to utilize \nagreat deal of leverage. It may seem like agood idea to write out-of-the-money puts \non \"quality\" stocks that you \"wouldn'tmind owning.\" However, any stock is subject \nto acrushing decline. In almost any year there are serious declines in one or more of \nthe largest stocks in America (IBM in 1991, Procter and Gamble in 1999, and Xerox \nin 1999, just to name afew). If one happens to be short puts on such stocks - and \nworse yet, ifhe happens to have overextended himself because he had the initial mar\ngin required to sell agreat deal of puts - then he could actually be wiped out on such \nadecline. Therefore, do not leverage your account heavily in the naked put strategy, \nregardless of the \"quality\" of the underlying stock. \nTHE COVERED PUT SALE \nBy definition, aput sale is covered only if the investor also owns acorresponding put \nwith striking price equal to or greater than the strike of the written put. This is aspread. However,formargin purposes, one is covered ifhe sells aput and is also short \nthe underlying stock. The margin required is strictly that for the short sale of the \nstock; there is none required for the short put. This creates aposition with limited \nprofit potential that is obtained if the underlying stock is anywhere below the strik\ning price of the put at expiration. There is unlimited upside risk, since if the under\nlying stock rises, the short sale of stock will accrue losses, while the profit from the \nput sale is limited. This is really aposition equivalent to anaked call write, except that \nthe covered put writer must pay out the dividend on the underlying stock, if one \nexists. The naked sale of acall also has an advantage over this strategy in that com\nmission costs are considerably smaller. In addition, the time value premium of acall \nis generally higher than that of aput, so that the naked call writer is taking in more \ntime premium. The covered put sale is alittle-used strategy that appears to be infe\nrior to naked call writing. As aresult, the strategy is not described more fully. \nRATIO PUT WRITING \nAratio put write involves the short sale of the underlying stock plus the sale of 2 puts \nfor each 100 shares sold short. This strategy has aprofit graph exactly like that of aratio call write, achieving its maximum profit at the striking price of the written \noptions, and having large potential losses if the underlying stock should move too far \nin either direction. The ratio call write is ahighly superior strategy, however, for the \nreasons just outlined. The ratio call writer receives dividends while the ratio put", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:332", "doc_id": "4d27467de9f29325062c799d7c0a5139527ae1192990fe7ff558368615a26916", "chunk_index": 0}
{"text": "CHAPTER 20 \nThe Sale of a Straddle \nSelling astraddle involves selling both aput and acall with the same terms. As with \nany type of option sale, the straddle sale may be either covered or uncovered. Both \nuses are fairly common. The covered sale of astraddle is very similar to the covered \ncall writing strategy and would generally appeal to the same type of investor. The \nuncovered straddle write is more similar to ratio call writing, and is attractive to the \nmore aggressive strategist who is interested in selling large amounts of time premi\num in hopes of collecting larger profits if the underlying stock remains fairly stable. \nTHE COVERED STRADDLE WRITE \nIn this strategy, one owns the underlying stock and simultaneously writes astraddle \non that stock. This may be particularly appealing to investors who are already \ninvolved in covered call writing. In reality, this position is not totally covered - only \nthe sale of the call is covered by the ownership of the stock. The sale of the put is \nuncovered. However, the name \"covered straddle\" is generally used for this type of \nposition in order to distinguish it from the uncovered straddle write. \nExample: XYZ is at 51 and an XYZ January 50 call is selling for 5 points while an XYZ \nJanuary 50 put is selling for 4 points. Acovered straddle write would be established \nby buying 100 shares of the underlying stock and simultaneously selling one put and \none call. The similarity between this position and acovered call writer'sposition \nshould be obvious. The covered straddle write is actually acovered write - long 100 \nshares of XYZ plus short one call - coupled with anaked put write. Since the naked \nput write has already been shown to be equivalent to acovered call write, this posi\ntion is quite similar to a 200-share covered call write. In fact, all the profit and loss \n302", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:334", "doc_id": "af9a2178956397f2b020c99c9d2c3fdbf7139a4a3c4bf24533b26900ccc2fa0a", "chunk_index": 0}
{"text": "er 20: The Sale of a Straddle 303 \naracteristics of acovered call write are the same for the covered straddle write. \nThere is limited upside profit potential and potentially large downside risk. \nReaders will remember that the sale of anaked put is equivalent to acovered \ncall write. Hence, acovered straddle write can be thought of either as the equivalent \nof a 200-share covered call write, or as the sale of two uncovered puts. In fact, there \n•• some merit to the strategy of selling two puts instead of establishing acovered \nstraddle write. Commission costs would be smaller in that case, and so would the ini\ntial investment required (although the introduction of leverage is not always agood \ntlting). \nThe maximum profit is attained if XYZ is anywhere above the striking price of \n50 at expiration. The amount of maximum profit in this example is $800: the premi\num received from selling the straddle, less the 1-point loss on the stock if it is called \n11way at 50. In fact, the maximum profit potential of acovered straddle write is quick\nly computed using the following formula: \nMaximum profit = Straddle premium + Striking price - Initial stock price \nThe break-even point in this example is 46. Note that the covered writing por\ntion of this example buying stock at 51 and selling acall for 5 points - has abreak\neven point of 46. The naked put portion of the position has abreak-even point of 46 \nas well, since the January 50 put was sold for 4 points. Therefore, the combined posi\ntion - the covered straddle write - must have abreak-even point of 46. Again, this \nobservation is easily defined by an equation: \nBak . Stock price + Strike price - Straddle premium re -even pnce = \n2 \nTable 20-1 and Figure 20-1 compare the covered straddle write to a 100-share cov\nered call write of the XYZ January 50 at expiration. \nThe attraction for the covered call writer to become acovered straddle writer is \nthat he may be able to increase his return without substantially altering the parame\nters of his covered call writing position. Using the prices in Table 20-1, if one had \ndecided to establish acovered write by buying XYZ at 51 and selling the January 50 \ncall at 5 points, he would have aposition with its maximum potential return anywhere \nabove 50 and with abreak-even point of 46. By adding the naked put to his covered \ncall position, he does not change the price parameters of his position; he still makes \nhis maximum profit anywhere above 50 and he still has abreak-even point of 46. \nTherefore, he does not have to change his outlook on the underlying stock in order \nto become acovered straddle writer. \nThe investment is increased by the addition of the naked put, as are the poten\ntial dollars of profit if the stock is above 50 and the potential dollars of loss if the stock", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:335", "doc_id": "1310957a5d0ea7b0f637d6ac111aea673cb402a41050a5d75a11709dd9ab215b", "chunk_index": 0}
{"text": "304 Part Ill: Put Option Strategies \nTABLE 20-1. \nResults at expiration of covered straddle write. \nStock (A) 100-Shore (8) Put \nPrice Covered Write Write \n35 \n40 \n46 \n50 \n60 \nFIGURE 20-1. \n-$1, 100 \n600 \n0 \n+ 400 \n+ 400 \nCovered straddle write. \n+$800 \n§ +$400 \ne ·5. \n~ \nal \nen $0 en 0 ...Jc5 \nea. ~, \n,,' ,, ,, \n,, ,, \n,, ,, \n,, \n-$1, 100 \n600 \n0 \n+ 400 \n+ 400 \n100-Share Covered \nCall Write \n~-----------------► \n, 46 50 \nStock Price at Expiration \nCovered Straddle \nWrite (A+ 8) \n-$2,200 \n- 1,200 \n0 \n+ 800 \n+ 800 \nis below 46 at expiration. The covered straddle writer loses money twice as fast on \nthe downside, since his position is similar to a 200-share covered write. Because the \ncommissions are smaller for the naked put write than for the covered call write, the \ncovered call writer who adds anaked put to his position will generally increase his \nreturn somewhat. \nFollow-up action can be implemented in much the same way it would be for acovered call write. Whenever one would normally roll his call in acovered situation,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:336", "doc_id": "9657ba7f74d23068d43adf85eebb300a61bbd978996bd986b577888b2224cebc", "chunk_index": 0}
{"text": "t,r 20: The Sale ol a Straddle 305 \nnow rolls the entire straddle - rolling down for protection, rolling up for an \nease in profit potential, and rolling forward when the time value premium of the \ndie dissipates. Rolling up or down would probably involve debits, unless one \nled to alonger maturity. \nSome writers might prefer to make aslight adjustment to the covered straddle \nting strategy. Instead of selling the put and call at the same price, they prefer to \nell an out-of-the-money put against the covered call write. That is, if one is buying \nXYZ at 50 and selling the call, he might then also sell aput at 45. This would increase \nhis upside profit potential and would allow for the possibility of both options expir\ning worthless if XYZ were anywhere between 45 and 50 at expiration. Such action \nwould, of course, increase the potential dollars of risk if XYZ fell below 45 by expira\ntion, but the writer could always roll the call down to obtain additional downside pro\ntection. \nOne final point should be made with regard to this strategy. The covered call \nwriter who is writing on margin and is fully utilizing his borrowing power for call writ\ning will have to add additional collateral in order to write covered straddles. This is \nbecause the put write is uncovered. However, the covered call writer who is operat\ning on acash basis can switch to the covered straddle writing strategy without put\nting up additional funds. He merely needs to move his stock to amargin account and \nuse the collateral value of the stock he already owns in order to sell the puts neces\nsary to implement the covered straddle writes. \nTHE UNCOVERED STRADDLE WRITE \nIn an uncovered straddle write, one sells the straddle without owning the underlying \nstock. In broad terms, this is aneutral strategy with limited profit potential and large \nrisk potential. However, the probability of making aprofit is generally quite large, \nand methods can be implemented to reduce the risks of the strategy. \nSince one is selling both aput and acall in this strategy, he is initially taking in \nlarge amounts of time value premium. If the underlying stock is relatively unchanged \nat expiration, the straddle writer will be able to buy the straddle back for its intrinsic \nvalue, which would normally leave him with aprofit. \nExample: The following prices exist: \nXYZ common, 45; \nXYZ January 45 call, 4; and \nXYZ January 45 put, 3.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:337", "doc_id": "80e2f450f3aff4ecc4ae16c9a63d3331f51ebb5c8ff4d1d2ececaeaf9e543dda", "chunk_index": 0}
{"text": "306 Part Ill: Put Option Strategies \nAstraddle could be sold for 7 points. If the stock were above 38 and below 52 at expi\nration, the straddle writer would profit, since the in-the-money option could ht· \nbought back for less than 7 points in that case, while the out-of-the-money option \nexpires worthless (Table 20-2). \nTABLE 20-2. \nThe naked straddle write. \nXYZ Price at Call Put Total \nExpiration Profit Profit Profit \n30 +$ 400 -$1,200 -$800 \n35 + 400 700 - 300 \n38 + 400 400 0 \n40 + 400 200 + 200 \n45 + 400 + 300 + 700 \n50 100 + 300 + 200 \n52 300 + 300 0 \n55 600 + 300 - 300 \n60 - 1,100 + 300 - 800 \nNotice that Figure 20-2 has ashape like aroof. The maximum potential profit \npoint is at the striking price at expiration, and large potential losses exist in either \ndirection if the underlying stock should move too far. The reader may recall that the \nratio call writing strategy - buying 100 shares of the underlying stock and selling two \ncalls - has the same profit graph. These two strategies, the naked straddle write and \nthe ratio call write, are equivalent. The two strategies do have some differences, of \ncourse, as do all equivalent strategies; but they are similar in that both are highly \nprobabilistic strategies that can be somewhat complex. In addition, both have large \npotential risks under adverse market conditions or if follow-up strategies are not \napplied. \nThe investment required for anaked straddle is the greater of the requirement \non the call or the put. In general, this means that the margin requirement is equal to \nthe requirement for the in-the-money option in asimple naked write. This require\nment is 20% of the stock price plus the in-the-money option premium. The straddle \nwriter should allow enough collateral so that he can take whatever follow-up actions \nhe deems necessary without having to incur amargin call. If he is intending to close \nout the straddle if the stock should reach the upside break-even point - 52 in the \nexample above - then he should allow enough collateral to finance the position with", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:338", "doc_id": "c85bf919323107b45a74023b4ee4a3d26526bc29c774e13b055d1b18afdb5c09", "chunk_index": 0}
{"text": "ler 20: The Sale of a Straddle \nGURE 20-2. \nked straddle sale. \n307 \nStock Price at Expiration \nthe stock at 52. If, however, he is planning to take other action that might involve \nstaying with the position if the stock goes to 55 or 56, he should allow enough collat\neral to be able to finance that action. If the stock never gets that high, he will have \nexcess collateral while the position is in place. \nSELECTING A STRADDLE WRITE \nIdeally, one would like to receive apremium for the straddle write that produces aprofit range that is wide in relation to the volatility of the underlying stock. In the \nexample above, the profit range is 38 to 52. This may or may not be extraordinarily \nwide, depending on the volatility of XYZ. This is asomewhat subjective measure\nment, although one could construct asimple straddle writer'sindex that ranked strad\ndles based on the following simple formula: \nId Straddle time value premium nex= _______ ..._ ___ _ \nStock price x Volatility \nRefinements would have to be made to such aranking, such as eliminating cases in \nwhich either the put or the call sells for less than ¼ point ( or even 1 point, if amore \nrestrictive requirement is desired) or cases in which the in-the-money time premium \nis small. Furthermore, the index would have to be annualized to be able to compare \nstraddles for different expiration months. More advanced selection criteria, in the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:339", "doc_id": "79b3fe2b992f4b0d5b23390fa5bf269bc81d6679a508c74b907a8812790347db", "chunk_index": 0}
{"text": "308 Part Ill: Put Option Strategies \nform of an expected return analysis, will be presented in Chapter 28 on mathemati\ncal applications. \nMore screens can be added to produce amore conservative list of straddl<' \nwrites. For example, one might want to ignore any straddles that are not worth at \nleast afixed percentage, say 10%, of the underlying stock price. Also, straddles that \nare too short-term, such as ones with less than 30 days of life remaining, might b<' \nthrown out as well. The remaining list of straddle writing candidates should be ones \nthat will provide reasonable returns under favorable conditions, and also should be \nreadily adaptable to some of the follow-up strategies discussed later. Finally, one \nwould generally like to have some amount of technical support at or above the lower \nbreak-even price and some technical resistance at or below the upper break-even \npoint. Thus, once the computer has generated alist of straddles ranked by an index \nsuch as the one listed above, the straddle writer can further pare down the list by \nlooking at the technical pictures of the underlying stocks. \nFOLLOW-UP ACTION \nThe risks involved in straddle writing can be quite large. When market conditions are \nfavorable, one can make considerable profits, even with restrictive selection require\nments, and even by allowing considerable extra collateral for adverse stock move\nments. However, in an extremely volatile market, especially abullish one, losses can \noccur rapidly and follow-up action must be taken. Since the time premium of aput \ntends to shrink when it goes into-the-money, there is actually slightly less risk to the \ndownside than there is to the upside. In an extremely bullish market, the time value \npremiums of call options will not shrink much at all and might even expand. This may \nforce the straddle writer to pay excessive amounts of time value premium to buy back \nthe written straddle, especially if the movement occurs well in advance of expiration. \nThe simplest form of follow-up action is to buy the straddle back when and if the \nunderlying stock reaches abreak-even point. The idea behind doing so is to limit the \nlosses to asmall amount, because the straddle should be selling for only slightly more \nthan its original value when the stock has reached abreak-even point. In practice, \nthere are several flaws in this theory. If the underlying stock arrives at abreak-even \npoint well in advance of expiration, the amount of time value premium remaining in \nthe straddle may be extremely large and the writer will be losing afairly large amount \nby repurchasing the straddle. Thus, abreak-even point at expiration is probably aloss \npoint prior to expiration. \nExample: After the straddle is established with the stock at 45, there is asudden rally \nin the stock and it climbs quickly to 52. The call might be selling for 9 points, even", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:340", "doc_id": "e403190e9129113a58a462ef8c9aaa3acf2a2d4221b7602fd3a61f3c992f8dd3", "chunk_index": 0}
{"text": "20: The Sale of a Straddle 309 \ngh it is 7 points in-the-money. This is not unusual in abullish situation. \nver, the put might be worth 1 ½points.This is also not unusual, as out-of-the\nyputs with alarge amount of time remaining tend to hold time value premium \nwell. Thus, the straddle writer would have to pay 10½ points to buy back this \ndle, even though it is at the break-even point, 7 points in-the-money on the call \nThis example is included merely to demonstrate that it is amisconception to \nieve that one can always buy the straddle back at the break-even point and hold \nlosses to mere fractions of apoint by doing so. This type of buy-back strategy \nks best when there is little time remaining in the straddle. In that case, the \noptions will indeed be close to parity and the straddle will be able to be bought back \nfor close to its initial value when the stock reaches the break-even point. \nAnother follow-up strategy that can be employed, similar to the previous one \nbut with certain improvements, is to buy back only the in-the-money option when it \nreaches aprice equal to that of the initial straddle price. \n~mple: Again using the same situation, suppose that when XYZ began to climb \nheavily, the call was worth 7 points when the stock reached 50. The in-the-money \noption the call - is now worth an amount equal to the initial straddle value. It could \nthen be bought back, leaving the out-of-the-money put naked. As long as the stock \nthen remained above 45, the put would expire worthless. In practice, the put could \nbe bought back for asmall fraction after enough time had passed or if the underly\nIng stock continued to climb in price. \nThis type of follow-up action does not depend on taking action at afixed stock \nprice, but rather is triggered by the option price itself. It is therefore adynamic sort \nof follow-up action, one in which the same action could be applied at various stock \nprices, depending on the amount of time remaining until expiration. One of the prob\nlems with closing the straddle at the break-even points is that the break-even point is \nC)nly avalid break-even point at expiration. Along time before expiration, this stock \nprice will not represent much of abreak-even point, as was pointed out in the last \nexample. Thus, buying back only the in-the-money option at afixed price may often \nbe asuperior strategy. The drawback is that one does not release much collateral by \nbuying back the in-the-money option, and he is therefore stuck in aposition with \nlittle potential profit for what could amount to aconsiderable length of time. The \ncollateral released amounts to the in-the-money amount; the writer still needs to \nC.'Ollateralize 20% of the stock price. \nOne could adjust this follow-up method to attempt to retain some profit. For \nexample, he might decide to buy the in-the-money option when it has reached a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:341", "doc_id": "760aca02a744d77cca4e2830d99832f6aada903a1ef29cbd2be6aa1a652c439c", "chunk_index": 0}
{"text": "310 Part Ill: Put Option Strategies \nvalue that is 1 point less than the total straddle value initially taken in. This would \nthen allow him the chance to make a I-point profit overall, if the other option expired \nworthless. In any case, there is always the risk that the stock would suddenly revers(' \ndirection and cause aloss on the remaining option as well. This method of follow-up \naction is akin to the ratio writing follow-up strategy of using buy and sell stops on th<' \nunderlying stock. \nBefore describing other types of follow-up action that are designed to combat \nthe problems described above, it might be worthwhile to address the method used in \nratio writing - rolling up or rolling down. In straddle writing, there is often little to \nbe gained from rolling up or rolling down. This is amuch more viable strategy in ratio \nwriting; one does not want to be constantly moving in and out of stock positions, \nbecause of the commissions involved. Howeve1~ with straddle writing, once one posi\ntion is closed, there is no need to pursue asimilar straddle in that same stock. It may \nbe more desirable to look elsewhere for anew straddle position. \nThere are two other very simple forms of follow-up action that one might con\nsider using, although neither one is for most strategists. First, one might consider \ndoing nothing at all, even if the underlying stock moves by agreat deal, figuring that \nthe advantage lies in the probability that the stock will be back near the striking price \nby the time the options expire. This action should be used only by the most diversi\nfied and well-heeled investors, for in extreme market periods, almost all stocks may \nmove in unison, generating tremendous losses for anyone who does not take some \nsort of action. Amore aggressive type off allow-up action would be to attempt to \"leg \nout\" of the straddle, by buying in the profitable side and then hoping for astock price \nreversal in order to buy back the remaining side. In the example above, when XYZ \nran up to 52, an aggressive trader would buy in the put at 1 ½, taking his profit, and \nthen hope for the stock to fall back in order to buy the call in cheaper. This is avery \naggressive type of follow-up action, because the stock could easily continue to rise in \nprice, thereby generating larger losses. This is atrader'ssort of action, not that of adisciplined strategist, and it should be avoided. \nIn essence, follow-up action should be designed to do two things: First, to limit \nthe risk in the position, and second, to still allow room for apotential profit to be \nmade. None of the above types of follow-up action accomplish both of these purpos\nes. There is, however, afollow-up strategy that does allow the straddle writer to limit \nhis losses while still allowing for apotential profit. \nExample: After the straddle was originally sold for 7 points when the stock was at 45, \nthe stock experiences arally and the following prices exist: \nXYZ common, 50; \nXYZ January 45 call, 7;", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:342", "doc_id": "d7a7ef9d1b622f34132f6b93a2a0717c73b910b5f514927bf46332ebdeb5168f", "chunk_index": 0}
{"text": "Cl,opter 20: The Sale of a Straddle \nXYZ January 45 put, l; and \nXYZ January 50 call, 3. \n311 \nThe January 50 call price is included because it will be part of the follow-up strategy. \nNotice that this straddle has aconsiderable amount of time value premium remain\nIng in it, and thus would be rather expensive to buy back at the current time. \nSuppose, however, that the straddle writer does not touch the January 45 straddle \ntliat he is short, but instead buys the January 50 call for protection to the upside. \nSince this call costs 3 points, he will now have aposition with atotal credit of 4 points. \n(The straddle was originally sold for 7 points credit and he is now spending 3 points \nfor the call at 50.) This action of buying acall at ahigher strike than the striking price \nof the straddle has limited the potential loss to the upside, no matter how far the \nstock might run up. If XYZ is anywhere above 50 at expiration, the put will expire \nworthless and the writer will have to pay 5 points to close the call spread short \nJanuary 45, long January 50. This means that his maximum potential loss is 1 point \nplus commissions if XYZ is anywhere above 50 at expiration. \nIn addition to being able to limit the upside loss, this type of follow-up action \nstill allows room for potential profits. If XYZ is anywhere between 41 and 49 at expi\nration - that is, less than 4 points away from the striking price of 45 - the writer will \nhe able to buy the straddle back for less than 4 points, thereby making aprofit. \nThus, the straddle writer has both limited his potential losses to the upside and \nalso allowed room for profit potential should the underlying stock fall back in price \ntoward the original striking price of 45. Only severe price reversal, with the stock \nfalling back below 40, would cause alarge loss to be taken. In fact, by the time the \nstock could reverse its current strong upward momentum and fall all the way back to \n40, asignificant amount of time should have passed, thereby allowing the writer to \npurchase the straddle back with only arelatively small amount of time premium left \nin it. \nThis follow-up strategy has an effect on the margin requirement of the position. \nWhen the calls are bought as protection to the upside, the writer has, for margin \npurposes, abearish spread in the calls and an uncovered put. The margin for this \nposition would normally be less than that required for the straddle that is 5 points \nin-the-money. \nAsecondary move is available in this strategy. \nExample: The stock continues to climb over the short term and the out-of-the\nmoney put drops to aprice of less than ½ point. The straddle writer might now \nconsider buying back the put, thereby leaving himself with abear spread in the \ncalls. His net credit left in the position, after buying back the put at ½, would be", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:343", "doc_id": "673fbd9c9c36acb6cf54fd83e0cc479559322d72f84f012f61fff0fef3e52c6a", "chunk_index": 0}
{"text": "312 Part Ill: Put Optian Strategies \n3½ points. Thus, if XYZ should reverse direction and be within 3½ points of the \nstriking price - that is, anywhere below 48½ - at expiration, the position will pro\nduce aprofit. In fact, if XYZ should be below 45 at expiration, the entire bear \nspread will expire worthless and the strategist will have made a 3½-point profit. \nFinally, this repurchase of the put releases the margin requirement for the naked \nput, and will generally free up excess funds so that anew straddle position can be \nestablished in another stock while the low-requirement bear spread remains in \nplace. \nIn summary, this type of follow-up action is broader in purpose than any of the \nsimpler buy-back strategies described earlier. It will limit the writer'sloss, but not \nprevent him from making aprofit. Moreover, he may be able to release enough mar\ngin to be able to establish anew position in another stock by buying in the uncov\nered puts at afractional price. This would prevent him from tying up his money \ncompletely while waiting for the original straddle to reach its expiration date. The \nsame type of strategy also works in adownward market. If the stock falls after the \nstraddle is written, one can buy the put at the next lower strike to limit the down\nside risk, while still allowing for profit potential if the stock rises back to the striking \nprice. \nEQUIVALENT STOCK POSITION FOLLOW-UP \nSince there are so many follow-up strategies that can be used with the short straddle, \nthe one method that summarizes the situation best is again the equivalent stock posi\ntion (ESP). Recall that the ESP of an option position is the multiple of the quantity \ntimes the delta times the shares per option. The quantity is anegative number if it is \nreferring to ashort position. Using the above scenario, an example of the ESP \nmethod follows: \nExample: As before, assume that the straddle was originally sold for 7 points, but the \nstock rallied. The following prices and deltas exist: \nXYZ common, 50; \nXYZ Jan 45 call, 7; delta, .90; \nXYZ Jan 45 put, l; delta, - .10; and \nXYZ Jan 50 call, 3; delta, .60. \nAssume that 8 straddles were sold initially and that each option is for 100 shares of \nXYZ. The ESP of these 8 short straddles can then be computed:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:344", "doc_id": "0c529b1538e71e7d103f041fedd5822170ff0d28ea050ae4aedbeffae2af16ce", "chunk_index": 0}
{"text": "Chapter 20: The Sale of a Straddle \nOption \nJan 45 call \nJan 45 put \nTotal ESP \nPosition \nshort 8 \nshort 8 \nDelta \n0.90 \n-0.10 \n313 \nESP \nshort 720 (-8 x . 9 x 1 00) \nlong 80 (-8 x -. 1 x 100) \nshort 640 shares \nObviously, the position is quite short. Unless the trader were extremely bearish \non XYZ, he should make an adjustment. The simplest adjustment would be to buy \n600 shares of XYZ. Another possibility would be to buy back 7 of the short January \n45 calls. Such apurchase would add adelta long of 630 shares to the position (7 x .9 \nx 100). This would leave the position essentially neutral. As pointed out in the previ\nous example, however, the strategist may not want to buy that option. If, instead, he \ndecided to try to buy the January 50 call to hedge the short straddle, he would have \nto buy 10 of those to make the position neutral. He would buy that many because the \ndelta of that January 50 is 0.60; apurchase of 10 would add adelta long of 600 shares \nto the position. \nEven though the purchase of 10 is theoretically correct, since one is only short \n8 straddles, he would probably buy only 8 January 50 calls as apractical matter. \nSTARTING OUT WITH THE PROTECTION IN PLACE \nIn certain cases, the straddle writer may be able to initially establish aposition that \nhas no risk in one direction: He can buy an out-of-the-money put or call at the same \ntime the straddle is written. This accomplishes the same purposes as the follow-up \naction described in the last few paragraphs, but the protective option will cost less \nsince it is out-of-the-money when it is purchased. There are, of course, both positive \nand negative aspects involved in adding an out-of-the-money long option to the strad\ndle write at the outset. \nExample: Given the following prices: \nXYZ, 45; \nXYZ January 45 straddle, 7; and \nXYZ January 50 call, 1 ½, \nthe upside risk will be limited. If one writes the January 45 straddle for 7 points and \nbuys the January 50 call for 1 ½ points, his overall credit will be 5½ points. He has no \nupside risk in this position, for if XYZ should rise and be over 50 at expiration, he will \nbe able to close the position by buying back the call spread for 5 points. The put will \nexpire worthless. The out-of-the-money call has eliminated any risk above 50 on the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:345", "doc_id": "4deb428032489d642f4ea7ff8b6f4920dc8838c774b5250cd9ddf73b0508945a", "chunk_index": 0}
{"text": "312 Part Ill: Put Option Strategies \n3½ points. Thus, if XYZ should reverse direction and be within 3½ points of the \nstriking price - that is, anywhere below 48½ - at expiration, the position will pro\nduce aprofit. In fact, if XYZ should be below 45 at expiration, the entire bear \nspread will expire worthless and the strategist will have made a 3½-point profit. \nFinally, this repurchase of the put releases the margin requirement for the naked \nput, and will generally free up excess funds so that anew straddle position can be \nestablished in another stock while the low-requirement bear spread remains in \nplace. \nIn summary, this type of follow-up action is broader in purpose than any of the \nsimpler buy-back strategies described earlier. It will limit the writer'sloss, but not \nprevent him from making aprofit. Moreover, he may be able to release enough mar\ngin to be able to establish anew position in another stock by buying in the uncov\nered puts at afractional price. This would prevent him from tying up his money \ncompletely while waiting for the original straddle to reach its expiration date. The \nsame type of strategy also works in adownward market. If the stock falls after the \nstraddle is written, one can buy the put at the next lower strike to limit the down\nside risk, while still allowing for profit potential if the stock rises back to the striking \nprice. \nEQUIVALENT STOCK POSITION FOLLOW-UP \nSince there are so many follow-up strategies that can be used with the short straddle, \nthe one method that summarizes the situation best is again the equivalent stock posi\ntion (ESP). Recall that the ESP of an option position is the multiple of the quantity \ntimes the delta times the shares per option. The quantity is anegative number if it is \nreferring to ashort position. Using the above scenario, an example of the ESP \nmethod follows: \nExample: As before, assume that the straddle was originally sold for 7 points, but the \nstock rallied. The following prices and deltas exist: \nXYZ common, 50; \nXYZ Jan 45 call, 7; delta, .90; \nXYZ Jan 45 put, l; delta, - .10; and \nXYZ Jan 50 call, 3; delta, .60. \nAssume that 8 straddles were sold initially and that each option is for 100 shares of \nXYZ. The ESP of these 8 short straddles can then be computed:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:346", "doc_id": "b1d359bdc7e8b6ec8dfe9b5eca3a5752e99e13af1056e6de341a519cffc01e26", "chunk_index": 0}
{"text": "Chapter 20: The Sale of a Straddle \nOption \nJan 45 call \nJan 45 put \nTotal ESP \nPosition \nshort 8 \nshort 8 \nDelta \n0.90 \n-0.10 \n313 \nESP \nshort 720 (-8 x .9 x 100) \nlong 80 (-8 x -. 1 x 1 00) \nshort 640 shares \nObviously, the position is quite short. Unless the trader were extremely bearish \non XYZ, he should make an adjustment. The simplest adjustment would be to buy \n600 shares of XYZ. Another possibility would be to buy back 7 of the short January \n45 calls. Such apurchase would add adelta long of 630 shares to the position (7 x .9 \nx 100). This would leave the position essentially neutral. As pointed out in the previ\nous example, however, the strategist may not want to buy that option. If, instead, he \ndecided to try to buy the January 50 call to hedge the short straddle, he would have \nto buy 10 of those to make the position neutral. He would buy that many because the \ndelta of that January 50 is 0.60; apurchase of 10 would add adelta long of 600 shares \nto the position. \nEven though the purchase of 10 is theoretically correct, since one is only short \n8 straddles, he would probably buy only 8 January 50 calls as apractical matter. \nSTARTING OUT WITH THE PROTECTION IN PLACE \nIn certain cases, the straddle writer may be able to initially establish aposition that \nhas no risk in one direction: He can buy an out-of-the-money put or call at the same \ntime the straddle is written. This accomplishes the same purposes as the follow-up \naction described in the last few paragraphs, but the protective option will cost less \nsince it is out-of-the-money when it is purchased. There are, of course, both positive \nand negative aspects involved in adding an out-of-the-money long option to the strad\ndle write at the outset. \nExample: Given the following prices: \nXYZ, 45; \nXYZ January 45 straddle, 7; and \nXYZ January 50 call, 1 ½, \nthe upside risk will be limited. If one writes the January 45 straddle for 7 points and \nbuys the January 50 call for 1 ½ points, his overall credit will be 5½ points. He has no \nupside risk in this position, for if XYZ should rise and be over 50 at expiration, he will \nbe able to close the position by buying back the call spread for 5 points. The put will \nexpire worthless. The out-of-the-money call has eliminated any risk above 50 on the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:347", "doc_id": "6c7301fe971c2e6a7f6e11830742235dc0b761b10101f83c75777328338b0b66", "chunk_index": 0}
{"text": "314 Part Ill: Put Option Strategies \nposition. Another advantage of buying the protection initially is that one is protected \nif the stock should experience agap opening or atrading halt. Ifhe already owns the \nprotection, such stock price movement in the direction of the protection is of little \nconsequence. However, if he was planning to buy the protection as afollow-up \naction, the sudden surge in the stock price may ruin his strategy. \nThe overall profit potential of this position is smaller than that of the normal \nstraddle write, since the premium paid for the long call will be lost if the stock is \nbelow 50 at expiration. However, the automatic risk-limiting feature of the long call \nmay prove to be worth more than the decrease in profit potential. The strategist has \npeace of mind in arally and does not have to worry about unlimited losses accruing \nto the upside. \nDownside protection for astraddle writer can be achieved in asimilar manner \nby buying an out-of-the-money put at the outset. \nExample: With XYZ at 45, one might write the January 45 straddle for 7 and buy a \nJanuary 40 put for Ipoint if he is concerned about the stock dropping in price. \nIt should now be fairly easy to see that the straddle writer could limit risk in \neither direction by initially buying both an out-of-the-money call and an out-of-the\nmoney put at the same time that the straddle is written. The major benefit in doing \nthis is that risk is limited in either direction. Moreover, the margin requirements are \nsignificantly reduced, since the whole position consists of acall spread and aput \nspread. There are no longer any naked options. The detriment of buying protection \non both sides initially is that commission costs increase and the overall profit poten\ntial of the straddle write is reduced, perhaps significantly, by the cost of two long \noptions. Therefore, one must evaluate whether the cost of the protection is too large \nin comparison to what is received for the straddle write. This completely protected \nstrategy can be very attractive when available, and it is described again in Chapter 23, \nSpreads Combining Calls and Puts. \nIn summary, any strategy in which the straddle writer also decides to buy pro\ntection presents both advantages and disadvantages. Obviously, the risk-limiting fea\nture of the purchased options is an advantage. However, the seller of options does not \nlike to purchase pure time value premium as protection at any time. He would gen\nerally prefer to buy intrinsic value. The reader will note that, in each of the protec\ntive buying strategies discussed above, the purchased option has alarge amount of \ntime value premium left in it. Therefore, the writer must often try to strike adelicate \nbalance between trying to limit his risk on one hand and trying to hold down the \nexpenses of buying long options on the other hand. In the final analysis, however, the \nrisk must be limited regardless of the cost.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:348", "doc_id": "721f7cc3523ba33fe43f4b3f21f88ac5acc4d7ceba8b3062c542c877d053968a", "chunk_index": 0}
{"text": "314 Part Ill: Put Option Strategies \nposition. Another advantage of buying the protection initially is that one is protected \nif the stock should experience agap opening or atrading halt. If he already owns the \nprotection, such stock price movement in the direction of the protection is of little \nconsequence. However, if he was planning to buy the protection as afollow-up \naction, the sudden surge in the stock price may ruin his strategy. \nThe overall profit potential of this position is smaller than that of the normal \nstraddle write, since the premium paid for the long call will be lost if the stock is \nbelow 50 at expiration. However, the automatic risk-limiting feature of the long call \nmay prove to be worth more than the decrease in profit potential. The strategist has \npeace of mind in arally and does not have to worry about unlimited losses accruing \nto the upside. \nDownside protection for astraddle writer can be achieved in asimilar manner \nby buying an out-of-the-money put at the outset. \nExample: With XYZ at 45, one might write the January 45 straddle for 7 and buy a \nJanuary 40 put for lpoint if he is concerned about the stock dropping in price. \nIt should now be fairly easy to see that the straddle writer could limit risk in \neither direction by initially buying both an out-of-the-money call and an out-of-the\nmoney put at the same time that the straddle is written. The major benefit in doing \nthis is that risk is limited in either direction. Moreover, the margin requirements are \nsignificantly reduced, since the whole position consists of acall spread and aput \nspread. There are no longer any naked options. The detriment of buying protection \non both sides initially is that commission costs increase and the overall profit poten\ntial of the straddle write is reduced, perhaps significantly, by the cost of two long \noptions. Therefore, one must evaluate whether the cost of the protection is too large \nin comparison to what is received for the straddle write. This completely protected \nstrategy can be very attractive when available, and it is described again in Chapter 23, \nSpreads Combining Calls and Puts. \nIn summary, any strategy in which the straddle writer also decides to buy pro\ntection presents both advantages and disadvantages. Obviously, the risk-limiting fea\nture of the purchased options is an advantage. However, the seller of options does not \nlike to purchase pure time value premium as protection at any time. He would gen\nerally prefer to buy intrinsic value. The reader will note that, in each of the protec\ntive buying strategies discussed above, the purchased option has alarge amount of \ntime value premium left in it. Therefore, the ·writer must often try to strike adelicate \nbalance between trying to limit his risk on one hand and trying to hold down the \nexpenses of buying long options on the other hand. In the final analysis, however, the \nrisk must be limited regardless of the cost.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:349", "doc_id": "e50a8b583277cc3465e08bfd69188b3729cd1742ef15ee9a5b3173296d05594c", "chunk_index": 0}
{"text": "314 Part Ill: Put Option Strategies \nposition. Another advantage of buying the protection initially is that one is protected \nif the stock should expe1ience agap opening or atrading halt. If he already owns the \nprotection, such stock price movement in the direction of the protection is of little \nconsequence. However, if he was planning to buy the protection as afollow-up \naction, the sudden surge in the stock price may ruin his strategy. \nThe overall profit potential of this position is smaller than that of the normal \nstraddle write, since the premium paid for the long call will be lost if the stock is \nbelow 50 at ex-piration. However, the automatic risk-limiting feature of the long call \nmay prove to be worth more than the decrease in profit potential. The strategist has \npeace of mind in arally and does not have to worry about unlimited losses accruing \nto the upside. \nDownside protection for astraddle writer can be achieved in asimilar manner \nby buying an out-of-the-money put at the outset. \nExample: With XYZ at 45, one might write the January 45 straddle for 7 and buy a \nJanuary 40 put for lpoint if he is concerned about the stock dropping in price. \nIt should now be fairly easy to see that the straddle writer could limit risk in \neither direction by initially buying both an out-of-the-money call and an out-of-the\nmoney put at the same time that the straddle is written. The major benefit in doing \nthis is that risk is limited in either direction. Moreover, the margin requirements are \nsignificantly reduced, since the whole position consists of acall spread and aput \nspread. There are no longer any naked options. The detriment of buying protection \non both sides initially is that commission costs increase and the overall profit poten\ntial of the straddle write is reduced, perhaps significantly, by the cost of two long \noptions. Therefore, one must evaluate whether the cost of the protection is too large \nin comparison to what is received for the straddle write. This completely protected \nstrategy can be very attractive when available, and it is described again in Chapter 23, \nSpreads Combining Calls and Puts. \nIn summary, any strategy in which the straddle writer also decides to buy pro\ntection presents both advantages and disadvantages. Obviously, the risk-limiting fea\nture of the purchased options is an advantage. However, the seller of options does not \nlike to purchase pure time value premium as protection at any time. He would gen\nerally prefer to buy intrinsic value. The reader will note that, in each of the protec\ntive buying strategies discussed above, the purchased option has alarge amount of \ntime value premium left in it. Therefore, the writer must often try to strike adelicate \nbalance between trying to limit his risk on one hand and trying to hold down the \nexpenses of buying long options on the other hand. In the final analysis, however, the \nrisk must be limited regardless of the cost.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:350", "doc_id": "c125401a7373dd361b32f7ad218cbd44193eb11186f1430c1f7d0cd1ac3e486f", "chunk_index": 0}
{"text": "Chapter 20: The Sale of a Straddle 315 \nSTRANGLE (COMBINATION) WRITING \nRecall that astrangle is any position involving both puts and calls, when there is some \ndifference in the terms of the options. Commonly, the puts and calls will have the \nsame expiration date but differing striking prices. Astrangle write is usually estab\nlished by selling both an out-of-the-money put and an out-of-the-money call with the \nstock approximately centered between the two striking prices. In this way, the naked \noption writer can remain neutral on the outlook for the underlying stock, even when \nthe stock is not near astriking price. \nThis strategy is quite similar to straddle writing, except that the strangle \nwriter makes his maximum profit over amuch wider range than the straddle \nwriter does. In this or any other naked writing strategy, the most money that the \nstrategist can make is the amount of the premium received. The straddle writer \nhas only aminute chance of making aprofit of the entire straddle premium, since \nthe stock would have to be exactly at the striking price at expiration in order for \nboth the written put and call to expire worthless. The strangle writer will make his \nmaximum profit potential if the stock is anywhere between the two strikes at expi\nration, because both options will expire worthless in that case. This strategy is \nequivalent to the variable ratio write described previously in Chapter 6 on ratio \ncall writing. \nExample: Given the following prices: \nXYZ common, 65; \nXYZ January 70 call, 4; and \nXYZ January 60 put, 3, \nastrangle write would be established by selling the January 70 call and the January \n60 put. IfXYZ is anywhere between 60 and 70 at January expiration, both options will \nexpire worthless and the strangle writer will make aprofit of 7 points, the amount of \nthe original credit taken in. If XYZ is above 70 at expiration, the strategist will have \nto pay something to buy back the call. For example, if XYZ is at 77 at expiration, the \nJanuary 70 call will have to be bought back for 7 points, thereby creating abreak-even \nsituation. To the downside, if XYZ were at 53 at expiration, the January 60 put would \nhave to be bought back for 7 points, thereby defining that as the downside break\neven point. Table 20-3 and Figure 20-3 outline the potential results of this strangle \nwrite. The profit range in this example is quite wide, extending from 53 on the down\nside to 77 on the upside. With the stock presently at 65, this is arelatively neutral \nposition.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:351", "doc_id": "e01e1a1798f3c41137f7035e960ac6e02db5559b31177c7323a9cebf7e5f620e", "chunk_index": 0}
{"text": "316 \nTABLE 20-3. \nResults of acombination write. \nStock Price at Coll \nExpiration Profit \n40 +$ 400 \n50 + 400 \n53 + 400 \n57 + 400 \n60 + 400 \n65 + 400 \n70 + 400 \n73 + 100 \n77 300 \n80 600 \n90 - 1,600 \nFIGURE 20-3. \nSale of acombination. \nC: \n~ +$700 \n·5. \nX \nUJ \nrn \nen en \n0 ....Ici \nea.. \n$0 \nPut \nProfit \n$1,700 \n700 \n400 \n0 \n+ 300 \n+ 300 \n+ 300 \n+ 300 \n+ 300 \n+ 300 \n+ 300 \nStock Price at Expiration \nPart Ill: Put Option Strategies \nTotal \nProfit \n-$1,300 \n300 \n0 \n+ 400 \n+ 700 \n+ 700 \n+ 700 \n+ 400 \n0 \n300 \n- 1,300 \nAt first glance, this may seem to be amore conservative strategy than straddle \nwriting, because the profit range is wider and the stock needs to move agreat deal to \nreach the break-even points. In the absence of follow-up action, this is atrue obser\nvation. However, if the stock begins to rise quickly or to drop dramatically, the stran\ngle writer often has little recourse but to buy back the in-the-money option in order", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:352", "doc_id": "a79e84990f87e3923bef0d40e2823dbcf3483a5402c9f171e325287daf8f7d50", "chunk_index": 0}
{"text": "Chapter 20: The Sale of a Straddle 317 \nto limit his losses. This can, as has been shown previously, entail apurchase price \ninvolving excess amounts of time value premium, thereby generating asignificant \nloss. \nThe only other alternative that is available to the strangle writer ( outside of \nattempting to trade out of the position) is to convert the position into astraddle if the \nstock reaches either break-even point. \nExample: IfXYZ rose to 70 or 71 in the previous example, the January 70 put would \nbe sold. Depending on the amount of collateral available, the January 60 put may or \nmay not be bought back when the January 70 put is sold. This action of converting \nthe strangle write into astraddle write will work out well if the stock stabilizes. It \nwill also lessen the pain if the stock continues to rise. However, if the stock revers\nes direction, the January 70 put write will prove to be unprofitable. Technical analy\nsis of the underlying stock may prove to be of some help in deciding whether or not \nto convert the strangle write into astraddle. If there appears to be arelatively large \nchance that the stock could fall back in price, it is probably not worthwhile to roll \nthe put up. \nThis example of astrangle write is one in which the writer received alarge \namount of premium for selling the put and the call. Many times, however, an aggres\nsive strangle writer is tempted to sell two out-of-the-money options that have only ashort life remaining. These options would generally be sold at fractional prices. This \ncan be an extremely aggressive strategy at times, for if the underlying stock should \nmove quickly in either direction through astriking price, there is little the strangle \nwriter can do. He must buy in the options to limit his loss. Nevertheless, this type of \nstrangle writing - selling short-term, fractionally priced, out-of-the-money options -\nappeals to many writers. This is asimilar philosophy to that of the naked call writer \ndescribed in Chapter 5, who writes calls that are nearly restricted, figuring there will \nbe alarge probability that the option will expire worthless. It also has the same risk: \nAlarge price change or gap opening can cause such devastating losses that many \nprofitable trades are wiped away. Selling fractionally priced combinations is apoor \nstrategy and should be avoided. \nBefore leaving the topic of strangle writing, it may be useful to determine how \nthe margin requirements apply to astrangle write. Recall that the margin require\nment for writing astraddle is 20% of the stock price plus the price of either the put \nor the call, whichever is in-the-money. In astrangle write, however, both options may \nbe out-of-the-money, as in the example above. When this is the case, the straddle \nwriter is allowed to deduct the smaller out-of-the-money amount from his require\nment. Thus, if XYZ were at 68 and the January 60 put and the January 70 call had \nbeen written, the collateral requirement would be 20% of the stock price, plus the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:353", "doc_id": "9acc56ca667bcdaeda830601defe9adab3565f668cbb611417976c6410501217", "chunk_index": 0}
{"text": "318 Part Ill: Put Option Strategies \ncall premium, less $200 - the lesser out-of-the-money amount. The call is 2 points \nout-of-the-money and the put is 8 points out-of-the-money. Actually, the true collat\neral requirement for any write involving both puts and calls - straddle write or stran\ngle write - is the greater of the requirement on the put or the call, plus the amount by \nwhich the other option is in-the-nwney. The last phrase, the amount by which the \nother option is in-the-money, applies to asituation in which astrangle had been con\nstructed by selling two in-the-money options. This is aless popular strategy, since the \nwriter generally receives less time value premium by writing two in-the-money \noptions. An example of an in-the-money strangle is to sell the January 60 call and the \nJanuary 70 put with the stock at 65. \nFURTHER COMMENTS ON UNCOVERED STRADDLE \nAND STRANGLE WRITING \nWhen ratio writing was discussed, it was noted that it was astrategy with ahigh prob\nability of making alimited profit. Since the straddle write is equivalent to the ratio \nwrite and the strangle write is equivalent to the variable ratio write, the same state\nment applies to these strategies. The practitioner of straddle and strangle writing \nmust realize, however, that protective follow-up action is mandatory in limiting loss\nes in avery volatile market. There are other techniques that the straddle writer can \nsometimes use to help reduce his risk. \nIt has often been mentioned that puts lose their time value premium more \nquickly when they become in-the-money options than calls do. One can often con\nstruct aneutral position by writing an extra put or two. That is, if one sells 5 or 6 puts \nand 4 calls 'Ai.th the same terms, he may often have created amore neutral position \nthan astraddle write. If the stock moves up and the call picks up time premium in abullish market, the extra puts 'Aill help to offset the negative effect of the calls. On \nthe other hand, if the stock drops, the 5 or 6 puts will not hold as much time premi\num as the 4 calls are losing - again aneutral, standoff position. If the stock begins to \ndrop too much, the writer can always balance out the position by selling another call \nor two. The advantage of writing an extra put or two is that it counterbalances the \nstraddle writer'smost severe enemy: aquick, extremely bullish rise by the underly\ning stock. \nUSING THE DELTAS \nThis analysis, that adding an extra short put creates aneutral position, can be sub\nstantiated more rigorously. Recall that aratio writer or ratio spreader can use the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:354", "doc_id": "cd0b9a8e8090079aeee2d9a5a5160f8cb88cd99c74bd0f8d694c299e494e0e7b", "chunk_index": 0}
{"text": "Chapter 20: The Sale of a Straddle 319 \ndeltas of the options involved in his position to determine aneutral ratio. The strad\ndle writer can do the same thing, of course. It was stated that the difference between \nacall'sdelta and aput' sdelta is approximately one. Using the same prices as in the \nprevious straddle writing example, and assuming the call'sdelta to be .60, aneutral \nratio can be determined. \nPrices \nXYZ common: \nXYZ January 45 call: \nXYZ January 45 put: \n45 \n4 \n3 \nDeltas \n.60 \n-.40 (.60 - 1) \nThe put has anegative delta, to indicate that the put and the underlying stock are \ninversely related. Aneutral ratio is determined by dividing the call'sdelta by the put'sdelta and ignoring the minus sign. The resultant ratio - 1.5:1 (.60/.40) in this case -\nis the ratio of puts to sell for each call that is sold. Thus, one should sell 3 puts and \nsell 2 calls to establish aneutral position. The reader may wonder if the assumption \nthat an at-the-money call has adelta of .60 is afair one. It generally is, although very \nlong-term calls will have higher at-the-money deltas, and very short-term calls will \nhave deltas near .50. Consequently, a 3:2 ratio is often aneutral one. When neutral \nratios were discussed with respect to ratio writing, it was mentioned that selling 5 \ncalls and buying 300 shares of stock often results in neutral ratio. The reader should \nnote that astraddle constructed by selling 3 puts and 2 calls is equivalent to the ratio \nwrite in which one sells 5 calls and buys 300 shares of stock. \nIf astraddle writer is going to use the deltas to determine his neutral ratio, he \nshould compute each one at the time of his initial investment, of course, rather than \nrelying on agenerality such as that 3 puts and 2 calls often result in aneutral posi\ntion. The deltas can be used as afollow-up action, by adjusting the ratio to remain \nneutral after amove by the underlying stock. \nAVOID EXCESS TRADING \nIn any of the straddle and strangle writing strategies described above, too much fol\nlow-up action can be detrimental because of the commission costs involved. Thus, \nalthough it is important to take protective action, the straddle writer should plan in \nadvance to make the minimum number of strategic moves to protect himself. That is \nwhy buying protection is often useful; not only does it limit the risk in the direction \nthat the stock is moving, but it also involves only one additional option commission. \nIn fact, if it is feasible, buying protection at the outset is often abetter strategy than \nprotecting as asecondary action.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:355", "doc_id": "18f7685381154e968c27e773c39979fe3effe1ce5a5f14425f9115ad806263dc", "chunk_index": 0}
{"text": "320 Part Ill: Put Option Strategies \nAn extension of this concept of trying to avoid too much follow-up action is that \nthe strategist should not attempt to anticipate movement in an underlying stock. For \nexample, if the straddle writer has planned to take defensive action should the stock \nreach 50, he should not anticipate by taking action with the stock at 48 or 49. It is \npossible that the stock could retreat back down; then the writer would have taken adefensive action that not only cost him commissions, but reduced his profit potential. \nOf course, there is alittle trader in everyone, and the temptation to anticipate (or to \nwait too long) is always there. Unless there are very strong technical reasons for doing \nso, the strategist should resist the temptation to trade, and should operate his strate\ngy according to his original plan. The ratio writer may actually have an advantage in \nthis respect, because he can use buy and sell stops on the underlying stock to remove \nthe emotion from his follow-up strategy. This technique was described in Chapter 6 \non ratio call writing. Unfortunately, no such emotionless technique exists for the \nstraddle or strangle writer. \nUSING THE CREDITS \nIn previous chapters, it was mentioned that the sale of uncovered options does not \nrequire any cash investment on the pait of the strategist. He may use the collateral \nvalue of his present portfolio to finance the sale of naked options. Moreover, once he \nsells the uncovered options, he can take the premium dollars that he has brought in \nfrom the sales to buy fixed-income securities, such as Treasury bills. The same state\nments naturally apply to the straddle writing and strangle writing strategies. However, \nthe strategist should not be overly obsessed with continuing to maintain acredit bal\nance in his positions, nor should he strive to hold onto the Treasury bills at all costs. If \none'sfollow-up actions dictate that he must take adebit to avoid losses or that he \nshould sell out his Treasury bills to keep acredit, he should by all means do so.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:356", "doc_id": "eb775cd905d90eda19e9457f66aa30be947a2ae757d5255ae97f5b6e4545b38d", "chunk_index": 0}
{"text": "Synthetic Stock Positions \nCreated by Puts and Calls \nIt is possible for astrategist to establish aposition that is essentially the same as astock position, and he can do this using only options. The option position generally \nrequires asmaller margin investment and may have other residual benefits over sim\nply buying stock or selling stock short. In brief, the strategies are summarized by: \n1. Buy call and sell put instead of buying stock. \n2. Buy put and sell call instead of selling stock short. \nSYNTHETIC LONG STOCK \nWhen one buys acall and sells aput at the same strike, he sets up aposition that is \nequivalent to owning the stock. His position is sometimes called \"synthetic\" long \nstock. \nExample: To verify that this option position acts much like along stock position \nwould, suppose that the following prices exist: \nXYZ common, 50; \nXYZ January 50 call, 5; and \nXYZ January 50 put, 4. \nIf one were bullish on XYZ and wanted to buy stock at 50, he might consider the \nalternative strategy of buying the January 50 call and selling (uncovered) the January \n321", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:357", "doc_id": "2000dc4b6e143c88f58678aa88852ad81bb25d2a34de386e421c7c9e377b49aa", "chunk_index": 0}
{"text": "322 Part Ill: Put Option Strategies \n50 put. By using the option strategy, the investor has nearly the same profit and loss \npotential as the stock buyer, as shown in Table 21-1. The two right-hand columns of \nthe table compare the results of the option strategy with the results that would be \nobtained by merely owning the stock at .50. \nThe table shows that the result of the option strategy is exactly $100 less than \nthe stock results for any price at expiration. Thus, the \"synthetic\" long stock and the \nactual long stock have nearly the same profit and loss potentials. The reason there is \nadifference in the results of the two equivalent positions lies in the fact that the \noption strategist had to pay 1 point of time premium in order to set up his position. \nThis time premium represents the $100 by which the \"synthetic\" position underper\nforms the actual stock position at expiration. Note that, with XYZ at 50, both the put \nand the call are completely composed of time value premium initially. The synthetic \nposition consists of paying out 5 points of time premium for the call and receiving in \n4 points of time premium for the put. The net time premium is thus a 1-point pay\nout. \nThe reason one would consider using the synthetic long stock position rather \nthan the stock position itself is that the synthetic position may require amuch small\ner investment than buying the stock would require. The purchase of the stock \nrequires $5,000 in acash account or $2,500 in amargin account (if the margin rate is \n50%). However, the synthetic position requires only a $100 debit plus acollateral \nrequirement - 20% of the stock price, plus the put premium, minus the difference \nbetween the striking price and the stock price. The balance, invested in short-term \nfunds, would earn enough money, theoretically, to offset the $100 paid for the syn\nthetic position. In this example, the collateral requirement would be 20% of $5,000, \nor $1,000, plus the $400 put premium, plus the $100 debit incurred by paying 5 for \nthe call and only receiving 4 for the put. This is atotal of $1,500 initially. There is no \nTABLE 21·1. \nSynthetic long stock position. \nXYZ Price at January 50 January 50 Total Option Long Stock \nExpiration Call Result Put Result Result Result \n40 -$500 -$600 -$1, 100 -$1,000 \n45 - 500 - 100 600 500 \n50 - 500 + 400 100 0 \n55 0 + 400 + 400 + 500 \n60 + 500 + 400 + 900 + 1,000", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:358", "doc_id": "456c014b78be15ebfc016d9d37e2343eceb18b94cec70f86bceb5a3b23152b07", "chunk_index": 0}
{"text": "Chapter 21: Synthetic Stock Positions Created by Puts and Calls 323 \ninitial difference between the stock price and the striking price. Of course, this col\nlateral requirement would increase if the stock fell in price, and would decrease if the \nstock rose in price, since there is anaked put. Also notice that buying stock creates a \n$5,000 debit in the account, whereas the option strategy'sdebit is $100; the rest is acollateral requirement, not acash requirement. \nThe effect of this reduction in margin required is that some leverage is obtained \nin the position. If XYZ rose to 60, the stock position profit would be $1,000 for areturn of 40% on margin ($1,000/$2,500). With the option strategy, the percentage \nreturn would be higher. The profit would be $900 and the return thus 60% \n($900/$1,500). Of course, leverage works to the downside as well, so that the percent \nrisk is also greater in the option strategy. \nThe synthetic stock strategy is generally not applied merely as an alternative to \nbuying stock. Besides possibly having asmaller profit potential, the option strategist \ndoes not collect dividends, whereas the stock owner does. However, the strategist is \nable to earn interest on the funds that he did not spend for stock ownership. It is \nimportant for the strategist to understand that along call plus ashort put is equiva\nlent to long stock. It thus may be possible for the strategist to substitute the synthet\nic option position in certain option strategies that normally call for the purchase of \nstock \nSYNTHETIC SHORT SALE \nAposition that is equivalent to the short sale of the underlying stock can be estab\nlished by selling acall and simultaneously buying aput. This alternative option strat\negy, in general, offers significant benefits when compared with selling the stock short. \nUsing the prices above - XYZ at 50, January 50 call at 5, and January 50 put at 4 -\nTable 21-2 depicts the potential profits and losses at January expiration. \nBoth the option position and the short stock position have similar results: large \npotential profits if the stock declines and unlimited losses if the underlying stock rises \nin price. However, the option strategy does better than the stock position, because \nthe option strategist is getting the benefit of the time value premium. Again, this is \nbecause the call has more time value premium than the put, which works to the \noption strategist'sadvantage in this case, when he is selling the call and buying the \nput. \nTwo important factors make the option strategy preferable to the short sale of \nstock: (1) There is no need to borrow stock, and (2) there is no need for an uptick. \nWhen one sells stock short, he must first borrow the stock from someone who owns \nit. This procedure is handled by one'sbrokerage firm'sstock loan department. If, for", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:359", "doc_id": "44724405d617d4f1f2bec6290675e30f9db507fa139bd81aee247321de6c099b", "chunk_index": 0}
{"text": "324 Part Ill: Put Option Strategies \nTABLE 21-2. \nSynthetic short sale position. \nXYZ Price at January 50 January 50 Total Option Short Stock \nExpiration Coll Result Put Result Result Result \n40 +$500 +$600 +$1, 100 +$1,000 \n45 + 500 + 100 + 600 + 500 \n50 + 500 - 400 + 100 0 \n55 0 - 400 400 500 \n60 - 500 - 400 900 - 1,000 \nsome reason, no one who owns the stock wants to loan it out, then ashort sale can\nnot be executed. In addition, both the NYSE and NASDAQ require that astock \nbeing sold short must be sold on an uptick. That is, the price of the short sale must \nbe higher than the previous sale. This rule was introduced (for the NYSE) years ago \nin order to prevent traders from slamming the market down in a \"bear raid.\" \nWith the option \"synthetic short sale\" strategy, however, one does not have to \nworry about either of these factors. First, calls can be sold short at will; there is no \nneed to borrow anything. Also, calls can be sold short (and puts bought) even though \nthe underlying stock might be trading on aminus tick (adowntick). Many profes\nsional traders use the \"synthetic short sale\" strategy because it allows them to get \nequivalently short the stock in avery timely manner. If one wants to short stock, and \nif he has not previously arranged to borrow it, then some time is wasted while one'sbroker checks with the stock loan department in order to make sure that the stock \ncan indeed be borrowed. \nThere is acaveat, however. If one sells calls on astock that cannot be borrowed, \nthen he must be sure to avoid assignment. For if one is assigned acall, then he too \nwill be short the stock. If the stock cannot be borrowed, the broker will buy him in. \nThus, in situations in which the stock might be difficult to borrow, one should use astriking price such that the call is out-of-the-money when sold initially. This will \ndecrease, but not eliminate, the possibility of early assignment. \nLeverage is afactor in this strategy also. The short seller would need $2,500 to \ncollateralize this position, assuming that the margin rate is 50%. The option strategist \ninitially only needs 20% of the stock price, plus the call price, less the credit received, \nfor a $1,400 requirement. Moreover, one of the major disadvantages that was men\ntioned with the synthetic long stock position is not adisadvantage in the synthetic \nshort sale strategy: The option trader does not have to pay out dividends on the \noptions, but the short seller of stock must.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:360", "doc_id": "479b94e4e2c0c9bd8175bac3ad4aec3f832f60e45878ea038d56e6555ade4f2a", "chunk_index": 0}
{"text": "Chapter 21: Synthetic Stock Positions Created by Puts and Calls 325 \nBecause of the advantages of the option position in not having to pay out the \ndividend and also having aslightly larger profit potential from the excess time value \npremium, it may often be feasible for the trader who is looking to sell stock short to \ninstead sell acall and buy aput. It is also important for the strategist to understand \nthe equivalence between the short stock position and the option position. He might \nbe able to substitute the option position in certain cases when the short sale of stock \nis normally called for. \nSPLITTING THE STRIKES \nThe strategist may be able to use aslight variation of the synthetic strategy to set up \nan aggressive, but attractive, position. Rather than using the same striking price for \nthe put and call, he can use alower striking price for the put and ahigher striking \nprice for the call. This action of splitting apart the striking prices gives him some \nroom for error, while still retaining the potential for large profits. \nBULLISHLY ORIENTED \nIf an out-of-the-money put is sold naked, and an out-of-the-money call is simultane\nously purchased, an aggressive bullish position is established - often for acredit. If \nthe underlying stock rises far enough, profits can be generated on both the long call \nand the short put. If the stock remains relatively unchanged, the call purchase will be \naloss, but the put sale will be aprofit. The risk occurs if the underlying stock drops \nin price, producing losses on both the short put and the long call. \nExample: The following prices exist: XYZ is at 53, a January 50 put is selling for 2, \nand a January 60 call is selling for 1. An investor who is bullish on XYZ sells the \nJanuary 50 put naked and simultaneously buys the January 60 call. This position \nbrings in acredit of 1 point, less commissions. There is acollateral requirement \nnecessary for the naked put. If XYZ is anywhere between 50 and 60 at January \nexpiration, both options would expire worthless, and the investor would make asmall \nprofit equal to the amount of the initial credit received. If XYZ rallies above 60 by \nexpiration, however, his potential profits are unlimited, since he owns the call at 60. \nHis losses could be very large if XYZ should decline well below 50 before expiration, \nsince he has written the naked put at 50. Table 21-3 and Figure 21-1 depict the \nresults at expiration of this strategy. \nEssentially, the investor who uses this strategy is bullish on the underlying stock \nand is attempting to buy an out-of-the-money call for free. If he is moderately wrong", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:361", "doc_id": "4b3e7ba3eb5e47fba6c66ef96d009dfef5839b69b7906c6200c4a02541ab9fb8", "chunk_index": 0}
{"text": "326 \nTABLE 21-3. \nBullishly split strikes. \nXYZ Price al January 50 \nExpirafion \n40 \n45 \n50 \n55 \n60 \n65 \n70 \nFIGURE 21-1. \nBullishly split strikes. \nPu! Profil \n-$800 \n- 300 \n+ 200 \n+ 200 \n+ 200 \n+ 200 \n+ 200 \nPart Ill: Put Option Strategies \nJanuary 60 Tolal \nCall Profil Profif \n-$100 -$ 900 \n- 100 400 \n- 100 + 100 \n- 100 + 100 \n- 100 + 100 \n+ 400 + 600 \n+ 900 + 1,100 \nStock Price at Expiration \nand the underlying stock rallies only slightly or even declines slightly, he can still \nmake asmall profit. If he is correct, of course, large profits could be generated in arally. He may lose heavily if he is very wrong and the stock falls by alarge amount \ninstead of rising. \nThis strategy is often useful when options are overpriced. Suppose that one has \nabullish opinion on the underlying stock, yet is dismayed to find that the calls are \nquite expensive. If he buys one of these expensive calls, he can mitigate the expen\nsiveness somewhat by also selling an out-of-the-money put, which is presumably", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:362", "doc_id": "81ba25df10dd8d00c6affe75282f930a83083cce53770e962942b461430e0709", "chunk_index": 0}
{"text": "Chapter 21: Synthetic Stock Positions Created by Puts and Calls 327 \nsomewhat expensive also. Thus, if he is right about the bullish attitude on the stock, \nhe owns acall that is more \"fairly priced\" because its cost was reduced by the amount \nof the put sale. \nBEARISHLY ORIENTED \nThere is acompanion strategy for the investor who is bearish on astock. He could \nattempt to buy an out-of-the-money put, giving himself the opportunity for substan\ntial profits in astock price decline, and could \"finance\" the purchase of the put by \nwriting an out-of-the-money call naked. The sale of the call would provide profits if \nthe stock stayed below the striking price of the call, but could cost him heavily if the \nunderlying stock rallies too far. \nExample: With XYZ at 65, the bearish investor buys a February 60 put for 2 points, \nand simultaneously sells a February 70 call for 3 points. These trades bring in acred\nit of 1 point, less commissions. The investor must collateralize the sale of the call. If \nXYZ should decline substantially by February expiration, large profits are possible \nbecause the February 60 put is owned. Even if XYZ does not perform as expected, \nbut still ends up anywhere between 60 and 70 at expiration, the profit will be equal \nto the initial credit because both options will expire worthless. However, if the stock \nrallies above 70, unlimited losses are possible because there is anaked call at 70. \nTable 21-4 and Figure 21-2 show the results of this strategy at expiration. \nThis is clearly an aggressively bearish strategy. The investor would like to own \nan out-of-the-money put for downside potential. In addition, he sells an out-of-the\nmoney call, normally for aprice greater than that of the purchased put. The call sale \nTABLE 21-4. \nBearishly split strikes. \nXYZ Price at February 60 February 70 Total \nExpiration Put Profit Call Profit Profit \n50 +$800 +$300 +$1, 100 \n55 + 300 + 300 + 600 \n60 - 200 + 300 + 100 \n65 - 200 + 300 + 100 \n70 - 200 + 300 + 100 \n75 - 200 - 200 400 \n80 - 200 - 700 900", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:363", "doc_id": "90837fae40bdccdcb0a82673603764742449b18f7418b4967d92ab86da21ad98", "chunk_index": 0}
{"text": "328 \nFIGURE 21-2. \nBearishly split strikes. \nC \n0 \ne ·15. \nXw \nPart Ill: Put Option Strategies \n1u +$100 \nw $0 I-----------'------ ................. -----\n~ 60 \n....J \n0 \n~ a. \nStock Price at Expiration \nessentially lets him own the put for free. In fact, he can still make profits even if the \nunderlying stock rises slightly or only falls slightly. His risk is realized if the stock rises \nabove the striking price of the written call. \nThis strategy of splitting the strikes in abearish manner is used very frequently \nin conjunction with the ownership of common stock. That is, astock owner who is \nlooking to protect his stock will buy an out-of-the-money put and sell an out-of-the\nmoney call to finance the put purchase. This strategy is called a \"protective collar\" \nand was discussed in more detail in the chapter on Put Buying in Conjunction with \nCommon Stock Ownership. Astrategy that is similar to these, but modifies the risk, \nis presented in Chapter 23, Spreads Combining Calls and Puts. \nSUMMARY \nIn either of these aggressive strategies, the investor must have adefinite opinion \nabout the future price movement of the underlying stock. He buys an out-of-the\nmoney option to provide profit potential for that stock movement. However, an \ninvestor can lose the entire purchase proceeds of an out-of-the-money option if the \nstock does not perform as expected. An aggressive investor, who has sufficient collat\neral, might attempt to counteract this effect by also writing an out-of-the-money \noption to cover the cost of the option that he bought. Then, he will not only make \nmoney if the stock performs as expected, but he will also make money if the stock \nremains relatively unchanged. He will lose quite heavily, however, if the underlying \nstock goes in the opposite direction from his original anticipation. That is why he \nmust have adefinite opinion on the stock and also be fairly certain of his timing.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:364", "doc_id": "5e0ead72a504b9dd503991e69833596447c7f894c8bf50faaf376703d3cc0d37", "chunk_index": 0}
{"text": "Basic Put Spreads \nPut spreading strategies do not differ substantially in theory from their accompany-\n;,,..,,. ,...,,1] v-n..-a<>rl vl-..-al-arriac Rol-hh11llich nnrl hP<>rich nocitionc r>!'.ln hP r>onctn1r>tPrl with .l.J..1.5 V(A,,1.1. .;Jt'.l.'\\,.,U'L.L J\\...l 1.Vf,A.VoJ• .Jl.,l''\\Jl,....t..1. J.J\\..1..1..1..1.V.a...._ f.4.1..1..._... ,._,...,_,'-4Ji.A.V..._.,._ ,t'\"-\"._,..._ ... ...__..._..._...,, .._,.__...,,._ -....,..., _.._,,.._.,....,,...,._ .....,._,_....,,_ , , ,,..._.,._\"\"-\nput spreads, as was also the case with call spreads. However, because puts are more \noriented toward downward stock movement than calls are, some bearish put spread \nstrategies are superior to their equivalent bearish call spread strategies. \nThe three simplest forms of option spreads· are: \n1. the bull spread, \n2. the bear spread, and \n3. the calendar spread. \nThe same types of spreads that were constructed with calls can be established with \nputs, but there are some differences. \nBEAR SPREAD \nIn acall bear spread, acall with alower striking price was sold while acall at ahigh\ner striking price was bought. Similarly, aput bear spread is established by selling aput at alower strike while buying aput at ahigher strike. The put bear spread is adebit spread. This is true because aput with ahigher striking price will sell for more \nthan aput with alower striking price. Thus, on astock with both puts and calls trad\ning, one could set up abear spread for acredit ( using calls) or alternatively set one \nup for adebit (using puts): \n329", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:365", "doc_id": "544804058314e8139f8d6678e9a4fb9a79b60dc60f75610ee9cd52869a674a23", "chunk_index": 0}
{"text": "330 \nPut Bear Spread \nBuy XYZ January 60 put \nSell XYZ January 50 put \n(debit spread) \nPart Ill: Put Option Strategies \nCall Bear Spread \nBuy XYZ January 60 call \nSell XYZ January 50 call \n(credit spread) \nThe put bear spread has the same sort of profit potential as the call bear spread. \nThere is alimited maximum potential profit, and this profit would be realized if XYZ \nwere below the lower striking price at expiration. The put spread would widen, in this \ncase, to equal the difference between the striking prices. The maximum risk is also \nlimited, and would be realized if XYZ were anywhere above the higher striking price \nat expiration. \nExample: The following prices exist: \nXYZ common, 55; \nXYZ January 50 put, 2; and \nXYZ January 60 put, 7. \nBuying the January 60 put and selling the January 50 would establish abear \nspread for a 5-point debit. Table 22-1 will help verify that this is indeed abearish \nposition. The reader will note that Figure 22-1 has the same shape as the call bear \nspread'sgraph (Figure 8-1). The investment required for this spread is the net debit, \nand it must be paid in full. Notice that the maximum profit potential is realized any\nwhere below 50 at expiration, and the maximum risk potential is realized anywhere \nabove 60 at expiration. The maximum risk is always equal to the initial debit required \nto establish the spread plus commissions. The break-even point is 55 in this example. \nThe following formulae allow one to quickly compute the meaningful statistics \nregarding aput bear spread. \nMaximum risk = Initial debit \nMaximum profit = Difference between strikes - Initial debit \nBreak-even price = Higher striking price - Initial debit \nPut bear spreads have an advantage over call bear spreads. With puts, one is \nselling an out-of-the-money option when setting up the spread. Thus, one is not risk\ning early exercise of his written option before the spread becomes profitable. For the \nwritten put to be in-the-money, and thus in danger of being exercised, the spread \nwould have to be profitable, because the stock would have to be below the lower \nstriking price. Such is not the case with call bear spreads. In the call spread, one sells \nan in-the-money call as part of the bear spread, and thus could be at risk of early exer\ncise before the spread has achance to become profitable.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:366", "doc_id": "69ac6b5d03bab63c16dff4541bbe68277bccec2324fd4f6d14451d5d1e2573f1", "chunk_index": 0}
{"text": "Chapter 22: Basic Put Spreads 331 \nTABLE 22-1. \nPut bear spread. \nXYZ Price at January 50 January 60 Total \nExpiration Put Profit Put Profit Profit \n40 -$800 +$1,300 +$500 \n45 - 300 + 800 + 500 \n50 + 200 + 300 + 500 \n55 + 200 200 0 \n60 + 200 700 - 500 \n70 + 200 700 - 500 \n80 + 200 700 - 500 \nFIGURE 22-1. \nPut bear spread. \nStock Price at Expiration \nBeside this difference in the probability of early exercise, the put bear spread \nholds another advantage over the call bear spread. In the put spread, if the underly\ning stock drops quickly, thereby making both options in-the-rrwney, the spread will \nnormally widen quickly as well. This is because, as has been mentioned previously, \nput options tend to lose time value premium rather quickly when they go into-the\nmoney. In the example above, if XYZ rapidly dropped to 48, the January 60 put would \nbe near 12, retaining very little time premium. However, the January 50 put that is \nshort would also not retain much time value premium, perhaps selling at 4 points or", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:367", "doc_id": "849b1197a7a45923d94cb2c6d9f862b9825803f0dad0945c5c6b77588e07c334", "chunk_index": 0}
{"text": "332 Part Ill: Put Option Strategies \nso. Thus, the spread would have widened to 8 points. Call bear spreads often do not \nproduce asimilar result on ashort-term downward movement. Since the call spread \ninvolves being short acall with alower striking price, this call may actually pick up \ntime value premium as the stock falls close to the lower strike. Thus, even though the \ncall spread might have asimilar profit at expiration, it often will not perform as well \non aquick downward movement. \nFor these two reasons - less chance of early exercise and better profits on ashort-term movement - the put bear spread is superior to the call bear spread. Some \ninvestors still prefer to use the call spread, since it is established for acredit and thus \ndoes not require acash investment. This is arather weak reason to avoid the superi\nor put spread and should not be an overriding consideration. Note that the margin \nrequirement for acall bear spread will result in areduction of one'sbuying power by \nan amount approximately equal to the debit required for asimilar put bear spread. \n(The margin required for acall bear spread is the difference between the striking \nprices less the credit received from the spread.) Thus, the only accounts that gain any \nsubstantial advantage from acredit spread are those that are near the minimum equi\nty requirement to begin with. For most brokerage firms, the minimum equity \nrequirement for spreads is $2,000. \nBULL SPREAD \nAbull spread can be established with put options by buying aput at alower striking \nprice and simultaneously selling aput with ahigher striking price. This, again, is the \nsame way abull spread was constructed with calls: selling the higher strike and buy\ning the lower strike. \nExample: The same prices can be used: \nXYZ common, 55; \nXYZ January 50 put, 2; and \nXYZ January 60 put, 7. \nThe bull spread is constructed by buying the January 50 put and selling the January \n60 put. This is acredit spread. The credit is 5 points in this example. If the underly\ning stock advances by January expiration and is anywhere above 60 at that time, the \nmaximum profit potential of the spread will be realized. In that case, with XYZ any\nwhere above 60, both puts would expire worthless and the spreader would make aprofit of the entire credit - 5 points in this example. Thus, the maximum profit poten\ntial is limited, and the maximum profit occurs if the underlying stock rises in price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:368", "doc_id": "d13cba1018602cdcf5ad97398ed5d523fd87e1ed973b1af18cee63db4d50b0ac", "chunk_index": 0}
{"text": "Chapter 22: Basic Put Spreads 333 \nabove the higher strike. These are the same qualities that were displayed by acall bull \nspread (Chapter 7). The name \"bull spread\" is derived from the fact that this is abull\nish position: The strategist wants the underlying stock to rise in price. \nThe risk is limited in this spread. If the underlying stock should decline by expi\nration, the maximum loss will be realized with XYZ anywhere below 50 at that time. \nThe risk is 5 points in this example. To see this, note that if XYZ were anywhere below \n50 at expiration, the differential between the two puts would widen to 10 points, \nsince that is the difference between their striking prices. Thus, the spreader would \nhave to pay 10 points to buy the spread back, or to close out the position. Since he \ninitially took in a 5-point credit, this means his loss is equal to 5 points - the 10-point \ncost of closing out less the 5 points he received initially. \nThe investment required for abullish put spread is actually acollateral require\nment, since the spread is acredit spread. The amount of collateral required is equal \n-1-r.. f-ha rliffa:rannci, hahuaan tho cfr-il;nrr r\\rint::u.:- lace th.-:;). not nrorlit ror-A-iuorl fnr thA \n\\..Vl,,J...111._, Ul.J..J..V.lV.l.l.\\..,V LIV\\..VVVVJ..l '-- J.'L, oJ\\..l..l.J.'-l.J.J..o .t'.l.J..\\,.,VoJ J.VoJ,J I..J.J.'-' J..1.V\\.. \\,.,.l.V\"-AJ.l.- .LVV'-'..l.Y'-'\"'--4 .J..'-.-\".I. .__...._.._ ....... \nspread. In this example, the collateral requirement is $500- the $1,000, or 10-point, \ndifferential in the striking prices less the $500 credit received from the spread. Note \nthat the maximum possible loss is always equal to the collateral requirement in abull\nish put spread. \nIt is not difficult to calculate the break-even point in abullish spread. ·In this \nexample, the break-even point before commissions is 55 at expiration. With XYZ at \n55 in January, the January 50 put would expire worthless and the January 60 put \nwould have to be bought back for 5 points. It would be 5 points in-the-money with \nXYZ at 55. Thus, the spreader would break even, since he originally received 5 points \ncredit for the spread and would then pay out 5 points to close the spread. The fol\nlowing formulae allow one to quickly compute the details of abullish put spread: \nMaximum potential risk = Initial collateral requirement \n= Difference in striking prices - Net credit received \nMaximum potential profit= Net credit \nBreak-even price = Higher striking price - Net credit \nCALENDAR SPREAD \nIn acalendar spread, anear-term option is sold and alonger-term option is bought, \nboth with the same striking price. This definition applies to either aput or acall cal\nendar spread. In Chapter 9, it was shown that there were two philosophies available \nfor call calendar spreads, either neutral or bullish. Similarly, there are two philoso\nphies available for put calendar spreads: neutral or bearish.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:369", "doc_id": "a73ee1e2da685485cac945609bf29cf44935105a465303670b72658c3fd12938", "chunk_index": 0}
{"text": "334 Part Ill: Put Option Strategies \nIn aneutral calendar spread, one sets up the spread with the idea of closing the \nspread when the near-term call or put expires. In this type of spread, the maximum \nprofit will be realized if the stock is exactly at the striking price at expiration. The \nspreader is merely attempting to capitalize on the fact that the time value premium \ndisappears more rapidly from anear-term option than it does from alonger-term one. \nExample: XYZ is at 50 and a January 50 put is selling for 2 points while an April 50 \nput is selling for 3 points. Aneutral calendar spread can be established for a 1-point \ndebit by selling the January 50 put and buying the April 50 put. The investment \nrequired for this position is the amount of the net debit, and it must be paid for in \nfull. If XYZ is exactly at 50 at January expiration, the January 50 put will expire worth\nless and the April 50 put will be worth about 2 points, assuming other factors are the \nsame. The neutral spreader would then sell the April 50 put for 2 points and take his \nprofit. The spreader'sprofit in this case would be one point before commissions, \nbecause he originally paid a 1-point debit to set up the spread and then liquidates the \nposition by selling the April 50 put for 2 points. Since commission costs can cut into \navailable profits substantially, spreads should be established in alarge enough quan\ntity to minimize the percentage cost of commissions. This means that at least 10 \nspreads should be set up initially. \nIn any type of calendar spread, the risk is limited to the amount of the net debit. \nThis maximum loss would be realized if the underlying stock moved substantially far \naway from the striking price by the time the near-term option expired. If this hap\npened, both options would trade at nearly the same price and the differential would \nshrink to practically nothing, the worst case for the calendar spreader. For example, \nif the underlying stock drops substantially, say to 20, both the near-term and the long\nterm put would trade at nearly 30 points. On the other hand, if the underlying stock \nrose substantially, say to 80, both puts would trade at avery low price, say 1/15 or 1/s, \nand again the spread would shrink to nearly zero. \nNeutral call calendar spreads are generally superior to neutral put calendar \nspreads. Since the amount of time value premium is usually greater in acall option \n(unless the underlying stock pays alarge dividend), the spreader who is interested in \nselling time value would be better off utilizing call options. \nThe second philosophy of calendar spreading is amore aggressive one. With put \noptions, abearish strategy can be constructed using acalendar spread. In this case, \none would establish the spread with out-of-the-money puts. \nExample: With XYZ at 55, one would sell the January 50 put for 1 point and buy the \nApril 50 put for 1 ½ points. He would then like the underlying stock to remain above \nthe striking price until the near-term January put expires. If this happens, he would", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:370", "doc_id": "a3b5857a1eec7c22a6ed23f59a3a3b299f96acca6cc78ccbd9ebc676b08ed3d4", "chunk_index": 0}
{"text": "Chapter 22: Basic Put Spreads 335 \nmake the I-point profit from the sale of that put, reducing his net cost for the April \n50 put to ½ point. Then, he would become bearish, hoping for the underlying stock \nto decline in price substantially before April expiration in order that he might be able \nto generate large profits on the April 50 put he holds. \nJust as the bullish calendar spread with calls can be arelatively attractive strat\negy, so can the bearish calendar spread with puts. Granted, two criteria have to be \nfulfilled in order for the position to work to the optimum: The near-term put must \nexpire worthless, and then the underlying stock must drop in order to generate prof\nits on the long side. Although these conditions may not occur frequently, one prof\nitable situation can more than make up for several losing ones. This is true because \nthe initial debit for abearish calendar spread is small, ½ point in the example above. \nThus, the losses will be small and the potential profits could be very large if things \nwork out right. \nThe aggressive spreader must be careful not to \"leg out\" of his spread, since he \ncould generate alarge loss by doing so. The object of the strategy is to accept arather \nlarge number of small losses, with the idea that the infrequent large profits will more \nthan offset the sum of the losses. If one generates alarge loss somewhere along the \nway, this may ruin the overall strategy. Also, if the underlying stock should fall to the \nstriking price before the near-term put expires, the spread will normally have \nwidened enough to produce asmall profit; that profit should be taken by closing the \nspread at that time.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:371", "doc_id": "195c243e15fe067a770552c6e55ef3ed1e7acbaac905365dabac36dbc5f48963", "chunk_index": 0}
{"text": "Spreads Cotnbining \nCalls and Puts \nCertain types of spreads can be constructed that utilize both puts and calls. One of \nthese strategies has been discussed before: the butterfly spread. However, other \nstrategies exist that off er potentially large profits to the spreader. These other strate\ngies are all variations of calendar spreads and/or straddles that involve both put and \ncall options. \nTHE BUTTERFLY SPREAD \nThis strategy has been described previously, although its usage in Chapter 10 was \nrestricted to constructing the spread with calls. Recall that the butterfly spread is aneutral position that has limited risk as well as limited profits. The position involves \nthree striking prices, utilizing abull spread between the lower two strikes and abear \nspread between the higher two strikes. The maximum profit is realized at the middle \nstrike at expiration, and the maximum loss is realized if the stock is above the higher \nstrike or below the lower strike at expiration. \nSince either abull spread or abear spread can be constructed with puts or calls, \nit should be obvious that abutterfly spread ( consisting of both abull spread and abear spread) can be constructed in anumber of ways. In fact, there are four ways in \nwhich the spread can be established. If option prices are fairly balanced - that is, the \narbitrageurs are keeping prices in line - any of the four ways will have the same \npotential profits and losses at expiration of the options. However, because of the ways \nin which puts and calls behave prior to their expiration, certain advantages or disad-\n336", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:372", "doc_id": "194f133ef1297e028418220e11b735cc782d739e6a5d69fd6f1b8df7204db065", "chunk_index": 0}
{"text": "Chapter 23: Spreads Combining Calls and Puts 331 \nvantages are connected with some of the methods of establishing the butterfly \nspread. \nExample: The following prices exist: \nStrike: \nCall: \nPut: \nXYZ common: 60 \n50 \n12 \n60 \n6 \n5 \n70 \n2 \n1 1 \nThe method using only the calls indicates that one would buy the 50 call, sell two 60 \ncalls, and buy the 70 call. Thus, there would be abull spread in the calls between the \n50 and 60 strikes, and abear spread in the calls between the 60 and 70 strikes. In asimilar manner, one could establish abutterfly spread by combining either type of bull \nspread between the 50 and 60 strikes with any type of bear spread between the 60 and \n70 strikes. Some of these spreads would be credit spreads, while others would be debit \nspreads. In fact, one'spersonal choice between two rather equivalent makeups of the \nbutterfly spread might be decided by whether there were acredit or adebit involved. \nTable 23-1 summarizes the four ways in which the butterfly spread might be \nconstructed. In order to verify the debits and credits listed, the reader should recall \nthat abull spread consists of buying alower strike and selling ahigher strike, whether \nputs or calls are used. Similarly, bear spreads with either puts or calls consist of buy\ning ahigher strike and selling alower strike. Note that the third choice - bull spread \nwith puts and bear spread with calls - is ashort straddle protected by buying the out\nof-the-money put and call. \nIn each of the four spreads, the maximum potential profit at expiration is 8 \npoints if the underlying stock is exactly at 60 at that time. The maximum possible loss \nin any of the four spreads is 2 points, if the stock is at or above 70 at expiration or is \nat or below 50 at expiration. For example, either the top line in the table, where the \nspread is set up only with calls; or the bottom line, where the spread is set up only \nwith puts, has arisk equal to the debit involved - 2 points. The large-debit spread \n(second line of table) will be able to be liquidated for aminimum of 10 points at expi\nration no matter where the stock is, so the risk is also 2 points. (It cost 12 points to \nbegin with.) Finally, the credit combination (third line) has amaximum buy-back of \n10 points, so it also has risk of 2 points. In addition, since the striking prices are 10 \npoints apart, the maximum potential profit is 8 points (maximum profit = striking \nprice differential minus maximum risk) in all the cases.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:373", "doc_id": "946480128132163d91915a4735ea9ac0d76ca6e16492232bd849c64d2978045d", "chunk_index": 0}
{"text": "338 \nTABLE 23-1. \nButterfly spread. \nBull Spread \n(Buy Option at 50, ... plus ... \nSell at 60) \nCalls (6 debit) \nCalls (6 debit) \nPuts (4 credit) \nPuts (4 credit) \nBear Spread \n(Buy Option at 70, \nSell at 60) \nCalls (4 credit) \nPuts (6 debit) \nCalls (4 credit) \nPuts (6 debit) \nPart Ill: Put Option Strategies \nTotal Money \n2 debit \n12 debit \n8 credit \n2 debit \nThe factor that causes all these combinations to be equal in risk and reward is \nthe arbitrageur. If put and call prices get too far out of line, the arbitrageur can take \nriskless action to force them back. This particular form of arbitrage, known as the box \nspread, is described later, in Chapter 27, Arbitrage. \nEven though all four ways of constructing the butterfly spread are equal at \nexpiration, some are superior to others for certain price movements prior to expira\ntion. Recall that it was previously stated that bull spreads are best constructed with \ncalls, and bear spreads are best constructed with puts. Since the butterfly spread is \nmerely the combination of abull spread and abear spread, the best way to set up the \nbutterfly spread is to use calls for the bull spread and puts for the bear spread. This \ncombination is the one listed on the second line of Table 23-1. This strategy involves \nthe largest debit of the four combinations and, as aresult, many investors shun this \napproach. However, all the other combinations involve selling an in-the-money put \nor call at the outset, asituation that could lead to early exercise. The reader may also \nrecall that the credit combination, listed on the third line of Table 23-1, was previ\nously described as aprotected straddle position. That is, one sells astraddle and \nsimultaneously buys both an out-of-the-money put and an out-of-the-money call with \nthe same expiration month, as protection for the straddle. Thus, abutterfly spread is \nactually the equivalent of acompletely protected straddle wiite. \nAbutterfly spread is not an overly attractive strategy, although it may be useful \nfrom time to time. The commissions required are extremely high, and there is no \nchance of making alarge profit on the position. The limited risk feature is good to \nhave in aposition, but it alone cannot compensate for the less attractive features of \nthe strategy. Essentially, the strategist is looking for the stock to remain in aneutral \npattern until the options expire. If the potential profit is at least three times the max\nimum 1isk (and preferably four times) and the underlying stock appears to be in trad\ning range, the strategy is feasible. Othe:nvise, it is not.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:374", "doc_id": "66b693af5224c08d72b9e4f65b71a13f7960c196c8de0354774f48c7e965015a", "chunk_index": 0}
{"text": "Chapter 23: Spreads Combining Calls and Puts 339 \nCOMBINING AN OPTION PURCHASE AND A SPREAD \nIt is possible to combine the purchase of acall and acredit put spread to produce aposition that behaves much like acall buy, although it has less risk over much of the \nprofit range. This strategy is often used when one has aquite bullish opinion regard\ning the underlying security, yet the call one wishes to purchase is \"overpriced.\" In asimilar manner, if one is bearish on the underlying, he can sometimes combine the \npurchase of aput with the sale of acall credit spread. Both approaches are described \nin this section. \nTHE BULLISH SCENARIO \nIt sometimes happens that one arrives at abullish opinion regarding astock, only to \nfind that the options are very expensive. In fact, they may be so expensive as to pre\nclude thoughts of making an outright call purchase. This might happen, for example, \nif the stock has suddenly plummeted in price (perhaps during an ongoing, rapid bear\nish move by the overall stock market). To buy calls at this time would be overly risky. \nIf the underlying began to rally, it would often be the case that the implied volatility \nof the calls would shrink, thus harming one'slong call position. \nAs acounter to this, it might make sense to buy the call, but at the same time \nto sell aput credit spread. Recall that aput credit spread is abullish strategy. \nMoreover, since it is presumed that the options are expensive on this particular stock, \nthe puts being used in the spread would be expensive as well. Thus, the credit \nreceived from the spread would be slightly larger than \"normal\" because the options \nare expensive. \nExample: XYZ is selling at 100. One wishes to purchase the December 100 call as an \noutright bullish speculation. That call is selling for 10. However, one determines that \nthe December 100 call is overpriced at these levels. (In order to make this determi\nnation, one would use an option model whose techniques are described in Chapter \n28 on mathematical applications.) Hence, he decides to use the following put spread \nin addition to buying the December 100 call: \nSell December 90 put, 6 \nBuy December 80 put, 3 \nThe sale of the put spread brings in a 3-point credit. Thus, his total expenditure for \nthe entire position is 7 points ( 10 for the December 100 call, less 3 credit from the sale \nof the put spread). If one is correct about his bullish outlook for the stock (i.e., the \nstock goes up), he can in some sense consider that he paid 7 for the call. Another way", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:375", "doc_id": "79e3d6c79a6b77389580933deaa867dd888e890410c8ff7ed61f621caf416de7", "chunk_index": 0}
{"text": "340 Part Ill: Put Option Strategies \nto look at it is this: The sale of the put spread reduces the call price down to amore \nmoderate level, one that might be in line with its \"theoretical value.\" In other words, \nthe call would not be considered expensive if it were priced at 7 instead of 10. The sale \nof the put spread can be considered away to reduce the overall cost of the call. \nOf course, the sale of the put spread brings some extra risk into the position \nbecause, if the stock were to fall dramatically, the put spread could lose 7 points ( the \nwidth of the strikes in the spread, 10 points, less the initial credit received, 3 points). \nThis, added to the call'scost of 10 points, means that the entire risk here is 17 points. \nIn fact, that is the margin required for this spread as well. Thus, the overall spread \nstill has limited risk, because both the call purchase and the put credit spread are lim\nited-risk strategies. However, the total risk of the two combined is larger than for \neither one separately. \nRemember that one must be bullish on the underlying in order to employ this \nstrategy. So, if his analysis is correct, the upside is what he wants to maximize. If he \nis wrong on his outlook for the stock, then he needs to employ some sort of stop-loss \nmeasures before the maximum risk of the position is realized. \nThe resulting position is shown in Figure 23-1, along with two other plots. The \nstraight line marked \"Spread at expiration\" shows how the profitability of the call pur\nchase combined with abull spread would look at December expiration. In addition, \nthere is aplot with straight lines of the purchase of the December 100 call for 10 \npoints. That plot can be compared with the three-way spread to see where extra risk \nand reward occur. Note that the three-way spread does better than the outright pur\nchase of the December 100 call as long as the stock is higher than 87 at expiration. \nSince the stock is initially at 100 and,since one is initially bullish on the stock, one \nwould have to surmise that the odds of it falling to 87 are fairly small. Thus, the three\nway spread outperforms the outright purchase of the call over alarge range of stock \nprices. \nThe final plot in Figure 23-1 is that of the three-way spread'sprofit and losses \nhalfway to the expiration date. You can see that it looks much like the profitability of \nmerely owning acall: The curve has the same shape as the call pricing curve shown \nin Chapter 1. \nHence, this three-way strategy can often be more attractive and more profitable \nthan merely owning acall option. Remember, though, that it does increase risk and \nrequire alarger collateral deposit than the outright purchase of the at-the-money call \nwould. One can experiment with this strategy, too, in that he might consider buying \nan out-of-the-money call and selling aput spread that brings in enough credit to com\npletely pay for the call. In that way, he would have no risk as long as the stock \nremained above the higher striking price used in the put credit spread.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:376", "doc_id": "7502a83f2497ea668fb59d35156cde40441b0417a3fd5bf97efe2344852e34e1", "chunk_index": 0}
{"text": "Chapter 23: Spreads Combining Calls and Puts \nFIGURE 23-1. \nCall buy and put credit (bull) spread. \n+$2,000 \n+$1,000 \n(/J \n(/J \n0 ..J \n0 $0 -ea. \n-$1,000 \n-$2,000 \n70 80 \n.... ,, -----,, -=-----' \nTHE BEARISH SCENARIO \n~ Spread at Expiration \nCall Buy Only, at Expiration \n341 \nStock \nIn asimilar manner, one can construct aposition to take advantage of abearish opin\nion on astock. Again, this would be most useful when the options were overpriced \nand one felt that an at-the-money put was too expensive to purchase by itself. \nExample: XYZ is trading at 80, and one has adefinite bearish opinion on the stock. \nHowever, the December 80 put, which is selling for 8, is expensive according to an \noption analysis. Therefore, one might consider selling acall credit spread (out-of-the\nmoney) to help reduce the cost of the put. The entire position would thus be: \nBuy 1 December 80 put: \nSell l December 90 call: \nBuy 1 December 100 call: \nTotal cost: \n8 debit \n4 credit \n2 debit \n6 debit ($600) \nThe profitability of this position is shown in Figure 23-2. The straight line on that \ngraph shows how the position would behave at expiration. The introduction of the \ncall credit spread has increased the risk to $1,600 if the stock should rally to 100 or \nhigher by expiration. Note that the risk is limited since both the put purchase and the \ncall credit spread are limited-risk strategies. The margin required would be this max\nimum risk, or $1,600.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:377", "doc_id": "d153fd89c1f8dfb0c07bbc26e296d54ca9d677e6c23cb4d44b56b2ca4b86ff1d", "chunk_index": 0}
{"text": "342 Part Ill: Put Option Strategies \nFIGURE 23-2. \nPut buy and call credit (bear) spread. \n+$1,000 Halfway to Expiration \n/ \nStock \n0 60 110 \n-ea. \n-$1,000 At Expiration \n-$2,000 \nThe curved line on Figure 23-2 shows how the three-way spread would behave \nif one looked at it halfway to its expiration date. In that case, it has acurved appear\nance much like the outright purchase of aput option. \nThus, this strategy could be appealing to bearishly-oriented traders, especially \nwhen the options are expensive. It might have certain advantages over an outright put \npurchase in that case, but it does require alarger margin investment and has theo\nretically larger risk. \nA SIMPLE FOLLOW-UP ACTION \nFOR BULL OR BEAR SPREADS \nAnother way of combining puts and calls in aspread can sometimes be used when \none has abull or bear spread already in place. Suppose that one owns acall bull \nspread and the underlying stock has advanced nicely. In fact, it is above both of the \nstrikes used in the spread. However, as is often the case, the bull spread may not have \nwidened out to its maximum profit potential. One can use the puts for two purposes \nat this point: (1) to determine whether the call spread is trading at a \"reasonable\" \nvalue, and (2) to try to lock in some profits. First, let'slook at an example of the \"rea\nsonable value\" verification.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:378", "doc_id": "e9d6f66bb7392bc3fc1b5c05683ed60d008d044ec3872f08da684918e4c67622", "chunk_index": 0}
{"text": "Chapter 23: Spreads Combining Calls and Puts 343 \nExample: Atrader buys an XYZ call bull spread for 5 points. The spread uses the \nJanuary 70 calls and the January 80 calls. Later, XYZ advances to aprice of 88, but \nthere is still agood deal of time remaining in the options. Perhaps the spread has \nwidened out only to 7 points at that time. The trader finds it somewhat disappoint\ning that the spread has not widened out to its maximum profit potential of 10 points. \nHowever, this is afairly common occurrence with bull and bear spreads, and is one \nof the factors that may make them less attractive than outright call or put purchases. \nIn any case, suppose the following prices exist: \nJanuary 80 put, 5 \nJanuary 70 put, 2 \nWe can use these put prices to verify that the call spread is \"in line.\" Notice that the \nput spread is 3 points and the call spread is 7 points (both are the January 70-January \n80 spread). Thus, they add up to 10 points the width of the strikes. When that \noccurs, we can conclude that the spreads are \"in line\" and are trading at theoretical\nly correct prices. \nKnowing this information doesn'thelp one make any more profits, but it does \nprovide some verification of the prices. Many times, one feels frustrated when he \nsees that acall bull spread has not widened out as he expected it to. Using the put \nspread as verification can help keep the strategist \"on track\" so that he makes ration\nal, not emotional, decisions. \nNow let'slook at asimilar example, in which perhaps the puts can be used to \nlock in profits on acall bull spread. \nExample: Using the same bull spread as in the previous example, suppose that one \nowns an XYZ call bull spread, having bought the January 70 call and sold the January \n80 call for adebit of 5 points. Now assume it is approaching expiration, and the stock \nis once again at 88. At this time, the spread is theoretically nearing its maximum price \nof 10. However, since both calls are fairly deeply in-the-money, the market-makers \nare making very wide spreads in the calls. Perhaps these are the markets, with the \nstock at 88 and only aweek or two remaining until expiration: \nColl \nJanuary 70 call \nJanuary 80 call \nBid Price \n17.50 \n8.80 \nAsked Price \n18.50 \n8.20 \nIf one were to remove this spread at market prices, he would sell his long \nJanuary 70 call for 17.50 and would buy his short January 80 call back for 8.20, acred-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:379", "doc_id": "c5a80ee7cc730b283a1ef73b0d9ac17f0445c16a986aea88f43bac29ea7fba02", "chunk_index": 0}
{"text": "344 Part Ill: Put Option Strategies \nit of 9.30. Since the maximum value of the spread is l 0, one is giving away 70 cents, \nquite abit for just such ashort time remaining. \nHowever, suppose that one looks at the puts and finds these prices: \nPut \nJanuary 80 put \nJanuary 70 put \nBid Price \n0.20 \nnone \nAsked Price \n0.40 \n0.10 \nOne could \"lock in\" his call spread profits by buying the January 80 put for 40 cents. \nIgnoring commissions for amoment, if he bought that put and then held it along with \nthe call spread until expiration, he would unwind the call spread for a 10 credit at \nexpiration. He paid 40 cents for the put, so his net credit to exit the spread would be \n9.60 - considerably better than the 9.30 he could have gotten above for the call \nspread alone. \nThis put strategy has one big advantage: If the underlying stock should sudden\nly collapse and tumble beneath 70 - admittedly, aremote possibility - large profits \ncould accrue. The purchase of the January 80 put has protected the bull spread'sprofits at all prices. But below 70, the put starts to make extra money, and the spread\ner could profit handsomely. Such adrop in price would only occur if some material\nly damaging news surfaced regarding X'iZ Company, but it does occasionally happen. \nIf one utilizes this strategy, he needs to carefully consider his commission costs \nand the possibility of early assignment. For aprofessional trader, these are irrelevant, \nand so the professional trader should endeavor to exit bull spreads in this manner \nwhenever it makes sense. However, if the public customer allows stock to be assigned \nat 80 and exercises to buy stock at 70, he will have two stock commissions plus one \nput option commission. That should be compared to the cost of two in-the-money \ncall option commissions to remove the call spread directly. Furthermore, if the pub\nlic customer receives an early assignment notice on the short January 80 calls, he may \nneed to provide day-trade margin as he exercises his January 70 calls the next day. \nWithout going into as much detail, abear spread'sprofits can be locked in via asimilar strategy. Suppose that one owns a January 60 put and has sold a January 50 \nput to create abear spread. Later, with the stock at 45, the spreader wants to remove \nthe spread, but again finds that the markets for the in-the-money puts are so wide \nthat he cannot realize anywhere near the 10 points that the spread is theoretically \nworth. He should then see what the January 50 call is selling for. If it is fractionally \npriced, as it most likely will be if expiration is drawing nigh, then it can be purchased \nto lock in the profits from the put spread. Again, commission costs should be con\nsidered by the public customer before finalizing his strategy.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:380", "doc_id": "5a25da9120d8cc9bb5a3667770f624b9641b364560227e2bc9cdfbd2251c2b3f", "chunk_index": 0}
{"text": "Chapter 23: Spreads Combining Calls and Puts 345 \nTHREE USEFUL BUT COMPLEX STRATEGIES \nThe three strategies presented in this section are all designed to limit risk while \nallowing for large potential profits if correct market conditions develop. Each is acombination strategy - that is, it involves both puts and calls and each is acalendar \nstrategy, in which near-term options are sold and longer-term options are bought. (Afourth strategy that is similar in nature to those about to be discussed is presented in \nthe next chapter.) Although all of these are somewhat complex and are for the most \nadvanced strategist, they do provide attractive risk/reward opportunities. In addition, \nthe strategies can be employed by the public customer; they are not designed strict\nly for professionals. All three strategies are described conceptually in this section; \nspecific selection criteria are presented in the next section. \nA TWO-PRONGED ATTACK {THE CALENDAR COMBINATION} \nAbullish calendar spread was shown to be arather attractive strategy. Abullish call \ncalendar spread is established with out-of-the-money calls for arelatively small debit. \nIf the near-term call expires worthless and the stock then rises substantially before \nthe longer-term call expires, the profits could potentially be large. In any case, the \nrisk is limited to the small debit required to establish the spread. In asimilar man\nner, the bearish calendar spread that uses put options can be an attractive strategy \nas well. In this strategy, one would set up the spread with out-of-the-money puts. He \nwould then want the near-term put to expire worthless, followed by asubstantial drop \nin the stock price in order to profit on the longer-term put. \nSince both strategies are attractive by themselves, the combination of the two \nshould be attractive as well. That is, with astock midway between two striking prices, \none might set up abullish out-of-the-money call calendar spread and simultaneously \nestablish abearish out-of-the-money put calendar spread. If the stock remains rela\ntively stable, both near-term options would expire worthless. Then asubstantial stock \nprice movement in either direction could produce large profits. With this strategy, \nthe spreader does not care which direction the stock moves after the near options \nexpire worthless; he only hopes that the stock becomes volatile and moves alarge dis\ntance in either direction. \nExample: Suppose that the following prices exist three months before the January \noptions expire: \nJanuary 70 call: 3 \nApril 70 call: 5 \nXYZ common: 65 \nJanuary 60 put: 2 \nApril 60 put: 3", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:381", "doc_id": "f6bb9bbbaa3f3465125fe77cc761ab7cbfda9872c79638334b96a4d5e5643a76", "chunk_index": 0}
{"text": "346 Part Ill: Put Option Strategies \nThe bullish portion of this combination of calendar spreads would be set up by sell\ning the shorter-term January 70 call for 3 points and simultaneously buying the \nlonger-term April 70 call for 5 points. This portion of the spread requires a 2-point \ndebit. The bearish portion of the spread would be constructed using the puts. The \nnear-term January 60 put would be sold for 2 points, while the longer-term April 60 \nput would be bought for 3. Thus, the put portion of the spread is a I-point debit. \nOverall, then, the combination of the calendar spreads requires a 3-point debit, plus \ncommissions. This debit is the required investment; no additional collateral is \nrequired. Since there are four options involved, the commission cost will be large. \nAgain, establishing the spreads in quantity can reduce the percentage cost of com\nmissions. \nNote that all the options involved in this position are initially out-of-the-money. \nThe stock is below the striking price of the calls and is above the striking price of the \nputs. One has sold anear-term put and call combination and purchased alonger-term \ncombination. For nomenclature purposes, this strategy is called a \"calendar combi\nnation.\" \nThere are avariety of possible outcomes from this position. First, it should be \nunderstood that the risk is limited to the amount of the initial debit, 3 points in this \nexample. If the underlying stock should rise dramatically or fall dramatically before \nthe near-term options expire, both the call spread and the put spread will shrink to \nnearly nothing. This would be the least desirable result. In actual practice, the spread \nwould probably have asmall positive differential left even after apremature move by \nthe underlying stock, so that the probability of aloss of the entire debit would be \nsmall. \nIf the near-term options both expire worthless, aprofit will generally exist at \nthat time. \nExample: IfXYZ were still at 65 at January expiration in the prior example, the posi\ntion should be profitable at that time. The January call and put would expire worth\nless with XYZ at 65, and the April options might be worth atotal of 5 points. The \nspread could thus be closed for aprofit with XYZ at 65 in January, since the April \noptions could be sold for 5 points and the initial \"cost\" of the spread was only 3 points. \nAlthough commissions would substantially reduce this 2-point gross profit, there \nwould still be agood percentage profit on the overall position. If the strategist decides \nto take his profit at this time, he would be operating in aconservative manner. \nHowever, the strategist may want to be more aggressive and hold onto the April \ncombination in hopes that the stock might experience asubstantial movement before \nthose options expire. Should this occur, the potential profits could be quite large.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:382", "doc_id": "c6670b4a22a7c0117173e0d11146f7aee230910cf324df43f23fdc61ffc4fb1c", "chunk_index": 0}
{"text": "Chapter 23: Spreads Combining Calls and Puts 347 \nExample: If the stock were to undergo avery bullish move and rise to 100 before \nApril expiration, the April 70 call could be sold for 30 points. (The April 60 put would \nexpire worthless in that case.) Alternatively, if the stock plunged to 30 by April expi\nration, the put at 60 could be sold for 30 points while the call expired worthless. In \neither case, the strategist would have made asubstantial profit on his initial 3-point \ninvestment. \nIt may be somewhat difficult for the strategist to decide what he wants to do \nafter the near-term options expire worthless. He may be torn between taking the lim\nited profit that is at hand or holding onto the combination that he owns in hopes of \nlarger profits. Areasonable approach for the strategist to take is to do nothing imme\ndiately after the near-term options expire worthless. He can hold the longer-term \noptions for some time before they will decay enough to produce aloss in the posi\ntion. Referring again to the previous example, when the January options expire \nworthless, the strategist then owns the April combination, which is worth 5 points at \nthat time. He can continue to hold the April options for perhaps 6 or 8 weeks before \nthey decay to avalue of 3 points, even if the stock remains close to 65. At this point, \nthe position could be closed for anet loss of the .commission costs involved in the var\nious transactions. \nAs ageneral rule, one should be willing to hold the combination, even if this \nmeans that he lets asmall profit decay into aloss. The reason for this is that one \nshould give himself the maximum opportunity to realize large profits. He will proba\nbly sustain anumber of small losses by doing this, but by giving himself the oppor\ntunity for large profits, he has areasonable chance of having the profits outdistance \nthe losses. \nThere is atime to take small profits in this strategy. This would be when either \nthe puts or the calls were slightly in-the-money as the near-term options expire. \nExample: IfXYZ moved to 71 just as the January options were expiring, the call por\ntion of the spread should be closed. The January 70 call could be bought back for 1 \npoint and the April 70 call would probably be worth about 5 points. Thus, the call \nportion of the spread could be \"sold\" for 4 points, enough to cover the entire cost of \nthe position. The April 60 put would not have much value with the stock at 71, but it \nshould be held just in case the stock should experience alarge price decline. Similar \nresults would occur on the put side of the spread if the underlying stock were slight\nly in-the-money, say at 58 or 59, at January expiration. At no time does the strategist \nwant to risk being assigned on an option that he is short, so he must always close the \nportion of the position that is in-the-money at near-term expiration. This is only nec\nessary, of course, if the stock has risen above the striking price of the calls or has fall\nen below the striking price of the puts.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:383", "doc_id": "8cecc4eff5fdbbf850cdf0e0c61e2b1d35a82bc07554fb7f445e07a76f0f2c33", "chunk_index": 0}
{"text": "348 Part Ill: Put Option Strategies \nIn summary, this is areasonable strategy if one operates it over aperiod of time \nlong enough to encompass several market cycles. The strategist must be careful not \nto place alarge portion of his trading capital in the strategy, however, since even \nthough the losses are limited, they still represent his entire net investment. Avaria\ntion of this strategy, whereby one sells more options than he buys, is described in the \nnext chapter. \nTHE CALENDAR STRADDLE \nAnother strategy that combines calendar spreads on both put and call options can be \nconstructed by selling anear-term straddle and simultaneously purchasing alonger\nterm straddle. Since the time value premium of the near-term straddle will decrease \nmore rapidly than that of the longer-term straddle, one could make profits on alim\nited investment. This strategy is somewhat inferior to the one described in the pre\nvious section, but it is interesting enough to examine. \nExample: Suppose that three months before January expiration, the following prices \nexist: \nXYZ common: 40 \nJanuary 40 straddle: 5 April 40 straddle: 7 \nAcalendar spread of the straddles could be established by selling the January 40 \nstraddle and simultaneously buying the April 40 straddle. This would involve acost \nof 2 points, or the debit of the transaction, plus commissions. \nThe risk is limited to the amount of this debit up until {he time the near-term \nstraddle expires. That is, even if XYZ moves up in price by asubstantial amount or \ndeclines in price by asubstantial amount, the worst that can happen is that the dif\nference between the straddle prices shrinks to zero. This could cause one to lose an \namount equal to his original debit, plus commissions. This limit on the risk applies \nonly until the near-term options expire. If the strategist decides to buy back the near\nterm straddle and continue to hold the longer-term one, his risk then increases by the \ncost of buying back the near-term straddle. \nExample: XYZ is at 43 when the January options expire. The January 40 call can now \nbe bought back for 3 points. The put expires worthless; so the whole straddle was \nclosed out for 3 points. The April 40 straddle might be selling for 6 points at that \ntime. If the strategist wants to hold on to the April straddle, in hopes that the stock \nmight experience alarge price swing, he is free to do so after buying back the January", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:384", "doc_id": "31c4e9d11fbe849d744815209e7b4fcd46045d906ccbc1ec2ed95a41cd687e09", "chunk_index": 0}
{"text": "Chapter 23: Spreads Combining Calls and Puts 349 \n40 straddle. However, he has now invested atotal of 5 points in the position: the orig\ninal 2-point debit plus the 3 points that he paid to buy back the January 40 straddle. \nHence, his risk has increased to 5 points. If XYZ were to be at exactly 40 at April expi\nration, he would lose the entire 5 points. While the probability of losing the entire 5 \npoints must be considered small, there is asubstantial chance that he might lose \nmore than 2 points his original debit. Thus, he has increased his risk by buying back \nthe near-term straddle and continuing to hold the longer-term one. \nThis is actually aneutral strategy. Recall that when calendar spreads were dis\ncussed previously, it was pointed out that one establishes aneutral calendar spread \nwith the stock near the striking price. This is true for either acall calendar spread or \naput calendar spread. This strategy - acalendar spread with straddles is merely the \ncombination of aneutral call calendar spread and aneutral put calendar spread. \nMoreover, recall that the neutral calendar spreader generally establishes the position \nwith the intention of closing it out once the near-term option expires. He is mainly \ninterested in selling time in an attempt to capitalize on the fact that anear-term \noption loses time value premium more rapidly than alonger-term option does. The \nstraddle calendar spread should be treated in the same manner. It is generally best \nto close it out at near-term expiration. If the stock is near the striking price at that \ntime, aprofit will generally result. To verify this, refer again to the prices in the pre\nceding paragraph, with XYZ at 43 at January expiration. The January 40 straddle can \nbe bought back for 3 points and the April 40 straddle can be sold for 6. Thus, the dif\nferential between the two straddles has widened to 3 points. Since the original dif\nferential was 2 points, this represents aprofit to the strategist. \nThe maximum profit would be realized if XYZ were exactly at the striking price \nat near-term expiration. In this case, the January 40 straddle could be bought back \nfor avery small fraction and the April 40 straddle might be worth about 5 points. The \ndifferential would have widened from the original 2 points to nearly 5 points in this \ncase. \nThis strategy is inferior to the one described in the previous section (the \"calen\ndar combination\"). In order to have achance for unlimited profits, the investor must \nincrease his net debit by the cost of buying back the near-term straddle. \nConsequently, this strategy should be used only in cases when the near-term straddle \nappears to be extremely overpriced. Furthermore, the position should be closed at \nnear-term expiration unless the stock is so close to the striking price at that time that \nthe near-term straddle can be bought back for afractional price. This fractional buy\nback would then give the strategist the opportunity to make large potential profits \nwith only asmall increase in his risk. This situation of being able to buy back the near\nterm straddle at afractional price will occur very infrequently, much more infre-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:385", "doc_id": "08c6393c321201c1610ed0a6f640132c4133fbb9d0018983746a0c229ee9172d", "chunk_index": 0}
{"text": "350 Part Ill: Put Option Strategies \nquently than the case in which both the out-of-the-money put and call expire worth\nless in the previous strategy. Thus, the \"calendar combination\" strategy will afford the \nspreader more opportunities for large profits, and will also never force him to \nincrease his risk. \nOWNING A ✓,,FREE\" COMBINATION (THE \"\"DIAGONAL \nBUTTERFLY SPREAD\") \nThe strategies described in the previous sections are established for debits. This \nmeans that even if the near-term options expire worthless, the strategist still has risk. \nThe long options he then holds could proceed to expire worthless as well, thereby \nleaving him with an overall loss equal to his original debit. There is another strategy \ninvolving both put and call options that gives the strategist the opportunity to own a \n\"free\" combination. That is, the profits from the near-term options could equal or \nexceed the entire cost of his long-term options. \nThis strategy consists of selling anear-term straddle and simultaneously pur\nchasing both alonger-term, out-of the-money call and alonger-term, out-of the\nmoney put. This differs from the protected straddle write previously described in that \nthe long options have amore distant maturity than do the short options. \nExample: \nXYZ common: 40 \nApril 35 put: \nJanuary 40 straddle: \nApril 45 call: \nIf one were to sell the short-term January 40 straddle for 7 points and simultaneous\nly purchase the out-of-the-money put and call combination -April 35 put and April \n45 call - he would establish acredit spread. The credit for the position is 3 points less \ncommissions, since 7 points are brought in from the straddle sale and 4 points are \npaid for the out-of-the-money combination. Note that the position technically con\nsists of abearish spread in the calls - buy the higher strike and sell the lower strike -\ncoupled with abullish spread in the puts - buy the lower strike and sell the higher \nstrike. The investment required is in the form of collateral since both spreads are \ncredit spreads, and is equal to the differential in the striking prices, less the net cred\nit received. In this example, then, the investment would be 10 points for the striking \nprice differential (5 points for the calls and 5 points for the puts) less the 3-point \ncredit received, for atotal collateral requirement of $700, plus commissions.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:386", "doc_id": "4de3839cc97fe102ef312285f6c69ad5d4daebf3199d5b2c030455103805c96f", "chunk_index": 0}
{"text": "Chapter 23: Spreads Combining Calls and Puts 351 \nThe potential results from this position may vary widely. However, the risk is \nlimited before near-tenn expiration. If the underlying stock should advance substan\ntially before January expiration, the puts would be nearly worthless and the calls \nwould both be trading near parity. With the calls at parity, the strategist would have \nto pay, at most, 5 points to close the call spread, since the striking prices of the calls \nare 5 points apart. In asimilar manner, if the underlying stock had declined substan\ntially before the near-term January options expired, the calls would be nearly worth\nless and the puts would be at parity. Again, it would cost amaximum of 5 points to \nclose the put spread, since the difference in the striking prices of the puts is also 5 \npoints. The worst result would be a 2-point loss in this example - 3 points of credit \nwere initially received, and the most that the strategist would have to pay to close the \nposition is 5 points. This is the theoretical risk. In actual practice, it is very unlikely \nthat the calls would trade as much as 5 points apart, even if the underlying stock \nadvanced by alarge amount, because the longer-term call should retain some small \ntime value premium even if it is deeply in-the-money. Asimilar analysis might apply \nto the puts. The risk can always be quickly computed as being equal to the difference \nbetween two contiguous striking prices ( two strikes next to each other), less the net \ncredit received. \nThe strategist'sobjective with this position is to be able to buy back the near\ntenn straddle for aprice less than the original credit received. If he can do this, he \nwill own the longer-term combination for free. \nExample: Near January expiration, the strategist is able to repurchase the January 40 \nstraddle for 2 points. Since he initially received a 3-point credit and is then able to \nbuy back the written straddle for 2 points, he is left with an overall credit in the posi\ntion of 1 point, less commissions. Once he has done this, the strategist retains the \nlong options, the April 35 put and April 45 call. If the underlying stock should then \nadvance substantially or decline substantially, he could make very large profits. \nHowever, even if the long combination expires worthless, the strategist still makes aprofit, since he was able to buy the straddle back for less than the amount of the orig\ninal credit. \nIn this example, the strategist'sobjective is to buy back the January 40 straddle \nfor less than 3 points, since that is the amount of the initial credit. At expiration, this \nwould mean that the stock would have to be between 37 and 43 for the buy-back to \nbe made for 3 points or less. Although it is possible, certainly, that the stock will be \nin this fairly narrow range at near-term expiration, it is not probable. However, the \nstrategist who is willing to add to his risk slightly can often achieve the same result by \n\"legging out\" of the January 40 straddle. It has repeatedly been stated that one should", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:387", "doc_id": "803fd1984adea7c09d422dbc1cf5d0d1a398fc77404ac5c57d3885937ebf33a6", "chunk_index": 0}
{"text": "352 Part Ill: Put Option Strategies \nnot attempt to leg out of aspread, but this is an exception to that rule, since one owns \nalong combination and therefore is protected; he is not subjecting himself to large \nrisks by attempting to \"leg out\" of the straddle he has written. \nExample: XYZ rallies before January expiration and the January 40 put drops to aprice of ½ during the rally. Even though there is time remaining until expiration, the \nstrategist might decide to buy back the put at ½. This could potentially increase his \noverall risk by ½ point if the stock continues to rise. However, if the stock then \nreversed itself and fell, he could attempt to buy the call back at 2½ points or less. In \nthis manner, he would still achieve his objective of buying the short-term straddle \nback for 3 points or less. In fact, he might be able to close both sides of the straddle \nwell before near-term expiration if the underlying stock first moves quickly in one \ndirection and then reverses direction by alarge amount. \nThe maximum risk and the optimum potential objectives have been described, \nbut interim results might also be considered in this strategy. \nExample: XYZ is at 44 at January expiration. The January 40 straddle must be bought \nback for 4 points. This means that the long combination will not be owned free, but \nwill have acost of Ipoint plus commissions. The strategist must decide at this time \nif he wants to hold on to the April options or if he wants to sell them, possibly pro\nducing asmall overall profit on the entire position. There is no ironclad rule in this \ntype of situation. If the decision is made to hold on to the longer-term options, the \nstrategist realizes that he has assumed additional risk by doing so. Nevertheless, he \nmay decide that it is worth owning the long combination at arelatively low cost. The \ncost in this example would be Ipoint plus commissions, since he paid 4 points to buy \nback the straddle after only taking in a 3-point credit initially. The more ex.pensive the \nbuy-back of the near-term straddle is, the more the strategist should be readily will\ning to sell his long options at the same time. For example, if XYZ were at 48 at \nJanuary expiration and the January 40 straddle had to be bought back for 8 points, \nthere should be no question that he should simultaneously sell his April options as \nwell. The most difficult decisions come when the stock is just outside the optimum \nbuy-back area at near-term expiration. In this example, the strategist would have afairly difficult decision if XYZ were in the 44 to 45 area or in the 35 to 36 area at \nJanuary expiration. \nThe reader may recall that, in Chapter 14 on diagonalizing aspread, it was men\ntioned that one is sometimes able to own acall free by entering into adiagonal cred\nit spread. Adiagonal bear spread was given as an example. The same thing happens \nto be true of adiagonal bullish put spread, since that is acredit spread as well. The", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:388", "doc_id": "761f5c084eb8056599c834c8934f6403cdca09d81716a748818df917c8f5bf45", "chunk_index": 0}
{"text": "Chapter 23: Spreads Combining Calls and Puts 3S3 \nstrategy discussed in this section is merely acombination of adiagonal bearish call \nspread and adiagonal bullish put spread and is known as a \"diagonal butterfly \nspread.\" The same concept that was described in Chapter 14 - being able to make \nmore on the short-term call than one originally paid for the long-term call - applies \nhere as well. One enters into acredit position with the hope of being able to buy back \nthe near-term written options for aprofit greater than the cost of the long options. If \nhe is able to do this, he will own options for free and could make large profits if the \nunderlying stock moves substantially in either direction. Even if the stock does not \nmove after the buy-back, he still has no risk. The risk occurs prior to the expiration \nof the near-term options, but this risk is limited. As aresult, this is an attractive strat\negy that, when operated over aperiod of market cycles, should produce some large \nprofits. Ideally, these profits would offset any small losses that had to be taken. Since \nlarge commission costs are involved in this strategy, the strategist is reminded that \nestablishing the spreads in quantity can help to reduce the percentage effect of the \ncommissions. \nSELECTING THE SPREADS \nNow that the concepts of these three strategies have been laid out, let us define \nselection criteria for them. The \"calendar combination\" is the easiest of these strate\ngies to spot. One would like to have the stock nearly halfway between two striking \nprices. The most attractive positions can normally be found when the striking prices \nare at least 10 points apart and the underlying stock is relatively volatile. The opti\nmum time to establish the \"calendar combination\" is two or three months before the \nnear-term options expire. Additionally, one would like the sum of the prices of the \nnear-term options to be equal to at least one-half of the cost of the longer-term \noptions. In the example given in the previous section on the \"calendar combination,\" \nthe near-term combination was sold for 5 points, and the longer-term combination \nwas bought for 8 points. Thus, the near-term combination was worth more than one\nhalf of the cost of the longer-term combination. These five criteria can be summa\nrized as follows: \n1. Relatively volatile stock. \n2. Stock price nearly midway between two strikes. \n3. Striking prices at least 10 points apart. \n4. Two or three months remaining until near-term expiration. \n5. Price of near-term combination greater than one-half the price of the longer\nterm combination.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:389", "doc_id": "cf572f7306bf13014cff51312950e8fb86face259d17788ab82c8a11e4b5e3eb", "chunk_index": 0}
{"text": "354 Part Ill: Put Option Strategies \nEven though five criteria have been stated, it is relatively easy to find aposition that \nsatisfies all five conditions. The strategist may also be able to rely upon technical \ninput. If the stock seems to be in anear-term trading range, the position may be more \nattractive, for that would indicate that the chances of the near-term combination \nexpiring worthless are enhanced. \nThe \"calendar straddle\" is astrategy that looks deceptively attractive. As the \nreader should know by now, options do not decay in alinear fashion. Instead, options \ntend to hold time value premium until they get quite close to expiration, when the \ntime value premium disappears at afast rate. Consequently, the sale of anear-term \nstraddle and the simultaneous purchase of alonger-term straddle often appear to be \nattractive because the debit seems small. Again, certain criteria can be set forth that \nwill aid in selecting areasonably attractive position. The stock should be at or very \nnear the striking price when the position is established. Since this is basically aneu\ntral strategy, one that offers the largest potential profits at near-term expiration, one \nshould want to sell the most time premium possible. This is why the stock must be \nnear the striking price initially. The underlying stock does not have to be avolatile \none, although volatile stocks will most easily satisfy the next two criteria. The near\nterm credit should be at least two-thirds of the longer-term debit. In the example \nused to explain this strategy, the near-term straddle was sold for 5, while the longer\nterm straddle was bought for 7 points. Thus, the near-term straddle was worth more \nthan two-thirds of the longer-term straddle'sprice. Finally, the position should be \nestablished with two to four months remaining until near-term expiration. If positions \nwith alonger time remaining are used, there is asignificant probability that the \nunderlying stock will have moved some distance away from the striking price by the \ntime the near-term options expire. Summarizing, the three criteria for a \"calendar \nstraddle\" are: \n1. Stock near striking price initially. \n2. Two to four months remaining until near-term expiration. \n3. Near-term straddle price at least two-thirds of longer-term straddle price. \nThe \"diagonal butterfly\" is the most difficult of these three types of positions to \nlocate. Again, one would like the stock to be near the middle striking price when the \nposition is established. Also, one would like the underlying stock to be somewhat \nvolatile, since there is the possibility that long-term options will be owned for free. If \nthis comes to pass, the strategist wants the stock to be capable of alarge move in \norder to have achance of generating large profits. The most restrictive criterion -:\none that will eliminate all but afew possibilities on adaily basis - is that the near\nterm straddle price should be at least one and one-half times that of the longer-term,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:390", "doc_id": "bd85b873cc495fe1b4f5ff8ffee1cc8d8850b04ae2b0a506a6d43157e9521025", "chunk_index": 0}
{"text": "Chapter 23: Spreads Combining Calls and Puts 355 \nout-of-the-money combination. By adhering to this criterion, one gives himself area\nsonable chance of being able to buy the near-term straddle back for aprice low \nenough to result in owning the longer-term options for free. In the example used to \ndescribe this strategy, the near-term straddle was sold for 7 while the out-of-the\nmoney, longer-term combination cost 4 points. This satisfies the criterion. Finally, \none should limit his possible risk before near-term expiration. Recall that the risk is \nequal to the difference between any two contiguous striking prices, less the net cred\nit received. In the example, the risk would be 5 minus 3, or 2 points. The risk should \nalways be less than the credit taken in. This precludes selling anear-term straddle at \n80 for 4 points and buying the put at 60 and the call at 100 for acombined cost of 1 \npoint. Although the credit is substantially more than one and one-half times the cost \nof the long combination, the risk would be ridiculously high. The risk, in fact, is 20 \npoints ( the difference between two contiguous striking prices) less the 3 points cred\nit, or 17 points - much too high. \nThe criteria can be summarized as follows: \n1. Stock near middle striking price initially. \n2. Three to four months to near-term expiration. \n3. Price of written straddle at least one and one-half times that of the cost of the \nlonger-term, out-of-the-money combination. \n4. Risk before near-term expiration less than the net credit received. \nOne way in which the strategist may notice this type of position is when he sees arel\natively short-term straddle selling at what seems to be an outrageously high price. \nProfessionals, who often have agood feel for astock'sshort-term potential, will some\ntimes bid up straddles when the stock is about to make avolatile move. This will \ncause the near-term straddles to be very overpriced. When astraddle seller notices \nthat aparticular straddle looks too attractive as asale, he should consider establish\ning adiagonal butterfly spread instead. He still sells the overpriced straddle, but also \nbuys alonger-term, out-of-the-money combination as ahedge against alarge loss. \nBoth factions can be right. Perhaps the stock will experience avery short-term \nvolatile movement, proving that the professionals were correct. However, this will \nnot worry the strategist holding adiagonal butterfly, for he has limited risk. Once the \nshort-term move is over, the stock may drift back toward the original strike, allowing \nthe near-term straddle to be bought back at alow price - the eventual objective of \nthe strategist utilizing the diagonal butterfly spread. \nThese are admittedly three quite complex strategies and thus are not to be \nattempted by anovice investor. If one wants to gain experience in how he would \noperate such astrategy, it would be far better to operate a \"paper strategy\" for a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:391", "doc_id": "5632a88fcc068aab53985bfc03c430b43a95f274c38b701106de14165f54210d", "chunk_index": 0}
{"text": "356 Part Ill: Put Option Strategies \nwhile. That is, one would not actually make investments, but would instead follow \nprices in the newspaper and make day-to-day decisions without actual risk. This will \nallow the inexperienced strategist to gain afeel for how these complex strategies per\nform over aparticular time period. The astute investor can, of course, obtain price \nhistory information and track anumber of market cycles in this same way. \nSUMMARY \nPuts and call can be combined to make some very attractive positions. The addition \nof acall or put credit spread to the outright purchase of aput or call can enhance the \noverall profitability of the position, especially if the options are expensive. In addi\ntion, three advanced strategies were presented that combined puts and calls at vari\nous expiration dates. These three various types of strategies that involve calendar \ncombinations of puts and calls may all be attractive. One should be especially alert \nfor these types of positions when near-term calls are overpriced. Typically, this would \nbe during, or just after, abullish period in the stock market. For nomenclature pur\nposes, these three strategies are called the \"calendar combination,\" the \"calendar \nstraddle,\" and the \"diagonal butterfly.\" \nAll three strategies offer the possibility of large potential profits if the underly\ning stock remains relatively stable until the near-term options expire. In addition, all \nthree strategies have limited risk, even if the underlying stock should move explo\nsively in either direction prior to near-term expiration. If an intermediate result \noccurs - for example, the stock moves amoderate distance in either direction before \nnear-term expiration - it is still possible to realize alimited profit in any of the strate\ngies, because of the fact that the time premiums decay much more rapidly in the \nnear-term options than they do in the longer-term options. \nThe three strategies have many things in common, but each has its own advan\ntages and disadvantages. The \"diagonal butterfly\" is the only one of the three strate\ngies whereby the strategist has apossibility of owning free options. Admittedly, the \nprobability of actually being able to own the options completely for free is small. \nHowever, there is arelatively large probability that one can substantially reduce the \ncost of the long options. The \"calendar combination,\" the first of the three strategies \ndiscussed, offers the largest probability of capturing the entire near-term premium. \nThis is because both near-term options are out-of-the-money to begin with. The \"cal\nendar straddle\" offers the largest potential profits at near-term expiration. That is, if \nthe stock is relatively unchanged from the time the position was established until the \ntime the near-term options expire, the \"calendar straddle\" will show the best profit \nof the three strategies at that time.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:392", "doc_id": "98d0f2933e3316bf8d4754624323d11bc42e33db42683ab8216f6922e4700291", "chunk_index": 0}
{"text": "Chapter 23: Spreads Combining Calls and l'uts 357 \nLooking at the negative side, the \"calendar straddle\" is the least attractive of the \nthree strategies, primarily because one is forced to increase his risk after near-term \nexpiration, if he wants to continue to hold the longer-term options. It is often diffi\ncult to find a \"diagonal butterfly\" that offers enough credit to make the position \nattractive. Finally, the \"calendar combination\" has the largest probability oflosing the \nentire debit eventually, because one may find that the longer-term options expire \nworthless also. (They are out-of-the-money to begin with, just as the near-term \noptions were.) \nThe strategist will not normally be able to find alarge number of these positions \navailable at attractive price levels at any particular time in the market. However, since \nthey are attractive strategies with little or no margin collateral requirements, the \nstrategist should constantly be looking for these types of positions. Acertain amount \nof cash or collateral should be reserved for the specific purpose of utilizing it for \nthese types of positions - perhaps 15 to 20% of one'sdollars.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:393", "doc_id": "450979d4c8cd07a6da56c664fc4191356466785f81f81b7afb488e503f1f0c7f", "chunk_index": 0}
{"text": "Ratio Spreads Using Puts \nThe put option spreader may want to sell more puts than he owns. This creates aratio \nspread. Basically, two types of put ratio spreads may prove to be attractive: the stan\ndard ratio put spread and the ratio calendar spread using puts. Both strategies are \ndesigned for the more aggressive investor; when operated properly, both can present \nattractive reward opportunities. \nTHE RATIO PUT SPREAD \nThis strategy is designed for aneutral to slightly bearish outlook on the underlying \nstock. In aratio put spread, one buys anumber of puts at ahigher strike and sells \nmore puts at alower strike. This position involves naked puts, since one is short more \nputs than he is long. There is limited upside risk in the position, but the downside risk \ncan be very large. The maximum profit can be obtained if the stock is exactly at the \nstriking price of the written puts at expiration. \nExample: Given the following: \nXYZ common, 50; \nXYZ January 45 put, 2; and \nXYZ January 50 put, 4. \nAratio put spread might be established by buying one January 50 put and simulta\nneously selling two January 45 puts. Since one would be paying $400 for the pur\nchased put and would be collecting $400 from the sale of the two out-of-the-money \nputs, the spread could be done for even money. There is no upside risk in this posi\ntion. If XYZ should rally and be above 50 at January expiration, all the puts would \n358", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:394", "doc_id": "8059472f66fc041782e9fc3a80808e32d25181b76c9adf1ac5711755d7bf8ad2", "chunk_index": 0}
{"text": "Cl,apter 24: Ratio Spreads Using Puts 359 \nexpire worthless and the result would be aloss of commissions. However, there is \ndownside risk. If XYZ should fall by agreat deal, one would have to pay much more \nto buy back the two short puts than he would receive from selling out the one long \nput. The maximum profit would be realized if XYZ were at 45 at expiration, since the \nshort puts would expire worthless, but the long January 50 put would be worth 5 \npoints and could be sold at that price. Table 24-1 and Figure 24-1 summarize the \nposition. Note that there is arange within which the position is profitable - 40 to 50 \nin this example. If XYZ is above 40 and below 50 at January expiration, there will be \nsome profit, before commissions, from the spread. Below 40 at expiration, losses will \nbe generated and, although these losses are limited by the fact that astock cannot \ndecline in price below zero, these losses could become very large. There is no upside \nrisk, however, as was pointed out earlier. The following formulae summarize the sit\nuation for any put ratio spread: \nMaximum upside risk \nMaximum profit \npotential \n= Net debit of spread (no upside risk if done for \nacredit) \n= Striking price differential x Number of long \nputs - Net debit (or plus net credit) \nDownside break-even price = Lower strike price - Maximum profit potential + \nNumber of naked puts \nThe investment required for the put ratio spread consists of the collateral \nrequirement necessary for anaked put, plus or minus the credit or debit of the entire \nposition. Since the collateral requirement for anaked option is 20% of the stock \nTABLE 24-1. \nRatio put spread. \nXYZ Price at Long January 50 Short 2 January 45 Total \nExpiration Put Profit Put Profit Profit \n20 +$2,600 -$4,600 -$2,000 \n30 + 1,600 - 2,600 - 1,000 \n40 + 600 600 0 \n42 + 400 200 + 200 \n45 + 100 + 400 + 500 \n48 200 + 400 + 200 \n50 400 + 400 0 \n60 400 + 400 0", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:395", "doc_id": "0ccb65a8e85b6565bfa523191b4169cdc09079fe0221692bf4cbda1853ada716", "chunk_index": 0}
{"text": "360 \nFIGURE 24-1. \nRatio put spread. \n+$500 \nC: \n0 \n~ ·5. \nXwiil \n(/) $0 (/) \n0 ....I \n0 \nea. \nPart Ill: Put Option Strategies \nStock Price at Expiration \nprice, plus the premium, minus the amount by which the option is out-of-the-money, \nthe actual dollar requirement in this example would be $700 (20% of $5,000, plus the \n$200 premium, minus the $500 by which the January 45 put is out-of-the-money). As \nwith all types of naked writing positions, the strategist should allow enough collater\nal for an adverse stock move to occur. This will allow enough room for stock move\nment without forcing early liquidation of the position due to amargin call. If, in this \nexample, the strategist felt that he might stay with the position until the stock \ndeclined to 39, he should allow $1,380 in collateral (20% of $3,900 plus the $600 in\nthe-money amount). \nThe ratio put spread is generally most attractive when the underlying stock is \ninitially between the two striking prices. That is, if XYZ were somewhere between 45 \nand 50, one might find the ratio put spread used in the example attractive. If the \nstock is initially below the lower striking price, aratio put spread is not as attractive, \nsince the stock is already too close to the downside risk point. Alternatively, if the \nstock is too far above the striking price of the written calls, one would normally have \nto pay alarge debit to establish the position. Although one could eliminate the debit \nby writing four or five short options to each put bought, large ratios have extraordi\nnarily large downside risk and are therefore very aggressive. \nFollow-up action is rather simple in the ratio put spread. There is very little that \none need do, except for closing the position if the stock breaks below the downside \nbreak-even point. Since put options tend to lose time value premium rather quickly \nafter they become in-the-money options, there is not normally an opportunity to roll", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:396", "doc_id": "94a6c810ab25d31d2fdc99594f59420443566d14562e08df456e7adef442e1e2", "chunk_index": 0}
{"text": "Chapter 24: Ratio Spreads Using Puts 361 \ndown. Rather, one should be able to close the position with the puts close to parity if \nthe stock breaks below the downside break-even point. The spreader may want to buy \nin additional long puts, as was described for call spreads in Chapter 11, but this is not \nas advantageous in the put spread because of the time value premium shrinkage. \nThis strategy may prove psychologically pleasing to the less experienced \ninvestor because he will not lose money on an upward move by the underlying stock. \nMany of the ratio strategies that involve call options have upside risk, and alarge \nnumber of investors do not like to lose money when stocks move up. Thus, although \nthese investors might be attracted to ratio strategies because of the possibility of col\nlecting the profits on the sale of multiple out-of-the-money options, they may often \nprefer ratio put spreads to ratio call spreads because of the small upside risk in the \nput strategy. \nUSING DELTAS \nThe \"delta spread\" concept can also be used for establishing and adjusting neutral \nratio put spreads. The delta spread was first described in Chapter 11. Aneutral put \nspread can be constructed by using the deltas of the two put options involved in the \nspread. The neutral ratio is determined by dividing the delta of the put at the higher \nstrike by the delta of the put at the lower strike. Referring to the previous example, \nsuppose the delta of the January 45 put is -.30 and the delta of the January 50 put is \n-.50. Then aneutral ratio would be 1.67 (-.50 divided by -.30). That is, 1.67 puts \nwould be sold for each put bought. One might thus sell 5 January 45 puts and buy 3 \nJanuary 50 puts. \nThis type of spread would not change much in price for small fluctuations in the \nunderlying stock price. However, as time passes, the preponderance of time value \npremium sold via the January 45 puts would begin to tum aprofit. As the underlying \nstock moves up or down by more than asmall distance, the neutral ratio between the \ntwo puts will change. The spreader can adjust his position back into aneutral one by \nselling more January 45'sor buying more January 50's. \nTHE RATIO PUT CALENDAR SPREAD \nThe ratio put calendar spread consists of buying alonger-term put and selling alarg\ner quantity of shorter-term puts, all with the same striking price. The position is gen\nerally established with out-of-the-money puts that is, the stock is above the striking \nprice - so that there is agreater probability that the near-term puts will expire worth-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:397", "doc_id": "f508faba5eab4cdb37d54597520c53b608c3783f3a0ea64d425bcf45ccaa7da3", "chunk_index": 0}
{"text": "362 Part Ill: Put Option Strategies \nless. Also, the position should be established for acredit, such that the money \nbrought in from the sale of the near-term puts more than covers the cost of the \nlonger-term put. If this is done and the near-term puts expire worthless, the strate\ngist will then own the longer-term put free, and large profits could result if the stock \nsubsequently experiences asizable downward movement. \nExample: If XYZ were at 55, and the January 50 put was at 1 ½ with the April 50 at \n2, one could establish aratio put calendar spread by buying the April 50 and selling \ntwo January 50 puts. This is acredit position, because the sale of the two January 50 \nputs would bring in $300 while the cost of the April 50 put is only $200. If the stock \nremains above 50 until January expiration, the January 50 puts will expire worthless \nand the April 50 put will be owned for free. In fact, even if the April 50 put should \nthen expire worthless, the strategist will make asmall profit on the overall position in \nthe amount of his original credit - $100 - less commissions. However, after the \nJanuarys have expired worthless, if XYZ should drop dramatically to 25 or 20, avery \nlarge profit would accrue on the April 50 put that is still owned. \nThe risk in the position could be very large if the stock should drop well below \n50 before the January puts expire. For example, if XYZ fell to 30 prior to January \nexpiration, one would have to pay $4,000 to buy back the January 50 puts and would \nreceive only $2,000 from selling out his long April 50 put. This would represent arather large loss. Of course, this type of tragedy can be avoided by taking appropri\nate follow-up action. Nomwlly, one would close the position if the stock fell rrwre than \n8 to 10% below the striking price before the near-term puts expire. \nAs with any type of ratio position, naked options are involved. This increases the \ncollateral requirement for the position and also means that the strategist should allow \nenough collateral in order for the follow-up action point to be reached. In this exam\nple, the initial requirement would be $750 (20% of $5,500, plus the $150 January \npremium, less the $500 by which the naked January 50 put is out-of-the-money). \nHowever, if the strategist decides that he will hold the position until XYZ falls to 46, \nhe should allow $1,320 in collateral (20% of $4,600 plus the $400 in-the-money \namount). Of course, the $100 credit, less commissions, generated by the initial posi\ntion can be applied against these collateral requirements. \nThis strategy is asensible one for the investor who is willing to accept the risk of \nwriting anaked put. Since the position should be established with the stock above the \nstriking price of the put options, there is areasonable chance that the near-term puts \nwill expire worthless. This means that some profit will be generated, and that the \nprofit could be large if the stock should then experience alarge downward move \nbefore the longer-term puts expire. One should take care, however, to limit his losses", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:398", "doc_id": "623e96c69540e24e2a974b953ccc89434e596290a8719ac56215c421910b52a7", "chunk_index": 0}
{"text": "Chapter 24: Ratio Spreads Using Puts 363 \nbefore near-term expiration, since the eventual large profits will be able to overcome \naseries of small losses, but could not overcome apreponderance oflarge losses. \nRATIO PUt CALENDARS \nUsing the deltas of the puts in the spread, the strategist can construct aneutral posi\ntion. If the puts are initially out-of-the-money, then the neutral spread generally \ninvolves selling more puts than one buys. Another type of ratioed put calendar can \nbe constructed with in-the-money puts. As with the companion in-the-money spread \nwith calls, one would buy more puts than he sells in order to create aneutral ratio. \nIn either case, the delta of the put to be purchased is divided by the delta of the \nput to be sold. The result is the neutral ratio, which is used to determine how many \nputs to sell for each one purchased. \nExample: Consider the out-of-the-money case. XYZ is trading at 59. The January 50 \nput has adelta of 0.10 and the April 50 put has adelta of -0.17. If acalendar spread \nis to be established, one would be buying the April 50 and selling the January 50. \nThus, the neutral ratio would be calculated as 1.7 to 1 (-0.17/-0.10). Seventeen puts \nwould be sold for every 10 purchased. \nThis spread has naked puts and therefore has large risk if the underlying stock \ndeclines too far. However, follow-up action could be taken if the stock dropped in an \norderly manner. Such action would be designed to limit the downside risk. \nConversely, the calendar spread using in-the-money puts would normally have \none buying more options than he is selling. An example using deltas will demonstrate \nthis fact: \nExample: XYZ is at 59. The January 60 put has adelta of -0.45 and the April 60 put \nhas adelta of -0.40. It is normal for shorter-term, in-the-money options to have adelta that is larger (in absolute terms) than longer-term, in-the-money options. \nThe neutral ratio for this spread would be 0.889 (-0.40/-0.45). That is, one \nwould sell only 0.889 puts for each one he bought. Alternatively stated, he would sell \n8 and buy 9. \nAspread of this type has no naked puts and therefore does have large downside \nprofit potential. If the stock should rise too far, the loss is limited to the initial debit \nof the spread. The optimum result would occur if the stock were at the strike at expi\nration because, even though the excess long put would lose money in that case, the \nspreads involving the other puts would overcome that small loss. \nAnother risk of the in-the-money put spread is that one might be assigned \nrather quickly if the stock should drop. In fact, one must be careful not to establish", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:399", "doc_id": "ae2d8bde90f2c91adf5d3135d2ccd09f402742a51fee320763e6664748da55a6", "chunk_index": 0}
{"text": "364 Part Ill: Put Option Strategies \nthe spread with puts that are too deeply in-the-money, for this reason. While being \nput will not necessarily change the profitability of the spread, it will mean increased \ncommission costs and margin charges for the customer, who must buy the stock upon \nassignment. \nA LOGICAL EXTENSION (THE RATIO CALENDAR COMBINATION) \nThe previous section demonstrated that ratio put calendar spreads can be attractive. \nThe ratio call calendar spread was described earlier as areasonably attractive strate\ngy for the bullish investor. Alogical combination of these two types of ratio calendar \nspreads (put and call) would be the ratio combination - buying alonger-term out-of\nthe-money combination and selling several near-term out-of-the-money combina\ntions. \nExample: The following prices exist: \nXYZ common: 55 \nXYZ January 50 put: \nXYZ January 60 call: \nXYZ April 50 put: 2 \nXYZ April 60 call: 5 \nOne could sell the near-term January combination (January 50 put and January 60 \ncall) for 5 points. It would cost 7 points to buy the longer-term April combination \n(April 50 put and April 60 call). By selling more January combinations than April com\nbinations bought, aratio calendar combination could be established. For example, \nsuppose that astrategist sold two of the near-term January combinations, bringing in \n10 points, and simultaneously bought one April combination for 7 points. This would \nbe acredit position, acredit of 3 points in this example. If the near-term, out-of-the\nmoney combination expires worthless, aguaranteed profit of 3 points will exist, even \nif the longer-term options proceed to expire totally worthless. If the near-term com\nbination expires worthless, the longer-term combination is owned for free, and alarge \nprofit could result on asubstantial stock price movement in either direction. \nAlthough this is asuperbly attractive strategy if the near-term options do, in \nfact, expire worthless, it must also be monitored closely so that large losses do not \noccur. These large losses would be possible if the stock broke out in either direction \ntoo quickly, before the near-term options expire. In the absence of atechnical opin\nion on the underlying stock, one can generally compute astock price at which it \nmight be reasonable to take follow-up action. This is asimilar analysis to the one", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:400", "doc_id": "260e7be793524400047a5ea62407f75ac13ef965b37ad4c4feefc92eb4889a36", "chunk_index": 0}
{"text": "Chapter 24: Ratio Spreads Using Puts 365 \ndescribed for ratio call calendar spreads in Chapter 12. Suppose the stock in this \nexample began to rally. There would be apoint at which the strategist would have to \npay 3 points of debit to close the call side of the combination. That would be his \nbreak-even point. \nExample: With XYZ at 65 at January expiration (5 points above the higher strike of \nthe original combination), the near-term January 60 call would be worth 5 points and \nthe longer-term April 60 call might be worth 7 points. If one closed the call side of \nthe combination, he would have to pay 10 points to buy back two January 60 calls, \nand would receive 7 points from selling out his April 60. This closing transaction \nwould be a 3-point debit. This represents abreak-even situation up to this point in \ntime, except for commissions, since a 3-point credit was initially taken in. The strate\ngist would continue to hold the April 50 put (the January 50 put would expire worth\nless) just in case the improbable occurs and the underlying stock plunges below 50 \nbefore April expiration. Asimilar analysis could be performed for the put side of the \nspread in case of an early downside breakout by the underlying stock. It might be \ndetermined that the downside break-even point at January expiration is 46, for exam\nple. Thus, the strategist has two parameters to work with in attempting to limit loss\nes in case the stock moves by agreat deal before near-term expiration: 65 on the \nupside and 46 on the downside. In practice, if the stock should reach these levels \nbefore, rather than at, January expiration, the strategist would incur asmall loss by \nclosing the in-the-money side of the combination. This action should still be taken, \nhowever, as the objective of risk management of this strategy is to take small losses, if \nnecessary. Eventually, large profits may be generated that could more than compen\nsate for any small losses that were incurred. \nThe foregoing follow-up action was designed to handle avolatile move by the \nunderlying stock prior to near-term expiration. Another, perhaps more common, time \nwhen follow-up action is necessary is when the underlying stock is relatively \nunchanged at near-term expiration. If XYZ in the example above were near 55 at \nJanuary expiration, arelatively large profit would exist at that time: The near-term \ncombination would expire worthless for again of 10 points on that sale, and the \nlonger-term combination would probably still be worth about 5 points, so that the \nunrealized loss on the April combination would be only 2 points. This represents atotal (realized and unrealized) gain of 8 points. In fact, as long as the near-term com\nbination can be bought back for less than the original 3-point credit of the position, \nthe position will show atotal unrealized gain at near-term expiration. Should the gain \nbe taken, or should the longer-term combination be held in hopes of avolatile move \nby the underlying stock? Although the strategist will normally handle each position", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:401", "doc_id": "985f9de62746b07a5920cdc266a4f60acf51ea423f14f22528def411f3d79809", "chunk_index": 0}
{"text": "366 Part Ill: Put Option Strategies \non acase-by-case basis, the general philosophy should be to hold on to the April com\nbination. Aprofit is already guaranteed at this time - the worst that can happen is a \n3-point profit (the original credit). Consequently, the strategist should allow himself \nthe opportunity to make large profits. The strategist may want to attempt to trade out \nof his long combination, since he will not risk making the position alosing one by \ndoing so. Technical analysis may be able to provide him with buy or sell zones on the \nstock, and he would then consider selling out his long options in accordance with \nthese technical levels. \nIn summary, this strategy is very attractive and should be utilized by strategists \nwho have the expertise to trade in positions with naked options. As long as risk man\nagement principles of taking small losses are adhered to, there will be alarge proba\nbility of overall profit from this strategy. \nPUT OPTION SUMMARY \nThis concludes the section on put option strategies. The put option is useful in avari\nety of situations. First, it represents amore attractive way to take advantage of abear\nish attitude with options. Second, the use of the put options opens up anew set of \nstrategies - straddles and combinations - that can present reasonably high levels of \nprofit potential. Many of the strategies that were described in Part II for call options \nhave been discussed again in this part. Some of these strategies were described more \nfully in terms of philosophy, selection procedures, and follow-up action when they \nwere first discussed. The second description the one involving put options - was \noften shortened to amore mechanical description of how puts fit into the strategy. \nThis format is intentional. The reader who is planning to employ acertain strategy \nthat can be established with either puts or calls (abear spread, for example) should \nfamiliarize himself with both applications by asimultaneous review of the call chap\nter and its analogous put chapter. \nThe combination strategies generally introduced new concepts to the reader. \nThe combination allows the construction of positions that are attractive with either \nputs or calls (out-of-the-money calendar spreads, for example) to be combined into \none position. The four combination strategies that involve selling short-term options \nand simultaneously buying longer-term options are complex, but are most attractive \nin that they have the desirable features of limited risk and large potential profits.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:402", "doc_id": "a234875bc0981cf2bfa8072f8d042e659d4c286d4ab90db5bad940b73cb9c31c", "chunk_index": 0}
{"text": "CHAPTER 25 \nLEAPS \nIn an attempt to provide customers with abroader range of derivative products, the \noptions exchanges introduced LEAPS. This chapter does afair amount of reviewing \nbasic option facts in order to explain the concepts behind LEAPS. The reader who \nhas aknowledge of the preceding chapters and therefore does not need the review \nwill be able to quickly skim through this chapter and pick out the strategically impor\ntant points. However, if one encounters concepts here that don'tseem familiar, he \nshould review the earlier chapter that discusses the pertinent strategy. \nThe term LEAPS is aname for \"long-term option.\" A LEAPS is nothing more \nthan alisted call or put option that is issued with two or more years of time remain\ning. It is alonger-term option than we are used to dealing with. Other than that, there \nis no material difference between LEAPS and the other calls and puts that have been \ndiscussed in the previous chapters. \nLEAPS options were first introduced by the CBOE in October 1990, and were \noffered on ahandful of blue-chip stocks. Their attractiveness spurred listings on \nmany underlying stocks on all option exchanges as well as on several indices. (Index \noptions are covered in alater section of the book.) \nStrategies involving long-term options are not substantially different from those \ninvolving shorter-term options. However, the fact that the option has so much time \nremaining seems to favor the buyer and be adetriment to the seller. This is one rea\nson why LEAPS have been popular. As astrategist, one knows that the length of time \nremaining has little to do with whether acertain strategy makes sense or not. Rather, \nit is the relative value of the option that dictates strategy. If an option is overpriced, \nit is aviable candidate for selling, whether it has two years of life remaining or two \nmonths. Obviously, follow-up action may become much more of anecessity during \nthe life of atwo-year option; that matter is discussed later in this chapter. \n361", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:403", "doc_id": "d92c2015f15b9d185860aa02693d62d1ff3a0c00405bb398228f8c52e29d6d53", "chunk_index": 0}
{"text": "368 Part Ill: Put Option Strategies \nTHE BASICS \nCertain facets of LEAPS are the same as for other listed equity options, while others \ninvolve slight differences. The amount of standardization is considerably less, which \nmakes the simple process of quoting LEAPS abit more tedious. LEAPS are listed \noptions that can be traded in asecondary market or can be exercised before expira\ntion. As with other listed equity options, they do not receive the dividend paid by the \nunderlying common stock. \nRecall that four specifications uniquely describe any option contract: \n1. the type (put or call), \n2. the underlying stock name (and symbol), \n3. the expiration date, and \n4. the striking price. \nType. LEAPS are puts or calls. The LEAPS owner has the right to buy the stock at \nthe striking price (LEAPS call) or sell it there (LEAPS put). This is exactly the same \nfor LEAPS and for regular equity options. \nUnderlying Stock and Quote Symbol. The underlying stocks are the \nsame for LEAPS as they are for equity options. The base symbol in an option quote \nis the part that designates the underlying stock. For equity options, the base symbol \nis the same as the stock symbol. However, until the Option Price Reporting Authority \n( OPRA) changes the way that all options are quoted, the base symbols for LEAPS are \nnot the same as the stock symbols. For example, LEAPS options on stock XYZ might \ntrade under the base symbol WXY; so it is possible that one stock might have listed \noptions trading with different base symbols even though all the symbols refer to the \nsame underlying stock. Check with your broker to determine the LEAPS symbol if \nyou need to know it. \nExpiration Date. LEAPS expire on the Saturday following the third Friday of \nthe expiration month, just as equity options do. One must look in the newspaper, ask \nhis broker, or check the Internet (www.cboe.com) to determine what the expiration \nmonths are, however, since they are also not completely standardized. When LEAPS \nwere first listed, there were differing expiration months through December 1993. At \nthe current time, LEAPS are issued to expire in January of each year, so some \nattempt is being made at standardization. However, there is no guarantee that vary\ning expiration months won'treappear at some future time.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:404", "doc_id": "92b6be09efdda7170e7917d0e9fda15d050d362bdd65843a13a8a1cbf4d3b8c6", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 369 \nStriking Price. There is no standardized striking price interval for LEAPS as \nthere is for equity options. If XYZ is a 95-dollar stock, there might be LEAPS with \nstriking prices of 80, 95, and 105. Again, one must look in the newspaper, ask his bro\nker, or check the Internet (www.cboe.com) to determine the actual LEAPS striking \nprices for any specific underlying stock. New striking prices can be introduced when \nthe underlying stock rises or falls too far. For example, if the lowest strike for XYZ \nwere 80 and the stock fell to 80, anew LEAPS strike of 70 might be introduced. \nOther Basic Factors. LEAPS may be exercised at any time during their life, \njust as is the case with equity options. Note that this statement regarding exercise is \nnot necessarily true for Index LEAPS or Index Options. See Part Vof this book for \ndiscussions of index products. \nStandard LEAPS contracts are for 100 shares of the underlying stock, just as \nequity options are. The number of shares would be adjusted for stock splits and stock \ndividends (leading to even more arcane LEAPS symbol problems). LEAPS are quot\ned on aper-share basis, as are other listed options. \nThere are position and exercise limits for LEAPS just as there are for other list\ned options. One must add his LEAPS position and his regular equity option position \ntogether in order to determine his entire position quantity. Exemptions may be \nobtained for bona fide hedgers of common stock. \nAs time passes, LEAPS eventually have less than 9 months remaining until expi\nration. When such atime is reached, the LEAPS are \"renamed\" and become ordi\nnary equity options on the underlying security. \nExample: Assume LEAPS on stock XYZ were initially issued to expire two years \nhence. Assume that one of these LEAPS is the XYZ January 90; that is, it has astrik\ning price of 90 and expires in January, two years from now. Its symbol is WXYAR \n(WXY being the LEAPS base symbol assigned by the exchange where XYZ is traded, \nAfor January, and Rfor 90). \nFifteen months later, the January LEAPS only have 9 months of life remaining. \nThe LEAPS symbol would be changed from WXYAR to XYZAR (aregular equity \noption), and the quotes would be listed in the regular equity option section of the \nnewspaper instead of in the LEAPS section. \nPRICING LEAPS \nTerms such as in-the-money, out-of-the-money, intrinsic value, time value premium, \nand parity all apply and have the same definitions. The factors influencing the prices \nof LEAPS are the same as those for any other option:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:405", "doc_id": "6195df1f692924af257c3bb95fdb5dff7b1bfce04fd86a5caa2ce076bb166d24", "chunk_index": 0}
{"text": "370 Part Ill: Put Option Strategies \n1. underlying stock price, \n2. striking price, \n3. time remaining, \n4. volatility, \n5. risk-free interest rate, and \n6. dividend rate. \nThe relative influence of these factors may be alittle more pronounced for \nLEAPS than it is for shorter-term equity options. Consequently, the trader may think \nthat a LEAPS is overly expensive or cheap by inspection, when in reality it is not. One \nshould be careful in his evaluation of LEAPS until he has acquired experience in \nobserving how their prices relate to the shorter-tenn equity options with which he is \nexperienced. \nIt might prove useful to reexamine the option pricing curve with some LEAPS \nincluded. Please refer to Figure 25-1 for the pricing curves of several options. As \nalways, the solid intrinsic value line is the bottom line; it is the same for any call \noption. The curves are all drawn with the same values for the pertinent variables: \nstock price, striking price, volatility, short-term interest rate, and dividends. Thus, \nthey can be compared directly. \nThe most obvious thing to notice about the curves in Figure 25-1 is that the \ncurve depicting the 2-year LEAPS is quite flat. It has the general shape of the \nshorter-term curves, but there is so much time value at stock prices even 25% in\nor out-of-the-money, that the 2-year curve is much flatter than the others. \nOther observations can be made as well. Notice the at-the-money options: The \n2-year LEAPS sells for alittle more than four times the 3-month option. As we shall \nsee, this can change with the effects of interest rates and dividends, but it confirms \nsomething that was demonstrated earlier: Time decay is not linear. Thus, the 2-year \nLEAPS, which has eight times the amount of time remaining as compared to the 3-\nmonth call, only sells for about four times as much. This LEAPS might appear cheap \nto the casual observer, but remember that these graphs depict the fair values for this \nset of input parameters. Do not be deluded into thinking that a LEAPS looks cheap \nmerely by comparing its price to anearer-term option; use amodel to evaluate it, or \nat least use the output of someone else'smodel. \nThe curves in Figure 25-1 depict the relationships between stock price, striking \nprice, and time remaining. The most important remaining determinant of an option'sprice is the volatility of the underlying stock. Changes in volatility can greatly change \nthe price of any option. This is especially true for LEAPS, since along-term option'sprice will fluctuate greatly when volatility changes only alittle. Some observations on \nthe differing effects that volatility changes have on short- and long-term options are \npresented later.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:406", "doc_id": "b60b8b0281ec565fbb2e8b6c1191d1c273ea6759ef829a613f40890dbaa2c84e", "chunk_index": 0}
{"text": "Chapter 25: LEAPS \nFIGURE 25-1. \nLEAPS call pricing curve. \n45 \n40 \n35 \nQ) 30 .go. 25 \n'lii U 20 \n15 \n10 \n5 \n, .... ,, \nVarious Expiration Dates \nStrike= 80 \n2 Years (LEAP) , ' \n' ,,,,' \n,, ,, \n,, ,, ,, \n\"' ,, ,, ,, ,, \n,,' ,, \n,. ,, ,, \n0 L----~==--..l.---..J£----1.---L----.I....--\n60 70 80 90 100 110 \nStock Price \n371 \nBefore that discussion, however, it may be beneficial to examine the effects that \ninterest rates and dividends can have on LEAPS. These effects are much, much \ngreater than those on conventional equity options. Recall that it was stated that inter\nest rates and dividends are minor determinants in the price of an option, unless the \ndividends were large. That statement pertains mostly to short-term options. For \nlonger-term options such as LEAPS, the cumulative effect of an interest rate or div\nidend over such along period of time can have amagnified effect in terms of the \nabsolute price of the option. \nFigure 25-2 presents the option pricing curve again, but the only option depict\ned is a 2-year LEAPS. The striking price is 100, and the straight line at the right \ndepicts the intrinsic value of the LEAPS. The three curves represent option prices \nfor risk-free interest rates of 3%, 6%, and 9%. All other factors (time to expiration, \nvolatility, and dividends) are fixed. The difference between option prices caused \nmerely by ashift in rates of 3% is very large. \nThe difference in LEAPS prices increases as the LEAPS becomes in-the\nmoney. Note that in this figure, the distance between the curves gets wider as one \nscans them from left to right. The price difference for out-of-the-money LEAPS is \nlarge enough- nearly apoint even for options fairly far out-of-the-money (that is, the \npoints on the left-hand side of the graph). Ashift of 3% in rates causes alarger price \ndifference of over 2 points in the at-the-money, 2-year LEAPS. The largest differen\ntial in option prices occurs in-the-rrwney ! This may seem somewhat illogical, but \nwhen LEAPS strategies are examined later, the reasons for this will become clear.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:407", "doc_id": "7da72f924c1340b91c999ddba975b59748049bf535406425936222ee050592ba", "chunk_index": 0}
{"text": "Chapter 25: LEAPS \nFIGURE 25-3. \nLEAPS call pricing curve as dividends increase. \n30 \n25 \n(I) \n.g 20 \n0.. \nC: \n:g_ 15 \n0 \n10 \n5 \n0 \n70 80 90 100 \nStock Price \nWith \nCurrent \nDividend \n110 \n373 \nDividend \n)> Increases \n$1 \nT Increases \n$2 \n120 \nThe actual amount that the LEAPS calls lose in price increases slightly as the \ncall is more in-the-money. That is, the curves are closer together on the left-hand \n(out-of-the-money) side than they are on the right-hand (in-the-money) side. For the \nin-the-money call, a $1 increase in dividends over two years can cause the LEAPS to \nbe worth about 1 ½ points less in value. \nFigure 25-3 is to the same scale as Figure 25-2, so they can be compared direct\nly in terms of magnitude. Notice that the effect of a $1 increase in dividends on the \nLEAPS call prices is much smaller than that of an increase in interest rates by 3%. \nGraphically speaking, one can observe this by noting that the spaces between the \nthree curves in the previous figure are much wider than the spaces between the three \ncurves in this figure. \nFinally, note that dividend increases have the opposite effect on puts. That is, \nan increase in the dividend payout of the underlying common will cause aput to \nincrease in price. If the put is along-term LEAPS put, then the effect of the increase \nwill be even larger. \nLest one think that LEAPS are too difficult to price objectively, note the follow\ning. The prior figures of interest rate and dividend effects tend to magnify the effects \non LEAPS prices for two reasons. First, they depict the effects on 2-year LEAPS. That \nis alarge amount of life for LEAPS. Many LEAPS have less life remaining, so the \neffects would be diminished somewhat for LEAPS with 10 to 23 months of life left.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:409", "doc_id": "3a2880d1c2cbe748bf301c39a7de94bcc74dd02f3b6f0d0ab157997cf28362d2", "chunk_index": 0}
{"text": "374 Part Ill: Put Option Strategies \nSecond, the figures depict the change in rates or dividends as being instantaneous. \nThis is not completely realistic. If rates change, they will change by alittle bit at atime, \nusually¼% or½% at atime, perhaps as much as 1 %. If dividends are increased, that \nincrease may be instantaneous, but it will not likely occur immediately after the \nLEAPS are purchased or sold. However, the point that these figures are meant to con\nvey is that interest rates and dividends have amuch greater effect on LEAPS than on \nordinary shorter-term equity options, and that is certainly atrue statement. \nCOMPARING LEAPS AND SHORT-TERM OPTIONS \nTable 25-1 will help to illustrate the problem in valuing LEAPS, either mentally or \nwith amodel. All of the variables - stock price, volatility, interest rates, and dividends \n- are given in increments and the comparison is shown between 3-month equity \noptions and 2-year LEAPS. There are three sets of comparisons: for options 20% out\nof-the-money, options at-the-money, and options 20% in-the-money. \nAfew words are needed here to explain how volatility is shown in this table. \nVolatility is normally expressed as apercent. The volatility of the stock market is \nabout 15%. The table shows what would happen if volatility changed by one per\ncentage point, to 16%, for example. Of course, the table also shows what would hap\npen if the other factors changed by asmall amount. \nMost of the discrepancies between the 3-month and the 2-year options are \nlarge. For example, if volatility increases by one percentage point, the 3-month out\nof-the-money call will increase in price by only 3 cents (0.03 in the left-hand column) \nwhile the 2-year LEAPS call will increase by 43 cents. As another example, look at \nthe bottom right-hand pair of numbers, which show the effect of adividend increase \non the options that are 20% in-the-money. The assumption is that the dividend will \nincrease 25 cents this quarter (and will be 25 cents higher every quarter thereafter). \nThis translates into aloss of 14 cents for the 3-month call, since there is only one ex\ndividend period that affects this call; but it translates into aloss of 1 ½ for the 2-year \nLEAPS, since the stock will go ex-dividend by an extra $2 over the life of that call. \nTABLE 25-1. \nComparing LEAPS and Short-Term Calls. \nChange in Price of the Options \n20% out at 20% in \nVariable Increment 3-mo. 2-yr. 3-mo. 2-yr. 3-mo. 2-yr . \nStock Pre. + 1 pt . 03 .41 .54 .70 .97 .89 \nVolatility + 1% .03 .43 .21 .48 .04 .33 \nInt. Rate + 1/2% .01 .27 .08 .55 .14 .72 \nDividend + $.25/qtr 0 -.62 -.08 -1.18 -.14 -1.50", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:410", "doc_id": "46da1846825bb9e07585f62cd570d66e549bd4367f08363d2f211eb8d8853176", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 375 \nThe table also shows that only three of the discrepancies are not large. Two \ninvolve the stock price change. If the stock changes in price by 1 point, neither the at\nthe-money nor the in-the-money options behave very differently, although the at-the\nmoney LEAPS do jump by 70 cents. The observant reader will notice that the top line \nof the table depicts the delta of the options in question; it shows the change in option \nprice for aone-point change in stock price. The only other comparison that is not \nextremely divergent is that of volatility change for the at-the-money option. The 3-\nmonth call changes by 21 cents while the LEAPS changes by nearly ½ point. This is \nstill afactor of two-to-one, but is much less than the other comparisons in the table. \nStudy the other comparisons in the table. The trader who is used to dealing with \nshort-term options might ordinarily ignore the effect of arise in interest rates of ½ \nof 1 %, of a 25-cent increase in the quarterly dividend, of the volatility increasing by \namere 1 %, or maybe even of the stock moving by one point (only if his option is out\nof-the-money). The LEAPS option trader will gain or suffer substantially and imme\ndiately if any of these occur. In almost every case, his LEAPS call will gain or lose ½ \npoint of value - asignificant amount, to be sure. \nLEAPS STRATEGIES \nMany of the strategies involving LEAPS are not significantly different from their \ncounterparts that involve short-term options. However, as shown earlier, the long\nterm nature of the LEAPS can sometimes cause the strategist to experience aresult \ndifferent from that to which he has become accustomed. \nAs ageneral rule, one would want to be abuyer of LEAPS when interest rates \nwere low and when the volatilities being implied in the marketplace are low. If the \nopposite were true (high rates and high volatilities), he would lean toward strategies \nin which the sale of LEAPS is used. Of course, there are many other specific consid\nerations when it comes to operating astrategy, but since the long-term nature of \nLEAPS exposes one to interest rate and volatility movements for such along time, \none may as well attempt to position himself favorably with respect to those two ele\nments when he enters aposition. \nLEAPS AS STOCK SUBSTITUTE \nAny in-the-money option can be used as asubstitute for the underlying stock. Stock \nowners may be able to substitute along in-the-money call for their long stock. Short \nsellers of stock may be able to substitute along put for their short stock. This is not \nanew idea; it was discussed briefly in Chapter 3 under reasons why people buy calls. \nIt has been available as astrategy for some time with short-term options. Its attrac\ntiveness seems to have increased somewhat with the introduction of LEAPS, howev-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:411", "doc_id": "a7ffd6d9d5d0620d2f3dc91005f167d02db897e5714fca13c1c7a1db8a8f7f8e", "chunk_index": 0}
{"text": "374 Part Ill: Put Option Strategies \nSecond, the figures depict the change in rates or dividends as being instantaneous. \nThis is not completely realistic. If rates change, they will change by alittle bit at atime, \nusually¼% or ½% at atime, perhaps as much as 1 %. If dividends are increased, that \nincrease may be instantaneous, but it will not likely occur immediately after the \nLEAPS are purchased or sold. However, the point that these figures are meant to con\nvey is that interest rates and dividends have amuch greater effect on LEAPS than on \nordinary shorter-term equity options, and that is certainly atrue statement. \nCOMPARING LEAPS AND SHORT-TERM OPTIONS \nTable 25-1 will help to illustrate the problem in valuing LEAPS, either mentally or \nwith amodel. All of the variables - stock price, volatility, interest rates, and dividends \n- are given in increments and the comparison is shown between 3-month equity \noptions and 2-year LEAPS. There are three sets of comparisons: for options 20% out\nof-the-money, options at-the-money, and options 20% in-the-money. \nAfew words are needed here to explain how volatility is shown in this table. \nVolatility is normally expressed as apercent. The volatility of the stock market is \nabout 15%. The table shows what would happen if volatility changed by one per\ncentage point, to 16%, for example. Of course, the table also shows what would hap\npen if the other factors changed by asmall amount. \nMost of the discrepancies between the 3-month and the 2-year options are \nlarge. For example, if volatility increases by one percentage point, the 3-month out\nof-the-money call will increase in price by only 3 cents (0.03 in the left-hand column) \nwhile the 2-year LEAPS call will increase by 43 cents. As another example, look at \nthe bottom right-hand pair of numbers, which show the effect of adividend increase \non the options that are 20% in-the-money. The assumption is that the dividend will \nincrease 25 cents this quarter ( and will be 25 cents higher every quarter thereafter). \nThis translates into aloss of 14 cents for the 3-month call, since there is only one ex\ndividend period that affects this call; but it translates into aloss of 1 ½ for the 2-year \nLEAPS, since the stock will go ex-dividend by an extra $2 over the life of that call. \nTABLE 25-1. \nComparing LEAPS and Short-Term Calls. \nChange in Price of the Options \n20% out al 20% in \nVariable Increment 3-mo. 2-yr. 3-mo. 2-yr. 3-mo. 2-yr. \nStock Pre. + 1 pt .03 .41 .54 .70 .97 .89 \nVolatility + 1% .03 .43 .21 .48 .04 .33 \nInt. Rate + 1/2% .01 .27 .08 .55 .14 .72 \nDividend + $.25/qtr 0 -.62 -.08 - l.18 -.14 -1.50", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:412", "doc_id": "5d79664475c8f1ff9fcbe66eb43e2e2081283bcf2c4e25932068f35597539b4c", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 375 \nThe table also shows that only three of the discrepancies are not large. Two \ninvolve the stock price change. If the stock changes in price by 1 point, neither the at\nthe-money nor the in-the-money options behave very differently, although the at-the\nmoney LEAPS do jump by 70 cents. The observant reader will notice that the top line \nof the table depicts the delta of the options in question; it shows the change in option \nprice for aone-point change in stock price. The only other comparison that is not \nextremely divergent is that of volatility change for the at-the-money option. The 3-\nmonth call changes by 21 cents while the LEAPS changes by nearly ½ point. This is \nstill afactor of two-to-one, but is much less than the other comparisons in the table. \nStudy the other comparisons in the table. The trader who is used to dealing with \nshort-term options might ordinarily ignore the effect of arise in interest rates of½ \nof 1 %, of a 25-cent increase in the quarterly dividend, of the volatility increasing by \namere 1 %; or maybe even of the stock moving by one point (only if his option is out\nof-the-money). The LEAPS option trader will gain or suffer substantially and imme\ndiately if any of these occur. In almost every case, his LEAPS call will gain or lose ½ \npoint of value - asignificant amount, to be sure. \nLEAPS STRATEGIES \nMany of the strategies involving LEAPS are not significantly different from their \ncounterparts that involve short-term options. However, as shown earlier, the long\nterm nature of the LEAPS can sometimes cause the strategist to experience aresult \ndifferent from that to which he has become accustomed. \nAs ageneral rule, one would want to be abuyer of LEAPS when interest rates \nwere low and when the volatilities being implied in the marketplace are low. If the \nopposite were true (high rates and high volatilities), he would lean toward strategies \nin which the sale of LEAPS is used. Of course, there are many other specific consid\nerations when it comes to operating astrategy, but since the long-term nature of \nLEAPS exposes one to interest rate and volatility movements for such along time, \none may as well attempt to position himself favorably with respect to those two ele\nments when he enters aposition. \nLEAPS AS STOCK SUBSTITUTE \nAny in-the-money option can be used as asubstitute for the underlying stock. Stock \nowners may be able to substitute along in-the-money call for their long stock. Short \nsellers of stock may be able to substitute along put for their short stock. This is not \nanew idea; it was discussed briefly in Chapter 3 under reasons why people buy calls. \nIt has been available as astrategy for some time with short-term options. Its attrac\ntiveness seems to have increased somewhat with the introduction of LEAPS, howev-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:413", "doc_id": "47dea1c4e6e59811f26a62b6fd090fb08ecd2ce8f41af67ba67fd2bb5b3543e2", "chunk_index": 0}
{"text": "376 Part Ill: Put Option Strategies \ner. More and more people are examining the potential of selling the stock they own \nand buying long-term calls (LEAPS) as asubstitute, or buying LEAPS instead of \nmaking an initial purchase in aparticular common stock. \nSubstitution for Stock Currently Held Long. Simplistically, this strate\ngy involves this line of thinking: If one owns stock and sells it, an investor could rein\nvest asmall portion of the proceeds in acall option, thereby providing continued \nupside profit potential if the stock rises in price, and invest the rest in abank to earn \ninterest. The interest earned would act as asubstitute for the dividend, if any, to \nwhich the investor is no longer entitled. Moreover, he has less downside risk: If the \nstock should fall dramatically, his loss is limited to the initial cost of the call. \nIn actual practice, one should carefully calculate what he is getting and what he \nis giving up. For example, is the loss of the dividend too great to be compensated for \nby the investment of the excess proceeds? How much of the potential gain will be \nwasted in the form of time value premium paid for the call? The costs to the stock \nowner who decides to switch into call options as asubstitute are commissions, the \ntime value premium of the call, and the loss of dividends. The benefits are the inter\nest that can be earned from freeing up asubstantial portion of his funds, plus the fact \nthat there is less downside risk in owning the call than in owning the stock. \nExample: XYZ is selling at 50. There are one-year LEAPS with astriking price of 40 \nthat sell for $12. XYZ pays an annual dividend of $0.50 and short-term interest rates \nare 5%. What are the economics that an owner of 100 XYZ common stock must cal\nculate in order to determine whether it is viable to sell his stock and buy the one-year \nLEAPS as asubstitute? \nThe call has time value premium of 2 points (40 + 12 - 50). Moreover, if the \nstock is sold and the LEAPS purchased, acredit of $3,800 less commissions would \nbe generated. First, calculate the net credit generated: \nCredit balance generated: \nSale of 1 00 XYZ stock \nLess stock commission \nNet sale proceeds: \nCost of one LEAPS call \nPlus option commission \nNet cost of call: \nTotal credit balance: \n$5,000 \n25 \n$4,975 credit \n$3,760 credit \n$1,200 \n15 \n$1,215 debit \nNow the costs and benefits of making the switch can be computed:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:414", "doc_id": "1fd8d4677e0ec49ae72f4835de03804191c39b4df4121581ee0dbc3799c4bad1", "chunk_index": 0}
{"text": "Chapter 25: LEAPS \nCosts of switching: \nTime value premium \nLoss of dividend \nStock commissions \nOption commissions \nTotal cost: \nFixed benefit from switching: \nInterest earned on \ncredit balance of $3,760 \nat 5% interest for one year= 0.05 x $3,760: \nNet cost of switching: \n317 \n-$200 \n-$ 50 \n-$ 25 \n- .l__Ll_ \n-$290 \n+ $188 \n- $102 \nThe stock owner must now decide if it is worth just over $1 per share in order \nto have his downside risk limited to aprice of 39½ over the next year. The price of \n39½ as his downside risk is merely the amount of the net credit he received from \ndoing the switch ($3,760) plus the interest earned ($188), expressed in per-share \nterms. That is, if XYZ falls dramatically over the next year and the LEAPS expires \nworthless, this investor will still have $3,948 in abank account. That is equivalent to \nlimiting his risk to about 39½ on the original 100 shares. \nIf the investor decides to make the substitution, he should invest the proceeds \nfrom the sale in a 1-year CD or Treasury bill, for two reasons. First, he locks in the \ncurrent rate - the one used in his calculations - for the year. Second, he is not tempt\ned to use the money for something else, an action that might negate the potential \nbenefits of the substitution. \nThe above calculations all assume that the LEAPS call or the stock would have \nbeen held for the full year. If that is known not to be the case, the appropriate costs \nor benefits must be recalculated. \nCaveats. This ($102) seems like areasonably small price to pay to make the switch \nfrom common stock to call ownership. However, if the investor were planning to sell \nthe stock before it fell to 39½ in any case, he might not feel the need to pay for this \nprotection. (Be aware, however, that he could accomplish essentially the same thing, \nsince he can sell his LEAPS call whenever he wants to.) Moreover, when the year is \nup, he will have to pay another stock commission to repurchase his XYZ common if \nhe still wants to own it ( or he will have to pay two option commissions to roll his long \ncall out to alater expiration date). One other detriment that might exist, although arelatively unlikely one, is that the underlying common might declare an increased \ndividend or, even worse, aspecial cash dividend. The LEAPS call owner would not \nbe entitled to that dividend increase in whatever form, while, obviously, the common", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:415", "doc_id": "7d02f4041ff5e0b1bbf305979648201fe313b68df06d19f989cd6b8d4b35c361", "chunk_index": 0}
{"text": "378 Part Ill: Put Option Strategies \nstock owner would have been. If the company declared astock dividend, it would \nhave no effect on this strategy since the call owner is entitled to those. Achange in \ninterest rates is not afactor either, since the owner of the LEAPS should invest in a \n1-year Treasury bill or a 1-year CD and therefore would not be subject to interim \nchanges in short-term interest rates. \nThere may be other mitigating circumstances. Mostly these would involve tax \nconsiderations. If the stock is currently aprofitable investment, the sale would gen\nerate acapital gain, and taxes might be owed. If the stock is currently being held at \naloss, the purchase of the call would constitute awash sale and the loss could not be \ntaken at this time. (See Chapter 41 on taxes for abroader discussion of the wash sale \nrule and option trading.) \nIn tl1eory, the calculations above could produce an overall credit, in which case the \nstockholder W(?uld normally want to substitute with the call, unless he has overriding tax \nconsiderations or suspects that acash dividend increase is going to be announced. Be \nvery careful about switching if this situation should arise. Normally, arbitrageurs - per\nsons trading for exchange members and paying no commission - would take advantage \nof such asituation before the general public could. If they are letting the opportunity \npass by, there must be areason (probably the cash dividend), so be extremely certain of \nyour economics and research before venturing into such asituation. \nIn summary, holders of common stock on which there exist in-the-money \nLEAPS should evaluate the economics of substituting the LEAPS call for the com\nmon stock. Even if arithmetic calculations call for the substitution, the stockholder \nshould consider his tax situation as well as his outlook for the cash dividends to be \npaid by the common before making the switch. \nBUYING LEAPS AS THE INITIAL PURCHASE \nINSTEAD OF BUYING A COMMON STOCK \nLogic similar to that used earlier to determine whether astockholder might want to \nsubstitute a LEAPS call for his stock can be used by aprospective purchaser of com\nmon stock. In other words, this investor does not already own the common. He is \ngoing to buy it. This prospective purchaser might want to buy a LEAPS call and put \nthe rest of the money he had planned to use in the bank, instead of actually buying \nthe stock itself. \nHis costs - real and opportunity - are calculated in asimilar manner to those \nexpressed earlier. The only real difference is that he has to spend the stock commis\nsion in this case, whereas he did not in the previous example (since he already owned \nthe stock).", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:416", "doc_id": "f091eb14efcf5df1bbbe6d2d43d86f7d8f29f3a08df04f48bc103e5fa819eb8a", "chunk_index": 0}
{"text": "380 Part Ill: Put Option Strategies \nUsing Margin. The same prospective initial purchaser of common stock might \nhave been contemplating the purchase of the stock on margin. If he used the LEAPS \ninstead, he could save the margin interest. Of course, he wouldn'thave as much \nmoney to put in the bank, but he should also compare his costs against those of buy\ning the LEAPS call instead. \nExample: As before, XYZ is selling at 50; there are 1-year LEAPS with astriking \nprice of 40 that sell for $12; XYZ pays an annual dividend of $0.50; and short-term \ninterest rates are 5%. Furthermore, assume the margin rate is 8% on borrowed debit \nbalances. \nFirst, calculate the difference in prospective investments: \nCost of buying the stock: \n$5,000 + $25 commission: \nAmount borrowed (50%) \nEquity required \nCost of buying LEAPS: \n$1,200 + $15 commission: \nDifference (available to be placed in bank account) \n$5,025 \n-2,512 \n$2,513 \n$1,215 \n$1,298 \nNow the costs and opportunities can be compared, if it is assumed that he buys \nthe LEAPS: \nCosts: \nTime value premium \nDividend loss \nSavings: \nInterest on $1,298 at 5% \nMargin interest on $2,512 debit balance at 8% for one year \nNet Savings: \n-$200 \n- 50 \n+$ 65 \n+ 201 \n+$ 16 \nFor the prospective margin buyer, there is areal savings in this example. The \nfact that he does not have to pay the margin interest on his debit balance makes the \npurchase of the LEAPS call acost-saving alternative. Finally, it should be noted that \ncurrent margin rules allow one to purchase a LEAPS option on margin. That can be \naccounted for in the above calculations as well; merely reduce the investment \nrequired and increase the margin charges on the debit balance.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:418", "doc_id": "32128dd66396da99d42dbb31bd8d49b1ee1ddd8e743a6fa4d931731df340272c", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 381 \nIn summary, aprospective purchaser of common stock may often find that if \nthere is an in-the-money option available, the purchase of that option is more attrac\ntive than buying the common stock itself. If he were planning to buy on margin, it is \neven more likely that the LEAPS purchase will be attractive. The main drawback is \nthat he will not participate if cash dividends are increased or aspecial dividend is \ndeclared. Read on, however, because the next strategy may be better than the one \nabove. \nPROTECTING EXISTING STOCK HOLDINGS WITH LEAPS PUTS \nWhat was accomplished in the substitution strategy previously discussed? The stock \nowner paid some cost ($102 in the actual example) in order to limit the risk of his \nstock ownership to aprice of 39½. What if he had bought a LEAPS put instead? \nForgetting the price of the put for amoment, concentrate on what the strategy would \naccomplish. He would be protected from alarge loss on the downside since he owns \nthe put, and he could participate in upside appreciation since he still owns the stock. \nIsn'tthis what the substitution strategy was trying to accomplish? Yes, it is. In this \nstrategy, only one commission is paid- that being on afairly cheap out-of-the-money \nLEAPS put - and there is no risk of losing out on dividend increases or special divi\ndends. \nThe comparison between substituting acall or buying aput is arelatively sim\nple one. First, do the calculations as they were performed in the initial example \nabove. That example showed that the stockholder'scost would be $102 to substitute \nthe LEAPS call for the stock, and such asubstitution would protect him at aprice of \n39½. In effect, he is paying $152 for a LEAPS put with astrike of 40- the $102 cost \nplus the difference between 40 and the 39½ protection price. Now, if an XYZ 1-year \nLEAPS put with strike 40 were available at 1 ½, he could accomplish everything he \nhad initially wanted merely by buying the put. \nMoreover, he would save commissions and still be in aposition to participate \nin increased cash dividends. These additional benefits should make the put worth \neven more to the stockholder, so that he might pay even slightly more than 1 ½ for \nthe put. If the LEAPS put were available at this price, it would clearly be the bet\nter choice and should be bought instead of substituting the LEAPS call for the com\nmon stock. \nThus, any stockholder who is thinking of protecting his position can do it in one \nof two ways: Sell the stock and substitute acall, or continue to hold his stock and buy \naput to protect it. LEAPS calls and puts are amenable to this strategy. Because of \nthe LEAPS' long-term nature, one does not have to keep reestablishing his position \nand pay numerous commissions, as he would with short-term options. The stock\nholder should perform the simple calculations as shown above in order to decide", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:419", "doc_id": "3d07d5a93a80bdf4dfbd0c211152aea0c7789551a2a1cecf0dc0e82197f77da2", "chunk_index": 0}
{"text": "382 Part Ill: Put Option Strategies \nwhether the move is feasible at all, and if it is, whether to use the call substitution \nstrategy or the put protection strategy. \nLEAPS INSTEAD OF SHORT STOCK \nJust as in-the-money LEAPS calls may sometimes be asmarter purchase than the \nstock itself, in-the-money puts may sometimes be abetter purchase than shorting the \ncommon stock. Recall that either the put purchase or the short sale of stock is abear\nish strategy, generally implemented by someone who expects the stock to decline in \nprice. The strategist knows, however, that short stock is acomponent of many strate\ngies and might reflect other opinions than pure bearishness on the common. In any \ncase, an in-the-money put may prove to be aviable substitute for shorting the stock \nitself. The two main advantages that the put owner has are that he has limited risk \n(whereas the short seller of stock has theoretically unlimited risk); and he does not \nhave to pay out any dividends on the underlying stock as the short seller would. Also, \nthe commissions for buying the put would normally be smaller than those required \nto sell the stock short. \nThere is not much in the way of calculating that needs to be done in order to \nmake the comparison between buying the in-the-money put and shorting the stock. \nIf the time value premium spent is small in comparison \\vith the dividend payout that \nis saved, then the put is probably the better choice. \nProfessional arbitrageurs and other exchange members, as well as some large \ncustomers, receive interest on their short sales. For these traders, the put would have \nto be trading with virtually no time premium at all in order for the comparison to \nfavor the put purchase over the stock short sale. However, the public customer who \nis going to be shorting stock should be aware of the potential for buying an in-the\nmoney put instead. \nSPECULATIVE OPTION BUYING WITH LEAPS \nStrategists know that buying calls and puts can have various applications; witness the \nstock substitution strntegies above. However, the most popular reason for buying \noptions is for speculative gain. The leverage inherent in owning options and their lim\nited risk feature make them attractive for this purpose as well. The risk, of course, \ncan be 100% of the investment, and time decay works against the option owner as \nwell. LEAPS calls and puts fit all of these descriptions; they simply have longer matu\nrities. \nTime decay is the major enemy of the speculative option holder. Purchasing \nLEAPS options instead of the shorter-term equity options generally exposes the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:420", "doc_id": "62515840e6b4db7c52358e1877c265da348e27d102538bd8e01f1c786a51bdad", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 383 \nbuyer to less risk of time decay on adaily basis. This is true because the extreme neg\native effects of time decay magnify as the option approaches its expiration. Recall that \nit was shown in Chapter 3 that time decay is not linear: An option decays more rap\nidly at the end of its life than at the beginning. Eventually, a LEAPS put or call will \nbecome anormal short-term equity option and time will begin to take amore rapid \ntoll. But in the beginning of the life of LEAPS, there is so much time remaining that \nthe short-term decay is not large in terms of price. \nTable 25-2 and Figure 25-4 depict the rate of decay of two options: one is at\nthe-money (the lower curve) and the other is 20% out-of-the-money (the upper \ncurve). The horizontal axis is months of life remaining until expiration. The vertical \naxis is the percent of the option price that is lost daily due to time decay. The options \nthat qualify as LEAPS are ones with more than 9 months oflife remaining, and would \nthus be the ones on the lower right-hand part of the graph. \nThe upward-sloping nature of both curves as time to expiration wanes shows \nthat time decay increases more rapidly as expiration approaches. Notice how much \nmore rapidly the out-of-the-money option decays, percentagewise, than the at-the\nmoney. LEAPS, however, do not decay much at all compared to normal equity \noptions. Most LEAPS, even the out-of-the-money ones, lose less than¼ of one per\ncent of their value daily. This is apittance when compared with a 6-month equity \noption that is 20% out-of-the-money- that option loses well over 1 % of its value daily \nand it still has 6 months of life remaining. \nFrom the accompanying table, observe that the out-of-the-money 2-month \noption loses over 4% of its value daily! \nThus, LEAPS do not decay at arapid rate. This gives the LEAPS holder achance to have his opinion about the stock price work for him without having to \nworry as much about the passage of time as the average equity option holder would. \nAn advantage of owning LEAPS, therefore, is that one'stiming of the option pur\nchase does not have to be as exact as that for shorter-term option buying. This can be \nagreat psychological advantage as well as astrategic advantage. The LEAPS option \nbuyer who feels strongly that the stock will move in the desired direction has the lux\nury of being able to wait calmly for the anticipated move to take place. If it does not, \neven in perhaps as long as 6 months' time, he may still be able to recoup areason\nable portion of his initial purchase price because of the slow percentage rate of decay. \nDo not be deluded into believing that LEAPS don'tdecay at all. Although the \nrate of decay is slow (as shown previously), an option that is losing 0.15% of its value \ndaily will still lose about 25% of its value in six months. \nExample: XYZ is at 60 and there are 18-month LEAPS calls selling for $8, with astriking price of 60. The daily decay of this call with respect to time will be minus-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:421", "doc_id": "f50409ba21cf2d082c8f03d358f3a1fa3160f0cf1b6efe12870f6598e2b60329", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 385 \nThose familiar with holding equity calls and puts are more accustomed to seeing \nan option lose 25% of its value in possibly as little as four or five weeks' time. Thus, the \nadvantage of holding the LEAPS is obvious from the viewpoint of slower time decay. \nThis observation leads to the obvious question: \"When is the best time to sell my \ncall and repurchase alonger-term one?\" Referring again to the figure above may help \nanswer the question. Note that for the at-the-money option, the curve begins to bend \ndramatically upward soon after the 6-month time barrier is passed. Thus, it seems log\nical that to minimize the effects of time decay, all other things being equal, one would \nsell his long at-the-money call when it has about 6 months of life left and simultane\nously buy a 2-year LEAPS call. This keeps his time decay exposure to a. minimum. \nThe out-of-the-money call is more radical. Figure 25-4 shows that the call that \nis 20% out-of-the-money begins to decay much more rapidly (percentagewise) at \nsometime just before it reaches one year until expiration. The same logic would dic\ntate, then, that if one is trading out-of-the-money options, he would sell his option \nheld long when it has about one year to go and reestablish his position by buying a 2-\nyear LEAPS option at the same time. \nADVANTAGES OF BUYING HCHEAP\" \nIt has been demonstrated that rising interest rates or rising volatility would make the \nprice of a LEAPS call increase. Therefore, if one is attempting to participate in \nLEAPS speculative call buying strategies, he should be more aggressive when rates \nand volatilities are low. \nAfew sample prices may help to demonstrate just how powerful the effects of \nrates and volatilities are, and how they can be afriend to the LEAPS call buyer. Suppose \nthat one buys a 2-year LEAPS call at-the-money when the following situation exists: \nXYZ: 100 \nJanuary 2-year LEAPS call with strike of 100: 14 \nShort-term interest rates: 3% \nVolatility: below average (historically) \nFor the purposes of demonstration, suppose that the current volatility is low for XYZ \n(historically) and that 3% is alow level for rates as well. If the stock moves up, there \nis no problem, because the LEAPS call will increase in price. But what if the stock \ndrops or stays unchanged? Is all hope of aprofit lost? Actually, no. If interest rates \nincrease or the volatility that the calls trade at increases, we know the LEAPS call will \nincrease in value as well. Thus, even though the direction in which the stock is mov\ning may be unfavorable, it might still be possible to salvage one'sinvestment. Table \n25-3 shows where volatility would have to be or where short-term rates would have", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:423", "doc_id": "be320a431189ef3cbef4810319284fe4da592a0f1e6ecc2c0ebef1d7c5bc1dc3", "chunk_index": 0}
{"text": "386 Part Ill: Put Option Strategies \nTABLE 25-3. \nFactors necessary for January 2-year LEAPS to be = 14. \nStock price After lmonth \n100 (unchanged) r = 3 .4% or \nV + 5% \n95 \n90 \nr = 6% or \nV + 20% \nr = 8.5% or \nV + 45% \nAfter 6 months \nr = 6% or \nV + 20% \nr = 9.4% or \nV + 45% \nr = 12.6% or \nV + 70% \nto go in order to keep the value of the LEAPS call at 14 even after the indicated \namount of time had expired. \nTo demonstrate the use of this table, suppose the stock price were 100 \n(unchanged) after one month. If interest rates had 1isen to 3.4% from their original \nlevel of 3% during that time, the call would still be worth 14 even though one month \nhad passed. Alternatively, if rates were the same, but volatility had increased by only \n5% from its original level, then the call would also still be worth 14. Note that this \nmeans that volatility would have to increase only slightly (by ½oth) from its original \nlevel, not by 5 percentage points. \nEven if the stock were to drop to 90 and six months had passed, the LEAPS call \nholder would still be even if rates had iisen to 12.6% (highly unlikely) or volatility had \nrisen by 70%. It is often possible for volatilities to fluctuate to that extent in six \nmonths, but not likely for interest rates. \nIn fact, as interest rates go, only the top line of the table probably represents \nrealistic interest rates; an increase of 0.4% in one month, or 3% in 6 months, is pos\nsible. The other lines, where the stock drops in price, probably require too large ajump in rates for rates alone to be able to salvage the call price. However, any \nincrease in rates will be helpful. Volatility is another matter. It is often feasible for \nvolatilities to change by as much as 50% from their previous level in amonth, and \ncertainly in six months. Hence, as has been stated before, the volatility factor is the \nmore dominant one. \nThis table shows the effect of rising interest rates and volatilities on LEAPS \ncalls. It would be beneficial to the LEAPS call owner and, of course, detrimental to \nthe LEAPS call seller. This is clear evidence that one should be aware of the gener\nal level of rates and volatility before using LEAPS options in astrategy.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:424", "doc_id": "3f93aed615e692d4aff9ca64d5be6464233d0759a8ada7bfeb29af2d54b5c11e", "chunk_index": 0}
{"text": "Chapter 25: LEAPS \nTHE DELTA \n387 \nThe delta of an option is the amount by which the option price will change if the \nunderlying stock changes in price by one point. In an earlier section of this chapter, \ncomparing the differences between LEAPS and short-term calls, mention was made \nof delta. The subject is explored in more depth here because it is such an important \nconcept, not only for option buyers, but for most strategic decisions as well. \nFigure 25-5 depicts the deltas of two different options: 2-year LEAPS and 3-\nmonth equity options. Their terms are the same except for their expiration dates; strik\ning price is 100, and volatility and interest rate assumptions are equal. The horizontal \naxis displays the stock price while the vertical axis shows the delta of the options. \nSeveral relevant observations can be made. First, notice that the delta of the at\nthe-money LEAPS is very large, nearly 0.70. This means that the LEAPS call will \nmove much more in line with the common stock than acomparable short-term equi\nty option would. Very short-term at-the-money options have deltas of about½, while \nslightly longer-term ones have deltas ranging up to the 0.55 to 0.60 area. What this \nimplies is that the longer the life of an at-the-nwney option, the greater its delta. \nIn addition, the figure shows that the deltas of the 3-month call and the 2-year \nLEAPS call are about equal when the options a~eapproximately 5% in-the-money. If \nthe options are more in-the-money than that, then the LEAPS call has alower delta. \nThis means that at- and out-of-the-money LEAPS will move more in line with the \ncommon stock than comparable short-term options will. Restated, the LEAPS calls \nwill move faster than the ordinary short-term equity calls unless both options are \nmore than 5% in-the-money. Note that the movement referred to is in absolute terms \nin change of price, not in percentage terms. \nThe delta of the 2-year LEAPS does not change as dramatically when the \nstock moves as does the delta of the 3-month option (see Figure 25-5). Notice that \nthe LEAPS curve is relatively flat on the chart, rising only slightly above horizon\ntal. In contrast, the delta of the 3-month call is very low out-of-the-money and very \nlarge in-the-money. What this means to the call buyer is that the amount by which \nhe can expect the LEAPS call to increase or decrease in price is somewhat stable. \nThis can affect his choice of whether to buy the in-the-money call or the out-of\nthe-money call. With normal short-term options, he can expect the in-the-money \ncall to much more closely mirror the movement in the stock, so he might be tempt\ned to buy that call if he expects asmall movement in the stock. With LEAPS, how\never, there is much less discrepancy in the amount of option price movement that \nwill occur.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:425", "doc_id": "b470a456c27bf3115203931cb7574114cded68ec4f6c9811ca08729281320440", "chunk_index": 0}
{"text": "388 Part Ill: Put Option Strategies \nFIGURE 25·5. \nCall delta comparison, 2-year LEAPS versus 3-month equity options. \n90 \n80 \n70 \n8 60 ,... \nX \n.l!l 50 \nQ) \n0 40 \n30 t= 3 months \n20 \n10 \nO 70 80 90 100 110 120 130 \nStock Price \nExample: XYZ is trading at 82. There are 3-month calls with strikes of 80 and 90, and \nthere are 2-year LEAPS calls at those strikes as well. The following table summarizes \nthe available information: \nXYZ: 82 Date: January, 2002 \nOption Price Delta \nApril ('02) 80 call 4 s/a \nApril ('02) 90 call i/a \nJanuary ('04) 80 LEAPS call 14 3/4 \nJanuary ('04) 90 LEAPS call 7 1/2 \nSuppose the trader expects a 3-point move by the underlying common stock, from 82 \nto 85. If he were analyzing short-term calls, he would see his potential as again of 17/sin the April 80 call versus again of 3/sin the April 90 call. Each of these gains is pro\njected by multiplying the call'sdelta times 3 (the expected stock move, in points). \nThus, there is alarge difference between the expected gains from these two options, \nparticularly after commissions are considered. \nNow observe the LEAPS. The January 80 would increase by 2¼ while the \nJanuary 90 would increase by 1 ½ if XYZ moved higher by 3 points. This is not near\nly as large adiscrepancy as the short-term options had. Observe that the January 90 \nLEAPS sells for half the price of the January 80. These movements projected by the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:426", "doc_id": "33da2b06cd8404f3390f9ee337f2281a6cbf8c3b0838bd83e168826615259b9b", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 389 \ndelta indicate that the January 90 LEAPS will move by alarger percentage than the \nJanuary 80 and therefore would be the better buy. \nPUT DELTAS \nMany of the previous observations regarding deltas of LEAPS calls can be applied to \nLEAPS puts as well. However, Figure 25-5 changes alittle when the following for\nmula is applied. Recall that the relationship between put deltas and call deltas, except \nfor deeply in-the-money puts, is: \nPut delta = Call delta - 1 \nThis has the effect of inverting the relationships that have just been described. \nIn other words, while the short-term calls didn'tmove as fast as the LEAPS, the \nshort-term puts move Jaster than the LEAPS puts in most cases. Figure 25-6 shows \nthe deltas of these options. \nThe vertical axis shows the puts' delta. Notice that out-of-the-money LEAPS \nputs and short-term equity puts don'tbehave very differently in terms of price \nchange (bottom right-hand section of figure). \nIn-the-money puts (when the stock is below the striking price) move faster if \nthey are shorter-term. This fact is accentuated even more when the puts are more \ndeeply in-the-money. The left-hand side of the figure depicts this fact. \nFIGURE 25-6. \nPut delta comparison, 2-year LEAPS versus 3-month equity options. \n90 \n80 \n70 t= 3 months \n0 60 \n0 \n1 50 \nX \nJg 40 \nQ) \n0 \n30 \n20 \n10 \nO 70 80 90 100 110 120 130 \nStock Price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:427", "doc_id": "cf6de49cbdcbe1929b86cf9ce8b68f900d4d3e4517c8e47cd926d1b098546e49", "chunk_index": 0}
{"text": "388 Part Ill: Put Option Strategies \nFIGURE 25-5. \nCall delta comparison, 2-year LEAPS versus 3-month equity options. \n90 \n80 \n70 \ng 60 \n; 50 \n~ \nO 40 \n30 t= 3 months \n20 \n10 \nO 70 80 90 100 110 120 130 \nStock Price \nExample: XYZ is trading at 82. There are 3-month calls with strikes of 80 and 90, and \nthere are 2-year LEAPS calls at those strikes as well. The following table summarizes \nthe available information: \nXYZ: 82 Date: January, 2002 \nOption Price Delta \nApril ('02) 80 call 4 s/a \nApril ('02) 90 call 1 i/s \nJanuary ('04) 80 LEAPS call 14 3/4 \nJanuary ('04) 90 LEAPS call 7 1/2 \nSuppose the trader expects a 3-point move by the underlying common stock, from 82 \nto 85. Ifhe were analyzing short-term calls, he would see his potential as again of F/sin the April 80 call versus again of 3/sin the April 90 call. Each of these gains is pro\njected by multiplying the call'sdelta times 3 (the expected stock move, in points). \nThus, there is alarge difference behveen the expected gains from these two options, \nparticularly after commissions are considered. \nNow observe the LEAPS. The January 80 would increase by 2¼ while the \nJanuary 90 would increase by 1 ½ if XYZ moved higher by 3 points. This is not near\nly as large adiscrepancy as the short-term options had. Observe that the January 90 \nLEAPS sells for half the price of the January 80. These movements projected by the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:428", "doc_id": "bc02e7273b20d2217a758255ccc6964f56addba2a52e96e0f3d758b739949795", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 389 \ndelta indicate that the January 90 LEAPS will move by alarger percentage than the \nJanuary 80 and therefore would be the better buy. \nPUT DELTAS \nMany of the previous observations regarding deltas of LEAPS calls can be applied to \nLEAPS puts as well. However, Figure 25-5 changes alittle when the following for\nmula is applied. Recall that the relationship between put deltas and call deltas, except \nfor deeply in-the-money puts, is: \nPut delta = Call delta - 1 \nThis has the effect of inverting the relationships that have just been described. \nIn other words, while the short-term calls didn'tmove as fast as the LEAPS, the \nshort-term puts nwve fa,ster than the LEAPS puts in nwst cases. Figure 25-6 shows \nthe deltas of these options. \nThe vertical axis shows the puts' delta. Notice that out-of-the-money LEAPS \nputs and short-term equity puts don'tbehave very differently in terms of price \nchange (bottom right-hand section offigure). \nIn-the-money puts (when the stock is below the striking price) move faster if \nthey are shorter-term. This fact is accentuated even more when the puts are more \ndeeply in-the-money. The left-hand side of the figure depicts this fact. \nFIGURE 25-6. \nPut delta comparison, 2-year LEAPS versus 3-month equity options. \n90 \n80 \n70 t= 3 months \n0 60 \n0 \n1 50 \nX \nJg 40 \nQ) \n0 \n30 \n20 \n10 \nO 70 80 90 100 110 120 130 \nStock Price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:429", "doc_id": "35af36520ea78ddf0c8e3c5dbe9a4bf10779f3bf6d3f92c96e09636a9dd8382c", "chunk_index": 0}
{"text": "390 Part Ill: Put Option Strategies \nThe LEAPS put delta curve is flat, just as the call delta curve was. Moreover, \nthe delta is not very large anywhere across the figure. For example, at-the-money 2-\nyear LEAPS puts move only about 30 cents for aone-point move in the underlying \nstock. LEAPS put buyers who want to speculate on astock'sdownward movement \nmust realize that the leverage factor is not large; it takes approximately a 3-point \nmove by the underlying common for an at-the-money LEAPS put to increase in \nvalue by one point. Long-term puts don'tmirror stock movement nearly as well as \nshorter-term puts do. \nIn summary, the option buyer who is considering buying LEAPS puts or calls as \nspeculation should be aware of the different price action that LEAPS exhibit when \ncompared to shorter-term options. Due to the large amount of time that LEAPS have \nremaining in their lives, the time decay of the LEAPS options is smaller. For this rea\nson, the LEAPS option buyer doesn'tneed to be as precise in his timing. In general, \nLEAPS calls move faster when the underlying stock moves, and LEAPS puts move \nmore slowly. Other than that, the general reasons for speculative option buying apply \nto LEAPS as well: leverage and limited risk. \nSELLING LEAPS \nStrategies involving selling LEAPS options do not differ substantially from those \ninvolving shorter-term options. The discussions in this section concentrate on the two \nmajor differences that sellers of LEAPS will notice. First, the slow rate of time decay \nof LEAPS options means that option writers who are used to sitting back and watch\ning their written options waste away will not experience the same effect with LEAPS. \nSecond, follow-up action for writing strategies usually depends on being able to buy \nback the w1itten option when it has little or no time value premium remaining. Since \nLEAPS retain time value even when substantially in- or out-of-the-money, follow-up \naction involving LEAPS may involve the repurchase of substantial amounts of time \nvalue premium. \nCOVERED WRITING \nLEAPS options can be sold against underlying stock just as short-term options can. \nNo extra collateral or investment is required to do so. The resulting position is again \none with limited profit potential, but enhanced profitability (as compared to stock \nownership), if the underlying stock remains unchanged or falls. The maximum prof\nit potential of the covered write is reached whenever the underlying stock is at or \nabove the striking price of the written option at expiration. \nThe LEAPS covered writer takes in substantial premium, in terms of price, \nwhen he sells the long-term option. He should compare the return that he could", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:430", "doc_id": "f404c405110d225b756afa770b9dac99bf0df5d19a73db69909f32a74f73314f", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 391 \nmake from the LEAPS write with returns that can be made from repeatedly writing \nshorter-term calls. Of course, there is no guarantee that he will actually be able to \nrepeat the short-term writes during the longer life of the LEAPS. \nAs an aside, the strategist who is utilizing the incremental return concept of cov\nered writing may find LEAPS call writing quite attractive. This is the strategy where\nin he has ahigher target price at which he would be willing to sell his common stock, \nand he writes calls along the way to earn an incremental return (see Chapter 2 for \ndetails). Since this type of writer is only concerned with absolute levels of premiums \nbeing brought into the account and not with things like return if exercised, he should \nutilize LEAPS calls if available, since the premiums are the largest available. \nMoreover, if the incremental return writer is currently in ashort-term call and is \ngoing to be called away, he might roll into a LEAPS call in order to retain his stock \nand take in more premium. \nThe rest of this section discusses covered writing from the more normal view\npoint of the investor who buys stock and sells acall against it in order to attain apar\nticular return. \nExample: XYZ is selling at 50. The investor is considering a 500-share covered write \nand he is unsure whether to use the 6-month call or the 2-year LEAPS. The July 50 \ncall sells for 4 and has 6 months of life remaining; the January 50 LEAPS call sells for \n8½ and has 2 years of life. Further assume that XYZ pays adividend of $0.25 per \nquarter. \nAs was done in Chapter 2, the net required investment is calculated, then the \nreturn (if exercised) is computed, and finally the downside break-even point is deter\nmined. \nStock cost (500 shares @ 50) \nPlus stock commission \nLess option premiums received \nPlus option commissions \nNet cash investment \nNet Investment Required \nJuly 50 call \n$25,000 \n+ 300 \n2,000 \n+ 50 \n$23,350 \nJanuary 50 LEAPS \n$25,000 \n+ 300 \n4,250 \n+ 100 \n$21,150 \nObviously, the LEAPS covered writer has asmaller cash investment, since he is sell\ning amore expensive call in his covered write. Note that the option premium is being \napplied against the net investment in either case, as is the normal custom when doing \ncovered writing. \nNow, using the net investment required, one can calculate the return (if exer\ncised). That return assumes the stock is above the striking price of the written option", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:431", "doc_id": "34712e5ebc75161528a031c3b62378d0f4e0370dd457f4958be83b7994fa580b", "chunk_index": 0}
{"text": "392 Part Ill: Put Option Strategies \nat its expiration, and the stock is called away. The short-term writer would have col\nlected two dividends of the common stock, while the LEAPS writer would have col\nlected eight by expiration. \nStock sale (500 @ 50) \nLess stock commission \nPlus dividends earned \nuntil expiration \nLess net investment \nNet profit if exercised \nReturn if exercised \n(net profit/net investment) \nReturn If Exercised \n+ \nJuly 50 call \n$25,000 \n300 \n250 \n- 23,350 \n$ 1,600 \n6.9% \nJanuary 50 LEAPS \n$25,000 \n300 \n+ 1,000 \n- 21,150 \n$ 4,550 \n21.5% \nThe LEAPS writer has amuch higher net return if exercised, again because he \nwrote amore expensive option to begin with. However, in order to fairly compare the \ntwo writes, one must annualize the returns. That is, the July 50 covered write made \n6.9% in six months, so it could make twice that in one year, if it can be duplicated six \nmonths from now. In asimilar manner, the LEAPS covered writer can make 21.5% \nin two years if the stock is called away. However, on an annualized basis, he would \nmake only half that amount. \nReturn If Exercised, Annualized \nJuly 50 call January 50 LEAPS \n13.8% 10.8% \nThus, on an annualized basis, the short-term write seems better. The shorter-term \ncall will generally have ahigher rate of return, annualized, than the LEAPS call. The \nproblems with annualizing are discussed in the following text. \nFinally, the downside break-even point can be computed for each write. \nDownside Break-Even Calculation \nNet investment \nLess dividends received \nTotal stock cost to expiration \nDivided by shares held (500), \nequals break-even price: \nJuly 50 call \n$23,350 \n250 \n$23,100 \n46.2 \nJanuary 50 LEAPS \n$21,150 \n1 000 \n$20,150 \n40.3", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:432", "doc_id": "ee1855fc3a3c57c01032a125dd54043f563b2c7913312d53be4bbf765dd9ae4a", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 393 \nThe larger premium of the LEAPS call that was written produces this dramatically \nlower break-even price for the LEAPS covered write. \nSimilar comparisons could be made for acovered write on margin if the investor \nis using amargin account. The steps above are the mechanical ones that acovered \nwriter should go through in order to see how the short-term write compares to the \nlonger-term LEAPS write. Analyzing them is often aless routine matter. It would \nseem that the short-term write is better if one uses the annualized rate of return. \nHowever, the annualized return is asomewhat subjective number that depends on \nseveral assumptions. \nThe first assumption is that one will be able to generate an equivalent return six \nmonths from now when the July 50 call expires worthless or the stock is called away. \nIf the stock were relatively unchanged, the covered writer would have to sell a 6-\nmonth call for 4 points again six months from now. Or, if the stock were called away, \nhe would have to invest in an equivalent situation elsewhere. Moreover, in order to \nreach the 2-year horizon offered by the LEAPS write, the 6-month return would \nhave to be regenerated three more times (six months from now, one year from now, \nand ayear and ahalf from now). The covered writer cannot assume that such returns \ncan be repeated with any certainty every six months. \nThe second assumption that was made when the annualized returns were cal\nculated was that one-half the return if exercised on the LEAPS call would be made \nwhen one year had passed. But, as has been demonstrated repeatedly in this chapter, \nthe time decay of an option is not linear. Therefore, one year from now, if XYZ were \nstill at 50, the January 50 LEAPS call would not be selling for half its current price \n(½ x 8½ = 4¼). It would be selling for something more like 5.00, if all other factors \nremained unchanged. However, given the variability of LEAPS call premiums when \ninterest rates, volatility, or dividend payouts change, it is extremely difficult to esti\nmate the call price one year from now. Consequently, to say that the 21.5% 2-year \nreturn if exercised would be 10.8% after one year may well be afalse statement. \nThus, the covered writer must make his decision based on what he knows. He \nknows that with the short-term July 50 write, if the stock is called away in six months, \nhe will make 6.9%, period. If he opts for the longer term, he will make 21.5% if he \nis called away in two years. Which is better? The question can only be answered by \neach covered writer individually. One'sattitude toward long-term investing will be amajor factor in making the decision. If he thinks XYZ has good prospects for the long \nterm, and he feels conservative returns will be below 10% for the next couple of \nyears, then he would probably choose the LEAPS write. However, if he feels that \nthere is atemporary expansion of option premium in the short-term XYZ calls that \nshould be exploited, and he would not really want to be along-term holder of the \nstock, then he would choose the short-term covered write.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:433", "doc_id": "79350e307f76005669a4a1285567c75490f498a64bf0f26c42c17dda1c251b66", "chunk_index": 0}
{"text": "394 Part Ill: Put Option Strategies \nDownside Protection. The actual downside break-even point might enter into \none'sthinking as well. Adownside break-even point of 40.3 is available by using the \nLEAPS write, and that is aknown quantity. No matter how far XYZ might fall, as long \nas it can recover to slightly over 40 by expiration two years from now, the investment \nwill at least break even. Aproblem arises if XYZ falls to 40 quickly. If that happened, \nthe LEAPS call would still have asignificant amount of time value premium remain\ning on it. Thus, if the investor attempted to sell his stock at that time and buy back \nhis call, he would have aloss, not abreak-even situation. \nThe short-term write offers downside protection only to astock price of 46.2. \nOf course, repeated writes of 6-month calls over the next 2 years would lower the \nbreak-even point below that level. The problem is that if XYZ declines and one is \nforced to keep selling 6-month calls every 6 months, he may be forced to use alower \nstriking price, thereby locking in asmaller profit ( or possibly even aloss) if premium \nlevels shrink. The concepts of rolling down are described in detail in Chapter 2. \nAfurther word about rolling down may be in order here. Recall that rolling \ndown means buying back the call that is currently written and selling another one \nwith alower striking price. Such action always reduces the profitability of the over\nall position, although it may be necessary to prevent further downside losses if the \ncommon stock keeps declining. Now that LEAPS are available, the short-term writer \nfaced with rolling down may look to the LEAPS as ameans of bringing in ahealthy \npremium even though he is rolling down. It is true that alarge premium could be \nbrought into the account. But remember that by doing so, one is committing himself \nto sell the stock at alower price than he had originally intended. This is why the \nrolling down reduces the original profit potential. If he rolls down into a LEAPS call, \nhe is reducing his maximum profit potential for alonger period of time. \nConsequently, one should not always roll dm,vn into an option with alonger maturi\nty. Instead, he should carefully analyze whether he wants to be committed for an \neven longer time to aposition in which the underlying common stock is declining. \nTo summarize, the large absolute premiums available in LEAPS calls may make \nacovered write of those calls seem unusually attractive. However, one should calcu\nlate the returns available and decide whether ashort-term write might not serve his \npurpose as well. Even though the large LEAPS premium might reduce the initial \ninvestment to amere pittance, be aware that this creates agreat amount of leverage, \nand leverage can be adangerous thing. \nThe large amount of downside protection offered by the LEAPS call is real, but \nif the stock falls quickly, there would definitely be aloss at the calculated downside \nbreak-even point. Finally, one cannot always roll down into a LEAPS call if trouble \ndevelops, because he will be committing himself for an even longer period of time to \nsell his stock at alower price than he had originally intended.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:434", "doc_id": "91697958b4431ac9d335d64fd7e6edb3c3f8afbaa16125f821c5cdea60ed71fd", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 39S \n✓,,FREE\" COVERED CALL WRITES \nIn Chapter 2, astrategy of writing expensive LEAPS options was briefly described. \nIn this section, amore detailed analysis is offered. Acertain type of covered call \nwrite, one in which the call is quite expensive, sometimes attracts traders looking for \na \"free ride.\" To acertain extent, this strategy is something of afree ride. As you \nmight imagine, though, there can be major problems. \nThe investment required for acovered call write on margin is 50% of the stock \nprice, less the proceeds received from selling the call. In theory, it is possible for an \noption to sell for more than 50% of the stock cost. This is amargin account, acov\nered write could be established for \"free.\" Let'sdiscuss this in terms of two types of \ncalls: the in-the-money call write and the out-of-the-money call write. \nOut-of-the-Money Covered Call Write. This is the simplest way to approach \nthe strategy. One may be able to find LEAPS options that are just slightly out-of-the\nmoney, which sell for 50% of the stock price. Understandably, such astock would be \nquite volatile. \nExample: GOGO stock is selling for $38 per share. GOGO has listed options, and a \n2-year LEAPS call with astriking price of 40 is selling for $19. The requirement for \nthis covered write would be zero, although some commission costs would be \ninvolved. The debit balance would be 19 points per share, the amount the broker \nloans you on margin. \nCertain brokerage firms might require some sort of minimum margin deposit, but \ntechnically there is no further requirement for this position. Of course, the leverage \nis infinite. Suppose one decided to buy 10,000 shares of GOGO and sell 100 calls, \ncovered. His risk is $190,000 if the stock falls to zero! That also happens to be the \ndebit balance in his account. Thus, for aminimal investment, one could lose afor\ntune. In addition, if the stock begins to fall, one'sbroker is going to want maintenance \nmargin. He probably wouldn'tlet the stock slip more than acouple of points before \nasking for margin. If one owns 10,000 shares and the broker wants two points main\ntenance margin, that means the margin call would be $20,000. \nThe profits wouldn'tbe as big as they might at first seem. The maximum gross \nprofit potential is $210,000 if the 10,000 shares are called away at 40. The covered \nwrite makes 21 points on each share - the $40 sale price less the original cost of $19. \nHowever, one will have had to pay interest on the debit balance of $190,000 for two \nyears. At 10%, say, that'satotal of $38,000. There would also be commissions on the \npurchase and the sale.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:435", "doc_id": "ab182c652c1da3963ca89045eb57fbac0d0c13da06fdd9273f25628ba65b9066", "chunk_index": 0}
{"text": "396 Part Ill: Put Option Strategies \nIn summary, this is aposition with tremendous, even dangerous, leverage. \nIn-the-Money Covered Call Write. The situation is slightly different if the \noption is in-the-money to begin with. The above margin requirements actually don'tquite accurately state the case for amargined covered call write. When acovered call \nis written against the stock, there is acatch: Only 50% of the stock price or the strike \nprice, whichever is less, is available for \"release.\" Thus, one will actually be required \nto put up more than 50% of the stock price to begin with. \nExample: XYZ is trading at 50, and there is a 2-year LEAPS call with astrike price \nof 30, selling for 25 points. One might think that the requirement for acovered call \nwrite would be zero, since the call sells for 50% of the stock price. But that'snot the \ncase with in-the-money covered calls. \nMargin requirement: \nBuy stock: 50 points \nLess option proceeds -25 \nLess margin release* -15* \nNet requirement: 10 points \n* 50% of the strike price or 50% of stock price, whichever is less. \nThis position still has alot ofleverage: One invests 10 points in hopes of making 5, if \nthe stock is called away at 30. One also would have to pay interest on the 15-point \ndebit balance, of course, for the two-year duration of the position. Furthermore, \nshould the stock fall below the strike price, the broker would begin to require main\ntenance margin. \nNote that the above \"formula\" for the net requirement works equally well for \nthe out-of-the-money covered call write, since 50% of the stock price is always less \nthan 50% of the strike price in that case. \nTo summarize this \"free ride\" strategy: If one should decide to use this strate\ngy, he must be extremely aware of the dangers of high leverage. One must not risk \nmore money than he can afford to lose, regardless of how small the initial investment \nmight be. Also, he must plan for some method of being able to make the margin pay\nments along the way. Finally, the in-the-money alternative is probably better, because \nthere is less probability that maintenance margin will be asked for. \nSELLING UNCOVERED LEAPS \nUncovered option selling can be aviable strategy, especially if premiums are over\npriced. LEAPS options may be sold uncovered with the same margin requirements \nas short-term options. Of course, the particular characteristics of the long-term \noption may either help or hinder the uncovered writer, depending on his objective.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:436", "doc_id": "389f0a9b20e75c90cd2b355d6298777ab8107f2f1be5983b84ebd329a59cfd82", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 397 \nUncovered Put Selling. Naked put selling is addressed first because, as astrat\negy, it is equivalent to covered writing, and covered writing was just discussed. Two \nstrategies are equivalent if they have the same profit picture at expiration. Naked put \nselling and covered call writing are equivalent because they have the profit picture \ndepicted in Graph I, Appendix D. Both have limited upside profit potential and large \nloss exposure to the downside. In general, when two strategies are equivalent, one of \nthe two has certain advantages over the other. \nIn this case, naked put selling is normally the more advantageous of the two \nbecause of the way margin requirements are set. One need not actually invest cash \nin the sale of anaked put; the margin requirement that is asked for may be satisfied \nwith collateral. This means the naked put writer may use stocks, bonds, T-bills, or \nmoney market funds as collateral. Moreover, the actual amount of collateral that is \nrequired is less than the cash or margin investment required to buy stock and sell acall. This means that one could operate his portfolio normally - buying stock, then \nselling it and putting the proceeds in a Treasury bill or perhaps buying another stock \n- without disturbing his naked put position, as long as he maintained the \ncollateral requirement. \nConsequently, the strategist who is buying stock and selling calls should probably \nbe selling naked puts instead. This does not apply to covered writers who are writing \nagainst existing stock or who are using the incremental return concept of covered writ\ning, because stock ownership is part of their strategy. However, the strategist who is \nlooking to take in premium to profit if the underlying stock remains relatively \nunchanged or rises, while having amodicum of downside protection ( which is the \ndefinition of both naked put writing and covered writing), should be selling naked \nputs. As an example of this, consider the LEAPS covered write discussed previously. \nExample: XYZ is selling at 50. The investor is debating between a 500-share covered \nwrite using 2-year LEAPS calls or selling five 2-year LEAPS puts. The January 50 \nLEAPS call sells for 8½ and has two years of life, while the January 50 LEAPS put \nsells for 3½. Further assume that XYZ pays adividend of $0.25 per quarter. \nThe net investment required for the covered write is calculated as it was before. \nNet Investment Required - Covered Write \nStock cost (500 shares @ 50) \nPlus stock commission \nLess option premiums received \nPlus option commissions \nNet cash investment \n+ \n$25,000 \n300 \n- 4,250 \n+ 100 \n$21,150", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:437", "doc_id": "d31c493308d132b1aed7a6f07057e78f1560414ae0b0c35c8d11f544554b3937", "chunk_index": 0}
{"text": "398 Part Ill: Put Option Strategies \nThe collateral requirement for the naked put write is the same as that for any \nnaked equity option: 20% of the stock price, plus the option price, less any out-of\nthe-money amount, with an absolute minimum requirement of 15% of the stock \nprice. \nCollateral Requirement - Naked Put \n20% of stock price (.20 x 500 x $50) \nPlus option premium \nLess out-of-the-money amount \nTotal collateral requirement \n$5,000 \n1,750 \n0 \n$6,750 \nNote that the actual premium received by the naked put seller is $1,750 less com\nmissions of $100, for example, or $1,650. This net premium could be used to reduce \nthe total collateral requirement. \nNow one can compare the profitability of the two investments: \nReturn If Stock Over 50 at Expiration \nStock sale {500 @ 50) \nLess stock commission \nPlus dividends earned until expiration \nLess net investment \nNet profit if exercised \nNet put premium received \nDividends received \nNet profit \nCovered Write \n$25,000 \n300 \n+ 1,000 \n- 21,150 \n$ 4,55_0 \nNaked Put Sole \n$1,650 \n0 \n$1,650 \nNow the returns can be compared, if XYZ is over 50 at expiration of the LEAPS: \nReturn if XYZ over 50 \n(net profit/net investment) \nNaked put sale: 24.4% \nCovered write: 21 .5% \nThe naked put write has abetter rate of return, even before the following fact \nis considered. The strategist who is using the naked put write does not have to spend \nthe $6,750 collateral requirement in the form of cash. That money can be kept in a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:438", "doc_id": "c89b94962091e8d83d9e6b5f20414f593d812955c9339480ed7c516b9334e3de", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 399 \nTreasury bill and earn interest over the two years that the put write is in place. Even \nif the T-bill were earning only 4% per year, that would increase the overall two-year \nreturn for the naked put sale by 8%, to 32.4%. This should make it obvious that naked \nput selling is rrwre strategically advantageous than covered call writing. \nEven so, one might rightfully wonder if LEAPS put selling is better than selling \nshorter-term equity puts. As was the case with covered call writing, the answer \ndepends on what the investor is trying to accomplish. Short-term puts will not bring \nas much premium into the account, so when they expire, one will be forced to find \nanother suitable put sale to replace it. On the other hand, the LEAPS put sale brings \nin alarger premium and one does not have to find areplacement until the longer\nterm LEAPS put expires. The negative aspect to selling the LEAPS puts is that time \ndecay won'thelp much right away and, even if the stock moves higher (which is \nostensibly good for the position), the put won'tdecline in price by alarge amount, \nsince the delta of the put is relatively small. \nOne other factor might enter in the decision regarding whether to use short\nterm puts or LEAPS puts. Some put writers are actually attempting to buy stock \nbelow the market price. That is, they would not mind being assigned on the put they \nsell, meaning that they would buy stock at anet cost of the striking price less the pre\nmium they received from the sale of the put. If they don'tget assigned, they get to \nkeep aprofit equal to the premium they received when they first sold the put. \nGenerally, aperson would only sell puts in this manner on astock that he had faith \nin, so that if he was assigned on the put, he would view that as abuying opportunity \nin the underlying stock. This strategy does not lend itself well to LEAPS. Since the \nLEAPS puts will carry asignificant amount of time premium, there is little (if any) \nchance that the put writer will actually be assigned until the life of the put shortens \nsubstantially. This means that it is unlikely that the put writer will become astock \nowner via assignment at any time in the near future. Consequently, if one is attempt\ning to wTite puts in order to eventually buy the common stock when he is assigned, \nhe would be better served to write shorter-term puts. \nUNCOVERED CALL SELLING \nThere are very few differences between using LEAPS for naked call selling and using \nshorter-term calls, except for the ones that have been discussed already with regard \nto selling uncovered LEAPS: Time value decay occurs more slowly and, if the stock \nrallies and the naked calls have to be covered, the call writer will normally be paying \nmore time premium than he is used to when he covers the call. Of course, the rea\nson that one is engaged in naked call writing might shed some more light on the use \nof LEAPS for that purpose.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:439", "doc_id": "ec9f4e07bcf063a25d28a8befa32858a0f918fbaddb70713cfd4f6fba5347c2b", "chunk_index": 0}
{"text": "400 Part Ill: Put Option Strategies \nThe overriding reason that most strategists sell naked calls is to collect the time \npremium before the stock can rise above the striking price. These strategists gener\nally have an opinion about the stock'sdirection, believing that it is perhaps trapped \nin atrading range or even headed lower over the short term. This strategy does not \nlend itself well to using LEAPS, since it would be difficult to project that the stock \nwould remain below the strike for so long aperiod of time. \nShort LEAPS Instead of Short Stock. Another reason that naked calls are \nsold is as astrategy akin to shorting the common stock. In this case, in-the-money \ncalls are sold. The advantages are threefold: \nl. The amount of collateral required to sell the call is less than that required to sell \nstock short. \n2. One does not have to borrow an option in order to sell it short, although one must \nborrow common stock in order to sell it short. \n3. An uptick is not required to sell the option, but one is required in order to sell \nstock short. \nFor these reasons, one might opt to sell an in-the-money call instead of shorting \nstock. \nThe profit potentials of the two strategies are different. The short seller of stock \nhas avery large profit potential if the stock declines substantially, while the seller of \nan in-the-money call can collect only the call premium no matter how far the stock \ndrops. Moreover, the call'sprice decline will slow as the stock nears the strike. \nAnother way to express this is to say that the delta of the call shrinks from anumber \nclose to l (which means the call mirrors stock movements closely) to something more \nlike 0.50 at the strike (which means that the call is only declining half as quickly as \nthe stock). \nAnother problem that may occur for the call seller is early assignment, atopic \nthat is addressed shortly. One should not attempt this strategy if the underlying stock \nis not borrowable for ordinary short sales. If the underlying stock is not available for \nborrowing, it generally means that extraneous forces are at work; perhaps there is atender offer or exchange offer going on, or some form of convertible arbitrage is tak\ning place. In any case, if the underlying stock is not borrowable, one should not be \ndeluded into thinking that he can sell an in-the-money call instead and have aworry\nfree position. In these cases, the call will normally have little or no time premium and \nmay be subject to early assignment. If such assignment does occur, the strategist will \nbecome short the stock and, since it is not borrowable, will have to cover the stock. \nAt the least, he will cost himself some commissions by this unprofitable strategy; and \nat worst, he will have to pay ahigher price to buy back the stock as well.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:440", "doc_id": "e07e1de8c6c245588d78a811466273930d2e0979607d9498375188ffdd1cc867", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 401 \nLEAPS calls may help to alleviate this problem. Since they are such long-term \ncalls, they are likely to have some time value premium in them. In-the-money calls that \nhave time value premium are not normally assigned. As an alternative to shorting astock that is not borrowable, one might try to sell an in-the-money LEAPS call, but \nonly if it has time value premium remaining. Just because the call has along time \nremaining until expiration does not mean that it must have time value premium, as will \nbe seen in the following discussion. Finally, if one does sell the LEAPS call, he must \nrealize that if the stock drops, the LEAPS call will not follow it completely. As the stock \nnears the strike, the amount of time value premium will build up to an even greater \nlevel in the LEAPS. Still, the naked call seller would make some profit in that case, and \nit presents abetter alternative than not being able to sell the stock short at all. \nEarly Assignment. An American-style option is one that can be exercised at any \ntime during its life. All listed equity options, LEAPS included, are of this variety. \nThus, any in-the-money option that has been sold may become subject to early \nassignment. The clue to whether early assignment is imminent is whether there is \ntime value premium in the option. If the option has no time value premium - in other \nwords, it is trading at parity or at adiscount then assignment may be close at hand. \nThe option writer who does not want to be assigned would want to cover the option \nwhen it no longer carries time premium. \nLEAPS may be subject to early assignment as well. It is possible, albeit far less \nlikely, that along-term option would lose all of its time value premium and therefore \nbe subject to early assignment. This would certainly happen if the underlying stock \nwere being taken over and atender off er were coming to fruition. However, it may \nalso occur because of an impending dividend payment, or more specifically, because \nthe stock is about to go ex-dividend. Recall that the call owner, LEAPS calls includ\ned, is not entitled to any dividends paid by the underlying stock. So if the call owner \nwants the dividend, he exercises his call on the day before the stock goes ex-dividend. \nThis makes him an owner of the common stock just in the nick of time to get the div\nidend. \nWhat economic factors motivate him to exercise the call? If there is any time \nvalue premium at all in the call, the call holder would be better off selling the call in \nthe open market and then purchasing the stock in the open market as well. In this \nmanner, he would still get the dividend, but he would get abetter price for his call \nwhen he sold it. If, however, there is no time value premium in the call, he does not \nhave to bother with two transactions in the open market; he merely exercises his call \nin order to buy stock. \nAll well and good, but what makes the call sell at parity before expiration? It has \nto do with the arbitrage that is available for any call option. In this case, the arbitrage", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:441", "doc_id": "9ec92cec74aac2e8b1cc473b3111caec4ec04e647f50432370ebc6a4e8e51983", "chunk_index": 0}
{"text": "402 Part Ill: Put Option Strategies \nis not the simple discount arbitrage that was discussed in Chapter lwhen this topic \nwas covered. Rather, it is amore complicated form that is discussed in greater detail \nin Chapter 28. Suffice it to say that if the dividend is larger than the interest that can \nbe earned from acredit balance equal to the striking price, then the time value pre\nmium will disappear from the call. \nExample: XYZ is a $30 stock and about to go ex-dividend 50 cents. The prevailing \nshort-term interest rate is 5% and there are LEAPS with astriking price of 20. \nA 50-cent quarterly dividend on astriking price of 20 is an annual dividend rate \n(on the strike) of 10%. Since short-term rates are much lower than that, arbitrageurs \neconomically cannot pay out 10% for dividends and earn 5% for their credit balances. \nIn this situation, the LEAPS call would lose its time value premium and would \nbe acandidate for early exercise when the stock goes ex-dividend. \nIn actual practice, the situation is more complicated than this, because the price \nof the puts comes into play; but this example shows the general reasoning that the \narbitrageur must go through. \nCertain arbitrageurs construct positions that allow them to earn interest on acredit balance equal to the striking price of the call. This position involves being short \nthe underlying stock and being long the call. Thus, when the stock goes ex-dividend, \nthe arbitrageur will owe the dividend. If, however, the amount of the dividend is \nmore than he vvill earn in interest from his credit balance, he will merely exercise his \ncall to cover his short stock. This action will prevent him from having to pay out the \ndividend. \nThe arbitrageur'sexercise of the call means that someone is going to be \nassigned. If you are awriter of the call, it could be you. It is not important to under\nstand the arbitrage completely; its effect will be reflected in the marketplace in the \nform of acall trading at parity or adiscount. Thus, even a LEAPS call with asub\nstantial anwunt of time rernaining may be assigned if it is trading at parity. \nSTRADDLE SELLING \nStraddle selling is equivalent to ratio writing and is astrategy whereby one attempts \nto sell ( overpriced) options in order to produce arange of stock prices within which \nthe option seller can profit. The strategy often involves follow-up action as the stock \nmoves around, and the strategist feels that he must adjust his position in order to pre\nvent large losses. LEAPS puts and calls might be used for this strategy. However, \ntheir long-term nature is often not conducive to the aims of straddle selling. \nFirst, consider the effect of time decay. One might normally sell athree-month \nstraddle. If the stock \"behaves\" and is relatively unchanged after two months have", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:442", "doc_id": "d9891a5df72182fb910c1d3026b37f68bfe18ed537e32b3130cd4b0c05a96625", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 403 \npassed, the straddle seller could reasonably expect to have aprofit of about 40% of \nthe original straddle price. However, if one had sold a 2-year LEAPS straddle, and \nthe stock were relatively unchanged after two months, he would only have aprofit of \nabout 7% of the original sale price. This should not be surprising in light of what has \nbeen demonstrated about the decaying of long-term options. It should make the \nstraddle seller somewhat leery of using LEAPS, however, unless he truly thinks the \noptions are overpriced. \nSecond, consider follow-up action. Recall that in Chapter 20, it was shown that \nthe bane of the straddle seller was the whipsaw. Awhipsaw occurs when one makes \nafollow-up protective action on one side (for instance, he does something bullish \nbecause the underlying stock is rising and the short calls are losing money), only to \nhave the stock reverse and come crashing back down. Obviously, the more time left \nuntil expiration, the more likely it is that awhipsaw will occur after any follow-up \naction, and the more expensive it will be, since there will be alot of time value pre\nmium left in the options that are being repurchased. This makes LEAPS straddle \nselling less than attractive. \nLEAPS straddles may look expensive because of their large absolute price, and \ntherefore may appear to be attractive straddle sale candidates. However, the price is \noften justified, and the seller of LEAPS straddles will be fighting sudden stock move\nments without getting much benefit from the passage of time. The best time to sell \nLEAPS straddles is when short-term rates are high and volatilities are high as well \n(i.e., the options are overpriced). At least, in those cases, the seller will derive some \nreal benefit if rates or volatilities should drop. \nSPREADS USING LEAPS \nAny of the spread strategies previously discussed can be implemented with LEAPS \nas well, if one desires. The margin requirements are the same for LEAPS spreads as \nthey are for ordinary equity option spreads. One general category of spread lends \nitself well to using LEAPS: that of buying alonger-term option and selling ashort\nterm one. Calendar spreads, as well as diagonal spreads, fall into that category. \nThe combinations are myriad, but the reasoning is the same. One wants to own \nthe option that is not so subject to time decay, while simultaneously selling the \noption that is quite subject to time decay. Of course, since LEAPS are long-term and \ntherefore expensive, one is generally taking on alarge debit in such aspread and \nmay have substantial risk if the stock performs adversely. Other risks may be pres\nent as well. As ameans of demonstrating these facts, let us consider asimple bull \nspread using calls.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:443", "doc_id": "6bc3808807985ff2ca158ee8c617a89532c5b3157b1cd7575eb694c15aa445dd", "chunk_index": 0}
{"text": "404 Part Ill: Put Option Strategies \nExample: The following prices exist in the month of January: \nXYZ: 105 \nApril 100 call: 10 1/2 \nApril 110 call: 5 1/2 \nJanuary (2-year) 100 call: 26 \nJanuary (2-year) 110 call: 21 1/2 \nAn investor is considering abull spread in XYZ and is unsure about whether to use \nthe short-term calls, the LEAPS calls, or amixture. These are his choices: \nShort-term bull spread: \nDiagonal bull spread: \nLEAPS bull spread: \nBuy April 100@ 101/2 \nSell April 110@ 51/2 \nNet Debit: $500 \nBuy January LEAPS 100 @ 26 \nSell April 110@ 51/2 \nNet Debit: $2,050 \nBuy January LEAPS 1 00 @ 26 \nSell January LEAPS 110@ 21 1/2 \nNet Debit: $450 \nNotice that the debit paid for the LEAPS spread is slightly less than that of the short\nterm bull spread. This means that they have approximately the same profit potential \nat their respective expiration dates. However, the strategist is more concerned with \nhow these compare directly with each other. The obvious point in time to make this \ncomparison is when the short-term options expire. \nFigure 25-7 shows the profitability of these three positions at April expiration. \nIt was assumed that all of the following were the same in April as they had been in \nJanuary: volatility, short-term rates, and dividend payout. \nNote that the short-term bull spread has the familiar profit graph from Chapter \n7, making its maximum profit over 110 and taking its maximum loss below 100. (See \nTable 25-4.) \nThe LEAPS spread doesn'tgenerate much of either aprofit or aloss in only \nthree months' time. Even if XYZ rises to 120, the LEAPS bull spread will have only \na $150 profit. Conversely, if XYZ falls to 80, the spread loses only about $200. This \nprice action is very typical for long-term bull spreads when both options have asig\nnificant amount of time premium remaining in them.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:444", "doc_id": "8a60a8fae5608b68c9a31dd66196b6afe7779066d7e40984219a9d86507d5316", "chunk_index": 0}
{"text": "Chapter 25: LEAPS \nFIGURE 25-7. \nBull spread comparison at April expiration. \nStock Price \n405 \nThe diagonal spread is different, however. Typically, the maximum profit poten\ntial of abull spread is the difference in the strikes less the initial debit paid. For this \ndiagonal spread, that would be $1,000 minus $2,050, aloss! Obviously, this simple \nformula is not applicable to diagonal spreads, because the purchased option still has \ntime value premium when the written option expires. The profit graph shows that \nindeed the diagonal spread is the most bullish of the three. It makes its best profit at \nthe strike of the written option - astandard procedure for any spread - and that prof\nit is greater than either of the other two spreads at April expiration ( under the sig-\nTABLE 25-4. \nBull spread comparison at April expiration. \nStock Price Short-Term Diagonal LEAPS \n80 -500 -1, 100 -200 \n90 -500 - 600 -150 \n100 -500 50 - 25 \n110 500 750 50 \n120 500 550 150 \n140 500 150 250 \n160 500 50 350 \n180 500 - 350 450", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:445", "doc_id": "8044c77ba4493d0befa937a91ad8675e2b8c43b2ca1134f2264b3b76dfd42369", "chunk_index": 0}
{"text": "406 Part Ill: Put Option Strategies \nnificant assumption that volatility and interest rates are unchanged). If XYZ trades \nhigher than llO, the diagonal spread will lose some of its profit; in fact, if XYZ were \nto trade at avery high price, the diagonal spread would actually have aloss (see Table \n25-4). Whenever the purchased LEAPS call loses its time value premium, the diag\nonal spread will not perform as well. \nIf the common stock drops in price, the diagonal spread has the greatest risk in \ndollar terms but not in percentage terms, because it has the largest initial debit. If \nXYZ falls to 80 in three months, the spread will lose about $1,100, just over half the \ninitial $2,050 debit. Obviously, the short-term spread would have lost 100% of its ini\ntial debit, which is only $500, at that same point in time. \nThe diagonal spread presents an opportunity to earn more money if the under\nlying common is near the strike of the written option when the written option expires. \nHowever, if the common moves agreat deal in either direction, the diagonal spread \nis the worst of the three. This means that the diagonal spread strategy is aneutral \nstrategy: One wants the underlying common to remain near the written strike until \nthe near-term option expires. This is atrue statement even if the diagonal spread is \nunder the guise of abullish spread, as in the previous example. \nMany traders are fond of buying LEAPS and selling an out-of-the-money near\nterm call as ahedge. Be careful about doing this. If the underlying common rises too \nfast and/or interest rates fall and/or volatility decreases, this could be apoor strategy. \nThere is really nothing quite as psychologically damaging as being right about the \nstock, but being in the wrong option strategy and therefore losing money. Consider \nthe above examples. Ostensibly, the spreader was bullish on XYZ; that'swhy he chose \nbull spreads. If XYZ became awildly bullish stock and rose from 100 to 180 in three \nmonths, the diagonal spreader would have lost money. He couldn'thave been happy \n- no one would be. This is something to keep in mind when diagonalizing a LEAPS \nspread. \nThe deltas of the options involved in the spread will give one agood clue as to \nhow it is going to perform. Recall that ashort-term, in-the-money option acquires arather high delta, especially as expiration draws nigh. However, an in-the-money \nLEAPS call will not have an extremely high delta, because of the vast amount of time \nremaining. Thus, one is short an option with ahigh delta and long an option with asmaller delta. These deltas indicate that one is going to lose money if the underlying \nstock rises in price. Consider the following situation: \nXYZ Stock, 120: \nCall \nLong 1 January LEAPS 100 call: \nShort 1 April 110 call: \nPosition Delta \n0.70 \n-0.90", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:446", "doc_id": "3a33556dc1f5c1cae9f7b38a94adfb0f201a6a95ffeec7cc282957e3fb93478f", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 401 \nAt this point, if XYZ rises in price by 1 point, the spread can be expected to lose 20 \ncents, since the delta of the short option is 0.20 greater than the delta of the long \noption. \nThis phenomenon has ramifications for the diagonal spreader of LEAPS. If the \ntwo strike prices of the spread are too close together, it may actually be possible to \nconstruct abull spread that loses money on the upside. That would be very difficult \nfor most traders to accept. In the above example, as depicted in Table 25-4, that'swhat happens. One way around this is to widen the strike prices out so that there is \nat least some profit potential, even if the stock rises dramatically. That may be diffi\ncult to do and still be able to sell the short-term option for any meaningful amount \nof premium. \nNote that adiagonal spread could even be considered as asubstitute for acov\nered write in some special cases. It was shown that a LEAPS call can sometimes be \nused as asubstitute for the common stock, with the investor placing the difference \nbetween the cost of the LEAPS call and the cost of the stock in the bank (or in Tbills). Suppose that an investor is acovered writer, buying stock and selling relative\nly short-term calls against it. If that investor were to make a LEAPS call substitution \nfor his stock, he would then have adiagonal bull spread. Such adiagonal spread \nwould probably have less risk than the one described above, since the investor pre\nsumably chose the LEAPS substitution because it was \"cheap.\" Still, the potential \npitfalls of the diagonal bull spread would apply to this situation as well. Thus, if one \nis acovered writer, this does not necessarily mean that he can substitute LEAPS calls \nfor the long stock without taking care. The resulting position may not resemble acov\nered write as much as he thought it would. \nThe \"bottom line\" is that if one pays adebit greater than the difference in the \nstrike prices, he may eventually lose money if the stock rises far enough to virtually \neliminate the time value premium of both options. This comes into play also if one \nrolls his options down if the underlying stock declines. Eventually, by doing so, he \nmay invert the strikes - i.e., the striking price of the written option is lower than the \nstriking price of the option that is owned. In that case, he will have locked in aloss if \nthe overall credit he has received is less than the difference in the strikes - aquite \nlikely event. So, for those who think this strategy is akin to aguaranteed profit, think \nagain. It most certainly is not. \nBackspreads. LEAPS may be applied to other popular forms of diagonal spreads, \nsuch as the one in which in-the-money, near-term options are sold, and agreater quan\ntity of longer-term (LEAPS) at- or out-of-the money calls are bought. (This was \nreferred to as adiagonal backspread in Chapter 14.) This is an excellent strategy, and", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:447", "doc_id": "4957c4a59c324238d855422488dfd88a386a48f798c1b32971c0196870ebd1c3", "chunk_index": 0}
{"text": "408 Part Ill: Put Option Strategies \na LEAPS may be used as the long option in the spread. Recall that the object of the \nspread is for the stock to be volatile, particularly to the upside if calls are used. If that \ndoesn'thappen, and the stock declines instead, at least the premium captured from \nthe in-the-money sale will be again to offset against the loss suffered on the longer\nterm calls that were purchased. The strategy can be established with puts as well, in \nwhich case the spreader would want the underlying stock to fall dramatically while the \nspread was in place. \nWithout going into as much detail as in the examples above, the diagonal back\nspreader should realize that he is going to have asignificant debit in the spread and \ncould lose asignificant portion of it should the underlying stock fall agreat deal in \nprice. To the upside, his LEAPS calls will retain some time value premium and will \nmove quite closely with the underlying common stock. Thus, he does not have to buy \nas many LEAPS as he might think in order to have aneutral spread. \nExample: XYZ is at 105 and aspreader wants to establish abackspread. Recall that \nthe quantity of options to use in aneutral strategy is determined by dividing the \ndeltas of the two options. Assume the following prices and deltas exist: \nOption \nApril 100 call \nJuly 110 call \nJanuary (2-year) LEAPS 100 call \nXYZ: 105 in January \nPrice \n8 \n5 \n15 \nDelta \n0.75 \n0.50 \n0.60 \nTwo backspreads are available with these options. In the first, one would sell the \nApril 100 calls and buy the July llO calls. He would be selling 3-month calls and buy\ning 6-month calls. The neutral ratio is 0.75/0.50 or 3 to 2; that is, 3 calls are to be \nbought for every 2 sold. Thus, aneutral spread would be: \nBuy 6 July 110 calls \nSell 4 April l 00 calls \nAs asecond alternative, he might use the LEAPS as the long side of the spread; he \nwould still sell the April 100 calls as the short side of the spread. In this case, his neu\ntral ratio would be 0.75/0.60, or 5 to 4. The resulting neutral spread would be: \nBuy 5 January LEAPS 110 calls \nSell 4 April 100 calls", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:448", "doc_id": "25b5d8e70ce56e7be53fb4c2149e4ec3a603c3334187de415d3f21700fb84362", "chunk_index": 0}
{"text": "Chapter 25: LEAPS 409 \nThus, aneutral backspread involving LEAPS requires buyingfewer calls than aneu\ntral backspread involving a 6-rnonth option on the long side. This is because the delta \nof the LEAPS call is larger. The significant point here is that, because of the time \nvalue retention of the LEAPS call, even when the stock moves higher, it is not nec\nessary to buy as many. If one does not use the deltas, but merely figures that 3 to 2 \nis agood ratio for any diagonal backspread, then he will be overly bullish if he uses \nLEAPS. That could cost him if the underlying stock declines. \nCalendar Spreads. LEAPS may also be used in calendar spreads - spreads in \nwhich the striking price of the longer-term option purchased and the shorter-term \noption sold are the same. The calendar spread is aneutral strategy, wherein the \nspreader wants the underlying stock to be as close as possible to the striking price \nwhen the near-term option expires. Acalendar spread has risk if the stock moves too \nfar away from the striking price (see Chapters 9 and 22). Purchasing a LEAPS call \nincreases that risk in terms of dollars, not percentage, because of the larger debit that \none must spend for the spread. \nSimplistically, calendar spreads are established with equal quantities of options \nbought and sold. This is often not aneutral strategy in the true sense. As was shown \nin Chapter 9 on call calendar spreads, one may want to use the deltas of the two \noptions to establish atruly neutral calendar spread, particularly if the stock is not ini\ntially right at the striking price. Out-of-the-money, one would sell more calls than he \nis buying. Conversely, in-the-money, one would buy more calls than he is selling. \nBoth strategies statistically have merit and are attractive. When using LEAPS deltas \nto construct the neutral spread, one need generally buy fewer calls than he might \nthink, because of the higher delta of a LEAPS call. This is the same phenomenon \ndescribed in the previous example of adiagonal backspread. \nSUMMARY \nLEAPS are nothing more than long-term options. They are usable in awide variety \nof strategies in the same way that any option would be. Their margin and investment \nrequirements are similar to those of the more familiar equity options. Both LEAPS \nputs and calls are traded, and there is asecondary market for them as well. \nThere are certain differences between the prices of LEAPS and those of short\ner-term options, but the greatest is the relatively large effect that interest rates and \ndividends have on the price of LEAPS, because LEAPS are long-term options. \nIncreases in interest rates will cause LEAPS to increase in price, while increases in \ndividend payout will cause LEAPS calls to decrease in price and LEAPS puts to", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:449", "doc_id": "ebc6b553449466c38d91c6862b22fa09cf8a81b344b5758946ed53f74c6151e3", "chunk_index": 0}
{"text": "410 Part Ill: Put Option Strategies \nincrease in price. As usual, volatility has amajor effect on the price of an option, and \nLEAPS are no exception. Even small changes in the volatility of the underlying com\nmon stock can cause large price differences in atwo-year option. The rate of decay \ndue to time is much smaller for LEAPS, since they are long-term options. Finally, the \ndeltas of LEAPS calls are larger than those of short-term calls; conversely, the deltas \nof LEAPS puts are smaller. \nSeveral common strategies lend themselves well to the usage of LEAPS. A \nLEAPS may be used as astock substitute if the cash not invested in the stock is \ninstead deposited in a CD or T-bill. LEAPS puts can be bought as protection for \ncommon stock. Speculative option buyers will appreciate the low rate of time decay \nof LEAPS. LEAPS calls can be written against common stock, thereby creating acovered write, although the sale of naked LEAPS puts is probably abetter strategy \nin most cases. Spread strategies with LEAPS may be viable as well, but the spreader \nshould carefully consider the ramifications of buying along-term option and selling \nashorter-term one against it. If the underlying stock moves agreat distance quickly, \nthe spread strategy may not perform as expected. \nOverall, LEAPS are not very different from the shorter-term options to which \ntraders and investors have become accustomed. Once these investors become famil\niar with the way these long-term options are affected by the various factors that \ndetermine the price of an option, they will consider the use of LEAPS as an integral \npart of astrategic arsenal.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:450", "doc_id": "00be0c711dd0f359015b7c80fe04e51e298d607db305f9b258ab7d64aa2b9b45", "chunk_index": 0}
{"text": "Buying Options \nand Treasury Bills \nNumerous strategies have been described, ranging from the simple to the complex. \nEach one has advantages, but there are disadvantages as well. In fact, some of them \nmay be too complex for the average investor to seriously consider implementing. The \nreader may feel that there should be an easier answer. Isn'tthere astrategy that \nmight not require such alarge investment or so much time spent in monitoring the \nposition, but would still have achance of returning areasonable profit? In fact, there \nis astrategy that has not yet been described, astrategy considered by some experts \nin the field of mathematical analysis to be the best of them all. Simply stated, the \nstrategy consists of putting 90% of one'smoney in risk-free investments (such as \nshort-term Treasury bills) and buying options with the remaining 10% of one'sfunds. \nIt has previously been pointed out that some of the more attractive strategies \nare those that involve small levels of risk with the potential for large profits. Usually, \nthese types of strategies inherently have arather large frequency of small losses, and \nasmall probability of realizing large gains. Their advantage lies in the fact that one or \ntwo large profits can conceivably more than make up for numerous small losses. This \nTreasury bill/option strategy is another strategy of this type. \nHOW THE TREASURY BILL/OPTION STRATEGY OPERATES \nAlthough there are certain details involved in operating this strategy, it is basically asimple one to approach. First, the most that one can lose is 10%, less the interest \nearned on the fixed-income portion of his portfolio (the remaining 90% of his assets), \nduring the life of the purchased options. It is asimple matter to space out one'scom-\n413", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:453", "doc_id": "f92149b1413c801426dfde37b6e53a64925fb6b17cf088adb38785f5ef0951c0", "chunk_index": 0}
{"text": "414 Part IV: Additional Considerations \nmitments to option purchases so that his overall risk in aone-year period can be kept \ndown to nearly 10%. \nExample: An investor might decide to put 2½% of his money into three-month \noption purchases. Thus, in any one year, he would be 1isking 10%. At the same time \nhe would be earning perhaps 6% from the overall interest generated on the fixed\nincome securities that make up the remaining 90% of his assets. This would keep his \noverall risk down to approximately 4.6% per year. \nThere are better ways to monitor this risk, and they are described shortly. The \npotential profits from this strategy are limited only by time. Since one is owning \noptions - say call options - he could profit handsomely from alarge upward move in \nthe stock market. As with any strategy in which one has limited risk and the poten\ntial of large profits, asmall number of large profits could offset alarge number of \nsmall losses. In actual practice, of course, his profits will never be overwhelming, \nsince only approximately 10% of the money is committed to option purchases. \nIn total, this strategy has greatly reduced 1isk with the potential of making \nabove-average profits. Since the 10% of the money that is invested in options gives \ngreat leverage, it might be possible for that portion to double or triple in ashort time \nunder favorable market conditions. This strategy is something like owning aconvert\nible bond. Aconvertible bond, since it is convertible into the common stock, moves \nup and down in price with the price of the underlying stock. However, if the stock \nshould fall agreat deal, the bond will not follow it all the way down, because eventu\nally its yield will provide a \"floor\" for the price. \nAstrategy that is not used very often is called the \"synthetic convertible bond.\" \nOne buys adebenture and acall option on the same stock. If the stock rises in price, \nthe call does too, and so the combination of the debenture and the call acts much like \naconvertible bond would to the upside. If, on the other hand, the stock falls, the call \nwill expire worthless; but the investor will retain most of his investment, because he \nwill still have the debenture plus any interest that the bond has paid. \nThe strategy of placing 90% of one'smoney into risk-free, interest-bearing cer\ntificates and buying options with the remainder is superior to the convertible bond \nor the \"synthetic convertible bond,\" since there is no risk of price fluctuation in the \nlargest portion of the investment. \nThe Treasury bill/option strategy is fairly easy to operate, although one does \nhave to do some work every time new options are purchased. Also, periodic adjust\nments need to be made to keep the level of risk approximately the same at all times. \nAs for which options to buy, the reader may recall that specifications were outlined \nin Chapters 3 and 16 on how to select the best option purchases. These criteria can \nbe summarized briefly as follows:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:454", "doc_id": "ae686f0fbdbb1845a04aa18e7dd434d9137b95c40ad3cc0223560fa7a2762527", "chunk_index": 0}
{"text": "Chapter 26: Buying Options and Treasury Bills 415 \n1. Assume that each underlying stock can advance or decline in accordance with its \nvolatility over afixed time period (30, 60, or 90 days). \n2. Estimate the call prices after the advance, or put prices after the decline. \n3. Rank all potential purchases by the highest reward opportunity. \nThe user of this strategy need only be interested in those option purchases that \nprovide the highest reward opportunity under this ranking method. In the previous \nchapters on option buying, it was mentioned that one might want to look at the \nrisk/reward ratios of his potential option purchases in order to have amore conser\nvative list. However, that is not necessary in the Treasury bill/option strategy, since \nthe overall risk has already been limited. Aranking of option purchases via the fore\ngoing criteria will generally give alist of at- or slightly out-of-the-money options. \nThese are not necessarily \"underpriced\" options; although if an option is truly under\npriced, it will have abetter chance of ranking higher on the selection list than one \nthat is \"overpriced.\" \nAlist of potential option purchases that is constructed with criteria similar to \nthose outlined above is available from many data services and brokerage firms. The \nstrategist who is willing to select his option purchases in this manner will find that he \ndoes not have to spend agreat deal of time on the selection process. The reader \nshould note that this type of option purchase ranking completely ignores the outlook \nfor the underlying stock. If one would rather make his purchases based on an outlook \nfor the underlying stock - preferably atechnical outlook - he will be forced to spend \nmore time on his selection process. Although this may be appealing to some \ninvestors, it will probably yield worse results in the long run than the previously \ndescribed unbiased approach to option purchases, unless the strategist is extremely \nadept at stock selection. \nKEEPING THE RISK LEVEL EQUAL \nThe second function that the strategist has to perform in this Treasury bill/option \nstrategy is to keep his risk level approximately equal at all times. \nExample: An investor starts the strategy with $90,000 in Treasury bills (T-bills) and \n$10,000 in option purchases. After some time has passed, the option purchases may \nhave worked out well and perhaps he now has $90,000 in T-bills plus $30,000 worth \nof options, plus interest from the T-bills. Obviously, he no longer has 90% of his \nmoney in fixed-income securities and 10% in option purchases. The ratio is now 75% \nin T-bills and 25% in option purchases. This is too risky aratio, and the strategist \nmust consequently sell some of his options and buy T-bills with the proceeds. Since \nhis total assets are $120,000 currently, he must sell out $18,000 of options to bring his", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:455", "doc_id": "f7a6643296e73fe2c46ccdb70ad598dec1c54662cbea5b61c7f6e28228db46c2", "chunk_index": 0}
{"text": "416 Part IV: Additional Considerations \noption investment down from the current $30,000 figure to $12,000, or 10% of his \ntotal assets. If one fails to adhere to this readjustment of his funds after profits are \nmade, he may eventually lose those profits. Since options can lose agreat percentage \nof their worth in ashort time pe1iod, the investor is always running the risk that the \noption portion of his investment may be nearly wiped out. If he has kept all his prof\nits in the option portion of his strategy, he is constantly risking nearly all of his accu\nmulated profits, and that is not wise. \nOne must also adjust his ratio of T-bills to options after losses occur. \nExample: In the first year, the strategist loses all of the $10,000 he originally placed \nin options. This would leave him with total assets of $90,000 plus interest (possibly \n$6,000 of interest might be earned). He could readjust to a 90:10 ratio by selling out \nsome of the T-bills and using the proceeds to buy options. If one follows this strate\ngy, he will be risking 10% of his funds each year. Thus, aseries of loss years could \ndepreciate the initial assets, although the net losses in one year would be smaller than \n10% because of the interest earned on the T-bills. It is recommended that the strate\ngist pursue this method of readjusting his ratios in both up and down markets in \norder to constantly provide himself with essentially similar risk/reward opportunities \nat all times. \nThe individual can blend the option selection process and the adjustment of the \nT-bill/option ratio to fit his individual portfolio. The larger portfolio can be diversi\nfied into options \\vith differing holding periods, and the ratio adjustments can be \nmade quite frequently, perhaps once amonth. The smaller investor should concen\ntrate on somewhat longer holding periods for his options, and would adjust the ratio \nless often. Some examples might help to illustrate the way in which both the large \nand small strategist might operate. It should be noted that this T-bill/option strategy \nis quite adaptable to fairly small sums of money, as long as the 10% that is going to \nbe put into option purchases allows one to be able to participate in areasonable man\nner. Atactic for the extremely small investor is also described below. \nANNUALIZED RISK \nBefore getting into portfolio size, let us describe the concept of annualized risk. \nOne might want to purchase options with the intent of holding some of them for 30 \ndays, some for 90 days, and some for 180 days. Recall that he does not want his \noption purchases to represent more than 10% annual risk at any time. In actual \npractice, if one purchases an option that has 90 days of life, but he is planning to \nhold the option only 30 days, he will most likely not lose 100% of his investment in", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:456", "doc_id": "4040a5fab0be1f043f8faef46f7735c1aa63405e7f84dd2765387216b29f45ab", "chunk_index": 0}
{"text": "Chapter 26: Buying Options and Treasury Bills 417 \nthe 30-day period. However, for purposes of computing annualized risk easily, the \nassumption that will be made is that the risk during any holding period is 100%, \nregardless of the length of time remaining in the life of the option. Thus, a 30-day \noption purchase represents an annualized risk of 1,200% (100% risk every 30 days \ntimes twelve 30-day periods in one year). Ninety-day purchases have 400% annual\nized risk, and 180-day purchases have 200% annualized risk. There is amultitude \nof ways to combine purchases in these three holding periods so that the overall risk \nis 10% annualized. \nExample: An investor could put 2½% of his total money into 90-day purchases four \ntimes ayear. That is, 2½% of his total assets are being subjected to a 400% annual\nized risk; 400% times 2½% equals 10% annualized risk on the total assets. Of course, \nthe remainder of the assets would be placed in risk-free, income-bearing securities. \nAnother of the many combinations might be to place 1 % of the total assets in 90-day \npurchases and also place 3% of the total assets in 180-day purchases. Thus, 1 % of \none'stotal money would be subjected to a 400% annual risk and 3% would be sub\njected to a 200% annual risk (.01 times 400 plus .03 times 200 equals 10% annualized \nrisk on the entire assets). If one prefers aformula, annualized risk can be computed \nas: \nAal. d • k • r 1. Percent of total 360 nnu 1ze ns on entire portro 10 = dxassets investe Holding period \nIf one is able to diversify into several holding periods, the annualized risk is merely \nthe sum of the risks for each holding period. \nWith this information in mind, the strategist can utilize option purchases of 1 \nmonth, 3 months, and 6 months, preferably each generated by aseparate computer \nanalysis similar to the one described earlier. He will know how much of his total \nassets he can place into purchases of each holding period, because he will know his \nannualized risk. \nExample: Suppose that avery large investor, or pool of investors, has $1 million com\nmitted to this T-bill/option strategy. Further, suppose ½ of 1 % of the money is to be \ncommitted to 30-day option purchases with the idea of reinvesting every 30 days. \nSimilarly, ½ of 1 % is to be placed in 90-day purchases and 1 % in 180-day purchases. \nThe annualized risk is 10%: \nTotal annualized risk = ½% x 360 + ½% x 360 + 1 % x 360 \n30 90 180 \n= .06 + .02 + .02 = 10%", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:457", "doc_id": "390c023bcb2e25e40fcac34f87dd2676a9020ca862575aaf9eb139ad1371b29f", "chunk_index": 0}
{"text": "418 Part IV: Additional Considerations \nWith asset.sof $1 million, this means that $.5,000 would be committed to 30-day pur\nchases; $.5,000 to 90-day purchases; and $10,000 to 180-day purchases. This money \nwould be reinvested in similar quantities at the end of each holding period. \nRISK ADJUSTMENT \nThe subject of adjusting the ratio to constantly reflect 10% risk must be addressed at \nthe end of each holding period. Although it is correct for the investor to keep his per\ncentage commitments constant, he must not be deluded into automatically reinvest\ning the same amount of dollars each time. \nExample: At the end of 30 days, the value of the entire portfolio, including potential \noption profits and losses, and interest earned, was down to $990,000. Then only ½ of \n1 % of that amount should be invested in the next 30-day purchase ($4,9.50). \nBy operating in this manner - first computing the annualized risk and balanc\ning it through predetermined percentage commitments to holding periods of various \nlengths; and second, readjusting the actual dollar commitment at the end of each \nholding period - the overall risk/reward ratios v,ill be kept close to the levels \ndescribed in the earlier, simple desciiption of this strategy. This may require arela\ntively large amount of work on the part of the strategist, but large portfolios usually \ndo require work. \nThe smaller investor does not have the luxury of such complete diversification, \nbut he also does not have to adjust his total position as often. \nExample: An investor decided to commit $.50,000 to this strategy. Since there is a \n1,200% annualized risk in 30-day purchases, it does not make much sense to even \nconsider purchases that are so short-term for assets of this size. Rather, he might \ndecide to commit 1 % of his assets to a 90-day purchase and 3% to a 180-day pur\nchase. In dollar amounts, this would be $.500 in a 90-day option and $1,.500 in 180-\nday options. Admittedly, this does not leave much room for diversification, but to risk \nmore in the short-term purchases would expose the investor to too much risk. In \nactual practice, this investor would probably just invest .5% of his assets in 180-day \npurchases, also a 10% annualized risk. This would mean that he could operate with \nonly one option buyer'sanalysis (the 180-day one) and could place $2,.500 into selec\ntions from that list. \nHis adjustments of the assets committed to option purchases could not be done \nas frequently as the large investor, because of the commissions involved. He certain\nly would have to adjust every 180 days, but might prefer to do so more frequently -\nperhaps every 90 days - to be able to space his 180-day commitments over different", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:458", "doc_id": "c9584e889b98863f4a2540b944a6ed2d6b2e30c5cce07b1db144707aacdc5c5e", "chunk_index": 0}
{"text": "Chapter 26: Buying Options and Treasury Bills 419 \noption expiration cycles. It should also be pointed out that T-bills can be bought and \nsold only in amounts of at least $10,000 and in increments of $5,000 thereafter. That \nis, one could buy or sell $10,000 or $15,000 or $20,000 or $25,000, and so on, but \ncould not buy or sell $5,000 or $8,000 or $23,000 in T-bills. This is of little concern \nto the investor with $1 million, since it takes only afraction of apercentage of his \nassets to be able to round up to the next $5,000 increment for a T-bill sale or pur\nchase. However, the medium-sized investor with a $50,000 portfolio might run into \nproblems. While short-term T-bills do represent the best risk-free investment, the \nmedium-sized investor might want to utilize one of the no-load, money market funds \nfor at least part of his income-bearing assets. Such funds have only slightly more risk \nthan T-bills and offer the ability to deposit and withdraw in any amount. \nThe truly small investor might be feeling somewhat left out. Could it be possi\nble to operate this strategy with avery small amount of money, such as $5,000? Yes \nit could, but there are several disadvantages. \nExample: It would be extremely difficult to keep the risk level down to 10% annual\nly with only $5,000. For example, 5% of the money invested every 180 days is only \n$250 in each investment period. Since the option selection process that is described \nwill tend to select at- or slightly out-of-the-money calls, many of these will cost more \nthan 2½ points for one option. The small investor might decide to raise his risk level \nslightly, although the risk level should never exceed 20% annually, no matter how \nsmall the actual dollar investment. To exceed this risk level would be to completely \ndefeat the purpose of the fixed-income/option purchase strategy. Obviously, this \nsmall investor cannot buy T-bills, for his total investable assets are below the mini\nmum $10,000 purchase level. He might consider utilizing one of the money market \nfunds. Clearly, an investor of this small magnitude is operating at adouble disadvan\ntage: His small dollar commitment to option purchases may preclude him from buy\ning some of the more attractive items; and his fixed-income portion will be earning asmaller percentage interest rate than that of the larger investor who is in T-bills or \nsome other form of relatively risk-free, income-bearing security. Consequently, the \nsmall investor should carefully consider his financial capability and willingness to \nadhere strictly to the criteria of this strategy before actually committing his dollars. \nIt may appear to the reader that the actual dollars being placed at risk in each \noption purchase are quite small in these examples. In fact, they are rather small, but \nthey have been shown to represent 10% annualized risk. An assumption was made in \nthese examples that the risk in each option purchase was 100% for the holding peri\nod. This is afairly restrictive assumption and, if it were lessened, would allow for alarger dollar commitment in each holding period. It is difficult and dangerous, how-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:459", "doc_id": "22703753b385ab71d4c43564b94d16eb5cde95f4fe008020238ebd59e884aae3", "chunk_index": 0}
{"text": "420 Part IV: Additional Considerations \never, to assume that the risk in holding acall option is less than 100% in aholding \nperiod as short as 30 days. The strategist may feel that he is disciplined enough to sell \nout when losses occur and thereby hold the risk to less than 100%. Alternatively, \nmathematical analysis will generally show that the expected loss in afixed time peri\nod is less than 100%. One can also mitigate the probability oflosing all of his money \nin an option purchase by buying in-the-money options. While they are more expen\nsive, of course, they do have alarger probability of having some residual worth even \nif the underlying stock doesn'trise to the trader'sexpectations. Adhering to any of \nthese criteria can lead one to become too aggressive and therefore be too heavily \ncommitted to option purchases. It is far safer to stick to the simpler, more restrictive \nassumption that one is risking all his money, even over afairly short holding period, \nwhen he buys an option. \nAVOIDING EXCESSIVE RISK \nOne final word of caution must be inserted. The investor should not attempt to \nbecome 'Janey\" with the income-bearing portion of his assets. T-bills may appear to \nbe too \"tame\" to some investors, and they consider using GNMA's (Government \nNational Mortgage Association certificates), corporate bonds, convertible bonds, or \nmunicipal bonds for the fixed-income portion. Although the latter securities may \nyield aslightly higher return than do T-bills, they may also prove to be less liquid and \nthey quite clearly involve more risk than ashort-term T-bill does. Moreover, some \ninvestors might even consider placing the balance of their funds in other places, such \nas high-yield stock or covered call writing. While high-yield stock purchases and cov\nered call writing are conservative investments, as most investments go, they would \nhave to be considered very speculative in comparison to the purchase of a 90-day Thill. In this strategy, the profit potential is represented by the option purchases. The \nyield on short-term T-bills will quite adequately offset the risks. One should take \ngreat care not to attempt to generate much higher yields on the fixed-income portion \nof his investment, for he may find that he has assumed risk with the portion of his \nmoney that was not intended to have any risk at all. \nAfair amount of rigorous mathematical work has been done on the evaluation \nof this strategy. The theoretical papers are quite favorable. Scholars have generally \nconsidered only the purchase of call options as the risk portion of the strategy. \nObviously, the strategist is quite free to purchase put options without harming the \noverall intent of the strategy. When only call options are purchased, both static and \ndown markets harm the performance. If some puts are included in the option pur\nchases, only static markets could produce the worst results.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:460", "doc_id": "36fa6d8bd81c727beefc27b0c741c5676dcdfb98cc37783a65e26d14818599e0", "chunk_index": 0}
{"text": "Chapter 26: Buying Options and Treasury Bills 421 \nThere are trade-offs involved as well. If, after purchasing the options, the mar\nket experiences asubstantial rally, that portion of the option purchase money that is \ndevoted to put option purchases will be lost. Thus, the combination of both put and \ncall purchases would do better in adown market than astrategy of buying only calls, \nbut would do worse in an up market. In abroad sense, it makes sense to include some \nput purchases if one has the funds to diversify, since the frequency of market rallies \nis smaller than the combined frequency of market rallies and declines. The investor \nwho owns both puts and calls will be able to profit from substantial moves in either \ndirection, because the profitable options will be able to overcome the limited losses \non the unprofitable ones. \nSUMMARY \nIn summary, the T-bill/option strategy is attractive from several viewpoints. Its true \nadvantage lies in the fact that it has predefined risk and does not have alimit on \npotential profits. Some theorists claim it is the best strategy available, if the options \nare \"underpriced\" when they are purchased. The strategy is also relatively simple to \noperate. It is not necessary to have amargin account or to compute collateral require\nments for uncovered options; the strategy can be operated completely from acash \naccount. There are no spreads involved, nor is it necessary to worry about details such \nas early assignment (because there are no short options in this strategy). \nThe investor who is going to employ this strategy, however, must not be delud\ned into thinking that it is so simple that it does not take any work at all. The concepts \nand application of annualized risk management are very important to the strategy. So \nare the mechanics of option buying - particularly adisciplined, rational approach to \nthe selection of which calls and/or puts to buy. Consequently, this strategy is suitable \nonly for the investor who has both the time and the discipline to operate it correctly.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:461", "doc_id": "c6bb2c71b27753b30edcc62bc5ec4dd240e399a3bee0231a7360afa28527bb07", "chunk_index": 0}
{"text": "Arbitrage \nArbitrage in the securities market often connotes that one is buying something in \none marketplace and selling it in another marketplace, for asmall profit with little \nor no risk. For example, one might buy XYZ at 55 in New York and sell it at 55¼ in \nChicago. Arbitrage, especially option arbitrage, involves afar wider range of tactics \nthan this simple example. Many of the option arbitrage tactics involve buying one \nside of an equivalent position and simultaneously selling the other side. Since there \nis alarge number of equivalent strategies, many of which have been pointed out in \nearlier chapters, afull-time option arbitrageur is able to construct arather large \nnumber of positions, most of which have little or no risk. The public customer can\nnot generally operate arbitrage-like strategies because of the commission costs \ninvolved. Arbitrageurs are firm traders or floor traders who are trading through aseat on the appropriate securities exchange, and therefore have only minimal trans\naction costs. \nThe public customer can benefit from understanding arbitrage techniques, even \nifhe does not personally employ them. The arbitrageurs perform auseful function in \nthe option marketplace, often making markets where amarket might not otherwise \nexist (deeply in-the-money options, for example). This chapter is directed at the \nstrategist who is actually going to be participating in arbitrage. This should not be \nconfusing to the public customer, for he will better understand the arbitrage strate\ngies if he temporarily places himself in the arbitrageur'sshoes. \nIt is virtually impossible to perform pure arbitrage on dually listed options; that \nis, to buy an option on the CBOE and sell it on the American exchange in New York \nfor aprofit. Such discrepancies occur so infrequently and in such small size that an \noption arbitrageur could never hope to be fully employed in this type of simple arbi\ntrage. Rather, the more complex forms of arbitrage described here are the ones on \nwhich he would normally concentrate. \n422", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:462", "doc_id": "c77d82d7f3cce4524fcadbec2b5743cff52adf13d1370753f488b3aac636d41d", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 423 \nBASIC PUT AND CALL ARBITRAGE (\"DISCOUNTING\") \nThe basic call and the basic put arbitrages are two of the simpler forms of option arbi\ntrage. In these situations, the arbitrageur attempts to buy the option at adiscount \nwhile simultaneously taking an opposite position in the underlying stock. He can then \nexercise his option immediately and make aprofit equal to the amount of the discount. \nThe basic call arbitrage is described first. This was also outlined in Chapter 1, \nunder the section on anticipating exercise. \nExample: XYZ is trading at 58 and the XYZ July 50 call is trading at 7¾. The call is \nactually at adiscount from parity of ¼ point. Discount options generally either are \nquite deeply in-the-money or have only ashort time remaining until expiration, or \nboth. The call arbitrage would be constructed by: \n1. buying the call at 7¾; \n2. selling the stock at 58; \n3. exercising the call to buy the stock at 50. \nThe arbitrageur would make 8 points of profit from the stock, having sold it at 58 and \nbought it back at 50 via the option exercise. He loses the 7¾ points that he paid for \nthe call option, but this still leaves him with an overall profit of¼ point. Since he is \namember of the exchange, or is trading the seat of an exchange member, the arbi\ntrageur pays only asmall charge to transact the trades. \nIn reality, the stock is not sold short per se, even though it is sold before it is \nbought. Rather, the position is designated, at the time of its inception, as an \"irrevo\ncable exercise.\" The arbitrageur is promising to exercise the call. As aresult, no \nuptick is required to sell the stock. \nThe main goal in the call arbitrage is to be able to buy the call at adiscount from \nthe price at which the stock is sold. The differential is the profit potential of the arbi\ntrage. The basic put arbitrage is quite similar to the call arbitrage. Again, the arbi\ntrageur is looking to buy the put option at adiscount from parity. The put arbitrage \nis completed with astock purchase and option exercise. \nExample: XYZ is at 58 and the XYZ July 70 put is at 11 ¾. With the put at ¼ discount \nfrom parity, the arbitrageur might take the following action: \n1. Buy put at 11 ¾. \n2. Buy stock at 58. \n3. Exercise put to sell stock at 70.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:463", "doc_id": "d4d54df213b687d0c17d23c04f13a79318eb87c91d0cf3836c1cdac94976b5a9", "chunk_index": 0}
{"text": "424 Part IV: Additional Considerations \nThe stock transaction is a 12-point profit, since the stock was bought at 58 and is sold \nat 70 via the put exercise. The cost of the put - 11 ¾ points - is lost, but the arbi\ntrageur still makes ¼-point profit. Again, this profit is equal to the arrwunt of the dis\ncount in the option when the position was established. Generally, the arbitrageur \nwould exercise his put option immediately, because he would not want to tie up his \ncapital to carry the long stock. An exception to this would be if the stock were about \nto go ex-dividend. Dividend arbitrage is discussed in the next section. \nThe basic call and put arbitrages may exist at any time, although they will be \nmore frequent when there is an abundance of deeply in-the-money options or when \nthere is avery short time remaining until expiration. After market rallies, the call \narbitrage may be easier to establish; after market declines, the put arbitrage will be \neasier to find. As an expiration date draws near, an option that is even slightly in-the\nmoney on the last day or two of trading could be acandidate for discount arbitrage. \nThe reason that this is true is that public buying interest in the option will normally \nwane. The only public buyers would be those who are short and want to cover. Many \ncovered writers will elect to let the stock be called away, so that will reduce even fur\nther the buying potential of the public. This leaves it to the arbitrageurs to supply the \nbuying interest. \nThe arbitrageur obviously wants to establish these positions in as large asize as \npossible, since there is no risk in the position if it is established at adiscount. Usually, \nthere will be alarger market for the stock than there will be for the options, so the \narbitrageur spends more of his time on the option position. However, there may be \noccasions when the option markets are larger than the corresponding stock quotes. \nWhen this happens, the arbitrageur has an alternative available to him: He might sell \nan in-the-money option at parity rather than take astock position. \nExample: XYZ is at 58 and the XYZ July 50 call is at 7¾. These are the same figures \nas in the previous example. Furthermore, suppose that the trader is able to buy more \noptions at 7¾ than he is able to sell stock at 58. If there were another in-the-money \ncall that could be sold at parity, it could be used in place of the stock sale. For exam\nple, if the XYZ July 40 call could be sold at 18 (parity), the arbitrage could still be \nestablished. Ifhe is assigned on the July 40 that he is short, he will then be short stock \nat anet price of 58 - the striking price of 40, plus the 18 points that were brought in \nfrom the sale of the July 40 call. Thus, the sale of the in-the-money call at parity is \nequivalent to shorting the stock for the arbitrage purpose. \nIn asimilar manner, an in-the-money put can be used in the basic put arbitrage. \nExample: With XYZ at 58 and the July 70 put at 11¾, the arbitrage could be estab\nlished. However, if the trader is having trouble buying enough stock at 58, he might", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:464", "doc_id": "e1df513550430b52e004a013691286056a67223128db6c8ff0d691bf3532ed86", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 425 \nbe able to use another in-the-money put. Suppose the XYZ July 80 put could be sold \nat 22. This would be the same as buying the stock at 58, because if the put were \nassigned, the arbitrageur would be forced to buy stock at 80 - the striking price - but \nhis net cost would be 80 minus the 22 points he received from the sale of the put, for \nanet cost of 58. Again, the arbitrageur is able to use the sale of adeeply in-the-money \noption as asubstitute for the stock trade. \nThe examples above assumed that the arbitrageur sold adeeper in-the-money \noption at parity. In actual practice, if an in-the-money option is at adiscount, an even \ndeeper in-the-money option will generally be at adiscount as well. The arbitrageur \nwould normally try to sell, at parity, an option that was less deeply in-the-money than \nthe one he is discounting. \nIn abroader sense, this technique is applicable to any arbitrage that involves astock trade as part of the arbitrage, except when the dividend in the stock itself is \nimportant. Thus, if the arbitrageur is having trouble buying or selling stock as part of \nhis arbitrage, he can always check whether there is an in-the-money option that could \nbe sold to produce aposition equivalent to the stock position. \nDIVIDEND ARBITRAGE \nDividend arbitrage is actually quite similar to the basic put arbitrage. The trader can \nlock in profits by buying both the stock and the put, then waiting to collect the divi\ndend on the underlying stock before exercising his put. In theory, on the day before \nastock goes ex-dividend, all puts should have atime value premium at least as large \nas the dividend amount. This is true even for deeply in-the-money puts. \nExample: XYZ closes at 45 and is going to go ex-dividend by $1 tomorrow. Then aput with striking price of 50 should sell for at least 6 points ( the in-the-money amount \nplus the amount of the dividend), because the stock will go ex-dividend and is expect\ned to open at 44, six points in-the-money. \nIf, however, the put' stime value premium should be less than the amount of the \ndividend, the arbitrageur can take ariskless position. Suppose the XYZ July 50 put is \nselling for 5¾, with the stock at 45 and about to go ex-dividend by $1. The arbi\ntrageur can take the following steps: \n1. Buy the put at 5¼. \n2. Buy the stock at 45. \n3. Hold the put and stock until the stock goes ex-dividend (1 point in this case). \n4. Exercise the put to sell the stock at 50.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:465", "doc_id": "2c76082ec18775ff157ac8e721e7450ae2d9763e8999171b782fb03347d8bd99", "chunk_index": 0}
{"text": "426 Part IV: Additional Considerations \nThe trader makes 5 points from the stock trade, buying it at 45 and selling it at 50 via \nthe put exercise, and also collects the I-point dividend, for atotal inflow of 6 points. \nSince he loses the 5¾ points he paid for the put, his net profit is ¼ point. \nFar in advance of the ex-dividend date, adeeply in-the-money put may trade \nvery close to parity. Thus, it would seem that the arbitrageur could \"load up\" on these \ntypes of positions and merely sit back and wait for the stock to go ex-dividend. There \nis aflaw in this line of thinking, however, because the arbitrageur has acarrying cost \nfor the rrwney that he must tie up in the long stock. This carrying cost fluctuates with \nshort-term interest rates. \nExample: If the current rate of carrying charges were 6% annually, this would be \nequivalent to 1 % every 2 months. If the arbitrageur were to establish this example \nposition 2 months prior to expiration, he would have acarrying cost of .5075 point. \n(His total outlay is 50¾ points, 45 for the stock and 5¾ for the options, and he would \npay 1 % to carry that stock and option for the two months until the ex-dividend date.) \nThis is more than ½ point in costs - clearly more than the ¼-point potential profit. \nConsequently, the arbitrageur must be aware of his carrying costs if he attempts to \nestablish adividend arbitrage well in advance of the ex-dividend date. Of course, if \nthe ex-dividend date is only ashort time away, the carrying cost has little effect, and \nthe arbitrageur can gauge the profitability of his position mostly by the amount of the \ndividend and the time value premium in the put option. \nThe arbitrageur should note that this strategy of buying the put and buying the \nstock to pick up the dividend might have aresidual, rather profitable side effect. If \nthe underlying stock should rally up to or above the striking price of the put, there \ncould be rather large profits in this position. Although it is not likely that such arally \ncould occur, it would be an added benefit if it did. Even arather small rally might \ncause the put to pick up some time premium, allowing the arbitrageur to trade out \nhis position for aprofit larger than he could have made by the arbitrage discount. \nThis form of arbitrage occasionally lends itself to alimited form of risk arbi\ntrage. Risk arbitrage is astrategy that is designed to lock in aprofit if acertain event \noccurs. If that event does not occur, there could be aloss (usually quite limited); \nhence, the position has risk. This risk element differentiates arisk arbitrage from astandard, no-risk arbitrage. Risk arbitrage is described more fully in alater section, \nbut the following example concerning aspecial dividend is one form of risk arbitrage. \nExample: XYZ has been known to declare extra, or special, dividends with afair \namount of regularity. There are several stocks that do so - Eastman Kodak and \nGeneral Motors, for example. In this case, assume that ahypothetical stock, XYZ, has", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:466", "doc_id": "dd1a251c8773d536000f2caaa90c5239382251f8020e05c22fb4d977ca58bccb", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 427 \ngenerally declared aspecial dividend in the fourth quarter of each year, but that its \nnormal quarterly rate is $1.00 per share. Suppose the special dividend in the fourth \nquarter has ranged from an extra $1.00 to $3.00 over the past five years. If the arbi\ntrageur were willing to speculate on the size of the upcoming dividend, he might be \nable to make anice profit. Even if he overestimates the size of the special dividend, \nhe has alimited loss. Suppose XYZ is trading at 55 about two weeks before the com\npany is going to announce the dividend for the fourth quarter. There is no guarantee \nthat there will, in fact, be aspecial dividend, but assume that XYZ is having arela\ntively good year profitwise, and that some special dividend seems forthcoming. \nFurthermore, suppose the January 60 put is trading at 7½. This put has 2½ points of \ntime value premium. If the arbitrageur buys XYZ at 55 and also buys the January 60 \nput at 7½, he is setting up arisk arbitrage. He will profit regardless of how far the \nstock falls or how much time value premium the put loses, if the special dividend is \nlarger than $1.50. Aspecial dividend of $1.50 plus the regular dividend of $1.00 \nwould add up to $2.50, or 2½ points, thus covering his risk in the position. Note that \n$1.50 is in the low end of the $1.00 to $3.00 recent historical range for the special \ndividends, so the arbitrageur might be tempted to speculate alittle by establishing \nthis dividend risk arbitrage. Even if the company unexpectedly decided to declare no \nspecial dividend at all, it would most likely still pay out the $1.00 regular dividend. \nThus, the most that the arbitrageur would lose would be 1 ½ points (his 2½-point ini\ntial time value premium cost, less the 1-point dividend). In actual practice, the stock \nwould probably not change in price by agreat deal over the next two weeks (it is ahigh-yield stock), and therefore the January 60 put would probably have some time \nvalue premium left in it after the stock goes ex-dividend. Thus, the practical risk is \neven less than 1 ½ points. \nWhile these types of dividend risk arbitrage are not frequently available, the \narbitrageur who is willing to do some homework and also take some risk may find that \nhe is able to put on aposition with asmall risk and aprofitability quite abit larger \nthan the normal discount dividend arbitrage. \nThere is really not adirect form of dividend arbitrage involving call options. If \narelatively high-yield stock is about to go ex-dividend, holders of the calls will \nattempt to sell. They do so because the stock will drop in price, thereby generally \nforcing the call to drop in price as well, because of the dividend. However, the hold\ner of acall does not receive cash dividends and therefore is not willing to hold the \ncall if the stock is going to drop by arelatively large amount (perhaps ¾ point or \nmore). The effect of these call holders attempting to sell their calls may often pro\nduce adiscount option, and therefore abasic call arbitrage may be possible. The arbi\ntrageur should be careful, however, if he is attempting to arbitrage astock that is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:467", "doc_id": "5ccff9a01f18f72cad18a47ba29c38e3aff195a52dc886c8412ebad299d5890f", "chunk_index": 0}
{"text": "428 Part IV: Additional Considerations \ngoing ex-dividend on the following day. Since he must sell the stock to set up the arbi\ntrage, he cannot afford to wind up the day being short any stock, for he will then have \nto pay out the dividend the following day (the ex-dividend date). Furthermore, his \nrecords must be accurate, so that he exercises all his long options on the day before \nthe ex-dividend date. If the arbitrageur is careless and is still short some stock on the \nex-date, he may find that the dividend he has to pay out wipes out alarge portion of \nthe discount profits he has established. \nCONVERSIONS AND REVERSALS \nIn the introductory material on puts, it was shown that put and call prices are relat\ned through aprocess known as conversion. This is an arbitrage process whereby atrader may sometimes be able to lock in aprofit at absolutely no risk. Aconversion \nconsists of buying the underlying stock, and also buying aput option and selling acall option such that both options have the same terms. This position will have alocked-in profit if the total cost of the position is less than the striking price of the \noptions. \nExample: The following prices exist: \nXYZ common, 55; \nXYZ January 50 call, 6½; and \nXYZ January 50 put, 1. \nThe total cost of this conversion is 49½ - 55 for the stock, plus 1 for the put, less 6½ \nfor the call. Since 49½ is less than the striking price of 50, there is alocked-in profit \non this position. To see that such aprofit exists, suppose the stock is somewhere \nabove 50 at expiration. It makes no difference how far above 50 the stock might be; \nthe result will be the same. With the stock above 50, the call will be assigned and the \nstock will be sold at aprice of 50. The put will expire worthless. Thus, the profit is½ \npoint, since the initial cost of the position was 49½ and it can eventually be liquidat\ned for aprice of 50 at expiration. Asimilar result occurs if XYZ is below 50 at expi\nration. In this case, the trader would exercise his put to sell his stock at 50, and the \ncall would expire worthless. Again, the position is liquidated for aprice of 50 and, \nsince it only cost 49½ to establish, the same ½-point profit can be made. No matter \nwhere the stock is at expiration, this position has alocked-in-profit of½ point. \nThis example is rather simplistic because it does not include two very important \nfactors: the possible dividend paid by the stock and the cost of carrying the position", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:468", "doc_id": "f59eaf71dd11566e6b12070dd34ca13c3aeb91abf057bdbc6602cc2fbabaaf12", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 429 \nuntil expiration. The inclusion of these factors complicates things somewhat, and its \ndiscussion is deferred momentarily while the companion strategy, the reversal, is \nexplained. \nAreversal (or reverse conversion, as it is sometimes called) is exactly the oppo\nsite of aconversion. In areversal, the trader sells stock short, sells aput, and buys acall. Again, the put and call have the same terms. Areversal will be profitable if the \ninitial credit ( sale price) is greater than the striking price of the options. \nExample: Adifferent set of prices will be used to describe areversal: \nXYZ common, 55; \nXYZ January 60 call, 2; and \nXYZ January 60 put, 7½. \nThe total credit of the reversal is 60½ - 55 from the stock sale, plus 7½ from the put \nsale, less the 2-point cost of the call. Since 60½ is greater than the striking price of \nthe options, 60, there is alocked-in profit equal to the differential of½ point. To ver\nify this, first assume that XYZ is anywhere below 60 at January expiration. The put \nwill be assigned - stock is bought at 60 - and the call will expire worthless. Thus, the \nreversal position is liquidated for acost of 60. A ½-point profit results since the orig\ninal sale value ( credit) of the position was 60½. On the other hand, if XYZ were above \n60 at expiration, the trader would exercise his call, thus buying stock at 60, and the \nput would expire worthless. Again, he would liquidate the position at acost of 60 and \nwould make a ½-point profit. \nDividends and carrying costs are important in reversals, too; these factors are \naddressed here. The conversion involves buying stock, and the trader will thus \nreceive any dividends paid by the stock during the life of the arbitrage. However, the \nconverter also has to pay out arather large sum of money to set up his arbitrage, and \nmust therefore deduct the cost of carrying the position from his potential profits. In \nthe example above, the conversion position cost 49½ points to establish. If the trad\ner'scost of money were 6% annually, he would thus lose .06/12 x 49½, or .2475 point \nper month for each month that he holds the position. This is nearly ¼ of apoint per \nmonth. Recall that the potential profit in the example is ½ point, so that if one held \nthe position for more than two months, his carrying costs would wipe out his profit. \nIt is extremely important that the arbitrageur compute his carrying costs accurately \nprior to establishing any conversion arbitrage. \nIf one prefers formulae, the profit potentials of aconversion or areversal can \nbe stated as:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:469", "doc_id": "29d72ba6c3ea40ae205cffa08332575ac127b434c864b6911949925302dae75e", "chunk_index": 0}
{"text": "430 l'art IV: Additional Considerations \nConversion profit = Striking price + Call price - Stock price - Put price + \nDividends to be received - Carrying cost of position \nReversal profit = Stock + Put - Strike - Call + Carrying cost - Dividends \nNote that during any one trading day, the only items in the formulae that can change \nare the prices of the securities involved. The other items, dividends and carrying cost, \nare fixed for the day. Thus, one could have asmall computer program prepared that \nlisted the fixed charges on aparticular stock for all the strikes on that stock. \nExample: It is assumed that XYZ stock is going to pay a ½-point dividend during the \nlife of the position, and that the position will have to be held for three months at acarrying cost of 6% per year. If the arbitrageur were interested in aconversion with \nastriking price of 50, his fixed cost would be: \nConversion fixed cost = Carrying rate x Time held x Striking price -\nDividend to be received \n= .06 X 3/12 X 50 - ½ \n= .75- ½ = .25, or¼ point \nThe arbitrageur would know that if the profit potential, computed in the simplistic \nmanner using only the prices of the securities involved, was greater than ¼ point, he \ncould establish the conversion for an eventual profit, including all costs. Of course, \nthe carrying costs would be different if the striking price were 40 or 60, so acom\nputer printout of all the possible striking prices on each stock would be useful in \norder for the trader to be able to refer quickly to atable of his fixed costs each day. \nMORE ON CARRYING COSTS \nThe computation of carrying costs can be made more involved than the simple \nmethod used above. Simplistically, the carrying cost is computed by multiplying the \ndebit of the position by the interest rate charged and the time that the position will \nbe held. That is, it could be formulated as: \nCarrying cost = Strike xrxtwhere ris the interest rate and tis the time that the position will be held. Relating \nthis formula for the carrying cost to the conversion profit formula given above, one \nwould get: \nConversion profit = Call - Stock - Put + Dividend + Strike - Carrying cost \n= Call - Stock - Put + Dividend + Strike ( 1 - rt)", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:470", "doc_id": "c3b680efaac24135c79793cda0b6f632a06fb529fb6b93f747b70922fdbb9c77", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 431 \nIn an actuarial sense, the carrying cost could be expressed in aslightly more complex \nmanner. The simple formula (strike xrxt) ignores two things: the compounding \neffect of interest rates and the \"present value\" concept ( the present value of afuture \namount). The absolutely correct formula to include both present value and the com\npounding effect would necessitate replacing the factor strike (1- rt) in the profit for\nmula by the factor \nStrike \n(1 + r)f \nIs this effect large? No, not when rand tare small, as they would be for most option \ncalculations. The interest rate per month would normally be less than 1 %, and the \ntime would be less than 9 months. Thus, it is generally acceptable, and is the com\nmon practice among many arbitrageurs, to use the simple formula for carrying costs. \nIn fact, this is often amatter of convenience for the arbitrageur if he is computing \nthe carrying costs on ahand calculator that does not perform exponentiation. \nHowever, in periods of high interest rates when longer-term options are being ana\nlyzed, the arbitrageur who is using the simple formula should double-check his cal\nculations with the correct formula to assure that his error is not too large. \nFor purposes of simplicity, the remaining examples use the simple formula for \ncarrying-cost computations. The reader should remember, however, that it is only aconvenient approximation that works best when the interest rate and the holding \nperiod are small. This discussion of the compounding effect of interest rates also rais\nes another interesting point: Any investor using margin should, in theory, calculate \nhis potential interest charge using the compounding formula. However, as amatter \nof practicality, extremely few investors do. An example of this compounding effect on \nacovered call write is presented in Chapter 2. \nBACK TO CONVERSIONS AND REVERSALS \nProfit calculation similar to the conversion profit formula is necessary for the rever\nsal arbitrage. Since the reversal necessitates sho1ting stock, the trader must pay out \nany dividends on the stock during the time in which the position is held. However, \nhe is now bringing in acredit when the position is established, and this money can \nbe put to work to earn interest. In areversal, then, the dividend is acost and the \ninterest earned is aprofit.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:471", "doc_id": "90b42ad70bff4886fe0c673f92835755dcae80242886e022427f9a1bb0fb3455", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 433 \navailable in the marketplace at anet profit of ½ point, or 50 cents. Such areversal \nmay not be equally attractive to all arbitrageurs. Those who have \"box\" stock may be \nwilling to do the reversal for 50 cents; those who have to pay 1 % to borrow stock may \nwant 0.55 for the reversal; and those who pay 2% to borrow stock may need 0.65 for \nthe reversal. Thus, arbitrageurs who do conversions and reversals are in competition \nwith each other not only in the marketplace, but in the stock loan arena as well. \nReversals are generally easier positions for the arbitrageur to locate than are \nconversions. This is because the fixed cost of the conversion has arather burdensome \neffect. Only if the stock pays arather large dividend that outweighs the carrying cost \ncould the fixed portion of the conversion formula ever be aprofit as opposed to acost. In practice, the interest rate paid to carry stock is probably higher than the \ninterest earned from being short stock, but any reasonable computer program should \nbe able to handle two different interest rates. \nThe novice trader may find the term \"conversion\" somewhat illogical. In the \nover-the-counter option markets, the dealers create aposition similar to the one \nshown here as aresult of actually converting aput to acall. \nExample: When someone owns aconventional put on XYZ with astriking price of \n60 and the stock falls to 50, there is often little chance of being able to sell the put \nprofitably in the secondary market. The over-the-counter option dealer might offer \nto convert the put into acall. To do this, he would buy the put from the holder, then \nbuy the stock itself, and then offer acall at the original striking price of 60 to the \nholder of the put. Thus, the dealer would be long the stock, long the put, and short \nthe call - aconversion. The customer would then own acall on XYZ with astriking \nprice of 60, due to expire on the same date that the put was destined to. The put \nthat the customer owned has been converted into acall. To effect this conversion, \nthe dealer pays out to the customer the difference between the current stock price, \n50, and the striking price, 60. Thus, the customer receives $1,000 for this conver\nsion. Also, the dealer would charge the customer for costs to carry the stock, so that \nthe dealer had no risk. If the stock rallied back above 60, the customer could make \nmore money, because he owns the call. The dealer has no risk, as he has an arbitrage \nposition to begin with. In asimilar manner, the dealer can effect areverse conver\nsion - converting acall to aput - but will charge the dividends to the customer for \ndoing so. \nRISKS IN CONVERSIONS AND REVERSALS \nConversions and reversals are generally considered to be riskless arbitrage. That is, \nthe profit in the arbitrage is fixed from the start and the subsequent movement of the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:473", "doc_id": "c7a8774572b6863139708e65f8f13e696c646dc0466cb403c18223ea2e2b9ea9", "chunk_index": 0}
{"text": "434 Part IV: Additional Considerations \nunderlying stock makes no difference in the eventual outcome. This is generally atrue statement. However, there are some risks, and they are great enough that one \ncan actually lose money in conversions and reversals if he does not take care. The \nrisks are fourfold in reversal arbitrage: An extra dividend is declared, the interest rate \nfalls while the reversal is in place, an early assignment is received, or the stock is \nexactly at the striking price at expiration. Converters have similar risks: adividend \ncut, an increase in the interest rate, early assignment, or the stock closing at the strike \nat expiration. \nThese risks are first explored from the viewpoint of the reversal trader. If the \ncompany declares an extra dividend, it is highly likely that the reversal will become \nunprofitable. This is so because most extra dividends are rather large - more than the \nprofit of areversal. There is little the arbitrageur can do to avoid being caught by the \ndeclaration of atruly extra dividend. However, some companies have atrack record \nof declaring extras with annual regularity. The arbitrageur should be aware of which \ncompanies these are and of the timing of these extra dividends. Aclue sometimes \nexists in the marketplace. If the reversal appears overly profitable when the arbi\ntrageur is first examining it (before he actually establishes it), he should be somewhat \nskeptical. Perhaps there is areason why the reversal looks so tempting. An extra div\nidend that is being factored into the opinion of the marketplace may be the answer. \nThe second risk is that of variation in interest rates while the reversal is in \nprogress. Obviously, rates can change over the life of areversal, normally 3 to 6 \nmonths. There are two ways to compensate for this. The simplest way is to leave \nsome room for rates to move. For example, if rates are currently at 12% annually, one \nmight allow for amovement of 2 to 3% in rates, depending on the length of time the \nreversal is expected to be in place. In order to allow for a 2% move, the arbitrageur \nwould calculate his initial profit based on arate of 10%, 2% less than the currently \nprevailing 12%. He would not establish any reversal that did not at least break even \nwith a 10% rate. The rate at which areversal breaks even is often called the \"effec\ntive rate\" - 10% in this case. Obviously, if rates average higher than 10% during the \nlife of the reversal, it will make money. Normally, when one has an entire portfolio of \nreversals in place, he should know the effective rate of each set of reversals expiring \nat the same time. Thus, he would have an effective rate for his 2-month reversals, his \n3-month ones, and so forth. \nAllowing this room for rates to move does not necessarily mean that there will \nnot be an adverse affect if rates do indeed fall. For example, rates could fall farther \nthan the room allowed. Thus, afurther measure is necessary in order to completely \nprotect against adrop in rates: One should invest his credit balances generated by the \nreversals in interest-bearing paper that expires at approximately the same time the \nreversals do, and that bears interest at arate that locks in aprofit for the reversal", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:474", "doc_id": "d86e49f8bb92b27cef30d8c30876602cd74be739b85d1f922298bfcd36e5b2ca", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 435 \naccount. For example, suppose that an arbitrageur has $5 million in 3-month rever\nsals at an effective rate of 10%. If he can buy $5 million worth of 3-month Certificates \nof Deposit with arate of 11 ½%, then he would lock in aprofit of 1 ½% on his $5 mil\nlion. This method of using paper to hedge rate fluctuations is not practiced by all \narbitrageurs; some think it is not worth it. They believe that by leaving the credit bal\nances to fluctuate at prevailing rates, they can make more if rates go up, and that will \ncushion the effect when rates decline. \nThe third risk of reversal arbitrage is reception of an early assignment on the \nshort puts. This forces the arbitrageur to buy stock and incur adebit. Thus, the posi\ntion does not earn as much interest as was originally assumed. If the assignment is \nreceived early enough in the life of the reversal (recall that in-the-money puts can \nbe assigned very far in advance of expiration), the reversal could actually incur an \noverall loss. Such early assignments normally occur during bearish markets. The only \nadvantage of this early assignment is that one is left with unhedged long calls; these \ncalls are well out-of-the-money and normally quite low-priced (¼ or less). If the \nmarket should reverse and turn bullish before the expiration of the calls, the arbi\ntrageur may make money on them. There is no way to hedge completely against amarket decline, but it does help if the arbitrageur tries to establish reversals with the \ncall in-the-money and the put out-of-the-money. That, plus demanding abetter \noverall return for reversals near the strike, should help cushion the effects of the \nbear market. \nThe final risk is the most common one, that of the stock closing exactly at the \nstrike at expiration. This presents the arbitrageur with adecision to make regarding \nexercise of his long calls. Since the stock is exactly at the strike, he is not sure whether \nhe will be assigned on his short puts at expiration. The outcome is that he may end \nup with an unhedged stock position on Monday morning after expiration. If the stock \nshould open on agap, he could have asubstantial loss that wipes out the profits of \nmany reversals. This risk of stock closing at the strike may seem minute, but it is not. \nIn the absence of any real buying or selling in the stock on expiration day, the process \nof discounting will force astock that is near the strike virtually right onto the strike. \nOnce it is near the strike, this risk materializes. \nThere are two basic scenarios that could occur to produce this unhedged stock \nposition. First, suppose one decides that he will not get put and he exercises his calls. \nHowever, he was wrong and he does get put. He has bought double the amount of \nstock - once via call exercise and again via put assignment. Thus, he will be long on \nMonday morning. The other scenario produces the opposite effect. Suppose one \ndecides that he will get put and he decides not to exercise his calls. If he is wrong in \nthis case, he does not buy any stock - he didn'texercise nor did he get put. \nConsequently, he will be short stock on Monday morning.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:475", "doc_id": "38071b8a1eaebb255e12df41a0f5a8995a32a604f19aa74acecfe9c077c18bad", "chunk_index": 0}
{"text": "436 Part IV: Additional Considerations \nIf one is truly undecided about whether he will be assigned on his short puts, \nhe might look at several clues. First, has any late news come out on Friday evening \nthat might affect the market'sopening or the stock'sopening on Monday morning? If \nso, that should be factored into the decision regarding exercising the calls. Another \nclue arises from the price at which the stock was trading during the Friday expiration \nday, prior to the close. If the stock was below the strike for most of the day before \nclosing at the strike, then there is agreater chance that the puts will be assigned. This \nis so because other arbitrageurs (discounters) have probably bought puts and bought \nstock during the day and will exercise to clean out their positions. \nIf there is still doubt, it may be wisest to exercise only half of the calls, hoping \nfor apartial assignment on the puts (always apossibility). This halfway measure will \nnormally result in some sort of unhedged stock position on Monday morning, but it \nwill be smaller than the maximum exposure by at least half. \nAnother approach that the arbitrageur can take if the stock is near the strike of \nthe reversal during the late trading of the options' life - during the last few days - is \nto roll the reversal to alater expiration or, failing that, to roll to another strike in the \nsame expiration. First, let us consider rolling to another expiration. The arbitrageur \nknows the dollar price that equals his effective rate for a 3-month reversal. If the cur\nrent options can be closed out and new options opened at the next expiration for at \nleast the effective rate, then the reversal should be rolled. This is not alikely event, \nmostly due to the fact that the spread between the bid and asked prices on four sep\narate options makes it difficult to attain the desired price. Note: This entire four-way \norder can be entered as aspread order; it is not necessary to attempt to \"leg\" the \nspread. \nThe second action - rolling to another strike in the same expiration month -\nmay be more available. Suppose that one has the July 45 reversal in place (long July \n45 call and short July 45 put). If the underlying stock is near 45, he might place an \norder to the exchange floor as athree-way spread: Sell the July 45 call (closing), buy \nthe July 45 put (closing), and sell the July 40 call ( opening) for anet credit of 5 points. \nThis action costs the arbitrageur nothing except asmall transaction charge, since he \nis receiving a 5-point credit for moving the strike by 5 points. Once this is accom\nplished, he will have moved the strike approximately 5 points away and will thus have \navoided the problem of the stock closing at the strike. \nOverall, these four risks are significant, and reversal arbitrageurs should take \ncare that they do not fall prey to them. The careless arbitrageur uses effective rates \ntoo close to current market rates, establishes reversals with puts in-the-money, and \nroutinely accepts the risk of acquiring an unhedged stock position on the morning \nafter expiration. He will probably sustain alarge loss at some time. Since many rever\nsal arbitrageurs work with small capital and/or have convinced their backers that it is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:476", "doc_id": "90496fa881ff4e48cb5ecfb1b8255f46e511321239f574cbf40b251d3c59c58d", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 437 \nariskless strategy, such aloss may have the effect of putting them out of business. \nThat is an unnecessary risk to take. There are countermeasures, as described above, \nthat can reduce the effects of the four risks. \nLet us consider the risks for conversion traders more briefly. The risk of stock \nclosing near the strike is just as bad for the conversion as it is for the reversal. The \nsame techniques for handling those risks apply equally well to conversions as to \nreversals. The other risks are similar to reversal risks, but there are slight nuances. \nThe conversion arbitrage suffers if there is adividend cut. There is little the \narbitrageur can do to predict this except to be aware of the fundamentals of the com\npany before entering into the conversion. Alternatively, he might avoid conversions \nin which the dividend makes up amajor part of the profit of the arbitrage. \nAnother risk occurs if there is an early assignment on the calls before the ex-div\nidend date and the dividend is not received. Moreover, an early assignment leaves the \narbitrageur with long puts, albeit fractional ones since they are surely deeply out-of\nthe-money. Again, the policy of establishing conversions in which the dividend is not \namajor factor would help to ease the consequences of early assignment. \nThe final risk is that interest rates increase during the time the conversion is in \nplace. This makes the carrying costs larger than anticipated and might cause aloss. \nThe best way to hedge this initially is to allow amargin for error. Thus, if the pre\nvailing interest rate is 12%, one might only establish reversals that would break even \nif rates rose to 14%. If rates do not rise that far on average, aprofit will result. The \narbitrageur can attempt to hedge this risk by shorting interest-bearing paper that \nmatures at approximately the same time as the conversions. For example, if one has \n$5 million worth of 3-month conversions established at an effective rate of 14% and \nhe shorts 3-month paper at 12½%, he locks in aprofit of 1 ½%. This is not common \npractice for conversion arbitrageurs, but it does hedge the effect of rising interest \nrates. \nSUMMARY OF CONVERSION ARBITRAGE \nThe practice of conversion and reversal arbitrage in the listed option markets helps \nto keep put and call prices in line. If arbitrageurs are active in aparticular option, the \nprices of the put and call will relate to the stock price in line with the formulae given \nearlier. Note that this is also avalid reason why puts tend to sell at alower price than \ncalls do. The cost of money is the determining factor in the difference between put \nand call prices. In essence, the \"cost\" (although it may sometimes be acredit) is sub\ntracted from the theoretical put price. Refer again to the formula given above for the \nprofit potential of aconversion. Assume that things are in perfect alignment. Then \nthe formula would read:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:477", "doc_id": "b6bf075fd95c7012f5febb8eaa24ab2f0e49ffa6d5aef58ac0931d5cfcbbbb37", "chunk_index": 0}
{"text": "438 Part IV: Additional Considerations \nPut price = Striking price + Call price - Stock price - Fixed cost \nFurthermore, if the stock is at the striking price, the formula reduces to: \nPut price = Call price - Fixed cost \nSo, whenever the fixed cost, which is equal to the carrying charge less the dividends, \nis greater than zero (and it usually is), the put will sell for less than the call if astock \nis at the striking price. Only in the case of alarge-dividend-paying stock, when the \nfixed cost becomes negative (that is, it is not acost, but acredit), does the reverse \nhold true. This is supportive evidence for statements made earlier that at-the-money \ncalls sell for more than at-the-money puts, all other things being equal. The reader \ncan see quite clearly that it has nothing to do with supply and demand for the puts \nand calls, afallacy that is sometimes proffered. This same sort of analysis can be used \nto prove the broader statement that calls have agreater time value premium than \nputs do, except in the case of alarge-dividend-paying stock. \nOne final word of advice should be offered to the public customer. He may \nsometimes be able to find conversions or reversals, by using the simplistic formula, \nthat appear to have profit potentials that exceed commission costs. Such positions do \nexist from time to time, but the rate of return to the public customer will almost \nassuredly be less than the short-term cost of money. If it were not, arbitrageurs would \nbe onto the position very quickly. The public option trader may not actually be think\ning in terms of comparing the profit potential of aposition with what he could get by \nplacing the money into abank, but he must do so to convince himself that he cannot \nfeasibly attempt conversion or reversal arbitrages. \nTHE \"INTEREST PLAY\" \nIn the preceding discussion of reversal arbitrage, it is apparent that asubstantial por\ntion of the arbitrageur'sprofits may be due to the interest earned on the credit of the \nposition. Another type of position is used by many arbitrageurs to take advantage of \nthis interest earned. The arbitrageur sells the underlying stock short and simultane\nously buys an in-the-money call that is trading slightly over parity. The actual amount \nover parity that the arbitrageur can afford to pay for the call is determined by the \ninterest that he will earn from his short sale and the dividend payout before expira\ntion. He does not use aput in this type of position. In fact, this \"interest play\" strat\negy is merely areversal arbitrage without the short put. This slight variation has aresidual benefit for the arbitrageur: If the underlying stock should drop dramatically \nin price, he could make large profits because he is short the underlying stock. In any \ncase, he will make his interest credit less the amount of time value premium paid for \nthe call less any dividends lost.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:478", "doc_id": "c59d8bc029eb2e59308a83ad83bbe593d1361e5f5c3c39bd6356c3cc80b59544", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 439 \nExample 1: XYZ is sold short at 60, and a January 50 call is bought for 10¼ points. \nAssume that the prevailing interest rate is 1 % per month and that the position is \nestablished one month prior to expiration. XYZ pays no dividend. The total credit \nbrought in from the trades is $4,975, so the arbitrageur will earn $49.75 in interest \nover the course of 1 month. If the stock is above 50 at expiration, he will exercise his \ncall to buy stock at 50 and close the position. His loss on the security trades will be \n$25 the amount of time value premium paid for the call option. (He makes 10 \npoints by selling stock at 60 and buying at 50, but loses 10¼ points on the exercised \ncall.) His overall profit is thus $24.75. \nExample 2: Areal-life example may point out the effect of interest rates even more \ndramatically. In early 1979, IBM April 240 calls with about six weeks of life remain\ning were over 60 points in-the-money. IBM was not going to be ex-dividend in that \ntime. Normally, such adeeply in-the-money option would be trading at parity or even \nadiscount when the time remaining to expiration is so short. However, these calls \nwere trading 3½ points over parity because of the prevailing high interest rates at the \ntime. IBM was at 300, the April 240 calls were trading at 63½, and the prevailing \ninterest rate was approximately 1 % per month. The credit from selling the stock and \nbuying the call was $23,700, so the arbitrageur earned $365.50 in interest for 1 ½ \nmonths, and lost $350 - the 3½ points of time value premium that he paid for the \ncall. This still left enough room for aprofit. \nIn Chapter 1, it was stated that interest rates affect option prices. The above \nexamples of the \"interest play\" strategy quite clearly show why. As interest rates rise, \nthe arbitrageur can afford to pay more for the long call in this strategy, thus causing \nthe call price to increase in times of high interest rates. If call prices are higher, so \nwill put prices be, as the relationships necessary for conversion and reversal arbitrage \nare preserved. Similarly, if interest rates decline, the arbitrageur will make lower \nbids, and call and put prices will be lower. They are active enough to give truth to the \ntheory that option prices are directly related to interest rates. \nTHE BOX SPREAD \nAn arbitrage consists of simultaneously buying and selling the same security or equiv\nalent securities at different prices. For example, the reversal consists of selling aput \nand simultaneously shorting stock and buying acall. The reader will recall that the \nshort stock/long call position was called asynthetic put. That is, shorting the stock \nand buying acall is equivalent to buying aput. The reversal arbitrage therefore con\nsists of selling a (listed) put and simultaneously buying a (synthetic) put. In asimilar", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:479", "doc_id": "c8bb09c5b0c327cea2908ad874efaeb3eda3f097fe1aa01d8123982ca7ac5260", "chunk_index": 0}
{"text": "440 Part IV: Additional Considerations \nmanner, the conversion is merely the purchase of a (listed) put and the simultaneous \nsale of a (synthetic) put. Many equivalent strategies can be combined for arbitrage \npurposes. One of the more common ones is the box spread. \nRecall that it was shown that abull spread or abear spread could be construct\ned with either puts or calls. Thus, if one were to simultaneously buy a (call) bull \nspread and buy a (put) bear spread, he could have an arbitrage. In essence, he is \nmerely buying and selling equivalent spreads. If the price differentials work out cor\nrectly, arisk-free arbitrage may be possible. \nExample: The following prices exist: \nXYZ common, 55 \nXYZ January 50 call, 7 \nXYZ January 50 put, 1 \nXYZ January 60 call, 2 \nXYZ January 60 put, 5½ \nThe arbitrageur could establish the box spread in this example by executing the \nfollowing transactions: \nBuy acall bull spread: \nBuy XYZ January 50 call \nSell XYZ January 60 call \nNet call cost \nBuy aput bear spread: \nBuy XYZ January 60 put \nSell XYZ January 50 put \nNet put cost \nTotal cost of position \n7 debit \n2 credit \n51/2 debit \n1 credit \n5 debit \nNo matter where XYZ is at January expiration, this position will be worth 10 points. \nThe arbitrageur has locked in arisk-free profit of½ point, since he \"bought\" the box \nspread for 9½ points and will be able to \"sell\" it for 10 points at expiration. To verify \nthis, evaluate the position at expiration, first with XYZ above 60, then with XYZ \nbetween 50 and 60, and finally with XYZ below 50. If XYZ is above 60 at expiration, \nthe puts will expire worthless and the call bull spread will be at its maximum poten\ntial of 10 points, the difference between the striking prices. Thus, the position can be \nliquidated for 10 points if XYZ is above 60 at expiration. Now assume that XYZ is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:480", "doc_id": "808a37d7ff71bdd0794224ef716373840ebf3fae7967c3e50ceade051c3befcb", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 441 \nbetween 50 and 60 at expiration. In that case, the out-of-the-money, written options \nwould expire worthless-the January 60 call and the January 50 put. This would leave \nalong, in-the-money combination consisting of a January 50 call and a January 60 \nput. These two options must have atotal value of 10 points at expiration with XYZ \nbetween 50 and 60. (For example, the arbitrageur could exercise his call to buy stock \nat 50 and exercise his put to sell stock at 60.) Finally, assume that XYZ is below 50 at \nexpiration. The calls would expire worthless if that were true, but the remaining put \nspread- actually abear spread in the puts -would be at its maximum potential of 10 \npoints. Again, the box spread could be liquidated for 10 points. \nThe arbitrageur must pay acost to carry the position, however. In the prior \nexample, if interest rates were 6% and he had to hold the box for 3 months, it would \ncost him an additional 14 cents (.06 x 9½ x 3112). This still leaves room for aprofit. \nIn essence, abull spread ( using calls) was purchased while abear spread ( using \nputs) was bought. The box spread was described in these terms only to illustrate the \nfact that the arbitrageur is buying and selling equivalent positions. The arbitrageur \nwho is utilizing the box spread should not think in terms of bull or bear spread, how\never. Rather, he should be concerned with \"buying\" the entire box spread at acost of \nless than the differential between the two striking prices. By \"buying\" the box spread, \nit is meant that both the call spread portion and the put spread portion are debit \nspreads. Whenever the arbitrageur observes that acall spread and aput spread using \nthe same strikes and that are both debit spreads can be bought for less than the dif\nference in the strikes plus carrying costs, he should execute the arbitrage. \nObviously, there is acompanion strategy to the one just described. It might \nsometimes be possible for the arbitrageur to \"sell\" both spreads. That is, he would \nestablish acredit call spread and acredit put spread, using the same strikes. If this \ncredit were greater than the difference in the striking prices, arisk-free profit would \nbe locked in. \nExample: Assume that adifferent set of prices exists: \nXYZ common, 75 \nXYZ April 70 call, 8½ \nXYZ April 70 put, 1 \nXYZ April 80 call, 3 \nXYZ April 80 put, 6 \nBy executing the following transactions, the box spread could be \"sold\":", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:481", "doc_id": "7f9fff566a12ae030af4f01e013892975f8582abc656bfb39e75f1611919ddd7", "chunk_index": 0}
{"text": "442 \nSell acall (bear) spread: \nBuy April 80 call \nSell April 70 call \nNet credit on calls \nSell aput (bull) spread: \nBuy April 70 put \nSell April 80 put \nNet credit on puts \nTotal credit of position \n3 debit \n81/2 credit \n1 debit \n6 credit \nPart IV: Additional Considerations \n5 credit \n10 1/2 credit \nIn this case, no matter where XYZ is at expiration, the position can be bought back \nfor 10 points. This means that the arbitrageur has locked in risk-free profit of¼ \npoint. To verify this statement, first assume that XYZ is above 80 at April expiration. \nThe puts will expire worthless, and the call spread will have widened to 10 points -\nthe cost to buy it back. Alternatively, if XYZ were between 70 and 80 at April expira\ntion, the long, out-of-the-money options would expire worthless and the in-the\nmoney combination would cost 10 points to buy back. (For example, the arbitrageur \ncould let himself be put at 80, buying stock there, and called at 70, selling the stock \nthere - anet \"cost\" to liquidate of 10 points.) Finally, if XYZ were below 70 at expi\nration, the calls would expire worthless and the put spread would have widened to 10 \npoints. It could then be closed out at acost of 10 points. In each case, the arbitrageur \nis able to liquidate the box spread by buying it back at 10. \nIn this sale of abox spread, he would earn interest on the credit received while \nhe holds the position. \nThere is an additional factor in the profitability of the box spread. Since the sale \nof abox generates acredit, the arbitrageur who sells abox will earn asmall amount \nof money from that sale. Conversely, the purchaser of abox spread will have acharge \nfor carrying cost. Since profit margins may be small in abox arbitrage, these carrying \ncosts can have adefinite effect. As aresult, boxes may actually be sold for 5 points, \neven though the striking prices are 5 points apart, and the arbitrageur can still make \nmoney because of the interest earned. \nThese box spreads are not easy to find. If one does appear, the act of doing the \narbitrage will soon make the arbitrage impossible. In fact, this is true of any type of \narbitrage; it cannot be executed indefinitely because the mere act of arbitraging will \nforce the prices back into line. Occasionally, the arbitrageur will be able to find the \noption quotes to his liking, especially in volatile markets, and can establish arisk-free", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:482", "doc_id": "9fad9f44faa6c8ad8f8fef64c3b391f266289e910d1b9e491472661f298f7c77", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 443 \narbitrage with the box spread. It can be evaluated at aglance. Only two questions \nneed to be answered: \n1. If one were to establish adebit call spread and adebit put spread, using the same \nstrikes, would the total cost be less than the difference in the striking prices plus \ncarrying costs? If the answer is yes, an arbitrage exists. \n2. Alternatively, if one were to sell both spreads - establishing acredit call spread \nand acredit put spread - would the total credit received plus interest earned be \ngreater than the difference in the striking prices? If the answer is yes, an arbi\ntrage exists. \nThere are some risks to box arbitrage. Many of them are the same as those risks \nfaced by the arbitrageur doing conversions or reversals. First, there is risk that the \nstock might close at either of the two strikes. This presents the arbitrageur with the \nsame dilemma regarding whether or not to exercise his long options, since he is not \nsure whether he will be assigned. Additionally, early assignment may change the prof\nitability: Assignment of ashort put will incur large carrying costs on the resulting long \nstock; assignment of ashort call will inevitably come just before an ex-dividend date, \ncosting the arbitrageur the amount of the dividend. \nThere are not many opportunities to actually transact box arbitrage, but the fact \nthat such arbitrage exists can help to keep markets in line. For example, if an under\nlying stock begins to move quickly and order flow increases dramatically, the special\nist or market-markers in that stock'soptions may be so inundated with orders that \nthey cannot be sure that their markets are correct. They can use the principles of box \narbitrage to keep prices in line. The most active options would be the ones at strikes \nnearest to the current stock price. The specialist can quickly add up the markets of \nthe call and put at the nearest strike above the stock price and add to that the mar\nkets of the options at the strike just below. The sum of the four should add up to aprice that surrounds the difference in the strikes. If the strikes are 5 points apart, \nthen the sum of the four markets should be something like 4½ bid, 5½ asked. If, \ninstead, the four markets add up to aprice that allows box arbitrage to be established, \nthen the specialist will adjust his markets. \nVARIATIONS ON EQUIVALENCE ARBITRAGE \nOther variations of arbitrage on equivalent positions are possible, although they are \nrelatively complicated and probably not worth the arbitrageur'stime to analyze. For \nexample, one could buy abutterfly spread with calls and simultaneously sell abut\nterfly spread using puts. Alisted straddle could be sold and asynthetic straddle", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:483", "doc_id": "7466861ddf64007c467a90688d53ea8a3460502a179eac0a57d522f6e2aff29a", "chunk_index": 0}
{"text": "444 Part IV: Additional Considerations \ncould be bought - short stock and long 2 calls. Inversely, alisted straddle could be \nbought against aratio write - long stock and short 2 calls. The only time the arbi\ntrageur should even consider anything like this is when there are more sizable mar\nkets in certain of the puts and calls than there are in others. If this were the case, he \nmight be able to take an ordinary box spread, conversion, or reversal and add to it, \nkeeping the arbitrage intact by ensuring that he is, in fact, buying and selling equiv\nalent positions. \nTHE EFFECTS OF ARBITRAGE \nThe arbitrage process serves auseful purpose in the listed options market, because it \nmay provide asecondary market where one might not otherwise exist. Normally, \npublic interest in an in-the-money option dwindles as the option becomes deeply in\nthe-money or when the time remaining until expiration is very short. There would be \nfew public buyers of these options. In fact, public selling pressure might increase, \nbecause the public would rather liquidate in-the-money options held long than exer\ncise them. The few public buyers of such options might be writers who are closing \nout. However, if the writer is covered, especially where call options are concerned, \nhe might decide to be assigned rather than close out his option. This means that the \npublic seller is creating arather larger supply that is not offset by apublic demand. \nThe market created by the arbitrageur, especially in the basic put or call arbitrage, \nessentially creates the demand. Without these arbitrageurs, there could conceivably \nbe no buyers at all for those options that are short-lived and in-the-money, after pub\nlic writers have finished closing out their positions. \nEquivalence arbitrage - conversion, reversals, and box spreads - helps to keep \nthe relative prices of puts and calls in line with each other and with the underlying \nstock price. This creates amore efficient and rational market for the public to oper\nate in. The arbitrageur would help eliminate, for example, the case in which apublic \ncustomer buys acall, sees the stock go up, but cannot find anyone to sell his call to \nat higher prices. If the call were too cheap, arbitrageurs would do reversals, which \ninvolve call purchases, and would therefore provide amarket to sell into. \nQuestions have been raised as to whether option trading affects stock prices, \nespecially at or just before an expiration. If the amount of arbitrage in acertain issue \nbecomes very large, it could appear to temporarily affect the price of the stock itself. \nFor example, take the call arbitrage. This involves the sale of stock in the market. The \ncorresponding stock purchase, via the call exercise, is not executed on the exchange. \nThus, as far as the stock market is concerned, there may appear to be an inordinate \namount of selling in the stock. If large numbers of basic call arbitrages are taking \nplace, they might thus hold the price of the stock down until the calls expire.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:484", "doc_id": "d5a62ad6c92b9082fa66db76a55cd0bd74ff21b7b3cd992aad71fc8954cc5d93", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 445 \nThe put arbitrage has an opposite effect. This arbitrage involves buying stock in \nthe market. The offsetting stock sale via the put exercise takes place off the exchange. \nIf alarge amount of put arbitrage is being done, there may appear to be an inordi\nnate amount of buying in the stock. Such action might temporarily hold the stock \nprice up. \nIn avast majority of cases, however, the arbitrage has no visible effect on the \nunderlying stock price, because the amount of arbitrage being done is very small in \ncomparison to the total number of trades in agiven stock. Even if the open interest \nin aparticular option is large, allowing for plenty of option volume by the arbi\ntrageurs, the actual act of doing the arbitrage will force the prices of the stock and \noption back into line, thus destroying the arbitrage. \nRather elaborate studies, including doctoral theses, have been written that try \nto prove or disprove the theory that option trading affects stock prices. Nothing has \nbeen proven conclusively, and it may never be, because of the complexity of the task. \nLogic would seem to dictate that arbitrage could temporarily affect astock'smove\nment if it has discount, in-the-money options shortly before expiration. However, one \nwould have to reasonably conclude that the size of these arbitrages could almost \nnever be large enough to overcome adirectional trend in the underlying stock itself. \nThus, in the absence of adefinite direction in the stock, arbitrage might help to per\npetuate the inertia; but if there were truly apreponderance of investors wanting to \nbuy or sell the stock, these investors would totally dominate any arbitrage that might \nbe in progress. \nRISK ARBITRAGE USING OPTIONS \nRisk arbitrage is astrategy that is well described by its name. It is basically an arbi\ntrage - the same or equivalent securities are bought and sold. However, there is gen\nerally risk because the arbitrage usually depends on afuture event occurring in \norder for the arbitrage to be successful. One form of risk arbitrage was described \nearlier concerning the speculation on the size of aspecial dividend that an underly\ning stock might pay. That arbitrage consisted of buying the stock and buying the put, \nwhen the put' stime value premium is less than the amount of the projected special \ndividend. The risk lies in the arbitrageur'sspeculation on the size of the anticipated \nspecial dividend. \nMERGERS \nRisk arbitrage is an age-old type of arbitrage in the stock market. Generally, it con\ncerns speculation on whether aproposed merger or acquisition will actually go \nthrough as proposed.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:485", "doc_id": "dc1af51e3c11ec53d3e9f4dd0e47dd01d32ceb2c22e30a54a14c7a5288a8b917", "chunk_index": 0}
{"text": "446 Part IV: Additional Considerations \nExample: XYZ, which is selling for $50 per share, offers to buy out LMN and is offer\ning to swap one share of its (XYZ's) stock for every two shares of LMN. This would \nmean that LMN should be worth $25 per share if the acquisition goes through as pro\nposed. On the day the takeover is proposed, LMN stock would probably rise to about \n$22 per share. It would not trade all the way up to 25 until the takeover was approved \nby the shareholders of LMN stock. The arbitrageur who feels that this takeover will \nbe approved can take action. He would sell short XYZ and, for every share that he is \nshort, he would buy 2 shares of LMN stock. If the merger goes through, he will prof\nit. The reason that he shorts XYZ as well as buying LMN is to protect himself in case \nthe market price of XYZ drops before the acquisition is approved. In essence, he has \nsold XYZ and also bought the equivalent of XYZ (two shares of LMN will be equal to \none share of XYZ if the takeover goes through). This, then, is clearly an arbitrage. \nHowever, it is arisk arbitrage because, if the stockholders of LMN reject the offer, \nhe will surely lose money. His profit potential is equal to the remaining differential \nbetween the current market price of LMN (22) and the takeover price (25). If the \nproposed acquisition goes through, the differential disappears, and the arbitrageur \nhas his profit. \nThe greatest risk in amerger is that it is canceled. If that happens, stock being \nacquired (LMN) will fall in price, returning to its pre-takeover levels. In addition, the \nacquiring stock (XYZ) will probably rise. Thus, the risk arbitrageur can lose money \non both sides of his trade. If either or both of the stocks involved in the proposed \ntakeover have options, the arbitrageur may be able to work options into his strategy. \nIn merger situations, since large moves can occur in both stocks ( they move in \nconcert), option purchases are the preferable option strategy. If the acquiring com\npany (XYZ) has in-the-money puts, then the purchase of those puts may be used \ninstead of selling XYZ short. The advantage is that if XYZ rallies dramatically during \nthe time it takes for the merger to take effect, then the arbitrageur'sprofits will be \nincreased. \nExample: As above, assume that XYZ is at 50 and is acquiring LMN in a 2-for-lstock \ndeal. LMN is at 22. Suppose that XYZ rallies to 60 by the time the deal closes. This \nwould pull LMN up to aprice of 30. If one had been short 100 XYZ at 50 and long \n200 LMN at 22, then his profit would be $600 - a $1,600 gain on the 200 long LMN \nminus a $1,000 loss on the XYZ short sale. \nCompare that result to asimilar strategy substituting along put for the short \nXYZ stock. Assume that he buys 200 LMN as before, but now buys an XYZ put. If \none could buy an XYZ July 55 put with little time premium, say at 5½ points, then \nhe would have nearly the same dollars of profit if the merger should go through with \nXYZ below 55.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:486", "doc_id": "9b8f2be5e901f6b11fc437c5e0738154942081f3efa2dc007ebc7d2129b07223", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 447 \nHowever, when XYZ rallies to 60, his profit increases. He would still make the \n$1,600 on LMN as it rose from 22 to 30, but now would only lose $550 on the XYZ \nput - atotal profit of $1,050 as compared to $600 with an all-stock position. \nThe disadvantage to substituting long puts for short stock is that the arbitrageur \ndoes not receive credit for the short sale and, therefore, does not earn money at the \ncarrying rate. This might not be as large adisadvantage as it initially seems, however, \nsince it is often the case that it is very expensive - even impossible - to borrow the \nacquiring stock in order to short it. If the stock borrow costs are very large or if no \nstock can be located for borrowing, the purchase of an in-the-money put is aviable \nalternative. The purchase of an in-the-money put is preferable to an at- or out-of-the\nmoney put, because the amount of time value premium paid for the latter would take \ntoo much of the profitability away from the arbitrage if XYZ stayed unchanged or \ndeclined. This strategy may also save money if the merger falls apart and XYZ rises. \nThe loss on the long put may well be less than the loss would be on short XYZ stock. \nNote also that one could sell the XYZ July 55 call short as well as buy the put. \nThis would, of course, be synthetic short stock and is apure substitute for shorting \nthe stock. The use of this synthetic short is recommended only when the arbitrageur \ncannot borrow the acquiring stock. If this is his purpose, he should use the in-the\nmoney put and out-of-the-money call, since if he were assigned on the call, he could \nnot borrow the stock to deliver it as ashort sale. The use of an out-of-the-money call \nlessens the chance of eventual assignment. \nThe companion strategy is to buy an in-the-money call instead of buying the \ncompany being acquired (LMN). This has advantages if the stock falls too far, either \nbecause the merger falls apart or because the stocks in the merger decline too far. \nAdditionally, the cost of carrying the long LMN stock is eliminated, although that is \ngenerally built into the cost of the long calls. The larger amount of time value pre\nmium in calls as compared to puts makes this strategy often less attractive than that \nof buying the puts as asubstitute for the short sale. \nOne might also consider selling options instead of buying them. Generally this \nis an inferior strategy, but in certain instances it makes sense. The reason that option \nsales are inferior is that they do not limit one'srisk in the risk arbitrage, but they cut \noff the profit. For example, if one sells puts on the company being acquired (LMN), \nhe has abullish situation. However, if the company being acquired (XYZ) rallies too \nfar, there will be aloss, because the short puts will stop making money as soon as \nLMN rises through the strike. This is especially disconcerting if atakeover bidding \nwar should develop for LMN. The arbitrageur who is long LMN will participate nice\nly as LMN rises heavily in price during the bidding war. However, the put seller will \nnot participate to nearly the same extent.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:487", "doc_id": "e2dd0e4db1f45d5f3991acba3b329d62ffd3990a947e1482359455d36f1b38cd", "chunk_index": 0}
{"text": "448 Part IV: Additional Considerations \nThe sale of in-the-money calls as asubstitute for shorting the acquiring compa\nny (XYZ) can be beneficial at certain times. It is necessary to have aplus tick in order \nto sell stock short. When many arbitrageurs are trying to sell astock short at the same \ntime, it may be difficult to sell such stock short. Morever, natural owners of XYZ may \nsee the arbitrageurs holding the price down and decide to sell their long stock rather \nthan suffer through apossible decline in the stock'sprice while the merger is in \nprogress. Additionally, buyers of XYZ will become very timid, lowering their bids for \nthe same reasons. All of this may add up to asituation in which it is very difficult to \nsell the stock short, even if it can be borrowed. The sale of an in-the-money call can \novercome this difficulty. The call should be deeply in-the-money and not be too long\nterm, for the arbitrageur does not want to see XYZ decline below the strike of the \ncall. If that happened, he would no longer be hedged; the other side of the arbitrage \n- the long LMN stock - would continue to decline, but he would not have any \nremaining short against the long LMN. \nLIMITS ON THE MERGER \nThere is another type of merger for stock that is more difficult to arbitrage, but \noptions may prove useful. In some merger situations, the acquiring company (XYZ) \npromises to give the shareholders of the company being acquired (LMN) an amount \nof stock equal to aset dollar price. This amount of stock would be paid even if the \nacquiring company rose or fell moderately in price. If XYZ falls too far, however, it \ncannot pay out an extraordinarily increased number of shares to LMN shareholders, \nso XYZ puts alimit on the maximum number of shares that it will pay for each share \nof LMN stock. Thus, the shareholders ofXYZ are guaranteed that there will be some \ndownside buffer in terms of dilution of their company in case XYZ declines, as is \noften the case for an acquiring company. However, ifXYZ declines too far, then LMN \nshareholders will receive less. In return for getting this downside guarantee, XYZ will \nusually also stipulate that there is aminimum amount of shares that they will pay to \nLMN shareholders, even if XYZ stock rises tremendously. Thus, if XYZ should rise \ntremendously in price, then LMN shareholders will do even better than they had \nanticipated. An example will demonstrate this type of merger accord. \nExample: Assume that XYZ is at 50 and it intends to acquire LMN for astated price \nof $25 per share, as in the previous example. However, instead of merely saying that \nit will exchange two shares of LMN for one share of XYZ, the company says that it \nwants the offer to be worth $25 per share to LMN shareholders as long as XYZ is \nbetween 45 and 55. Given this information, we can determine the maximum and \nminimum number of shares that LMN shareholders will receive: The maximum is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:488", "doc_id": "c8d24dd4814c3d6dc5eedcd419a58a03071ca4c312e922da02f610f5f26b46ea", "chunk_index": 0}
{"text": "450 Part IV: Additional Considerations \nProblems arise if XYZ begins to fall below 45 well before the closing of the \nmerger, the lower \"hook\" in the merger. If it should remain below 45, then one \nshould set up the arbitrage as being short 0.556 shares ofXYZ for each share of LMN \nthat is held long. As long as XYZ remains below 45 until the merger closes, this is the \nproper ratio. However, if, after establishing that ratio, XYZ rallies back above 45, the \narbitrageur can suffer damaging losses. XYZ may continue to rise in price, creating aloss on the short side. However, LMN will not follow it, because the merger is struc\ntured so that LMN is worth 25 unless XYZ rises too far. Thus, the long side stops fol\nlowing as the short side moves higher. \nOn the other hand, no such problem exists if XYZ rises too far from its original \nprice of 50, going above the upper \"hook\" of 55. In that case, the arbitrageur would \nalready be long the LMN and would not yet have shorted XYZ, since the merger was \nnot yet closing. LMN would merely follow XYZ higher after the latter had crossed 55. \nThis is not an uncommon dilemma. Recall that it was shown that the acquiring \nstock will often fall in price immediately after amerger is announced. Thus, XYZ may \nfall close to, or below, the lower \"hook.\" Some arbitrageurs attempt to hedge them\nselves by shorting alittle XYZ as it begins to fall near 45 and then completing the \nshort if it drops well below 45. The problem with handling the situation in this way \nis that one ends up with an inexact ratio. Essentially, he is forcing himself to predict \nthe movements of XYZ. \nIf the acquiring stock drops below the lower \"hook,\" there may be an opportu\nnity to establish ahedge without these risks if that stock has listed options. The idea \nis to buy puts on the acquiring company, and for those puts to have astriking price \nnearly equal to the price of the lower \"hook.\" The proper amount of the company \nbeing acquired (LMN) is then purchased to complete the arbitrage. If the acquiring \ncompany subsequently rallies back into the stated price range, the puts will not lose \nmoney past the striking price and the problems described in the preceding paragraph \nwill have been overcome. \nExample: Amerger is announced as described in the preceding example: XYZ is to \nacquire LMN at astated value of $25 per share, with the stipulation that each share \nof LMN will be worth at least 0.455 shares of XYZ and at most 0.556 shares. These \nshare ratios equate to prices of 45 and 55 on XYZ. \nSuppose that XYZ drops immediately in price after the merger is announced, \nand it falls to 40. Furthermore, suppose that the merger is expected to close some\ntime during July and that there are XYZ August 45 puts trading at 5½. This repre\nsents only ½ point time value premium. The arbitrageur could then set up the arbi\ntrage by buying 10,000 LMN and buying 56 of those puts. Smaller investors might \nbuy 1,000 LMN and buy 6 puts. Either of these is in approximately the proper ratio \nof 1 LMN to 0.556 XYZ.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:490", "doc_id": "874102f2037e48ec0d64730a6c9882227027a9ea3399700ba45fea2306f98bb1", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage \nTENDER OFFERS \n451 \nAnother type of corporate takeover that falls under the broad category of risk arbi\ntrage is the tender offer. In atender offer, the acquiring company normally offers to \nexchange cash for shares of the company to be acquired. Sometimes the off er is for \nall of the shares of the company being acquired; sometimes it is for afractional por\ntion of shares. In the latter case, it is important to know what is intended to be done \nwith the remaining shares. These might be exchanged for shares of the acquiring \ncompany, or they might be exchanged for other securities (bonds, most likely), or \nperhaps there is no plan for exchanging them at all. In some cases, acompany ten\nders for part of its own stock, so that it is in effect both the acquirer and the acquiree. \nThus, tender offers can be complicated to arbitrage properly. The use of options can \nlessen the risks. \nIn the case in which the acquiring company is making acash tender for all the \nshares (called an \"any and all\" offer), the main use of options is the purchase of puts \nas protection. One would buy puts on the company being acquired at the same time \nthat he bought shares of that company. If the deal fell apart for some reason, the puts \ncould prevent adisastrous loss as the acquiring stock dropped. The arbitrageur must \nbe judicious in buying these puts. If they are too expensive or too far out-of-the\nmoney, or if the acquiring company might not really drop very far if the deal falls \napart, then the purchase of puts is awaste. However, if there is substantial downside \nrisk, the put purchase may be useful. \nSelling options in an \"any and all\" deal often seems like easy money, but there \nmay be risks. If the deal is completed, the company being acquired will disappear and \nits options would be delisted. Therefore, it may often seem reasonable to sell out-of\nthe-money puts on the acquiring company. If the deal is completed, these expire \nworthless at the closing of the merger. However, if the deal falls through, these puts \nwill soar in price and cause alarge loss. On the other hand, it may also seem like easy \nmoney to sell naked calls with astriking price higher than the price being offered for \nthe stock. Again, if the deal goes through, these will be delisted and expire worthless. \nThe risk in this situation is that another company bids ahigher price for the compa\nny on which the calls were written. If this happens, there might suddenly be alarge \nupward jump in price, and the written calls could suffer alarge loss. \nOptions can play amore meaningful role in the tender off er that is for only part \nof the stock, especially when it is expected that the remaining stock might fall sub\nstantially in price after the partial tender offer is completed. An example of apartial \ntender offer might help to establish the scenario. \nExample: XYZ proposes to buy back part of its own stock It has offered to pay $70 \nper share for half the company. There are no plans to do anything further. Based on", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:491", "doc_id": "4dddcd62bf4b431253dacc7aec3d2d7aa99f1e674e71c11ae5dbaed502b5d330", "chunk_index": 0}
{"text": "452 Part IV: Additional Considerations \nthe fundamentals of the company, it is expected that the remaining stock will sell for \napproximately $40 per share. Thus, the average share of XYZ is worth 55 if the ten\nder offer is completed ( one-half can be sold at 70, and the other half will be worth \n40). XYZ stock might sell for $52 or $53 per share until the tender is completed. On \nthe day after the tender offer expires, XYZ stock will drop immediately to the $40 per \nshare level. \nThere are two ways to make money in this situation. One is to buy XYZ at the \ncurrent price, say 52, and tender it. The remaining portion would be sold at the lower \nprice, say 40, when XYZ reopened after the tender expired. This method would yield \naprofit of $3 per share if exactly 50% of the shares are accepted at 70 in the tender \noffer. In reality, aslightly higher percentage of shares is usually accepted, because afew people make mistakes and don'ttender. Thus, one'saverage net price tnight be \n$56 per share, for a $4 profit from this method. The risk in this situation is that XYZ \nopens substantially below 40 after the tender at 70 is completed. \nTheoretically, the other way to trade this tender off er might be to sell XYZ short \nat 52 and cover it at 40 when it reopens after the tender offer expires. Unfortunately, \nthis method cannot be effected because there will not be any XYZ stock to borrow in \norder to sell it short. All owners will tender the stock rather than loan it to arbi\ntrageurs. Arbitrageurs understand this, and they also understand the risk they take if \nthey try to short stock at the last minute: They might be forced to buy back the stock \nfor cash, or they may be forced to give the equivalent of $70 per share for half the \nstock to the person who bought the stock from them. For some reason, many indi\nvidual investors believe that they can \"get away\" with this strategy. They short stock, \nfiguring that their brokerage firm will find some way to borrow it for them. \nUnfortunately, this usually costs the customer alot of money. \nThe use of calls does not provide amore viable way of attempting to capitalize \non the drop of XYZ from 52 to 40. In-the-money call options on XYZ will normally \nbe selling at parity just before the tender offer expires. If one sells the call as asub\nstitute for the short sale, he will probably receive an assignment notice on the day \nafter the tender offer expires, and therefore find himself with the same problems the \nshort seller has. \nThe only safe way to play for this drop is to buy puts on XYZ. These puts will be \nvery expensive. In fact, with XY\"Lat 52 before the tender offer expires, if the con\nsensus opinion is that XYZ will trade at 40 after the offer expires, then puts with a 50 \nstrike will sell for at least $10. This large price reflects the expected drop in price of \nXYZ. Thus, it is not beneficial to buy these puts as downside speculation unless one \nexpects the stock to drop farther than to the $40 level. There is, however, an oppor\ntunity for arbitrage by buying XYZ stock and also buying the expensive puts.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:492", "doc_id": "1cefd30d4175f0c6238f603efe85c6ddecb662009120e7d829e437a7be70bb93", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 453 \nBefore giving an example of that arbitrage, aword about short tendering is in \norder. Short tendering is against the law. It comes about when one tenders stock into \natender offer when he does not really own that stock. There are complex definitions \nregarding what constitutes ownership of stock during atender offer. One must be net \nlong all the stock that he tenders on the day the tender offer expires. Thus, he can\nnot tender the stock on the day before the offer expires, and then short the stock on \nthe next day ( even if he could borrow the stock). In addition, one must subtract the \nnumber of shares covered by certain calls written against his position: Any calls with \nastrike price less than the tender off er price must be subtracted. Thus, if he is long \n1,000 shares and has written 10 in-the-money calls, he cannot tender any shares. The \nnovice and experienced investor alike must be aware of these definitions and should \nnot violate the short tender rules. \nLet us now look at an arbitrage consisting of buying stock and buying the expen\nsive puts. \nExample: XYZ is at 52. As before, there is atender offer for half the stock at 70, with \nno plans for the remainder. The July 55 puts sell for 15, and the July 50 puts sell for \n10. It is common that both puts would be predicting the same price in the after-mar\nket: 40. \nIf one buys 200 shares ofXYZ at 52 and buys one July 50 put at 10, he has alocked\nin profit as long as the tender offer is completed. He only buys one put because he \nis assuming that 100 shares will be accepted by the company and only 100 shares will \nbe returned to him. Once the 100 shares have been returned, he can exercise the put \nto close out his position. \nThe following table summarizes these results: \nInitial purchase \nBuy 200 XYZ at 52 \nBuy 1 July 50 put at 10 \nTotal Cost \nClosing sale \nSell 1 00 XYZ at 70 via tender \nSell 1 00 XYZ at 50 via put exercise \nTotal proceeds \nTotal profit: $600 \n$10,400 debit \n1,000 debit \n$11 ,400 debit \n7,000 credit \n5,000 credit \n$12,000 credit \nThis strategy eliminates the risk ofloss ifXYZ opens substantially below 40 after \nthe tender offer. The downside price is locked in by the puts.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:493", "doc_id": "8c4a04dcdd9b1cd55c5e0d426b2a81b961723e699e0f0d2e31283dcf17c54a00", "chunk_index": 0}
{"text": "454 Part IV: Additional Considerations \nIf more than 50% of XYZ should be accepted in the tender offer, then alarger \nprofit will result. Also, if XYZ should subsequently trade at ahigh enough price so \nthat the July 50 put has some time value premium, then alarger profit would result \nas well. (The arbitrageur would not exercise the put, but would sell the stock and the \nput separately in that case.) \nPartial tender offers can be quite varied. The type described in the above exam\nple is called a \"two-tier\" offer because the tender offer price is substantially different \nfrom the remaining price. In some partial tenders, the remainder of the stock is slat\ned for purchase at substantially the same price, perhaps through acash merger. The \nabove strategy would not be applicable in that case, since such an offer would more \nclosely resemble the \"any and all\" offer. In other types of partial tenders, debt secu\nrities of the acquiring company may be issued after the partial cash tender. The net \nprice of these debt securities may be different from the tender offer price. If they \nare, the above strategy might work. \nIn summary, then, one should look at tender offers carefully. One should be \ncareful not to take extraordinary option risk in an \"any and all\" tender. Conversely, \none should look to take advantage of any \"two-tier\" situation in apartial tender offer \nby buying stock and buying puts. \nPROFITABILITY \nSince the potential profits in risk arbitrage situations may be quite large, perhaps 3 \nor 4 points per 100 shares, the public can participate in this strategy. Commission \ncharges will make the risk arbitrage less profitable for apublic customer than it \nwould be for an arbitrageur. The profit potential is often large enough, however, to \nmake this type of risk arbitrage viable even for the public customer. \nIn summary, the risk arbitrageur may be able to use options in his strategy, \neither as areplacement for the actual stock position or as protection for the stock \nposition. Although the public cannot normally participate in arbitrage strategies \nbecause of the small profit potential, risk arbitrages may often offer exceptions. The \nprofit potential can be large enough to overcome the commission burden for the \npublic customer. \nPAIRS TRADING \nAstock trading strategy that has gained some adherents in recent years is pairs trad\ning. Simplistically, this strategy involves trading pairs of stocks - one held long, the \nother short. Thus, it is ahedged strategy. The two stocks' price movements are relat\ned historically. The pairs trader would establish the position when one stock was", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:494", "doc_id": "2575f2a5318db9deeba5f4fba671a614c9e0227694bfb886c610d211374cd61c", "chunk_index": 0}
{"text": "Chapter 27: Arbitrage 455 \nexpensive with respect to the other one, historically. Then, when the stocks return to \ntheir historical relationship, aprofit would result. In reality, some fairly complicated \ncomputer programs search out the appropriate pairs. \nThe interest on the short sale offsets the cost of carry of the stock purchased. \nTherefore, the pairs trader doesn'thave any expense except the possible differential \nin dividend payout. \nThe bane of pairs trading is apossible escalation of the stock sold short without \nany corresponding rise in price of the stock held long. Atakeover attempt might \ncause this to happen. Of course, pairs traders will attempt to research the situation \nto ensure that they don'toften sell short stocks that are perceived to be takeover can\ndidates. \nPairs traders can use options to potentially reduce their risk if there are in-the\nmoney options on both stocks. One would buy an in-the-money put instead of selling \none stock short, and would buy an in-the-money call on the other stock instead of \nbuying the stock itself. In this option combination, traders are paying very little time \nvalue premium, so their profit potential is approximately the same as with the pairs \ntrading strategy using stocks. ( One would, however, have adebit, since both options \nare purchased; so there would be acost of carry in the option strategy.) \nIf the stocks return to their historical relationship, the option strategy will \nreflect the same profit as the stock strategy, less any loss of time value premium. One \nadded advantage of the option strategy, however, is that if atakeover occurs, the put \nhas limited liability, and the trader'sloss would be less. \nAnother advantage of the option strategy is that if both stocks should experience \nlarge moves, it could make money even if the pair doesn'treturn to historical norms. \nThis would happen, for example, if both stocks dropped agreat deal: The call has lim\nited loss, while the put' sprofits would continue to accrue. Similarly, to the upside, alarge move by both stocks would make the put worthless, but the call would keep \nmaking money. In both cases, the option strategy could profit even if the pair of \nstocks didn'tperform as predicted. \nThis type of strategy- buying in-the-money options as substitutes for both sides \nof aspread or hedge strategy - is discussed in more detail in Chapter 31 on index \nspreading and Chapter 35 on futures spreads. \nFACILITATION (BLOCK POSITIONING) \nFacilitation is the process whereby atrader seeks to aid in making markets for the \npurchase or sale of large blocks of stock. This is not really an arbitrage, and its \ndescription is thus deferred to Chapter 28.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:495", "doc_id": "84bc0f87d610a179cd1bcb5fd0d21d55b4f1aad5a4e788a411ef7518426e0034", "chunk_index": 0}
{"text": "CHAPTER 28 \nMathetnatical Applications \nIn previous chapters, many references have been made to the possibility of applying \nmathematical techniques to option strategies. Those techniques are developed in this \nchapter. Although the average investor - public, institutional, or floor trader - nor\nmally has alimited grasp of advanced mathematics, the information in this chapter \nshould still prove useful. It will allow the investor to see what sorts of strategy deci\nsions could be aided by the use of mathematics. It will allow the investor to evaluate \ntechniques of an information service. Additionally, if the investor is contemplating \nhiring someone knowledgeable in mathematics to do work for him, the information \nto be presented may be useful as afocal point for the work. The investor who does \nhave aknowledge of mathematics and also has access to acomputer will be able to \ndirectly use the techniques in this chapter. \nTHE BLACK-SCHOLES MODEL \nSince an option'sprice is the function of stock price, striking price, volatility, time to \nexpiration, and short-term interest rates, it is logical that aformula could be drawn \nup to calculate option prices from these variables. Many models have been conceived \nsince listed options began trading in 1973. Many of these have been attempts to \nimprove on one of the first models introduced, the Black-Scholes model. This model \nwas introduced in early 1973, very near the time when listed options began trading. \nIt was made public at that time and, as aresult, gained arather large number of \nadherents. The formula is rather easy to use in that the equations are short and the \nnumber of variables is small. \nThe actual formula is: \n456", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:496", "doc_id": "64ef1063ff9068dab074ae2e7b8239c09bd251c1cf4d5d953c579e55ffde0d93", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications \nTheoretical option price= pN(d 1) se-rtN(d2) \npv2 \nln(8 )+ (r +2 )twhere d1 = _ r. \nV-4 td2 = d1 - v--ft \nThe variables are: \np = stock price \ns = striking price \nt = time remaining until expiration, expressed as apercent of ayear \nr = current risk-free interest rate \nv = volatility measured by annual standard deviation \nln = natural logarithm \nN(x) = cumulative normal density function \n457 \nAn important by-product of the model is the exact calculation of the delta - that \nis, the amount by which the option price can be expected to change for asmall \nchange in the stock price. The delta was described in Chapter 3 on call buying, and \nis more formally known as the hedge ratio. \nDelta= N(d1) \nThe formula is so simple to use that it can fit quite easily on most programmable cal\nculators. In fact, some of these calculators can be observed on the exchange floors as \nthe more theoretical floor traders attempt to monitor the present value of option pre\nmiums. Of course, acomputer can handle the calculations easily and with great \nspeed. Alarge number of Black-Scholes computations can be performed in avery \nshort period of time. \nThe cumulative normal distribution function can be found in tabular form in \nmost statistical books. However, for computation purposes, it would be wasteful to \nrepeatedly look up values in atable. Since the normal curve is asmooth curve (it is \nthe \"bell-shaped\" curve used most commonly to describe population distributions), \nthe cumulative distribution can be approximated by aformula: \nx = l-z(l.330274y 5 - l.821256y 4 + l.781478y 3 - .356538y 2 + .3193815y) \nwhere y 1 and z = .3989423e-<r212 \n= 1 + .2316419lcrl \nThen N(cr) = xif cr > 0 or N(cr) = 1- xif cr < 0", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:497", "doc_id": "c2b070ee76a27fb475409909e2da07ff8eba861b8a5aa25fc55d50d92a78de6c", "chunk_index": 0}
{"text": "458 Part IV: Additional Considerations \nThis approximation is quite accurate for option pricing purposes, since one is not \nreally interested in thousandths of apoint where option prices are concerned. \nExample: Suppose that XYZ is trading at 45 and we are interested in evaluating the \nJuly 50 call, which has 60 days remaining until expiration. Furthermore, assume that \nthe volatility of XYZ is 30% and that the risk-free interest rate is currently 10%. The \ntheoretical value calculation is shown in detail, in order that those readers who wish \nto program the model will have something to compare their calculations against. \npage: \nInitially, determine t, d1, and d2, by referring to the formulae on the previous \nt = 60/365 = .16438 years \nd _ In (45/50) + (.1 + .3 x .3/2) x .16438 \n1-\n.3 X ✓.16438 \n= -.10536 + (.145 X .16438) = __ 67025 .3 X .40544 \nd2 = -.67025 - .3 ✓.16438 = -.67025 - (.3 x .40544) = -.79189 \nNow calculate the cumulative normal distribution function for d1 and d2 by \nreferring to the above formulae: \ndl = -.67025 \nl 1 \ny = l + (.2316419 I -.67025 I) = 1.15526 = ·86561 \nz = .3989423e--(-.67025 X -.67025)/2 \n= .3989423e-0·22462 = .31868 \nThere are too many calculations involved in the computation of the fifth-order \npolynomial to display them here. Only the result is given: \nX = .74865 \nSince we are determining the cumulative normal distribution of anegative \nnumber, the distribution is determined by subtracting xfrom l. \nN(d1) = N(-.67O25) = l -x = l - .74865 = .25134 \nIn asimilar manner, which requires computing new values for x, y, and z, \nN(d2) = N(-.79179) = 1- .78579 = .21421", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:498", "doc_id": "cd73bb080bb91d5a27efe183e93c714d8c1fee1aff85eedb07eb0c8a12c1ddcd", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications 459 \nNow, returning to the formula for theoretical option price, we can complete the \ncalculation of the July 50 call'stheoretical value, called value here for short: \nvalue = 45 x N(d1) - 50 xe-·1 x ·16438 x N(d2) \n= 45 X .25134 - 50 X .9837 X .21421 \n= .7746 \nThus, the theoretical value of the July 50 call is just slightly over¼ of apoint. \nNote that the delta of the call was calculated along the way as N(d1) and is equal to \njust over .25. That is, the July 50 call will change price about¼ as fast as the stock \nfor asmall price change by the stock. \nThis example should answer many of the questions that readers of the first edi\ntion have posed. The reader interested in amore in-depth description of the model, \npossibly including the actual derivation, should refer to the article \"Fact and Fantasy \nin the Use of Options.\" 1 One of the less obvious relationships in the model is that call \noption prices will increase (and put option prices will decrease) as the risk-free inter\nest rate increases. It may also be observed that the model correctly preserves rela\ntionships such as increased volatility, higher stock prices, or more time to expiration, \nwhich all imply higher option prices. \nCHARACTERISTICS Of THE MODEL \nSeveral aspects of this model are worth further discussion. First, the reader will \nnotice that the model does not include dividends paid by the common stock. As has \nbeen demonstrated, dividends act as anegative effect on call prices. Thus, direct \napplication of the model will tend to give inflated call prices, especially on stocks that \npay relatively large dividends. There are ways of handling this. Fisher Black, one of \nthe coauthors of the model, suggested the following method: Adjust the stock price \nto be used in the formula by subtracting, from the current stock price, the present \nworth of the dividends likely to be paid before maturity. Then calculate the option. \nprice. Second, assume that the option expires just prior to the last ex-dividend date \npreceding actual option expiration. Again adjust the stock price and calculate the \noption price. Use the higher of the two option prices calculated as the theoretical \nprice. \nAnother, less exact, method is to apply aweighting factor to call prices. The \nweighting factor would be based on the dividend payment, with aheavier weight \nbeing applied to call options on high-yielding stock. It should be pointed out that, in \n1Fisher Black, Financial Analysts Journal, July-August 1975, pp. 36-70.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:499", "doc_id": "b564cb589a94c8c51a67dda7b0da7c77f931dcb354a2463b8e396f4faee671df", "chunk_index": 0}
{"text": "460 Part IV: Additional Considerations \nmany of the applications that are going to be prescribed, it is not necessary to know \nthe exact theoretical price of the call. Therefore, the dividend \"correction\" might not \nhave to be applied for certain strategy decisions. \nThe model is based on alognormal distribution of stock prices. Even though the \nnormal distribution is part of the model, the inclusion of the exponential functions \nmakes the distribution lognormal. For those less familiar with statistics, anormal dis\ntribution has abell-shaped curve. This is the most familiar mathematical distribution. \nThe problem with using anormal distribution is that it allows for negative stock \nprices, an impossible occurrence. Therefore, the lognormal distribution is generally \nused for stock prices, because it implies that the stock price can have arange only \nbetween zero and infinity. Furthermore, the upward (bullish) bias of the lognormal \ndistribution appears to be logically correct, since astock can drop only 100% but can \nrise in price by more than 100%. Many option pricing models that antedate the \nBlack-Scholes model have attempted to use empirical distributions. An empirical \ndistribution has adifferent shape than either the normal or the lognormal distribu\ntion. Reasonable empirical distributions for stock prices do not differ tremendously \nfrom the lognormal distribution, although they often assume that astock has agreater probability of remaining stable than does the lognormal distribution. Critics \nof the Black-Scholes model claim that, largely because it uses the lognormal distri\nbution, the model tends to overprice in-the-money calls and underprice out-of-the\nmoney calls. This criticism is true in some cases, but does not materially subtract \nfrom many applications of the model in strategy decisions. True, if one is going to buy \nor sell calls solely on the basis of their computed value, this would create alarge prob\nlem. However, if strategy decisions are to be made based on other factors that out\nweigh the overpriced/underpriced criteria, small differentials will not matter. \nThe computation of volatility is always adifficult problem for mathematical \napplication. In the Black-Scholes model, volatility is defined as the annual standard \ndeviation of the stock price. This is the regular statistical definition of standard devi\nation: \nwhere \nP = average stock price of all P/s \nPi = daily stock price \nn \n~ (Pi -P)2 \ncr2 = _1=_1 __ _ \nn-1 \nv = a!P", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:500", "doc_id": "2bf7923e5a5f20b174706e6b24761ebcec7d1e7dff15ad193e2e5a6d0b94f679", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications 463 \nThis is then the proper way to calculate historical volatility. Obviously, the \nstrategist can calculate 10-, 20-, and 50-day and annual volatilities if he wishes - or \nany other number for that matter. In certain cases, one can discern valuable infor\nmation about astock or future and its options by seeing how the various volatilities \ncompare with one another. \nThere is, in fact, away in which the strategist can let the market compute the \nvolatility for him. This is called using the implied volatility; that is, the volatility that \nthe market itself is implying. This concept makes the assumption that, for options \nwith striking prices close to the current stock price and for options with relatively \nlarge trading volume, the market is fairly priced. This is something like an efficient \nmarket hypothesis. If there is enough trading interest in an option that is close to the \nmoney, that option will generally be fairly priced. Once this assumption has been \nmade, acorollary arises: If the actual price of an option is the fair price, it can be fixed \nin the Black-Scholes equation while letting volatility be the unknown variable. The \nvolatility can be determined by iteration. In fact, this process of iterating to compute \nthe volatility can be done for each option on aparticular underlying stock This might \nresult in several different volatilities for the stock If one weights these various results \nby volume of trading and by distance in- or out-of-the-money, asingle volatility can \nbe derived for the underlying stock This volatility is based on the closing price of all \nthe options on the underlying stock for that given day. \nExample: XYZ is at 33 and the closing prices are given in Table 28-1. Each option \nhas adifferent implied volatility, as computed by determining what volatility in the \nBlack-Scholes model would result in the closing price for each option: That is, if .34 \nwere used as the volatility, the model would give 4¼ as the price of the January 30 \ncall. In order to rationally combine these volatilities, weighting factors must be \napplied before avolatility for XYZ stock itself can be arrived at. \nThe weighting factors for volume are easy to compute. The factor for each \noption is merely that option'sdaily volume divided by the total option volume on all \nXYZ options (Table 28-2). The weighting functions for distance from the striking \nprice should probably not be linear. For example, if one option is 2 points out-of-the\nmoney and another is 4 points out-of-the-money, the former option should not nec\nessarily get twice as much weight as the latter. Once an option is too far in- or out-of\nthe-money, it should not be given much or any weight at all, regardless of its trading \nvolume. Any parabolic function of the following form should suffice: \n{ \n(x - a)2 if xis less than a \nWeighting factor = -;;,r-\n= 0 if xis greater than a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:503", "doc_id": "4769c6954f9d74697c04613ce84049f947c2c321c01fed1aa1ce9edd3fc4b04d", "chunk_index": 0}
{"text": "464 Part IV: Additional Considerations \nTABLE 28-1. \nImplied volatilities, closing price, and volume. \nOption \nOption Price Volume \nJanuary 30 41/2 \nJanuary 35 11/2 \nApril 35 21/2 \nApril 40 11/2 \nTABLE 28-2. \nVolume weighting factors. \nOption \nJanuary 30 \nJanuary 35 \nApril 35 \nApril 40 \nVolume \n50 \n90 \n55 \n5 \n50 \n90 \n55 \n~ \n200 \nImplied \nVolatility \n.34 \n.28 \n.30 \n.38 \nVolume Weighting Factor \n.25 (50/200) \n.45 (90/200) \n.275 (55/200) \n.025 ( 5/200) \nwhere xis the percentage distance between stock price and strike price and ais the \nmaximum percentage distance at which the modeler wants to give any weight at all \nto the option'simplied volatility. \nExample: An investor decides that he wants to discard options from the weighting \ncriterion that have striking prices more than 25% from the current stock price. The \nvariable, a, would then be equal to .25. The weighting factors, with XYZ at 33, could \nthus be computed as shown in Table 28-3. To combine the weighting factors for both \nvolume and distance from strike, the two factors are multiplied by the implied volatil\nity for that option. These products are summed up for all the options in question. \nThis sum is then divided by the products of the weighting factors, summed over all \nthe options in question. As aformula, this would read: \nImplied _ I,(Volume factor x Distance factor x Implied volatility) \nvolatility - I,(Volume factor x Distance factor) \nIn our example, this would give an implied volatility for XYZ stock of 29.8% \n(Table 28-4). Note that the implied volatility, .298, is not equal to any of the individ-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:504", "doc_id": "7bba8c8958ba71649fcae4d78c39a3a4e01446575af6b524c6cbad52dd243845", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications \nTABLE 28-3. \nDistance weighting factors. \n465 \nOption \nDistonce \nfrom \nStock Price \nDistance \nWeighting Factor \nJanuary 30 \nJanuary 35 \nApril 35 \nApril 40 \nTABLE 28-4. \nOption'simplied volatility. \n.091 (3/33) \n.061 (2/33) \n.061 (2/33) \n.212 (7 /33) \n.41 \n.57 \n.57 \n.02 \nVolume Distance Option's Implied \nOption Factor Factor Volotility \nJanuary 30 .25 .41 .34 \nJanuary 35 .45 .57 .28 \nApril 35 .275 .57 .30 \nApril40 .025 .02 .38 \nImplied = .25 x .41 x .34 + .45 x .57 x .28 + .275 x .57 x .30 + .025 x .02 x .38 \nvolatility. .25 x .41 + .45 x .57 + .275 x .57 + .025 x .02 \n= .298 \nual option'simplied volatilities. Rather, it is acomposite figure that gives the most \nweight to the heavily traded, near-the-money options, and very little weight to the \nlightly-traded (5 contracts), deeply out-of-the-money April 40 call. This implied \nvolatility is still aform of standard deviation, and can thus be used whenever astan\ndard deviation volatility is called for. \nThis method of computing volatility is quite accurate and proves to be sensitive \nto changes in the volatility of astock. For example, as markets become bullish or \nbearish (generating large rallies or declines), most stocks will react in avolatile man\nner as well. Option premiums expand rather quickly, and this method of implied \nvolatility is able to pick up the change quickly. One last bit of fine-tuning needs to be \ndone before the final volatility of the stock is arrived at. On aday-to-day basis, the \nimplied volatility for astock - especially one whose options are not too active may \nfluctuate more than the strategist would like. Asmoothing effect can be obtained by", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:505", "doc_id": "2b51cb6320b56bc634472f1d626e400622df82dd17041fa19e3e678cea0512f1", "chunk_index": 0}
{"text": "466 Part IV: Additional Considerations \ntaking amoving average of the last 20 or 30 days' implied volatilities. An alternative \nthat does not require the saving of many previous days' worth of data is to use amomentum calculation on the implied volatility. For example, today'sfinal volatility \nmight be computed by adding 5% of today'simplied volatility to 95% of yesterday'sfinal volatility. This method requires saving only one previous piece of data - yester\nday'sfinal volatility - and still preserves a \"smoothing\" effect. \nOnce this implied volatility has been computed, it can then be used in the \nBlack-Scholes model ( or any other model) as the volatility variable. Thus one could \ncompute the theoretical value of each option according to the Black-Scholes formu\nla, utilizing the implied volatility for the stock. Since the implied volatility for the \nstock will most likely be somewhat different from the implied volatility of this par\nticular option, there will be adiscrepancy between the option'sactual closing price \nand the theoretical price as computed by the model. This differential represents the \namount by which the option is theoretically overpriced or underpriced, compared to \nother options on that same stock. \nEXPECTED RETURN \nCertain investors will enter positions only when the historical percentages are on \ntheir side. When one enters into atransaction, he normally has abelief as to the pos\nsibility of making aprofit. For example, when he buys stock he may think that there \nis a \"good chance\" that there will be arally or that earnings will increase. The investor \nmay consciously or unconsciously evaluate the probabilities, but invariably, an invest\nment is made based on apositive expectation of profit. Since options have fixed \nterms, they lend themselves to amore rigorous computation of expected profit than \nthe aforementioned intuitive appraisal. This more rigorous approach consists of com\nputing the expected return. The expected retum is nothing more than the retum that \nthe position should yield over alarge number of cases. \nAsimple example may help to explain the concept. The crucial variable in com\nputing expected return is to outline what the chances are of the stock being at acer\ntain price at some future time. \nExample: XYZ is selling at 33, and an investor is interested in determining where \nXYZ will be in 6 months. Assume that there is a 20% chance of XYZ being below 30 \nin 6 months, and that there is a 40% chance that XYZ will be above 35 in 6 months. \nFinally, assume that XYZ has an equal 10% chance of being at 31, 32, 33, or 34 in 6 \nmonths. All other prices are ignored for simplification. Table 28-5 summarizes these \nassumptions.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:506", "doc_id": "879c8dd35028b811c073836d113c16761ab33041dd3901ef645fcee09930c1a2", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications \nTABLE 28-5. \nCalculation of expected returns. \nPrice of XYZ in 6 Months \nBelow 30 \n31 \n32 \n33 \n34 \nAbove 35 \n467 \nChance of XYZ Being at That Price · \n20% \n10% \n10% \n10% \n10% \n40% \n100% \nSince the percentages total 100%, all the outcomes have theoretically been \nallowed for. Now suppose a February 30 call is trading at 4 and a February 35 call is \ntrading at 2 points. Abull spread could be established by buying the February 30 and \nselling the February 35. This position would cost 2 points - that is, it is a 2-point \ndebit. The spreader could make 3 points if XYZ were above 35 at expiration for areturn of 150%, or he could lose 100% if XYZ were below 30 at expiration. The \nexpected return for this spread can be computed by multiplying the outcome at expi\nration for each price by the probability of being at that price, and then summing the \nresults. For example, if XYZ is below 30 at expiration, the spreader loses $200. It was \nassumed that there is a 20% chance of XYZ being below 30 at expiration, so the \nexpected loss is 20% times $200, or $40. Table 28-6 shows the computation of the \nexpected results at all the prices. The total expected profit is $100. This means that \nthe expected return (profit divided by investment) is 50% ($100/$200). This appears \nto be an attractive spread, because the spreader could \"expect\" to make 50% of his \nmoney, less commissions. \nWhat has really been calculated in this example is merely the return that one \nwould expect to make in the long run if he invested in the same position many times \nthroughout history. Saying that aparticular position has an expected return of 8 or \n9% is no different from saying that common stocks return 8 or 9% in the long run. \nOf course, in bull markets stock would do much better, and in bear markets much \nworse. In asimilar manner, this example bull spread with an expected return of 50% \nmay do as well as the maximum profit or as poorly as losing 100% in any one case. It \nis the total return on many cases that has the expected return of 50%. Mathematical \ntheory holds that, if one constantly invests in positions with positive expected returns, \nhe should have abetter chance of making rrwney.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:507", "doc_id": "58cb863e22e1d26f8c640e5d13bc42dd4bc0a4ac88687c4eb436864cb82b5867", "chunk_index": 0}
{"text": "468 Part IV: Additional Considerations \nTABLE 28-6. \nComputation of expected profit. \nChance of Being Profit at Expected \nXYZ Price at at That Price That Price Profit: \nExpiration (A) (B) (A) x (8) \nBelow 30 20% -$200 -$ 40 \n31 10% - 100 - 10 \n32 10% 0 0 \n33 10% + 100 + 10 \n34 10% + 200 + 20 \nAbove 35 40% + 300 + 120 \nTotal expected profit $100 \nAs is readily observable, the selection of what percentages to assign to the pos\nsible outcomes in the stock price is acrucial choice. In the example above, if one \naltered his assumption slightly so that XYZ had a 30% chance of being below 30 and \na 30% chance of being above 35 at expiration, the expected return would drop con\nsiderably, to 25%. Thus, it is important to have areasonably accurate and consistent \nmethod of assigning these percentages. Furthermore, the example above was too sim\nplistic, in that it did not allow for the stock to close at any fractional prices, such as \n32½. Acorrect expected return computation must take into account all possible out\ncomes for the stock. \nFortunately, there is astraightforward method of computing the expected per\ncentage chance of agiven stock being at acertain price at acertain point in time. This \ncomputation involves using the distribution of stock prices. As mentioned earlier, the \nBlack-Scholes model assumes alognormal distribution for stock prices, although \nmany modelers today use nonstandard (empirical or heuristic) distributions. No mat\nter what the distribution, the area under the distribution curve between any two \npoints gives the probability of being between those two points. \nFigure 28-1 is agraph of atypical lognormal distribution. The peak always lies \nat the \"mean,\" or average, of the distribution. For stock price distributions, under the \nrandom walk assumption, the \"mean\" is generally considered to be the current stock \nprice. The graph allows one to visualize the probability of being at any given price. \nNote that there is afairly great chance that the stock will be relatively unchanged; \nthere is no chance that the stock will be below zero; and there is abullish bias to the \ngraph - the stock could rise infinitely, although the chances of it doing so are \nextremely small.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:508", "doc_id": "faee40ca129610c633303a6898e11c6baa708c53e26fc01bed8ec2f30760b075", "chunk_index": 0}
{"text": "470 \nwhere \nv = annual volatility \nt = time, in years \nvt = volatility for time, t. \nPart IV: Additional Considerations \nAs an example, a 3-month volatility would be equal to one-half of the annual \nvolatility. In this case, twould equal .25 (one fourth of ayear), so v_25 = v65 = .5v. \nThe necessary groundwork has been laid for the computation of the probabili\nty necessary in the expected return calculation. The following formula gives the prob\nability of astock that is currently at price pbeing below some other price, q, at the \nend of the time period. The lognormal distribution is assumed. \nProbability of stock being below price qat end of time period t: \nP (below) = N (In~)) \nwhere \nN = cumulative normal distribution \np = current price of the stock \nq = price in question \nIn = natural logarithm for the time period in question. \nIf one is interested in computing the probability of the stock being above the \ngiven price, the formula is \nP (above)= 1- P (below) \nWith this formula, the computation of expected return is quickly accomplished \nwith acomputer. One merely has to start at some price - the lower strike in abull \nspread, for example - and work his way up to ahigher price - the high strike for abull spread. At each price point in between, the outcome of the spread is multiplied \nby the probability of being at that price, and arunning sum is kept. \nSimplistically, the following iterative equation would be used. \nP ( of being at price x) = P (below x) - P (below y) \nwhere yis close to but less than xin price. As an example: \nP (of being at 32.4) = P (below 32.4) - P (below 32.3)", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:510", "doc_id": "4fc95efa7f207f3a234b06920e7af99d64cb94e5375609b8e2f8e07be1d49027", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications 471 \nThus, once the low starting point is chosen and the probability of being below that \nprice is determined, one can compute the probability of being at prices that are suc\ncessively higher merely by iterating with the preceding formula. In reality, one is \nusing this information to integrate the distribution curve. Any method of approxi\nmating the integral that is used in basic calculus, such as the Trapezoidal Rule or \nSimpson's Rule, would be applicable here for more accurate results, if they are \ndesired. \nApartial example of an expected return calculation follows. \nExample: XYZ is currently at 33 and has an annual volatility of 25%. The previous \nbull spread is being established- buy the February 30 and sell the February 35 for a \n2-point debit - and these are 6-month options. Table 28-7 gives the necessary com\nponents for computing the expected return. Column (A), the probability of being \nbelow price q, is computed according to the previously given formula, where p = 33 \nand vt = .177 (t = .25-V ½). The first stock price that needs to be looked at is 30, since \nall results for the bull spread are equal below that price - a 100% loss on the spread. \nThe calculations would be performed for each eighth (or tenth) of apoint up through \naprice of 35. The expected return is compute<lby multiplying the two right-hand \ncolumns, (B) and (C), and summing the results. Note that column (B) is determined \nby subtracting successive numbers in column (A). It would not be particularly \nenlightening to carry this example to completion, since the rest of the computations \nare similar and there is alarge number of them. \nIn theory, if one had the data and the computer power, he could evaluate awide \nrange of strategies every day and come up with the best positions on an expected \nreturn basis. He would probably get afew option buys (puts or calls), some bull \nTABLE 28-7. \nCalculation of expected returns. \nPrice at Expiration (A) (B) (() \n(q) P (below q) P (of being at q) Profit on Spread \n30 .295 .295 -$200 \n30 1/s .301 .006 - 187.50 \n30 1/4 .308 .007 - 175 \n303/s .316 .008 - 162.50", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:511", "doc_id": "e1b50879f3b492cbf5663bac15c9721aff2832fa6d13072134af7ca857d95448", "chunk_index": 0}
{"text": "472 Part IV: Additional Considerations \nspreads, some naked writes and ratio calendar spreads, fewer straddles and ratio \nwrites, and afew covered call writes. This theory would be somewhat difficult to apply \nin practice, because of the massive numbers of calculations involved and also because \nof the accuracy of closing price data. It was mentioned previously that acomputer will \nassume that \"bad\" closing prices are actually attainable. By a \"bad\" closing price, it is \nmeant that the option did not trade simultaneously with the stock later in the day, and \nthat the actual market for the option is somewhat different in price than is reflected \nby the closing price for the option. Adaily contract volume \"screen\" will help allevi\nate this problem. For example, one may want to discard any option from his calcula\ntions if that option did not trade apredetermined, minimum number of contracts \nduring the previous day. Data that give closing bids and offers for each option are \nmore expensive but also more reliable, and would alleviate the problem of \"bad\" \nclosing prices. In addition to avolume screen, another way of reducing the calcula\ntions required is to limit oneself to strategies in which one has interest, or which one \nis reasonably certain will fit in well with his investment objectives. Regardless of the \nlimitations that one places upon the quantity of computations, some computer power \nis necessary to compute expected return. Asophisticated programmable calculator \nmay be able to provide areal-time calculation, but could never be used to evaluate \nthe entire option universe and come up with aranking of the preferable situations \neach day. On-line computer systems are also available that can provide these types of \ncalculations using up-to-the-minute prices. While real-time prices may occasionally \nbe useful, it is not an absolute necessity to have them. \nOne other by-product of the expected return calculation is that it could be used \nas another model for predicting the theoretical value of an option. All one would have \nto do is compute the probabilities of the stock being at each successive price above \nthe striking price of the option by expiration, and sum them up. The result would be \nthe theoretical option value. These data are published by some services and general\nly give adifferent theoretical value than would the Black-Scholes model. The reason \nfor the difference most readily lies in the inclusion of the risk-free interest rate in the \nBlack-Scholes model and its omission in the expected return model. \nAPPLYING THE CALCULATIONS TO STRATEGY DECISIONS \nCALL WRITING \nOne method of ranking covered call writes that was described in Chapter 2 was to \nrank all the writes that provided at least aminimal acceptable level of return by their \nprobability of not losing money. If one were interested in safety, he might decide to \nuse this approach. Suppose he decided that he would consider any write that provid-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:512", "doc_id": "aa736818e018c21e562b7ff4ae915576194c49a411b43f4be829a55e13311671", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications 413 \ned an annualized total return (capital gains, dividends, and commissions) of at least \n12%. This would eliminate many potential writes, but would leave him with afairly \nlarge number of writing candidates each day. He knows the downside break-even \npoint at expiration in each write. Therefore, the probability of the stock being below \nthat break-even point at expiration can be computed quickly. His final list would rank \nthose writes with the least chance of being below the break-even point at expiration \nas the best writes. Again, this ranking is based on an expected probability and is, of \ncourse, no guarantee that the stock will not, in reality, fall below the break-even \npoint. However, over time, alist of this sort should provide the rrwst conservative cov\nered writes. \nExample: XYZ is selling for 43 and a 6-month July 40 call is selling for 8 points. After \nincluding dividends and commission costs for a 500-share position, the downside \nbreak-even point at expiration is 36. If the annualized volatility of XYZ is 25%, the \nprobability of making money at expiration can be computed. The 6-month volatility \nis 17.7% (25% times the square root of½ year). The probability of being below 36 \ncan be computed by using the formula given earlier in this section: \nThe expected probability of XYZ being below 36 in 6 months is 15.8%. Therefore, \nthis would be an attractive write on aconservative basis, because it has alarge prob\nability of making money (nearly 85% chance of not being below the break-even point \nat expiration). The return if exercised in this example is approximately 20% annual\nized, so it should be acceptable from aprofit potential viewpoint as well. It is arela\ntively easy matter to perform asimilar calculation, with the aid of acomputer, on all \ncovered writing candidates. \nThe ability to measure downside protection in terms of acommon denomina\ntor - volatility - can be useful in other types of covered call writing analyses. The \nwriter interested in writing out-of-the-money calls, which generally have higher \nprofit potential, is still interested in having an idea of what his downside protection \nis. He might, for example, decide that he wants to invest in situations in which the \nprobability of making money is at least 60%. This is not an unusually difficult \nrequirement to fulfill, and will leave many attractive covered writes with ahigh prof\nit potential to choose from. Adownside requirement stated in terms of probability \nof success removes the necessity of having to impose arbitrary requirements. Typical", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:513", "doc_id": "9ecf4523aa8e9c5abbf787897306b4e676d9f19d2428b71ab563fadb42ea3fa1", "chunk_index": 0}
{"text": "I \nI I \nIi \nI ; \nIi ;· \n! \n474 Part IV: Additional Considerations \narbitra:ry requirements would be including only calls that sell for one point or more, \nor stating that the downside protection must be acertain percentage of the stock \nprice. These obviously cannot suffice for stocks with different volatilities. Rather, \nthe downside protection criterion should be stated in terms of \"probability of down \nprotection\" or, alternatively, in terms of the volatility itself. In this manner, auniform \ncomparison can be made between volatile and nonvolatile stocks. \nCALL BUYING \nThe option buyer can also constructively use the measurement of volatility to aid him \nin his option buying decisions. In Chapter 3, it was shown that evaluating the prof \nitability of calls based on the volatility of the underlying stock is the correct way to \nanalyze an option purchase. One specific method of analysis is described. There are \ncertain variables in this analysis that may be altered to fit the call buyer'sindividual \npreferences, but the general logic is applicable to all cases. \nAs afirst step, one should decide upon auniform stock rrwvement for ranking \ncall purchases. One might decide to rank all purchases by how they would perform \nif the underlying stock moved up in accordance with its volatility. The phrase \"in \naccordance with its volatility\" must be quantified. For example, one might decide to \nassume that eve:ry stock could move up one standard deviation, and then rank all call \npurchases on that basis. The prospective call buyer must also fix the time period that \nhe wants to use. Generally, one looks at purchases to be held for 30 days, 60 days, and \n90 days. \nThe exact steps to be followed in the analysis of profitability and risk can be list\ned as follows: \nI. Specify the distance that underlying stock can move, up or down, in terms of its \nvolatility. \n2. Select the holding period over which the analysis is to take place. \nPROFITABILITY \n3. Calculate the stock price that the stock would move up to, when the foregoing \nassumptions are implemented. \n4. Using apricing model, such as the Black-Scholes model, estimate what the \noption price would become after the upward stock movement. \n5. Calculate the percent profit, after deducting commissions. \n6. Repeat steps 4 and 5 for each option on the stock.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:514", "doc_id": "1f82f532c346754bf7cd6b75b4f617246f6b27902e97f3749edd3aa78dcbd9d7", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications 475 \nAfinal ranking of all potential call buys can be obtained by performing steps 3 \nthrough 6 on all stocks, and ranking the purchases by their percentage reward. \nRISK \n7. Calculate the stock price that the stock could fall to, when the assumptions in \nsteps 1 and 2 are applied. \n8. With amodel, price the option after the stock'sdecline. \n9. Calculate the percentage loss after commissions. \n10. Compute areward/risk ratio: Divide the percentage profit from step 5 by the \npercentage risk from step 9. \n11. Repeat steps 8 through 10 for each option on the stock. \nAfinal ranking of less aggressive option purchases can be constructed by performing \nsteps 7 through 11 on all stocks, and ranking the purchases by their reward/risk ratio. \nThe higher profitability list of option purchases will tend to be at- or slightly \nout-of-the-money calls. The less aggressive list, ranked by reward/risk potential, will \ntend to be in-the-money options. \nExample: Steps 1 and 2: Suppose an investor wants to look at option purchases for a \n90-day holding period, under the assumption that each stock could move up by one \nstandard deviation in that time. (There is only about a 16% chance that astock will \nmove more than one standard deviation in one direction in agiven time period. \nTherefore, in actual practice, one might want to use asmaller stock movement in his \nranking calculations.) Furthermore, assume that the following data are known: \nXYZ common, 41; \nXYZ volatility, 30% annually; \nXYZ January 40 call, 4; and \ntime to January expiration, 6 months \nStep 3: Calculate upward stock potential. This is accomplished by the following \nformula: \nwhere \np = current stock price \nq = potential stock price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:515", "doc_id": "b121ddd301dbe422694c9024e33e2fce486469685acfa49acab4cdb94f6cf03c", "chunk_index": 0}
{"text": "476 Part IV: Additional Considerations \nvt == volatility for the time period, ta == aconstant (see below). \nThe constants, aand t, are fixed under the assumptions in steps 1 and 2. The first \nconstant, a, is the number of standard deviations of movement to be allowed. In our \nexample, a == I. That is, the analysis is being made under the assumption that the \nstock could move up by one standard deviation. The second constant, t, is .25, since \nthe analysis is for a 90-day holding period, which is 25% of ayear. In this example: \nVt == v-ft == .30 {is== .30 X .50 == .15 \nso \nq == 4le· 15 == 41 X 1.16 == 47.64 \nThus, this stock would move up to approximately 475/sif it moved one standard devi\nation in exactly 90 days. \nStep 4: Using the Black-Scholes model, the XYZ January 40 call can be priced. \nIt would be worth approximately 81/sif XYZ were at 475/sand there were 90 days' less \nlife in the call. \nStep 5: Calculate the profit potential. For this example, commissions will be \nignored, but they should be included in areal-life situation. \n81/s-4 41/s Percent profit == --- == - == 103% 4 4 \nThus, if XYZ stock moves up by one standard deviation over the next 90 days, this call \nwould yield aprojected profit of 103%. Recall again that there is only about a 16% \nchance of the stock actually moving at least this far. If all options on all stocks are \nranked under this same assumption, however, afair comparison of profitable options \nwill be obtained. \nStep 6 is omitted from this example. It would consist of performing asimilar \nprofit analysis (steps 4 and 5) on all other XYZ options, with the assumption that XYZ \nis at 475/safter 90 days. \nStep 7: Calculate the downside potential of XYZ. The formula for the downside \npotential of the stock is nearly the same as that used in step 3 for the upside poten\ntial: \nq = pe-avt \n== 4lc· 15 = 41 x .86 = 35.39 \nXYZ would fall to approximately 35¼ in 90 days if it fell by one standard deviation. \nNote that the actual distances that XYZ could rise and fall are not the same. The", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:516", "doc_id": "3643b0865be222db0e2db9f9d21eb74e1d1090fffccb3e4993a907627ede8b4d", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications 477 \nupward potential was 65/spoints, while the downward potential is about 5¾ points. \nThis difference is due to the use of the lognormal distribution. \nStep 8: Using the Black-Scholes model, one could estimate that the XYZ \nJanuary 40 call would be worth about 11/sif XYZ were at 35¼ in 90 days. \nStep 9: The risk potential in the January 40 call would be: \n. 4- l1/s 27/s Percent nsk = --- = - 72% 4 4 \nStep 10: The reward/risk ratio is merely the percentage reward divided by the per\ncentage risk: \nReward/risk ratio = l03% = 1.43 72% \nStep 11: This analysis would be repeated for all XYZ options, and then for all other \noptionable stocks. The less aggressive call purchases would be ranked by their \nreward/risk ratios, with higher ratios representing more attractive purchases. More \naggressive purchases would be ranked by the potential rewards only (step 5). \nThis completes the call buying example. Before leaving this section, it should be \nnoted that the assumption of ranking the purchases after one full standard deviation \nmovement by the underlying stock is probably excessive. Amore moderate assump\ntion would be that the stock might be able to move . 7 standard deviation. There is \nabout a 25% expected chance that astock could move up at least . 7 standard devia\ntion at the end of afixed time period. \nPRICING A PUT OPTION \nTheoretical models for pricing put options have been derived; that is, ones that are \nseparate from call pricing models. Black and Scholes presented such amodel in their \noriginal paper. However, as has been demonstrated, there is arelationship between \nput and call prices in the listed option market due to the conversion and reversal \nstrategies. \nOne could use the ba,sic call pricing rrwdel for the purpose of predicting put \nprices if he a,ssumes that arbitrageurs will efficiently influence the market via con\nversions. Theoreticians will argue that such amethod of pricing puts assumes that the \narbitrage process is always present and works efficiently, and that this is not true. The \n\"conversion efficiency\" assumption could be aserious fault if one were trying to \ndetermine the exact overpriced or underpriced nature of the put option. However, if \none is merely comparing various put strategies under constant assumptions, the arbi\ntrage model for pricing puts works quite well.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:517", "doc_id": "76b1378965608012f418325c91503e15b0c062b09b2af4d4968a7ca913c3a775", "chunk_index": 0}
{"text": "478 Part IV: Additional Considerations \nThe listed put' sprice can be estimated by using the call pricing model and the \narbitrage formula. Recall that the arbitrageur must include the cost of carrying the \nposition as well as the dividends to be received. \nTheoretical Theoretical Strike Stock Carrying n· 'dd = + - - + IVI en sput call price price price cost \nThe \"theoretical call price\" is obtained from the Black-Scholes model. The carrying \ncost is the cost of money (interest rate) times the striking price, multiplied by the \ntime to expiration. Recall that this is the approximation formula for carrying cost (see \nChapter 27 for comments on present value and compounding). Consequently, ifXYZ \nwere at 41 and a 6-month January 40 call option were valued at 4 points by the \nBlack-Scholes model, the theoretical put price could be estimated. Assume that the \ncost of money interest rate is 10% annually, and that the stock will pay $.50 in divi\ndends in 6 months (t = ½ year). \nTheoretical put price = 4 + 40 - 41- (.10 x 40 x ½) + .50 \n=3-2+½ \n=l½ \nThis means that if the call could be sold for 4 points, the arbitrageur would be will\ning to pay up to 1 ½ points for the put to establish aconversion. The arbitrageur'sprice is used as the theoretical listed put price estimate. \nPUT BUYING \nPut option purchases can be ranked in amanner very similar to that described for call \noption buying. Reward opportunities occur when the stock falls in accordance with \nits volatility. An upward stock movement represents risk for the put buyer. All of the \n11 steps in the previous section on call buying are applicable to put buying. The pric\ning of the put necessary for steps 4 and 8 is done in accordance with the arbitrage \nmodel just presented. \nIf an underlying stock does not have listed puts trading, the synthetic put can \nbe considered. While all U.S.-listed stocks have both puts and calls at every strike, \nthere are still situations with warrants, especially in foreign countries, that are appli\ncable to the following discussion. Recall that synthetic puts are created for customers \nby some brokerage houses. The brokerage sells the stock short and buys acall. The \ncustomer can purchase the synthetic put for the amount of the risk involved, plus any \ndividends to be paid by the underlying stock. The synthetic put pricing formula that \nwould be used in steps 4 and 8 of the option buying analysis is exactly the same as the \narbitrage model for listed puts, except that the carrying costs are omitted:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:518", "doc_id": "e2285b4e00b80fe7be1391fe6edf77e48e9711c95bd529454c2cfab781b29405", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications 479 \nTheoretical synthetic Theoretical Strike Stock D\" .dd = + - + 1vi en sput price call price price price \nWhen the ranking analysis is performed, very few synthetic puts will appear as \nattractive put buys. This is because, when the customer buys asynthetic put, he must \nadvance the full cost of the dividend, but receives no offsetting cost reduction for the \ncredit being earned by the short stock position. Consequently, synthetic puts are \nalways more expensive, on arelative basis, than are listed puts. However, if one is par\nticularly bearish on astock that has no listed puts, asynthetic put may still prove to \nbe aworthwhile investment. The recommended analysis can give him afeeling for \nthe reward and risk potential of the investment. \nCALENDAR SPREADS \nThe pricing nwdel can help in determining which neutral calendar spreads are nwst \nattractive. Recall that in aneutral calendar spread, one is selling anear-term call and \nbuying alonger-term call, when the stock is relatively close to the striking price of the \ncalls. The object of the spread is to capture the time decay differential between the \ntwo options. The neutral calendar spread is normally closed when the near-term \noption expires. The pricing model can aid the spreader by estimating what the prof\nit potential of the spread is, as well as helping in the determination of the break-even \npoints of the position at near-term expiration. \nTo determine the maximum profit potential of the spread, assume that the near\nterm call expires worthless and use the pricing model to estimate the value of the \nlonger-term call with the stock exactly at the striking price. Since commission costs \nare relatively large in spread transactions, it would be best to have the computations \ninclude commissions. Calculating asecond profit potential is sometimes useful as \nwell the profit if unchanged. To determine how much profit would be made if the \nstock were unchanged at near-term expiration, assume that the spread is closed with \nthe near-term call equal to its intrinsic value (zero if the stock is currently below the \nstrike, or the difference between the stock price and the strike if the stock is initial\nly above the strike). Then use the pricing model to estimate the value of the longer\nterm call, which will then have three or six months of life remaining, with the stock \nunchanged. The resulting differential between the near-term call'sintrinsic value and \nthe estimated value of the longer-term call is an estimate of the price at which the \nspread could be liquidated. The profit, of course, is that differential minus the cur\nrent (initial) differential, less commissions. \nIn the earlier discussion of calendar spreads, it was pointed out that there is \nboth an upside break-even point and adownside break-even point at near-term expi\nration. These break-even points can be estimated with the use of the pricing model.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:519", "doc_id": "aeb2317cb03e9b3f3423b8d52aa553f1d5e96f545703027d68cf325016c9fac4", "chunk_index": 0}
{"text": "480 Part IV: Additional Considerations \nOne method of determination involves estimating the liquidating value of the spread \nat successive stock prices. When the liquidating value is found to be equal to the ini\ntial value, plus commissions, abreak-even point has been located. \nExample: If the spread in question is using options with astriking price of 30, one \nwould begin his break-even point calculations at aprice of 30. Estimate the liquidat\ning value of the spread at 30, 297/s, 29¾, 29-5/s, and so forth until the break-even point \nis found. Once the downside break-even point has been determined in this manner, \nthe iterations to locate the upside break-even point should begin again at the striking \nprice. Thus, one would evaluate the liquidating value at 30, 301/s, 30¼, and so on. This \nis somewhat of abrute-force method, but with acomputer it is fairly fast. The num\nber of calculations can be reduced by adopting amore complicated iteration process. \nAfinal useful piece of information can be obtained with the aid of the pricing \nmodel - the theoretical value of the spread. Recompute the estimated value of both \nthe near-term and longer-term calls at the current time and stock price, using the \nimplied volatility for the underlying stock. The resultant differential between the two \nestimated call prices may differ substantially from the actual differential, perhaps \nhighlighting an attractive calendar spread situation. One would want to establish \nspreads in which the theoretical differential is greater than the actual differential \n(that is, he would want to buy a \"cheap\" calendar spread). \nOnce these pieces of information have been computed, the strategist can rank \nthe spread possibilities by whatever criterion he finds most workable. The logical \nmethod of ranking the spreads is by their return if unchanged. The spreads with the \nhighest return if unchanged at near-term expiration are those in which the stock price \nand striking price were close together initially, abasic requirement of the neutral cal\nendar spread. More complicated ranking systems should tty to include the theoreti\ncal value of the spread and possibly even the maximum potential of the spread. Asimilar analysis can, of course, be worked out for put calendar spreads, using the \narbitrage pricing model for puts. \nRATIO STRATEGIES \nRatio strategies involve selling naked options. Therefore, the strategist has potential\nly large risk, either to the upside or to the downside or both. He should attempt to \nget afeeling for how probable this risk is. The formulae for determining the proba\nbility of astock being above or below acertain price at some time in the future can \ngive him these probabilities. For example, in astraddle writing situation, the strate\ngist would want to compute such arithmetic quantities as maximum profit potential, \nreturn if unchanged, collateral required at upside break-even point or at upside", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:520", "doc_id": "609643ea198e7e61a2048e57d804e6200025b56f57324d41b61001fe75e7eb2c", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications 481 \naction point (recall that the collateral requirement increases for naked options on an \nadverse stock movement), and the break-even points themselves. The probabilities of \nbeing above the upper break-even point at expiration or below the lower break-even \npoint should be computed as well. Moreover, an expected return analysis could be \nperformed on the position to determine the general level of profitability of the posi\ntion with respect to all other positions of the same type on other stocks. Such an \nexpected return analysis need not assume that the position is held to expiration. Firm \ntraders, paying little or no commissions, might be interested in seeing the expected \nreswts for aholding period as short as 30 days or less. Public customers might use alonger holding period, on the assumption that they would not trade the position as \nreadily because of commission costs. Ratio positions should be ranked either by \nreturn if unchanged or by expected return. \nThe analyses described for calendar spreads and ratio positions should not be \nrelied upon as gospel. In the proposed forms of analysis, one is projecting future \noption prices and stock prices under the assumption that the volatility of the under\nlying stock will remain the same. Although this may be true in some cases, there will \nalso be many times when the volatility of the underlying stock will change during the \nlife of the position. If the volatility decreases, the projected break-even points for acalendar spread will be too far away from the striking price. Thus, aloss would result \nat some prices where the spreader expected to make money. If the volatility increas\nes, the expected return of aratio position will drop, because the probabilities of the \nstock moving outside the profit range will increase, thereby increasing the probabil\nity ofloss. \nThe effect of achanging volatility can be counteracted, in theory, by continuing \nto monitor the position daily after it has been established. In astraddle write, for \nexample, if the stock begins to move dramatically, the expected return may become \nvery low. If this happens, adjustments could be made to the position to improve it. \nSuch monitoring is difficult to apply in practice for the public customer, because the \ncommission costs involved in constant position adjustments would mount rapidly. \nThere is no exact method that would allow for infrequent, periodic adjustments, but \nby using afollow-up analysis the public customer may be able to get abetter feeling \nfor the timing of adjusting aposition. For example, suppose that one initially wrote a \n5-point straddle when the stock was at 30. Sometime later, the stock is at 34. The \nexpected return of writing a 5-point straddle with astrike of 30 when the stock is at \n34 could be computed for the shorter time period remaining until expiration. If the \nexpected return is negative, an adjustment needs to be made. Adopting this form of \nadjusting would keep the number of trades to aminimum, but would still allow the \nstrategist to determine when his position has become improperly balanced. Of \ncourse, the current volatility would be used in making these determinations. Another", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:521", "doc_id": "287140994b7caa9d05c3abf6a7ded19b6f6de6cce44539335973dd88ffeafc33", "chunk_index": 0}
{"text": "482 Part IV: Additional Considerations \nfollow-up monitoring technique, using the deltas of the options involved, is present\ned later in this chapter, and has been described several times previously. \nFACILITATION OR INSTITUTIONAL BLOCK POSITIONING \nIn this and the following section, the advantages of using the hedge ratio are outlined. \nThese strategies are primarily member firm, not public customer, strategies, since \nthey are best applied in the absence of commission costs. An institutional block trad\ner may be able to use options to help him in his positioning, particularly when he is \ntrying to help aclient in astock transaction. \nSuppose that ablock trader wants to make abid for stock to facilitate acus\ntomer'ssell order. If he wants some sort of ahedge until he can sell the stock that he \nbuys, and the stock has listed options, he can sell some options to hedge his stock \nposition. To determine the quantity of options to sell, he can use the hedge ratio. The \nexact formula for the hedge ratio was given earlier in this chapter, in the section on \nthe Black-Scholes pricing model. It is one of the components of the formula. Simply \nstated, the hedge ratio is merely the delta of the option - that is, the amount by which \nthe option will change in price for small changes in the stock price. By selling the cor\nrect number of calls against his stock purchase, the block trader will have aneutral \nposition. This position would, in theory, neither gain nor lose for small changes in the \nstock price. He is therefore buying himself time until he can unwind the position in \nthe open market. \nExample: Atrader buys 10,000 shares of XYZ, and a January 30 call is trading with \nahedge ratio of .50. To have aneutral position, the trader should sell options against \n20,000 shares of stock (10,000 divided by .50 equals 20,000). Thus, he should sell 200 \nof the January 30's. If the hedge ratio is correct - largely afunction of the volatility \nestimate of the underlying stock - the trader will have greatly eliminated risk or \nreward on the position for small stock movements. Of course, if the block trader \nwants to assume some risk, that is adifferent matter. However, for the purposes of \nthis discussion, the assumption is made that the block trader merely wants to facili\ntate the trade in the most risk-free manner possible. In this sample position, if the \nstock moves up by 1 point, the option should move up by ½ point. The trader would \nmake $10,000 on his stock position and would lose $10,000 on his 200 short options \n- he has no gain or loss. Once the trader has the neutral position established, he can \nthen begin to concentrate on unwinding the position. \nIn actual practice, this hedge ratio may not work exactly, because it tends to \nchange constantly as the stock price changes. If the trader finds the stock moving", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:522", "doc_id": "06de14b9bb3870b2e6f1e1e58f148eb007e97ba11a5f89a7b9c9211698da48d3", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications 483 \nmore than fractionally, he may have to add more calls or buy some in, to maintain aneutral hedge ratio. This would expose him to some risk, but the risk is substantially \nsmaller than if he had not hedged at all. Of course, there would also be certain cases \nin which he would profit by the stock price change. For example, implied volatility \ncould decrease, making the calls cheaper. \nAsimilar hedge can be established by the block trader who sells stock to accom\nmodate acustomer buy order. He could buy calls in accordance with the hedge ratio, \nto set up aneutral position. \nThis process off acilitation is quite widely practiced, especially by brokerage \nhouses that are trying to attract the business of the large institutional customer. Since \nthe introduction of listed call options and their applications for facilitating orders, \nmany quotes for large blocks of stock have improved considerably. The block trader \n(who works for the brokerage house) is willing to make ahigher bid or alower offer \nif he can use options to hedge his position. This facilitation with options results in abetter market (higher bid or lower off er) from the point of view of the institutional \ncustomer. Without the availability of such listed options, the block trader would prob\nably make abid or an offer that was substantially away from the prevailing market \nprice in order to work out of his stock-only position with alessened degree of risk \nThis would obviously present apoorer market for the institutional customer. \nTHE NEUTRAL SPREAD \nThe hedge ratios of two or more options may be used to determine aneutral spread. \nThis strategy is especially useful to market-makers on the options exchanges who may \nwant to reduce the risk of options bought or sold in the process of providing apub\nlic market. If the hedge ratios of two options are known, the neutral ratio is deter\nmined by dividing the two hedge ratios. \nExample: An XYZ January 35 has ahedge ratio of .25, and an XYZ January 30 has ahedge ratio of .50, so aneutral ratio would be 2:1 (.50 divided by .25). That is, one \nwould sell 2 January 35'sagainst one long January 30, or, conversely, would buy 2 \nJanuary 35'sagainst one short January 30. Thus, amarket-maker who has just bought \n50 January 30'sin an effort to provide amarket for apublic seller of that call could \nhedge his position by selling 100 January 35's. This should keep his risk small, for \nsmall stock price changes, until he can unwind the position. The ratio for the neutral \nspread is not as sensitive to the volatility estimate of the underlying stock as is the \nratio concerning stock and options. This is because the same volatility estimate is \napplied to both options, and the resultant ratio for the spread would not tend to \nchange greatly.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:523", "doc_id": "b7e5d1f5c01c28d85cf26d51dc9e2a4ce0c9c0285dd430cfadb6af6433fd234e", "chunk_index": 0}
{"text": "484 Part IV: Additional Considerations \nThe risk trader can also use the neutral spread ratio to his advantage. This con\ncept was illustrated several times in previous chapters describing ratio writing, ratio \nspreads, and straddle writes. Ratio spreads are quite popular with member firm \ntraders and floor traders. Recall that aratio spread consists of buying options at acer\ntain strike, and selling more options further out-of-the-money. The hedge ratios can, \nof course, be used by the trader, or by apublic customer, to initially establish aneu\ntral position. Perhaps more important, the hedge ratio can also be used as afollow\nup action to keep the position neutral after the stock changes in price. This strategy \nis the \"delta spread\" described in Chapter 11. \nThe risk trader is not attempting to establish the spread with the idea of mini\nmizing risk for small stock movements. Rather, he is looking to make aprofit, but \nwould prefer to remain as neutral as possible on the underlying stock. He is imple\nmenting arisk strategy that has aneutral outlook on the underlying stock. He is sell\ning much more time value premium than he is buying. \nExample: The purchase of 15 January 30 calls and the sale of 30 January 35 calls - aratio call spread - may be aposition taken for profit potential. It would be aneutral \nposition if the deltas were .60 and .30, for example. This spread would do best if the \nstock were at exactly 35 at expiration. However, if the stock rose quickly before expi\nration, the spread ratio would decrease from 2:1 to perhaps 3:2. That is, the neutral \nratio between the January 30 call and the January 35 call should be 3 short January \n35'sto 2 long January 30's. If the trader wants to balance his position, he could buy 5 \nmore January 30's, giving him atotal of 20 long versus the 30 short January 35'sthat \nhe originally sold. Conversely, if the stock dropped in price, the neutral spread ratio \nmight increase, indicating that more calls should be sold. For example, if this stock \ndeclines, the neutral ratio might be 3:1. In that case, 15 more January 35'scould be \nsold, making the position short 45 calls versus 15 long calls, which would produce the \nneutral 3:1 ratio. \nIt would not be proper to adjust the ratio constantly, because the frequent \nwhipsaw losses on trading movements would wipe out the profit potential of the posi\ntion. However, the trader may want to pick out points, in advance, at which he wants \nto reevaluate his position before something drastic goes wrong. For example, if the \nforegoing spread were established with the stock at aprice of 30, the spreader might \nwant to readjust at 33 or 27, whichever comes first. \nBy monitoring the spread using the hedge ratio, the trader may also be able to \ndiscern whether he has established too bullish or too bearish aposition. \nExample: The trader starts with the example described above - long 15 January 30 \ncalls and short 30 January 35 calls - when the hedge ratios were .60 and .30, respec-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:524", "doc_id": "6d6cc493461b27a17529af5e629110dbfa34e4e49720e42432edacc94757be8f", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications 485 \ntively. Some later time, the stock falls to 27 and the trader needs to reevaluate his \nposition. The hedge ratios may have become .42 for the January 30 and .14 for the \nJanuary 35, indicating that a 3:1 ratio would be neutral (.42/.14 = 3). He now has abullish position, because his 2:1 ratio is less than the neutral 3:1 ratio. It is not manda\ntory that the trader act on this information. He may actually be bullish on the stock \nat this point and decide to remain with his position. The usefulness of the hedge ratio \nis that it allows him to see that his position is bullish, so he can make acorrect judg\nment. Without this knowledge, he might still think his position to be neutral, acriti\ncal mistake if he indeed wants to be neutral. If the trader'sratio is greater than the \nneutral ratio (2:1 vs. 3:2, for example), he is bearishly positioned. \nAs afinal point, it should be noted that the ratio can be adjusted by buying or \nselling either option. \nExample: If the stock falls and it is desired that the ratio be increased to 3:1, one \nmight sell more January 35'sor might decide to sell out some of his January 30's. Abullish adjustment could be made by buying on either side of the spread in asimilar \nmanner. In general, one should adjust by selling time premium or buying intrinsic \nvalue. That is, out-of-the-moneys are usually sold and in-the-moneys are usually \nbought, when adjusting. \nAIDING IN FOLLOW-UP ACTION \nThe computer can also be an invaluable aid to the strategist in that it can help him \nmonitor his positions. It is generally necessary for the strategist to have some way of \ninputting his positions into an inventory database and also to have some way of iden\ntifying different securities that are grouped within the same trading position. Once \nthis has been done, the computer can simultaneously read pricing data ( either real\ntime or closing prices) and the inventory database to generate information concern\ning the current status of any position. \nAcurrent mark to market (profit and loss) statement is of obvious use in that \nthe trader can see how he is doing each day. The computer can also easily generate \naset of warning flags that may be of interest to the trader, and could produce alist \nsummarizing possible positions that need action. In most of the strategies that were \ndescribed, it was shown that the strategist should avoid early assignment if at all pos\nsible. It is asimple matter for the computer to calculate the remaining time value \npremium of any short options, and to warn the trader if there is only asmall amount \nof time value premium remaining, perhaps ½ point or less. For similar reasons, the \ntrader may want to have adaily list of positions that are nearing maturity, perhaps", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:525", "doc_id": "c765165ca25b9b69aa5087ce2bc3c13d217a33d56d87362ebf27918f74405279", "chunk_index": 0}
{"text": "486 Part IV: Additional Considerations \nwith less than Imonth oflife remaining in the options. Aflag indicating an approach\ning ex-dividend date might also be useful for this purpose. \nIf the trader inputs another piece of information into the database, the com\nputer can help him in another follow-up action. In most strategies that were \ndescribed, especially those involving uncovered options, the trader wants to take \nsome sort of follow-up action based on the price movement of the underlying stock. \nIf the stock rallies too far, he may want to cover short calls or buy other calls as pro\ntection. If the stock declines too far, similar maneuvers would apply to put options or \nto rolling down short calls. If the trader inputs the stock prices at which he would like \nto take action, the computer can monitor each day'sclosing price of the stock and \ngenerate alist of positions that have exceeded their upside or downside action points. \nThe computer can also do more sophisticated types of position monitoring. \nRecall that it was pointed out that the deltas of the options involved in aposition can \nbe compared to each other to tell whether the position is bullish or bearish. The \nBlack-Scholes model can be used to calculate the deltas of the options in one'sposi\ntions. Then the net position can be determined by the computer, thereby telling the \ntrader whether his position has become \"delta long\" (bullish), \"delta short\" (bearish), \nor neutral. If he sees that aposition is bearish and he does not want to be structured \nin that way, he can make bullish adjustments. The delta spread and neutral spread \nstrategies very conveniently lend themselves to such types of follow-up action, \nalthough any of the more complicated straddle writing and protected straddle writ\ning positions can be monitored usefully in this way as well. \nThe computation for determining whether aposition is net short or net long \ngenerally involves calculating the \"equivalent stock position\" (ESP). If one owns 10 \ncalls that have adelta of .45, his equivalent stock position from those calls is IO X 100 \nshares per call x .45 = 450. That is, owning those IO calls is equivalent to owning 450 \nshares of the underlying stock, according to the delta. All puts and calls can be \nreduced to an ESP and can then, of course, be combined with any actual long or \nshort stock in the position to produce an ESP for the entire strategy. The resultant \nESP for each of the trader'spositions can be printed from the computer along with \nthe items described above. \nFurther sophisticated measures can be taken. The computer can generate atable of results at expiration. If so desired, this could be presented as agraph, but that \nis not really necessary. Atable suffices quite well, as shown by most of the examples \nin this book. Such apicture has meaning only if all options in the position expire at \nthe same time. If they don't, one may instead want the computer to mmpose atable \nof results or agraph at near-term expiration. Thus, in acalendar spread, for example, \none could see what sorts of profitability he would be looking at when it was time to \nremove the spread.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:526", "doc_id": "d9f677a7444eca966372f35a4937e4d8ffc16c47592e6815d566ee564e9ba9c6", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications 487 \nFinally, the computer can compute the expected return of aposition already in \nplace. This would give amore dynamic picture of the position, and this expected \nreturn is usually for arelatively short time period. That time period might be 30 days, \nor the time remaining until expiration, whichever is less. The expected return is cal\nculated in much the same manner as the expected return computation described ear\nlier in this chapter. First, one uses the stock'svolatility to construct arange of prices \nover which to examine the position. Second, one uses the Black-Scholes model to \ncalculate the values of the various options in the position at that future time and at \nthe various stock prices. Some of the results should be displayed in table form by the \ncomputer program. The expected profit is computed, as described earlier, by sum\nming the multiples of the probabilities of the stock being at each price by the result \nof the position at that price. The expected return is then computed by dividing the \nexpected profit by the expected investment. Since margin computations can require \ninvolved computer programs, it is sufficient to omit this last step and merely observe \nthe expected profit. The following example shows how asample position might look \nas the computer displays the position itself, the ESP, the profit at expiration, and the \nexpected profit in 30 days. Acomplex position is assumed, in order that the value of \nthese analyses can be demonstrated. \nExample: The following position exists when XYZ is at 31 ¾. It is essentially aback\nspread combined with areverse ratio write. It resembles along straddle in that there \nis increased profit potential in either direction if the stock moves far enough by expi\nration. Initially, the computer should display the position and the ESP. \nPosition Delta ESP \nShort 4,500 XYZ 1.00 Short 4,500 shares \nShort 100 XYZ April 25 calls 0.89 Short 8, 900 shares \nLong 50 XYZ April 30 calls 0.76 Long 3,800 shares \nLong 139 XYZ July 30 calls 0.74 Long 10,286 shares \nTotal ESP Long 686 shares \nTotal money in position: $163,500 credit \nThe advantage of using the ESP is that this fairly complex position is reduced to asin\ngle number. The entire position is equivalent to being long 686 shares of the com\nmon stock. Essentially, this is close to delta-neutral for such alarge position. The next \nitem that the computer should display is the total credit or debit in the position to \ndate. With this information, an expiration picture can be drawn if it is applicable. In \nthis position, since there is amixture of April and July options, astrict expiration pie-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:527", "doc_id": "7022679dcf1a33367d848e9377fc211d918599b3cf52eb3064ddc05a887cf962", "chunk_index": 0}
{"text": "Chapter 28: Mathematical Applications 489 \ninformation on the underlying stock are also necessary. The larger programmable cal\nculators can handle calculations such as the Black-Scholes model, computing the \nhedge ratio, and determining the probability of astock being above or below acer\ntain price at some future time. However, more involved calculations, such as com\nputing the implied volatility or determining the expected return of aposition, require \nthe use of acomputer. \nSUMMARY \nTwo basic mathematical aids have been presented: the pricing model and the ability \nto predict the probability of astock'smovement. The hedge ratio and the expected \nreturn analysis are extensions of the basic aids. Any strategy can be evaluated with \nthese tools. Such an analysis should be able to give the trader or strategist some idea \nof the relative attractiveness of establishing the position, and may also aid in making \nfollow-up adjustments to the position. All the analyses rely heavily on one'sestimate \nof the volatility of the underlying stock Using the implied volatility seems to be one \nof the best ways to obtain an accurate, current volatility estimate, since it is derived \nfrom the prices in the market itself. The applications presented here are not all-inclu\nsive. The strategist who is, or becomes, familiar with the advantages of rigorous math\nematical analysis will be able to construct many other aids for his trading that utilize \nthe basic mathematics described in this chapter.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:529", "doc_id": "3734eb8852a27de09e19dac468281d99e5ca4ac738b8d807f08c6dc8c1b36c51", "chunk_index": 0}
{"text": "Introduction to Index Option \nProducts and Futures \nSince their introduction in 1981, listed index options have proved to be very popular. \nIndex options are options whose underlying security is not asingle stock but rather an \nindex composed of many stocks. These include options on index futures contracts. \nMost popular types of cash settlement options are options on indices or subindices. The \nstrategies employed in trading these options are not substantially different from those \nused in trading stock options, with afew notable exceptions. However, the options \nthemselves tend to be priced differently and to trade differently. It is these differences \nbetween stock options and index options on which we will predominantly concentrate. \nIndex products - cash-based options, futures-based options, and index futures -\nwill be the main topic of discussion in this section of the book. We will look at how \nindices are constructed, how to use these products to speculate, how to hedge, and \nhow to spread one index against another. Both futures and options will be used in \nthese strategies. The discussion of other futures options - currencies, grains, bonds, \netc - will be deferred to alater chapter. \nIn this chapter, we will be looking at introductory facts about index options and \nfutures which differentiate them from the equity options that have encompassed the \nentire previous part of this book. First, however, we will take an in-depth look at stock \nindices and the methods of calculating them. Also in this chapter there will be adis\ncussion of futures contracts and how trading them differs from trading stocks and \nstock options. \nINDICES \nSince many cash-based or futures options have an index of stocks underlying the \noption, it is useful to understand how indices are calculated, in order that one may \nbe able to understand how an individual stock'smovement within the index affects \n493", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:533", "doc_id": "68ec9e5e1178117a18fb910c9c90789788bd2b4d4c8105a6b1fd275bf3588c03", "chunk_index": 0}
{"text": "Chapter 29: Introduction to Index Option Products and Futures 497 \nThus, if stock Agoes up by one point, then the value of the index would increase \nby 1.20 points since there are 1.2 shares of stock Ain the index. One can see the value \nof computing such astatistic - it readily allows him to see how any individual stock'smovement will affect the index movement during atrading day. This is especially use\nful when astock is halted, but the index itself keeps trading. \nExample: Suppose that, in the above index, stock Chas halted trading. There are \n0.68 shares of stock Cin the index. Suppose that stock Cis indicated 3 points lower, \nbut that the index is currently trading unchanged from the previous night'sclose due \nto the fact that both stocks Aand Bare unchanged on the day. If one were to try to \nprice the options on the index, he would be wrong to use the current price of the \nindex since that will soon change when stock Copens. However, there is not really aproblem since one can readily see that if stock Copens 3 points lower, then the index \nwill drop by 2.04 points (3 x 0.68). Thus one should price the options as if the index \nwere already trading about 2 points lower. This kind of anticipation depends, of \ncourse, on knowing the number of shares of stock Cin the index. \nAsimilar type of analysis is useful when trying to predict longer-term effects of \nastock on an index. If you thought stock Chad achance of rallying 30 points, then \none can see that this would cause the index to rise over 20 points. Given this type of \nrelationship, there are sometimes option spreads between the stock'soptions and the \nindex'soptions that will be profitable based on such an assumption. \nIt should also be noted that the number of shares of stock in acapitalization\nweighted index does not change on adaily basis since it does not depend on the price \nof the stocks in the index. However, the percent that each stock comprises of the index \ndoes change each day as prices change. Thus, the number of shares is amore stable \nstatistic to keep track of, and is also more directly usable to anticipate index value \nchanges as stock prices change. \nCapitalization-weighted indices are the most prevalent type, and most investors \nare familiar with several of them: the Standard and Poor's 500, the Standard and \nPoor's 400, the Standard and Poor's 100 (also called by its quote symbol, OEX), the \nNew York Stock Exchange Index, and the American Stock Exchange Index. \nPRICE-WEIGHTED INDICES \nAprice-weighted index contains an equal number of shares of each stock in the index. \nAprice-weighted index is computed by adding together the prices of the various \nstocks in the index and then dividing that sum by the divisor to produce the index \nvalue. Again, the divisor is initially an arbitrary number that is used to produce adesired original index value-something like 100.00, for example. Let us use the same", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:537", "doc_id": "87e0c025cec057c70df11826c19bffeac23ec9f6ce7db4cc148ef73b6ecf7daa", "chunk_index": 0}
{"text": "500 Part V: Index Options and Futures \nof IBM, one might figure that capitalization-weighted indices that contained that \nstock would also be showing somewhat unusual price changes in the same direction \nthat IBM is moving. Aprice-weighted index that contained IBM would, of course, \nalso be affected by IBM'sprice change, but not extraordinarily so since IBM would \nhave far less weight in the price-weighted index. \nSECTORS \nSector is aterm used to refer to an index of stocks in which all the stocks are mem\nbers of the same industry group. Examples of groups on which sectors have been cre\nated - and on which options have traded - are computers and technology, interna\ntional oils, domestic oils, gold, transportation, airlines, and gaming and hotels. These \nindices are computed in the same ways as described above - either price-weighted \nor capitalization-weighted. They generally consist of fewer stocks than their major \ncounterparts, however. Most sectors are comprised of between 20 and 30 stocks, \nsince that is about all of the stocks in any one specific industry group. The large \nindices are usually referred to as \"broad-based\" indices, as opposed to the smaller \nsectors which are often referred to as \"narrow-based\" indices. \nOptions trade on these sectors. The intent of these options is to allow portfolio \nmanagers -who often are group-oriented- to be able to hedge off parts of their port\nfolio by industry group. The options on these sectors are usually cash-based options. \nStrategies will be discussed later, but there is not much difference in strategy \nbetween broad-based or narrow-based index options. One difference is that broad\nbased option writers receive more favorable margin treatment ( that is, they are \nrequired to put up less collateral) than narrow-based option writers. \nCASH-BASED OPTIONS \nNow that the reader is familiar with indices, let us look at the most popular type of \nlisted index option, the cash-based option. \nCash-based options do not have any physical entity underlying the option con\ntract. Rather, if the option is exercised or assigned, the settlement is done with cash \nonly - there is no equity involved. This type of option is generally issued on an index, \nsuch as the S&P 500, for which it would be virtually impossible to actually deliver the \nunderlying securities in case of assignment or exercise. \nSince many investors feel that it is easier to predict the market'smovement \nrather than that of an individual stock, the cash-based index option has become very \npopular. Other indices that underlie cash-based option contracts are the New York \nStock Exchange Index, the S&P 500 Index, the S&P 100 Index (OEX - an index", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:540", "doc_id": "510ec76e3f58d19e4aa19a4dbb24767b9c20b5abd898f2461bbc2efef4d16984", "chunk_index": 0}
{"text": "Chapter 29: lntrodudion to Index Option Produds and Futures S01 \nintroduced by the CBOE), the NASDAQ Index ($NDX), the Dow-Jones 30 \nIndustrials ($DIX), and several other indices. In each of these cases there are too \nmany stocks in the index, and too many varying quantities of each of the stocks, to be \nable to handle the physical delivery of each of the stocks in the case of exercise or \nassignment. Some cash-based options are based on subindices ( that is, subgroups of \nthe larger indices such as the transportation group). \nEXERCISE AND ASSIGNMENT \nIt is important to understand the ramifications of exercise and assignment when deal\ning with this type of option. When acash-based option is exercised, the owner \nreceives cash equal to the difference between the index'sclosing price and the strike \nprice of the option. The option writer who is assigned must pay out an equal amount. \nThe following example shows how acall exercise might work. In this and the follow\ning examples we will use afictional index '.lYX (index symbols often end in X). \nExample: Suppose an investor buys a '.lYX September 160 call option. At alater date, \nthe index has risen substantially in price and closes at 175.24 on aparticular day. The \ninvestor decides it is time to take his profit by exercising his call option. Assuming the \n'.lYX contract is worth $100 per point, just as stock options are, he receives cash in \nthe amount of $100 times the difference between the index closing price and the \nstrike price: $100 x (175.24 - 160.00) = $1,524. He has no further position or rights \n- the option position disappears from his account by virtue of the exercise and he \ndoes not acquire any security by the exercise; he gets only cash. \nAn assignment would work in asimilar manner, with the seller of an option hav\ning to pay out of his account cash equal to the difference between the index closing \nprice and the option'sstriking price. As an example, suppose that atrader sells aput \noption on the '.lYX Index - the October 165 put. Subsequently, the index drops in \nprice, and one morning the writer of this put option finds that he has been assigned \n(as of the previous day, as is the case with stock options). If the index closed at 157.58 \non the previous day, then the option writer'saccount will be debited an amount equal \nto $100 X (165.00 - 157.58) = $742. \nEUROPEAN VERSUS AMERICAN EXERCISE \nBefore proceeding with more examples of index option exercise and the accompany\ning strategies, it is necessary to introduce two new definitions. American exercise \nmeans that an option may he exercised at any time; European exercise means that an \noption may only be exercised on its expiration day. Many of the cash-based index", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:541", "doc_id": "8f43169dea5228199de3c01693e15c4d79621c18fb2a713388a54c048e835714", "chunk_index": 0}
{"text": "502 Part V: Index Options and Futures \noptions have the European exercise feature. All stock options and some index options \nhave the American exercise feature. \nThe European exercise feature was introduced because institutional investors \nwho might tend to write calls against their portfolio of stocks wanted some assurance \nthat their protection wouldn'tbe unexpectedly taken away from them. Thus several \nindex option series became European exercise. Two major ones are the cash-based \nindex options on the S&P 500 Index (SPX) and the cash-based options on the Dow\nJones 30 Industrials. OEX remains an American exercise. \nIn-the-money European put options will be cheaper than their American coun\nterparts. This is because an arbitrageur would have to carry the position all the way \nto expiration; he could not exercise his puts and liquidate the position immediately. \nIn fact, deeply in-the-money European puts will trade at adiscount; the higher short\nterm interest rates are, the deeper the discount will be. \nThis can affect the full protective capability of long-term European puts. If aportfolio manager buys puts to protect his portfolio and the market crashes, the puts \nmight be deeply in the money. If these puts have a European exercise feature, they \nwould be selling at adeep discount and therefore would not have afforded all the \nprice protection that the portfolio manager had been looking for. \nAmerican Exercise Consideration. The primary reason for the holder of an \nindex option to exercise the option is to take his profit. One might think that, if the \nholder wanted to take aprofit, he would merely sell his option in the open market. \nOf course, if he could, he would. However, many times the deeply in-the-money \noptions sell at asubstantial discount during the trading day. Adeep discount is con\nsidered to be 1/2 to 3/4 of apoint, or more. Near the end of the day, these options \ntend to trade at only slight discounts. In either case, the holder of the option may \ndecide to exercise rather than to sell at any discount. Of course, if one is the holder \nof acall option that is trading at asubstantial discount in the morning of aparticular \nday, and he decides to exercise, he may lose more by the end of the day (if the mar\nket trades down) than he would have if he had merely sold at the deep discount in \nthe first place. In fact, some theoreticians feel that the \"job\" of adeeply in-the-money \ncash-based option during the trading day is to try to predict the market'sclose. This, \nof course, is not a \"job\" that can be consistently done with accuracy (if it could, the \ntraders doing the predicting would be rich beyond their wildest dreams). \nIf the holder of acash-based call option turned bearish, that would be another \nreason to exercise. That'sright - if the holder of acash-based call option is bearish, \nhe should exercise because, by so doing, he liquidates his bullish position and takes \nhis profit. This is somewhat opposite from an option that has aphysical underlying \nsecurity, such as astock option. This presents an interesting scenario: If one turns", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:542", "doc_id": "570eb8298b95e1071656561cee34d11ab14ec86644b47a2d31c0411a99f82b41", "chunk_index": 0}
{"text": "Chapter 29: Introduction to Index Option Products and Futures 503 \nbearish late in the day, even after the close, he might conceivably try to exercise his \ncalls to liquidate his position. The exchanges recognize that such tactics might not be \nin everyone'sbest interest - for example, if one waited to see how the money supply \nnumbers looked on aparticular evening before exercising, he would definitely have \nan advantage over the writers of those same options. The writers could no longer \nviably hedge their positions after the market had closed. In order to prevent this, \ncash-based option exercise notices are only acceptable until 5 minutes after the \noptions close trading on that exchange on any given trading day ( except expiration, of \ncourse), in order to allow both holders and writers to be on somewhat equal footing. \nThere is one more fact regarding exercise of cash-based options that will inter\nest brokerage customers, retail or institutional. Most brokerage firms will charge acommission for the cash-based option exercise or assignment. When index options \nwere first traded, commissions were quite high. Currently, however, one should gen\nerally be paying acommission based upon the equivalent option price. \nExample: In the previous example, one exercised a ZYX Sep 160 call at expiration \nwhen the index closed at 175.24. This is adifferential of 15.24. One should pay acommission as if he had sold his long calls at aprice of 15.24, not on anything more. \nFor writers of cash-based options, things are not so different from stock options. \nThe writer is still warned of impending assignment by the fact that the option is trad\ning at adiscount. If it is not trading at adiscount, it is probably not in danger of being \nassigned. Also, since there is no stock involved and therefore no dividends paid, the \nwriter of acash-based put option need only be concerned with whether the put is \ntrading at adiscount, not with whether it is trading at adiscount to underlying price \nless the dividend, as is the case with stock options. \nTraders doing spreads in cash-based options have special worries, however. \nWhat may seem to be alimited-risk spread may acquire more risk than one initially \nperceived, due to early assignment of the short options in the spread. Consider the \nfollowing example. \nExample: Suppose that an investor establishes abearish call spread in ZYX options \n- he buys the November 160 call at aprice of 1 and simultaneously sells the \nNovember 155 call at 3. His risk on the spread is $300 plus commissions if he has to \npay the maximum, limited debit of $500 to buy back the spread, or so it appears. \nHowever, suppose that the index rises substantially in price and the spreader is \nassigned on the short side of his spread with the index at 175.24. He thus is charged \nadebit of $2,024 to \"cover\" each short call via the assignment: $100 times the in-the\nmoney amount, 175.24 - 155.00, or 20.24. He receives this assignment notice in the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:543", "doc_id": "e112ba4c2791cd0aba06ec7f29bb886d089cbe738442bae67a49fb94fdc82721", "chunk_index": 0}
{"text": "504 Part V: Index Options and Futures \nmorning before the next trading day begins. Note that he cannot merely exercise his \nlong, since, if he did that, he would then receive the next night'sclosing price for his \nlong. Under the worst scenario, suppose the market receives disappointing econom\nic news the next day and opens sharply lower - with the index at 172. If he sells his \nlong Nov 160 calls at parity ($1,200), he will have paid adebit of $824 - larger than \nhis initial, theoretically \"limited\" maximum debit of $500. Thus he loses $624 on this \nspread ( $824 less the initial credit of $200) - over twice the theoretically limited loss \nof $300. \nIf the market should open sharply lower and trade down, he could lose more \nmoney than he thought because his long position is now exposed - there is no longer \naspread in place after the short option is assigned. Of course, this could work to his \nadvantage if the market rallied the next day. The point is, however, that aspread in \ncash-based options acquires more risk than the difference in the strikes (the maxi\nmum risk in stock options) if the short option in the spread becomes adeeply in-the\nmoney option, ripe for assignment. \nNAKED MARGIN \nWhen an index is designated as \"broad-based,\" alesser margin requirement applies \nto the writer of naked options. The SEC determines which indices are broad-based. \nAbroad-based index receives more favorable margin treatment because the under\nlying index will not normally change in price as quickly as astock or subindex. Thus, \nthe naked writer theoretically has less of arisk with anaked broad-based index \noption. \nThe requirement for writing abroad-based index option naked is 15% of the \nindex, plus the option premium, minus the amount, if any, that the option is out-of \nthe-money. There is aminimum requirement: for calls, it is 10% of the index value; \nfor puts, it is 10% of the striking price. Both minima are in addition to the option pre\nmium. \nExample: Suppose that the ZYX is at 168.00, with a Dec 170 call selling for 6 and a \nDec 170 put selling for 5. The requirement for selling the call naked would be cal\nculated as follows: \n15% of index \nPlus call premium \nLess out-of-money amount \nNaked call requirement \n$2,520 \n+ 600 \n200 \n$2,920", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:544", "doc_id": "1d4f3b695c69b0ced54b32fa59d05c16b4198d15a2e85da37c3dd7628c434ae6", "chunk_index": 0}
{"text": "Chapter 29: Introduction to Index Option Produds and Futures \nThe requirement for writing the Dec 170 put naked would be: \n15% of index \nPlus put premium \nNaked put requirement \n$2,520 \n+ 500 \n$3,020 \nBoth of these requirements are above the minimum of 10% of the index. \n505 \nOptions on narrow-based indices are subject to the same naked requirements \nas stock options: 20% of the index plus the premium less an out-of-the-money \namount, with aminimum requirement of 15% of the index. \nOther margin requirements are similar to those for stock options. For example, \nif one wanted to write the Dec 170 straddle naked, using the same prices as in the \nlast example, he would have amargin requirement equal to $3,020 - the larger of the \nput or call requirement, just as he would for stock options. Spread requirements for \nindex options work in exactly the same manner as they do for stock options. \nLEAPS INDEX OPTIONS \nLEAPS (Long-term Equity AnticiPation Securities) have been introduced on indices \nin recent years. Readers not familiar with LEAPS should review the prior chapter on \nthat subject. Since LEAPS have become popular for stocks, it is only logical to think \nthat they would become popular for indices as well. \nThe main problem was that a LEAPS could be a 2-year option on a 350 dollar \nunderlying index. Such an option might cost 20 points. That is too expensive to attract \nthe public customer. Just one option would cost $2,000. Therefore, the exchanges \ncreated mini-indices out of OEX, SPX, XMI, and others. These mini-indices that \nwere created are exactly the same as the full indices, except that they are divided by \n10. This means that instead of having the 2-year put with strike of 350 cost 20 points, \na 2-year put with astrike of 35 costs 2 points. This is much more affordable for the \nindividual trader. \nThe following example is of OEX options and the corresponding OAX LEAPS \noptions on the same index. NOTE: OAX is not the universal symbol for this mini\nindex. OEX LEAPS are American exercise, while SPX LEAPS are European. Abro\nker should be contacted for symbols, expiration dates, and other details. \nExample: The following is asample comparison of prices for OEX and for its com\npanion index OLX, which is OEX divided by 5. (Originally, OLX was OEX divided by \n10, but when OEX split 2-for-1 in late 1997, OLX did not split so OLX was thereafter \nequal to OEX divided by 5).", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:545", "doc_id": "21fea4f7481a01efb4abf65357966f31f16eaa33a70db32a5f0fbf234d27b1a2", "chunk_index": 0}
{"text": "506 \nOEX: 712 \nPart V: Index Options and Futures \nOLX: 142.40 \nOLX 2-year LEAPS options: \nDec 140 call: 30 \nDec 150 call: 26.5 \nDec 160 call: 20.5 \nNote that striking prices of 140, 150, and 160 for OLX correspond to 700, 750, and \n800 for OEX itself. Also, if a 2-year OEX Dec 700 call existed, it would sell for \napproximately five times as much as the OLX Dec 140 call, or about 150 points (5 \ntimes 30). This is why the LEAPS options use reduced-value strikes, because very \nfew people would have interest in trading an at-the-money option that cost 150 \npoints ($15,000). \nFUTURES \nWe will now take alook at how futures contracts work. This section will be concerned \nonly with cash-based index futures; futures for physical delivery are included in alater chapter. The ordinary stock investor might think that he will be able to employ \nindex option strategies without getting involved in futures. While it may be possible \nto avoid futures, the strategist will realize that they are anecessary part of the entire \nindex-trading strategy. Thus, in order to be completely prepared to hedge one'sposi\ntions and to operate in an optimum manner, the use of index futures or index futures \noptions is anecessary complement to nearly all index strategies. \nAcomnwdities futures contract is astandardized contract calling for the deliv\nery of aspecified quantity of acertain comnwdity at some future time. The older, \nmore conventional types of commodities contracts were futures on grains, meats, and \nmetals. In recent years, futures have expanded extensively and have encompassed \nfinancial securities - bonds, T-bills, Eurodollar Time Deposits, etc. Most recently, \nfutures have been issued that are cash-based; that is, no actual commodity is deliver\nable. Rather, the contract settles for cash. Some of these cash-based futures contracts \nhave stock market indices as their underlying 'commodity. \"It is this latter type of \nfuture that will be the subject of the examples in this section, although the basic facts \nregarding futures are applicable to all futures contracts, cash-based or not. \nSeveral types of traders or investors use futures contracts. One is the specula\ntor: He is able to generate tremendous leverage with futures and may be able to cap\nitalize on small swings in the price of the underlying commodity. Another is the true \nhedger: He is adealer in the actual underlying commodity and uses futures to hedge \nhis price risk. This is the more economic function of futures. Examples of hedges for \nphysical commodities as well as stocks will be presented in later chapters. However,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:546", "doc_id": "ed66976cbb5006a48a85369c5210f14446bf71518175cbf00c8f6b3c0dea8006", "chunk_index": 0}
{"text": "Chapter 29: Introduction to Index Option Products and Futures 507 \nlet us look at asimple example of how one might hedge astock portfolio with stock \nindex futures. \nExample: Suppose that astock mutual fund operates under the philosophy that \ninvestors cannot outperform abullish market, so the best investment strategy when \none is bullish is just to \"buy the market.\" That is, this mutual fund actually buys all \nthe stocks in the Standard & Poor's 500 Index and holds them. \nIf the manager of this fund turns bearish, he would want to sell out his positions. \nHowever, the commission costs for liquidating the entire portfolio would be large. \nAlso, the act of selling so much stock might actually depress the market, thereby \ndevaluing the remainder of his portfolio before he can sell it. \nThis manager might sell S&P 500 futures against his portfolio instead of selling \nhis stocks. Such afutures contract would move up or down in line with the S&P 500 \nIndex as it rises or falls. Suppose that he sold enough futures to hedge the entire dol\nlar value of his stock portfolio. Then, even if the stock market declined, his futures \ncontracts would decline also and would theoretically prevent him from having aloss. \nOf course, he couldn'tmake much of again if the market went up, since the futures \nwould then lose money. What this money manager has accomplished is that he has \neffectively sold his stock portfolio without incurring stock commission costs (futures \ncommissions are normally quite small). \nIf he turns bullish again at some later date, he can buy the futures back, and \nhave his long stocks free to profit if the market rises. Again, he does not spend the \nstock commission nor does he have to go through the tedious process of placing 500 \nstock orders to \"buy\" the S&P 500 - he merely places one order in futures contracts. \nFutures contracts often trade at premiums to the underlying commodity, due to \nthe fact that the investor who buys the future does not have to spend the money that \none who buys all the stocks would have to spend. Thus, he saves the carrying costs \nbut forsakes any dividends. This savings is reflected by the marketplace in that apre\nmium is placed on the price of the futures contract. As aconsequence, longer-term \ncontracts trade at alarger premium than do near-term contracts, much as is the case \nwith options. In most cases, however, the index futures trader is concerned with the \nnearest-term contract, and perhaps the next one out in time. \nTERMS OF THE CONTRACT \nThere are cash-based index futures on several indices, although some of these futures \ncontracts are not heavily traded. The most heavily traded contract is the future on the \nS&P 500 Index. This contract trades on the Chicago Mercantile Exchange. It has con\ntracts that expire every 3 months (March, June, September, December) and a 1-point", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:547", "doc_id": "7c85073a9a5560940fad6c046eae9804ce57d80fa7b3b303843c034fac94a9a3", "chunk_index": 0}
{"text": "508 Part V: Index Options and Futures \nmove in the futures contract is worth $250. There is no particular reason why a I-point \nmove is worth $250, that is merely how the contract is defined. These numbers are \nsubject to change. Originally, a I-point move in S&Pfutures was worth $500, but \nwhen the S&Padvanced so much during the bull market of the 1990's, the point value \nwas halved in order to reduce the trading exposure in trader'saccounts. One could \nsurmise that afurther bull market advance might cause the number to be reduced \nagain, or possibly aprolonged bear market could result in an increase from $250 back \nto $500, conceivably. \nExample: Afutures trader buys I March S&P 500 contract at 401.00 (the smallest \nunit of trading is 0.10 points, a \"dime\"). The contract rises in price to 403.30. The \ntrader has aprofit of 2.30 points, or $575 (2.30 points x $250 per point). \nThe terms of futures contracts can change as the exchanges on which they are \ntraded attempt to adjust the contracts to he more competitive in the current trading \nenvironment. Consequently, the strategist should check with his broker to determine \nthe exact terms of any contract before he begins trading it. \nOPEN OUTCRY \nFutures contracts trade on listed commodity exchanges. However, the method of \ntrading is different from that used for stocks and options. Futures trade by \"open \noutcry\" in rings or pits. Members of the exchange are the only ones allowed to trade \non the exchange, of course, just as is the case with stocks and options. If the. member \nis trying to execute abuy order, for example, he would announce his bid out loud \n(open outcry). Sellers would then respond by either showing him an offer or by sell\ning to him at his bid price. This differs from stocks and options which use the spe\ncialist system, in that many people can be buying and selling at once, all over the pit. \nIt also differs from the market-maker system used on some stock options exchanges \nbecause anyone can make the market in the commodity pit, not just adesignated few \ntraders. \nThis form of trading can produce some oddities not normally associated with \nstock or stock option trading. There may be slightly different markets at different \nplaces in alarge, busy trading pit. Hence abuyer on one side of the pit may be try\ning to pay aprice that is being offered on the other side of the pit, but the two do not \ntrade with each other because of the size of the trading crowd. The buyer might buy \non one side of the pit, but the seller on the other side does not sell. Then if the mar\nket trades lower, only one of the two will have received an execution even though \nthey were trying to buy and sell at the same price. Thus, one cannot be certain that \nhis futures order is executed unless the market trades through his price. That is, if", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:548", "doc_id": "ee4ae1cc3e30e7de0491bb237e32c1f7c1f0a22c441fa670d6bbd2e8707a8c84", "chunk_index": 0}
{"text": "Chapter 29: Introduction to Index Option Products and Futures 509 \none is bidding for futures at aprice of 1401.50 and atrade is printed at 1401.40, then \nhe can be certain that he has bought his contracts. \nFutures exchange members who trade mainly for their own account from the \nring or pit are known as locals.\" They are somewhat akin to the stock option market\nmaker in that they may take the other side of public orders. Note, however, that they \ndo not have to make apublic market as market-makers do. \nMARGIN, LIMITS, AND QUOTES \nFutures contracts are traded on margin and are marked to market every day. \nGenerally, the amount of margin required is small in comparison to the total size of \nthe contract, so that there is tremendous leverage in trading futures. Anyone trading \nthe futures must deposit the initial margin amount in his account on the day he ini\ntiates the trade. Then at the end of each day, the amount of gain or loss on the con\ntract is computed, and the account is credited if there is again or debited if there is \naloss. In case of aloss, the trader must add more cash to his account to cover the \nloss. This daily margin computation is known as maintenance margin. Treasury bills \nor other securities are good collateral for the initial margin, but the daily variation \nmargin is required in cash. \nExample: The S&P 500 futures contract is acash-based futures contract that trades \non the Chicago Mercantile Exchange. Since the contract is settled in cash, there is \nno actual physical commodity underlying the contract. Rather, the contract is based \non the value of the S&P 500 stock index. At the expiration of the contract, each open \ncontract is marked to market at the closing price of the S&P 500 stock index and dis\nappears. All contracts are settled for cash on their final day and then they no longer \nexist - they expire. The terms of the contract specify that each point of movement is \nworth $250. Thus, if the S&P 500 Index itself is at 1405, then the S&Pfutures con\ntract is acontract on $250 x 1405, or $351,250 worth of stocks comprising the index. \nAssume the initial margin for one of these contracts is $30,000, although it may vary \nat specific brokerage houses. \nSuppose that atrader buys one December S&Pfutures contract for his account \nsometime in October. With the underlying index at 1405.00, suppose he pays 1417.50 \nfor the futures contract. It is normal for the futures to trade at apremium to the actu\nal index price. The reasons regarding this will be discussed in alater section. Initially, \nthe customer puts up $30,000 as margin, and this may be in the form of T-bills. On \nthe next day, however, the market declines and the futures close at 1406.00. This rep\nresents aloss of 11.50 points from the purchase price. At $250 per point, the trader \nhas aloss of $2,875 (250 x 11.50) at this time. He is required to add $2,875 in cash \ninto the account.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:549", "doc_id": "df05f0c2c1085e8c7ae2e9daf276d43fde99935bd18658ca13a4baa86016a580", "chunk_index": 0}
{"text": "510 Part V: Index Options and Futures \nIf he continued to hold the contract until expiration, this process of adding his \ndaily gain or subtracting his daily loss from the account would recur each day. Finally, \non the last day, the futures contract is deemed to close at the exact opening price of \nthe S&P 500 Index and the variation margin is calculated again at that price. Then \nthe futures contract is expired, so it is \"erased\" from his account. He is then left with \nonly the cash that he made or lost on the trade of his contract. \nThe leverage produced by small margin requirements (as apercent of the total \nvalue of the contract) is amajor factor in making futures very volatile, in dollar terms. \nIn the preceding example, a $30,000 margin investment controls $351,250 worth of \nstocks. Due to their volatility, many futures contracts trade with alimit. That is, the \nprice can only fluctuate afixed amount above or below the previous day'sclosing \nprice. This concept is intended to prevent traders with large positions from being \nable to manipulate the market drastically in either direction. \nS&Pand NYSE Expiration. S&P 500 futures expiration occurs in asome\nwhat complex way, compared to those indices whose options and futures expire \nat the last sale on the final day of trading. Some years ago, in order to attempt \nto reduce the volatility that index futures and options expiration was causing in \nthe stock market, the NYSE and the Chicago Mercantile Exchange (where the \nS&P 500 futures trade) agreed to change the expiration of their index products \nfrom the end of trading on the last Friday to the morning of that day. The effect \nof expiration on the stock market is discussed in the next chapter. \nAs aresult, the S&Pfutures and futures options as well as futures, futures \noptions, and index options on the New York Stock Exchange Index settle in the fol\nlowing manner on their last day of trading. On expiration day - the third Friday of \nthe month - the \"final\" price for purposes of settling futures and options is comprised \nof taking the opening trade of each stock and calculating an index price based on \nthose opening prices. There is no actual trading in the futures and options on that last \nFriday; they cease trading at the close of trading on the previous day, Thursday. \nThe purpose of this change was to give the specialists on the New York Stock \nExchange more time to line up the other side of trades to handle order imbalances. \nUnder the new rules, index arbitrageurs are forced to enter their buy or sell orders \nas market on open orders on that last Friday before 9 am EST. The specialist can then \ntake his time in opening the stock if he needs to; he can solicit orders if there is too \nmuch stock to buy or sell. \nThe effect of all this is that the \"final\" index price for settlement purposes is not \nknown until all the stocks in the index have opened. It may take some time to open \nall 500 stocks in the S&P 500 Index if there is avolatile market that Friday morning", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:550", "doc_id": "20c38f6d32efccc1ec9bf3f190035a2e04451ef934429f111f957b58e277f8e7", "chunk_index": 0}
{"text": "Chapter 29: Introduction to Index Option Products and Futures 511 \n(perhaps caused by news) or if there are severe order imbalances in many of the \nstocks (caused by index arbitrageurs). Index arbitrage is described in Chapter 30. \nLimits. Originally, index futures traded without limits. However, the stock mar\nket crash of 1987 changed that. Certain parties felt that if the futures - which \nwere leading the market down - had ceased trading for awhile, the stock mar\nket could have stabilized. As aresult, aseries of trading limits now exists for \nstock index futures. These are designed to be \"circuit breakers\" - to prevent astock market crash. They are not limits in the sense that other futures have lim\nits, but they are similar. \nThe levels at which these circuit breakers occur may change from time to time, \nbased on the volatility of the stock market and the price levels at which the S&Pfutures are trading. That is, if the S&Pfutures are trading at 1500, one can expect \nwider circuit breakers than if they are trading at 600. These circuit breakers only \napply to downside moves by the stock market. The first in the series of circuit break\ners usually halts trading for only 10 minutes. After that, if the market trades lower -\nusually something on the order of a 10% decline - then alonger circuit breaker is \ninstituted for about 30 minutes or so. After that they could open again, and if they \nreached the next limit down - something probably on the order of 20% then trad\ning would be halted for alonger time ( two hours or so again, the details depend on \nthe current regulations). If there is any time left in the trading day, they can open \nagain, and trade down to afinal limit, at which time trading would be halted for the \nday. They could not trade any lower that day, although they could trade lower the \nnext day if need be. \nThere are similar limits imposed by the NYSE on its trading - based on the \nDow-Jones Industrial Averages. Those limits don'tnecessarily line up exactly with the \nlimits on the S&Pfutures. That fact might cause problems for hedgers should any of \nthese severe downside limits actually occur. \nThere are actually other \"circuit breakers\" designed to prevent runaway stock \nmarkets, but they are not related to limits on futures trading. They will be described \nalong with index arbitrage and program trading in Chapter 30. \nQuotes. While stocks and stock options are always quoted in dimes, or some\ntimes nickels, such is not the case with futures. Some futures trade in fractions, \nwhile others trade in cents. In the coming chapters, there will be many examples \nof the trading details of futures and options. However, the investor should famil\niarize himself with the details of an individual contract before beginning to trade \nit or its options. One'scommodity broker can easily supply this information.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:551", "doc_id": "5f33a1cac94276dca67ae5c707a2a58f3c02c5c06981cf3562bd634599a712fc", "chunk_index": 0}
{"text": "512 Part V: Index Options and Futures \nThere are certain differences between the way futures trade and the way stocks \ntrade. One difference that is extremely important to investors accustomed to dealing \nin stocks and stock options is that quotation vendors rarely show abid and offer for \nfutures. Thus, if one uses aquote machine to obtain the price of astock he might see \nthat the stock is currently 31 bid, 31.10 asked, with alast sale of 31. An active futures \ncontract traded on atrading floor (which is typically the type that one would want to \ntrade) virtually never shows abid and offer, but rather shows last sale only. In addi\ntion, each sale of astock or stock option is recorded both as to its time of execution \nand the quantity of execution. Such is not the case for futures. Only the price is \nrecorded - one cannot tell how many contracts traded at the price, nor can he tell if \nthere were repeated sales at that price. Where futures are traded in electronic mar\nkets, of course, the bid and offer are available for all to see, and volume may accu\nrately be recorded as well. \nOPTIONS ON INDEX FUTURES \nAs we saw earlier, futures contracts allow aperson dealing in acommodity to minimize \nprofit fluctuations in his commodity. The mutual fund manager who sold the futures \nlargely removed any possibility of further upside profit or downside loss. Options, \nhowever, allow alittle more leeway than futures do. With the option, aperson can lock \nin one side of his position, but can leave room for further profits if conditions improve. \nFor example, the mutual fund manager might buy put options on the S&P 500 Index \nto hedge his downside risk, but still leave room for upside profits if the stock market \nrises. This is different from the sale of afutures contract, which locks in his profit, but \ndoes not leave any room for further profits if the market moves favorably. \nOptions trade on many types of futures contracts. The security underlying the \noption is the futures contract having the same expiration month, not the entity under\nlying the futures contract itself. Thus, if one exercises alisted futures option, he \nreceives afutures contract position, not the physical commodity. \nExample: Atrader owns the ZYX futures December 165 call option (165 is the strik\ning price). Assume the ZYX December future closed at 171.20. Both the calls and the \nfutures are worth $500 per point. If the call is exercised, the trader then owns one \nZYX December (same expiration month as the option) futures contract at aprice of \n165. Since the current price is 171.20, there is amaintenance margin credit of $3,100 \nin his account (500 x 6.20 points). Note that even though the option is an option on \nafuture which is cash-based, the exercise provides the holder of the option with afutures contract position, not with cash.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:552", "doc_id": "d31277d800742773c08931ef8b79972efae03a292895f3d70eea4f8a51ecaa95", "chunk_index": 0}
{"text": "Chapter 29: Introduction to Index Option Products and Futures 513 \nAt the present time, there are futures options on all of the various index futures \ncontracts. \nEXPIRATION DATES \nFutures options have specifics much the same as stock options do: expiration month \n(agreeing with the expiration months of the underlying futures contract), striking \nprice, etc. If atrader buys afutures option, he must pay for it in full, just as with stock \noptions. Margin requirements vary for naked futures options, but are generally more \nlenient than stock options. Often, the naked requirement is based on the futures \nmargin, which is much less than the 20% of the underlying stock price as is the case \nwith listed stock options. \nWhen the futures option has acash-based futures contract underlying it, the \noption and the future generally expire on the same day. Thus, if one were to exercise \na '.ZYX option on expiration day, one would receive the future in his account, which \nwould in tum become cash because the future is cash-settled and expiring as well. \nExample: Suppose that atrader owns a '.ZYX December 165 futures worth $500 per \npoint - call option and holds it through the last day of trading. On that last day, the \n'.ZYX Index closes at 174.00. He gives instructions to exercise the call, so the follow\ning sequence occurs: \n1. Buy one '.ZYX future at 165.00 via the call exercise. \n2. Mark the future at 17 4.00, the closing price. This is avariation margin profit of \n$4,500 (174.00-165.00) X $500. \n3. The option is removed from the account because it was exercised, and the future \nis removed as well because it expired. \nThus, the exercise of the option generates $4,500 in cash into the account and leaves \nbehind no futures or option contracts. We do not know if this represents aprofit or \nloss for this call holder, since we do not know if his original cost was greater than \n$4,500 or not. \nIt should be noted that futures option expiration dates, in general, are fairly \ncomplex. They are not normally the third Friday of the expiration month, as stock \noptions are. Index futures options generally do expire on the third Friday of the expi\nration month, but many physical commodity options do not. These differences will \nbe discussed in the later chapter on futures options.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:553", "doc_id": "a48f189149c14b5ce07967c511781eb80c2c33e48bb3a96a99f3423cfd661c19", "chunk_index": 0}
{"text": "514 Part V: Index Options and Futures \nOPTION PREMIUMS \nThe dollar amount of trading of afutures option contract is normally the same as that \nof the underlying future. That is, since the S&P 500 future is worth $250 per point, \nso are the S&P 500 futures options. The same holds true for the New York Stock \nExchange Index options. \nExample: An investor buys an S&P 500 December 1410 call for 4.20 with the index \nat 1409.50. The cost of the call is $1,050 (4.20 x 250). The call must be paid for in \nfull, as with equity options. \nAn interesting fact about futures options is that the longer-term options have a \n\"double premium\" effect. The option itself has time value premium and its underly\ning security, the future, also has apremium over the physical commodity. This phe\nnomenon can produce some rather startling prices when looking at calendar spreads. \nExample: The ZYX Index is trading at 162.00 sometime during the month of \nJanuary. Suppose that the March ZYX futures contract is trading at 163.50 and the \nJune futures contract at 167.50. These prices are reasonable in that they represent apremium over the index itself which is 162.00. These premiums are related to the \namount of time remaining until the expiration of the futures contract. \nNow, however, let us look at two options - the March 165 put and the June 165 \nput. The March 165 put might be trading at 3 with its underlying security, the March \nfutures contract, trading at 163.50. The June 165 put option has as its underlying \nsecurity the June futures contract. Since the June option has more time remaining \nuntil expiration, it will have more time value premium than a March option would. \nHowever, the underlying June future is trading at 167.50, so the June 165 put option \nis 2½ points out-of-the-money and therefore might be selling for 2½. This makes avery strange-looking calendar spread with the longer-term option selling at 2½ and \nthe near-term option selling for 3. This is due to the fact, of course, that the two \noptions have different underlying securities. One is in-the-money and the other is \nout-of-the-money. These two underlyings - the March and June futures - have aprice differential of their own. So the option calendar spread is inverted due to this \ndouble premium effect. \nFUTURES OPTION MARGIN \nMost futures exchanges have gone to the form of option margin called SPAN, which \nstands for Standard Portfolio Analysis of Risk. This form of margining is very fair and \nattempts to base the margin requirement of an option position on the probability of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:554", "doc_id": "ef7efdf2862708adc5839340d3f7eb4c9c5121e1b0c4b8e042ae247f9ff6baa8", "chunk_index": 0}
{"text": "Chapter 29: Introduction to Index Option Products and Futures 515 \nmovement by the underlying futures contract, as well as on the potential change of \nimplied volatility of the options in question. \nThe older method of margining option positions is known as the \"customer mar~ \ngin\" method. The customer margin method generally results in higher margin \nrequirements. The reader is referred to the chapter on futures and futures options \nfor an in-depth discussion of SPAN and other option margin requirements. \nOTHER TERMS \nJust as futures on differing physical commodities have differing terms, so do options \non those futures. Some options have striking prices 5 points apart while others have \nstrikes only 1 point apart, reflecting the volatility of the commodity. Specifically, for \nindex futures options, the S&P 500 options have striking prices 5 points apart, and \nthe NYSE options have striking prices 2 points apart. \nThere is no standard method for quoting futures on options as there is with \nstock options. In some cases, striking price symbols are similar to stock option sym\nbols (A=5, B=lO, C=l5, etc.), while in others the letters are used incrementally (A=l, \nB=2, C=3, etc.). Moreover, the method used may differ with each quote vendor. In \nsome cases, quote systems use the numeric value of the strike instead of letters. This \nmakes quoting options much simpler, and perhaps the entire industry (including \nstock option vendors) will adopt this method someday. Since there is no standard \nmethod for quoting, one must obtain the symbols individually for futures options, afact that makes quoting them extremely inconvenient. \nThere are position limits for some futures options, hut they allow for very large \npositions. Check with your broker for exact limits in the various futures options. \nQUOTES \nMost futures option quotes (bids and offers) are not displayed on quote-vending \nmachines, as is also the case with futures. Options traded on the Chicago Mercantile \nExchange are the exception. This can he somewhat distressing to the trader used to \ndealing in stock options, since options are normally far less liquid than the underly\ning security. It might be acceptable to trade off of last sales in aliquid futures con\ntract, but not so with the options. As aresult, futures options have not attracted many \nstock option traders into their fold. Of course, where electronic markets exist, the \nbids and offers of options would be shown publicly. \nThe consequence of the inconsistencies in terms as well as the general unavail\nability of quotes has been that index futures options are generally traded by profes\nsionals, with the public largely ignoring them. This does not mean, however, that", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:555", "doc_id": "2387a4ca2bcad9722484741c23b927385c4b48cd620e26560302a2b70839446a", "chunk_index": 0}
{"text": "516 Part V: Index Options and Futures \nfutures options are unworthy of the strategist'stime and effort. In fact, just the oppo\nsite may be true - the lack of general information may produce some inefficiencies \nthat the strategist can benefit from. \nOne factor concerning the trading of futures options can be of major concern \nto many customers and salesmen. Salesmen who are registered to sell stocks are not \nnecessarily registered to sell futures - an additional test must be passed in order to \nsell many types of futures options. Similarly, many customers - primarily institutions \n- have received approval from their constituents to trade in stock options, but would \nneed further approvals to trade futures or futures options. Neither of these things \nshould stand in the way of the strategist - if there are opportunities in futures \noptions, then the customer should find abroker who can trade them. Also if the \nstrategist finds that he requires certain approvals from within his own institution \nbefore he can trade futures, then he should obtain those approvals. \nSTANDARD OPTIONS STRATEGIES USING INDEX OPTIONS \nThe stock option strategies described in all of the preceding chapters of this book can \nbe established with index options as well. The concepts are normally the same for \nindex options as they would be for stock options. If one buys acall at one strike and \nsells acall at ahigher strike, that is abullish spread; if one sells both aput and acall \nat the same strike (astraddle), that is aneutral strategy. One uses deltas to determine \nhow many options to sell against the ones that he buys in order to establish adelta \nneutral strategy. Likewise, he uses the deltas to tell, along the way, how his position \nis progressing and how to adjust it to keep it delta neutral. \nWe will not describe these same strategies over again. They have already been \ndescribed in detail. The risk of early assignment removing one side of aposition can \nalter some strategies. In some cases there are particular advantages or disadvantages \nwith index options and futures. Thus, we will briefly go over some major option \nstrategies, giving details pertaining to their usage as index option strategies. \nOPTION BUYING \nThe most common reason for wanting to buy index options is to take advantage of the \ndiversification that they provide, in addition to the normal advantages that option \npurchasing provides: leverage and limited dollar risk. Many people feel that it is eas\nier to predict the general market direction than it is to predict an individual stock'sdirection. This feeling, can, of course, be put to good advantage by buying index \noptions. However, sometimes it is not better to buy the index options. In such cases, \nit may actually be smarter to purchase apackage of individual stock options.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:556", "doc_id": "7b61dbb897ad58df236d30501fb67c9fa36eac85e4c952e07f4689a4027c9ea6", "chunk_index": 0}
{"text": "Chapter 29: Introduction to Index Option Products and Futures 517 \nDue to aphenomenon known as volatility skewing, it is possible for index \noptions to have implied volatilities that are out of line with projected index or stock \nprice movements. This phenomenon is discussed in detail in the chapter on advanced \nconcepts. \nFor example, suppose that index puts are expensive, as they became after the \n1987 stock market crash. When this happens it may actually be more profitable for atrader who is bearish on the market to buy apackage of equity puts instead of buy\ning index puts. The equity puts are forced to reflect the probability of stock price \nmovement because arbitrage strategies will keep them in line. They will therefore be \nless expensive than index puts when this type of volatility skewing is present. Index \nputs can remain expensive for several reasons - primarily excessive demand and \ninflated margin requirements. In such situations, it is theoretically correct to buy agroup of puts on stock options. In fact, one might even hedge this purchase by sell\ning out-of-the money, overpriced index puts. \nSELLING INDEX OPTIONS \nIn earlier chapters, we saw that many mathematically attractive strategies involve the \nsale of naked options - ratio writes, straddles, ratio spreads, etc. Index options pres\nent an even stronger case for these strategies. Recall that the greatest risk in these \nstrategies with naked options is that the underlying security might move agreat dis\ntance, thereby exposing the position to great loss if the movement is in the direction \nin which the naked options lie. That is, if one is naked calls and the underlying secu\nrity rises dramatically, perhaps on atakeover bid, then large losses - potentially \nunlimited in the absence of follow-up action - could occur. \nThe strategist would, of course, never let the loss run uncontrolled. He would \nattempt to take some follow-up action to limit the loss or to neutralize the position. \nHowever, even the best strategist cannot hedge his position if the movement in the \nunderlying occurs while the market is closed. For example, if the underlying securi\nty is astock, certain news items might cause alarge gap to occur between the closing \nprice of astock and its next opening price. Such news might be related to atakeover \nof the company or to adrastically negative earnings report, for example. \nIndex options do not have this particular drawback. An index - especially abroad-based index - is not as likely to open on awide gap as astock is. An index can\nnot be the subject of atakeover attempt. It cannot be severely depressed by bad earn\nings on one of its components. Thus, index options are more viable candidates for \nstrategies involving naked option writing than stock options are. Index futures and \noptions may often open on small gaps of apoint or so, due to emotion or possibly due \nto the fact that amarket that opens earlier (T-Bond futures, for example) has already", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:557", "doc_id": "4cb76d00471968c46e185d00c82e5748e38a64a3ca8c9833537b139aa71ff5d6", "chunk_index": 0}
{"text": "518 Part V: Index Options and Futures \nmade arather large move by the time the futures open. Such asmall gap is normal\nly not extremely damaging to the naked writer. \nOne cannot assume that an index can never gap open widely - if something \ndrastic were to happen in the marketplace that caused opening gaps in many stocks, \nthen agap could appear in the index itself. The worst case of such agap, percentage\nwise, was the stock market crash in 1987 when the major indices such as OEX and \nS&P 500 opened down over 20 points. Nothing has come close to that before or \nsince, but the possibility always exists that it could happen again. Therefore, one can\nnot assume that naked option writing of index options is alow-risk strategy; howev\ner, it is generally less risky than naked option writing of equity options. \nHANDLING EARLY ASSIGNMENT OF CASH-BASED OPTIONS \nThe greatest problem that aspreader of index options has is the possibility of early \nassignment. This removes his hedge on one side of his position, exposing him to \nmuch more risk than he had wanted or anticipated. \nOne can often obtain aclue before early assignment occurs by observing the \nprice of the in-the-money options. If they are trading at adiscount, one can expect \nassignment to be more likely. \nExample: '.lYX is trading at 357 afew days before expiration of the January options. \nThe stock market rallies heavily near the close, and the January 340 calls are trading \nwith amarket of 16½ to 16¾ after 4 pm EST. Since parity is 17 for these calls, it is \nlikely that awriter will receive an assignment notice in the morning. \nThe strategist who observes this situation taking place must make arather quick \ndecision. Since the market has rallied heavily on the close, it is likely that arbitrageurs \nor institutional accounts who are long index options are going to exercise them. The \ncynic among us would even think that they might be short stocks as well which they \nplan to cover in the morning. Notice that the effect of hedged call option sellers (i.e., \nspreaders) receiving assignment notices will be to make them all long the market. \nThe short side of their spread will have been removed via assignment, and they will \nbe left with only the long side. Therefore, in order to liquidate or hedge, they will \nhave to sell stocks or index futures and options in the morning. This would force the \nmarket down temporarily and would be aboon to anyone who was short overnight. \nThe spreader'sfirst potential choice of action is to notice what is happening near \nthe close of trading and to try to exercise his long calls since he expects assignment \nof his short calls. The assignment, of course, is not certain - he is merely projecting \nit. Therefore, he could outfox himself and end up being very short if he did not \nr~ceive an assignment notice on his short calls.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:558", "doc_id": "aab9f74f4fa625ee8d9cc066edd6f9d1356708d1186bde123f4c6064478dcc9e", "chunk_index": 0}
{"text": "Chapter 29: Introduction to Index Option Products and Futures 519 \nAssuming the strategist did not anticipate assignment and therefore did not \nexercise his long calls, he has several choices after receiving an assignment notice the \nnext morning. First, he could do nothing. This would be an overly aggressive bullish \nstance for someone who was previously in ahedged position, but it is sometimes \ndone. The strategist who takes this aggressive tack is banking on the fact that the sell\ning after the assignment will be temporary, and the market will rebound thereafter, \ngiving him the opportunity to close out his remaining longs at favorable prices. This \nis an overly aggressive strategy and is not recommended. \nThe most prudent approach to take when one receives an early assignment on \nacash-based option is to immediately try to do something to hedge the remaining \nposition. The simplest thing to do is to buy or sell futures, depending on whether the \nassignment was on aput or call. If one was assigned on aput, aportion of the bull\nishness (short puts are bullish) of one'sposition has been removed. Therefore, one \nmight buy futures to quickly add some bullishness to the remaining position. \nGenerally, if one were assigned early on calls, part of the bearishness of his position \nwould have been removed - short calls being bearish - and he might therefore sell \nfutures to add bearishness to his remaining position. Once hedged, the position can \nbe removed during that trading day, if desired; by trading out of the hedge estab\nlished that morning. \nOne should receive this assignment notice early in the morning, so he can \nimmediately hedge his position in the overnight markets. If he waits until the day ses\nsion opens, he might use futures or options to hedge. One should be particularly \ncareful about placing market orders in an opening option rotation, especially on index \noptions after asevere downside move has occurred the previous day. Market makers \nare very nervous and are not willing to sell puts as protection to the public in that sit\nuation. Consequently, puts are notoriously overpriced after alarge down day in the \nstock market. One should refrain from buying put options in the opening rotation in \nsuch acase. In the future, it is possible that comparable situations may exist on the \nupside. To date, however, all gaps and severe mispricing anomalies have been on the \nbearish side of the market, the downside. \nCONCLUSION \nThe introduction of index products has opened some new areas for option strategists. \nThe ideas presented in this chapter form afoundation for exploring this new realm \nof option strategies. Many traders are reluctant to trade futures options because \nfutures seem too foreign. Such should not be the case. By trading in futures options, \none can avail himself of the same strategies available in stock option. Moreover, he \nmay be able to take advantage of certain features of futures and futures options that", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:559", "doc_id": "0c74f7f3b20d29756393bedf670e5232c02fdd4ace4a512c24c267e8e9b61443", "chunk_index": 0}
{"text": "520 Part V: Index Options and Futures \nare not available with stock options. For example, if one were to try to use options to \nconstruct astrategy based on his expectation of interest rate movements, he could \nuse T-Bond futures and options, which is the easiest way. However, if he were to try \nto remain with stock options, he would probably be forced to do something with util\nity stocks or illiquid interest rate options - aclearly inferior alternative. \nTrading in index options can be very profitable, but only if one understands the \nrisks involved - especially the risk of early assignment in cash-based options. The \nadvantages to being able to \"trade the market\" as opposed to trading one stock at atime are obvious: If one is right on the market, his index option strategies will be \nprofitable. This is superior to stock-oriented buying whereby one might be right on \nthe market, but not make any money because calls were bought on stocks that didn'tfollow the market. \nThe strategist should consider all of his alternatives when trading in these mar\nkets. If he is bullish, should he really be buying OEX calls? Maybe futures calls on \nthe S&P 500 are better. Perhaps the OEX is expensive with respect to the NYSE and \nthe NYA calls would be abetter buy. In fact, perhaps all the calls are so expensive \nthat stock options are the best buy. The ideas presented in this chapter lay the \ngroundwork for the strategist to explore these questions and make the best decision \nfor his investment strategy. \nFinally, keep in mind that the index futures and options comprise avery diverse \nset of securities. They can be put to work for the investor, the trader, and the strate\ngist in amultitude of ways. The only practical limit is in the mind of the user of these \nderivative securities. \nPUT-CALL RATIO \nGenerally, we have not been concerned with technical trading systems in this book. \nNot that they aren'timportant, they are just in another category of investments other \nthan option strategies. However, the put-call ratio system is so closely related to \noptions that its inclusion is worthwhile. \nThe put-call ratio is simply the number of puts traded divided by the number \nof calls traded. It can be computed daily, weekly, or over any other time period. It \ncan be computed for stock options, index options, or futures options. Sometimes it \nis computed using open interest instead of volume. Another way to compute the put \ncall ratio is to divide the dollars spent on puts (sum of each put price times its trad\ning volume) divided by the dollars spent on calls (sum of each call price times its \ntrading volume). If it is calculated daily, one usually averages several days' worth of \nfigures to smooth out the fluctuations.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:560", "doc_id": "ba930f2cfe0c778dd64bf7260bf0c4ca89c6647013c7da55d8dd518ecaa02be7", "chunk_index": 0}
{"text": "Chapter 29: Introduction to Index Option Products and Futures 521 \nExample: The morning paper shows that yesterday the trading activity for OEX \noptions was: \nTotal OEX Call Volume: 125,000 Contracts \nTotal OEX Put Volume: 135,000 Contracts \nTherefore, the ratio is: \n. 135 000 Index Put-Call Ratio= ' = 1.08 for yesterday \n125,000 \nThis technical indicator is acontrary one. The contrarian thinking is along these lines: \nif everyone is buying puts, then everyone must be bearish; if everyone is doing some\nthing, they can'tall be right; therefore the contrarian must assume abullish stance. \nSo, if the put-call ratio is high, too many traders are buying puts; acontrarian \nwould interpret that as abullish sign. Conversely, if the put-call ratio is low, too many \ntraders are buying calls; the contrarian would consider that as abearish indicator. The \ntheory behind contrary systems is that the majority of traders are wrong at major \nturning points in the market. \nThere are several typical put-call ratios that can be computed. Generally, one \nwould not want to mix different types of options. For example, the equity put-call \nratio uses the option trading volume of equity options only. The index put-call ratio \nuses index options only. Each futures contract put-call ratio is generally computed \nseparately, gold, soybeans, currencies, etc. One might also attempt to screen his input \nalittle further: for example, the index put-call ratio should only include index options \non U.S. exchanges; the others can be computed separately. \nObviously, the more highly traded option contracts produce amore reliable put\ncall ratio: equity options and index options being very liquid. Gold futures options by \nthemselves are not that active and may produce distorted results for aperiod of time. \nThe Ratio Itself. Traders and investors almost always buy more calls than \nputs where stock options are concerned. Therefore, the equity put-call ratio is \nnormally anumber far less than 1.00. If call buying is rampant, the equity put\ncall ratio may dip into the 0.30 range on adaily basis. Very bearish days may \noccasionally produce numbers of 1.00 or higher. An average day will generally \nproduce aratio of around 0.50. \nIndex options, however, produce much larger ratios. Many institutional and \nother investors are constantly looking to avail themselves of the protective capability \nof index puts. Therefore, far more index puts are purchased than are equity puts. An \naverage day might produce readings of 2.00 for some indices.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:561", "doc_id": "e5448d08e6e464c6073321d97ffca1b1b5b1ccfa38af32fe6b351f4adbf9f135", "chunk_index": 0}
{"text": "S22 Part V: Index Options and Futures \nInterpreting the Ratio. There are several philosophies as to how to inter\npret the ratio once it has been calculated. All philosophies are of the contrarian \nvariety, so the general comments made earlier that high ratios are bullish and \nlow ratios are bearish still hold true. However, quantifying just what is \"high\" \nand what is \"low\" leaves room for interpretation. \nOne school believes that absolute ratios should be used. An example might be: \n\"if the 10-day moving average of the equity put-call ratio is over 0.60, that is abuy \nsignal.\" Unfortunately, applying absolute figures to any of the ratios can be counter\nproductive at times. If the market is in the grip of aprolonged bearish move, more \nand more puts will continue to be purchased, sending the ratio quite high before it \ncan reverse and start coming back to normal levels. Therefore, it is better to look for \nthe ratios to make ahigh or alow before calling abuy or sell signal. This is amore \ndynamic interpretation; it allows for buy and sell signals to come at different absolute \nlevels of the put-call ratio. \nFigure 29-1 shows the 50-day equity put-call ratio going back several years (the \ndaily figures for the previous 50 trading days are averaged to produce the number \nplotted on the chart each day). One can see that at certain times, the put-call ratio \nreached extreme heights before finally generating abuy signal. Attempting to call abuy on the market at an absolute level would have been an error because the entry \npoint would have come too early. Notice that the readings in late 1990- as the mar\nket bottomed in advance of Operation Desert Storm - were actually higher on an \nabsolute basis than those made after the stock market crash in 1987. Similar obser\nvations can be made for sell signals after the ratio has reached low levels: don'tantic\nipate - wait for the ratio to bottom out and tum up before declaring asell signal or \nto roll over and turn down before declaring abuy signal. \nThe index put-call ratio is shown in Figure 29-2. It tells asimilar story to the \nequity ratio, although there are certainly differences - beyond the obvious one that \nthe ratios have different absolute values. Note that this ratio averages about 1.00 \nwhile the equity ratio averaged about 0.50. \nAt times, index put buying becomes extensive even as the market climbs. This \ndoes not generally happen with equity options. It seems that institutional money \nmanagers, who are long stocks, are afraid that they will lose their profits after aquick \nstock market advance. However, rather than sell their stocks, they buy puts (possibly \noverpaying for them). Thus, they are really bullish (they own stocks), but they are \nbuying puts as ahedge. \nThis is adifficult situation for the contrarian. What is the institutional manag\ner'strue bias? Is he bullish because he still owns stocks or is he bearish because he \nis buying puts? This is the bane of contrary analysis - attempting to accurately inter\npret the data that is being received. Figure 29-2 shows that the index put-call ratio", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:562", "doc_id": "61c323943fd6d07e5ebca2bff10c30f063f73486b4dde07b0539b7cd6c1a8ece", "chunk_index": 0}
{"text": "Chapter 29: Introduction to Index Option Products and Futures 523 \nis less reliable than the equity ratio, but is still helpful in determining market tops \nand bottoms. \nIn summary, the put-call ratio is an easily calculated one. Daily fluctuations can \nbe smoothed out into 10-, 20-, or 50-day moving averages. The ratio should be inter\npreted bullishly when there is too much put buying and bearishly when there is too \nmuch call buying. The phrase \"too much\" is not easily interpreted, but looking for \nlocal maxima or local minima in the chart pattern is areasonable way to approach the \nproblem. When the put-call ratio moving average is increasing, abuy signal would \nnot be given until the average rolls over and begins declining; asell signal would be \ngenerated when the average which is declining bottoms out. \nSUMMARY \nThere are several kinds of indices and several kinds of trading vehicles: cash-based \noptions, futures options, and futures. These various underlying securities have dif\nfering terms in the way they trade and also in the way their options are designed. This \nvariety creates many opportunities for astute option strategists.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:563", "doc_id": "26f945d5bdb509e0981c15240f766fe27e8b3906865153729606cb63f9dc6174", "chunk_index": 0}
{"text": "532 Part V: Index Options and Futures \nThe key to determining whether it will be profitable to trade some derivative \nsecurity - options or futures - against aset of stocks is generally the level of premi\num in the futures contract itself. That is, if the S&P 500 Index is at 405.00 and the \nfutures are trading at 408.00, then there is apremium of 3.00 - the futures contract \nis trading 3.00 points higher than the index itself. The absolute level of the premium \nis not what is important, but rather the relationship between the premium and the \nfair value of the future. We will look at how to determine fair value shortly. \nThe futures are the leaders among the derivative securities, especially the S&P \n500 futures. Whenever these become overpriced, other derivative securities will gen\nerally follow suit. There are also futures on the NYSE Index, the Value Line Index, \nand the Japanese Nikkei 225 Index. Moreover, there are cash-based index options on \nthe S&P 500 Index (as opposed to the futures options on that index) and the NYSE \nIndex. These other securities would include the QEX (S&P 100) options and NYSE \nfutures and options. It follows as well that when the S&P 500 futures become under\npriced, the other derivative securities quickly fall into line. If the other derivative \nsecurities don'tfollow suit, then there is an opportunity for spreading one market \nagainst another. That type of spreading can frequently be profitable, and is discussed \nin the next chapter. \nThe normal scenario is for most of the derivative securities to follow the lead of \nthe S&P 500 futures. When this happens, the only thing that is fairly priced is the \nindex itself - that is, stocks. Consequently, the logical way to hedge the derivative \nsecurity is to do it with stocks. The small investor might hedge his own individual \nportfolio, although that would not be aperfect hedge since his own portfolio is not \ncomposed of the exact same stocks as any index. If the index is small enough, such as \nthe 30-stock DJX, then one might buy all 30 stocks and sell the futures when they are \noverpriced. This is acomplete hedge and would, in fact, be an arbitrage. In the case \nof alarger index such as the S&P 500, it would be possible only for the most profes\nsional traders to buy all 500 stocks, so one might buy asmaller subset of the index in \nhopes that this smaller set of stocks will mirror the performance of the index well \nenough to simulate having bought the entire index. We take in-depth looks at both \ntypes of hedging. \nEven if the investor is not planning to use these hedging strategies, it is impor\ntant for him to understand how they work These strategies have certain ramifications \nfor the way the entire stock market moves. In order to anticipate these movements, \naworking knowledge of these hedging strategies is necessary. The first thing that one \nmust know in order to implement any of these hedging strategies is how to determine \nthe fair value of afutures contract.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:572", "doc_id": "843beed589bd0c46b83d081a2f1278f371bdf1592aad9687d400bc40cc6588ac", "chunk_index": 0}
{"text": "Chapter 30: Stock Index Hedging Strategies \nFUTURES FAIR VALUE \n533 \nThe formula for calculating the fair value of the futures contract is extremely simple, \nalthough one of the factors is alittle difficult to obtain information on. First, let'slook \nat the simple futures fair value formula: \nSimple Formula: \nFutures fair value= Index x [l +Timex (Rate - Yield)] \nwhere index is the current value of the index itself, rate is the current carrying rate \n(typically, the broker loan rate), yield is the combined annual yield of all the stocks in \nthe index, and time is the time, in years, remaining until expiration of the contract. \nExample: Suppose the Zl'X Index is trading at 160.00, the broker loan rate is 10%, \nthe yield on the 500 stocks is 5%, and there are exactly 3 months remaining until \nexpiration of the futures contract. The time is .25, expressed in years, so the formu\nla becomes \nFuture fair value= 160.00 x [l + .25 x (.10- .05)] \n= 160.00 X (1 + .0125) = 162.00 \nThus, the future should be trading at about 2 points above the value of the index \nitself. This premium of the future over the index represents the savings in not having \nto pay for and carry 500 stocks, less the loss of the dividends on the stocks ( the future \ndoes not pay dividends). If the future should get very expensive - trading at 3.50 or \n4 points over the index - then it would have to be considered very overvalued, and \nan arbitrageur could move in to take advantage of that fact. Similarly, if the future \nshould trade cheaply, at less than apoint over fair value, there might be an arbitrage \navailable in that case as well. \nThe fair value is really only afunction of four things: the value of the index itself, \nthe time remaining until expiration, the current carrying rate, and the dividends \nbeing paid by the stocks in the index until expiration. Notice that \"the dividends paid \nby the stock in the index until expiration\" is not quite the same as the yield of the 500 \nstocks, which we used in the above simple formula. We will expand more on that dif\nference shortly. \nBefore doing that, however, let us look at how changes in the variables in the for\nmula affect the fair value of the futures contract. More important, we are interested in \nhow changes in the variables affect the premium of the futures contract over the index \nvalue. This is what one is primarily concentrating on when trading market baskets. \nAs the index value itself rises, the fair value premium rises. For example, if 2 \npoints is the fair premium when the index is at 160, as in the above example, then 4", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:573", "doc_id": "35093a0381b0398464f21ac38a499a138b40a98c34df1334e1b7b573a4d007bb", "chunk_index": 0}
{"text": "S34 Part V: Index Options and Futures \npoints would be the fair premium if the index were at 320 and all the other variables \nremained the same. Conversely, as the index falls, the fair value of the premium \nshrinks. \nThe premium rises and falls in direct correlation with the carrying rate as well \nas with time remaining until expiration. Note that this statement is true for stock \noptions also, and for the same reason: The savings in carrying costs are greater when \nrates are higher, or when one must hold for alonger time, or both. In the above \nexample, if one were to assume there were 6 months to expiration instead of 3, the \nfair value of the premium would increase to 4 points from 2 points. Similarly, if the \ntime were decreased, the fair value would be smaller. \nSome investors, primarily institutional investors, use the short-term T-bill rate \nrather than the carrying rate in order to determine the futures fair value. The reason \nthey do that is to determine whether the money they have in cash is better off in Tbills or in an arbitrage strategy such as this. More will be said about this use of the Thill rate later. \nDividends Have an Inverse Correlation to the Premium Value. \nAn increase in the overall yield of the index will shrink the fair value of the futures \ncontract. This is because the futures holder does not get the dividends and therefore \nthe future is not as valuable because of the loss of dividends. Conversely, if dividend \nyields fall, then the fair value of the premium increases. This is not the whole story \non dividends, however. \nRecall that afew paragraphs ago, it was pointed out that the yield and the \namount of dividends are not exactly the same thing. This is because stocks don'tpay \ntheir dividends in auniform manner. Rather than paying acontinuous yield as bonds \ndo, stocks normally pay their dividends in four lump sums ayear. This means that the \nyield variable in the simple formula shown above should be replaced by the actual \namount of dividends remaining until expiration. This fact makes the computation of \nthe fair value of the index alittle more difficult. In order to do it accurately, one must \nknow the dividend amounts and ex-dividend dates of each of the stocks in the index. \nKnowing all of this information is afar more formidable task than knowing the yield \nof the index, since the yield is published weekly in several places. In fact, the servic\nes of acomputer are required in order to compute the actual dividend on the larger \nindices, where 100 or more stocks are involved. \nAs aresult, the actual formula changes slightly from the simple formula shown \nabove: \nActual Formula: \nFutures fair value = Index x ( 1 + Time x Rate) - Dividends", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:574", "doc_id": "cdaf645a2d03db73df0bef9af006d4847516c49e3eedaea4348f2db4e0c5194f", "chunk_index": 0}
{"text": "Chapter 30: Stock Index Hedging Strategies 537 \nExample: Suppose that OEX is trading at 364.50 and a September OEX future - if \none existed would have afair value of 367.10. That is, the future would command \napremium of 2.60. Not only should afuture trade with that theoretical premium, but \nso should the \"synthetic OEX\" composed of puts and calls at the same strike. Hence, \nthe synthetic OEX constructed with options should trade at about 367.10 also. \nThat is, if the OEX Sep 365 call were selling for 4.60 and the Sep 365 put were \nselling for 2.50, then the synthetic OEX constructed by the use of these two options \nwould be priced at 367.10. Recall that one determines the synthetic cost by adding \nthe strike, 365, to the call price, 4.60, and then subtracting the put price: 365 + 4.60 \n2.50 = 367.0. This synthetic price of 367.10 is literally the same as the theoretical \nfutures price of 367.10. \nThe same calculations can be applied to any index with listed options trading. \nLet us now return to the broader subject at hand - trading market baskets of stocks \nagainst futures. \nPROGRAM TRADING \nTwo terms that conjure up images of the stock market crash in 1987 and other severe \nprice drops are \"program trading\" and \"index arbitrage.\" Neither one by itself should \naffect the stock market, since they are two-sided strategies - involving buying stocks \nand selling futures. This two-sided aspect should have little effect on the market, the\noretically. However, in practice, it is often the case that trades are not executed simul\ntaneously, and the stock market takes ajump or adive. \nProgram trading is nothing more than trading futures against ageneral stock \nportfolio. Index arbitrage is trading futures against the exact stocks that comprise an \nindex. \nLater discussions will assume that one is trying to create or simulate the index \nitself in order to hedge it with futures. This is the arbitrage approach. However, there \nare many other types of stock positions that may be hedged with the futures. These \nmight include aportfolio of one'sown construction containing various stocks, or \nmight include agroup of stocks from which one wants to remove \"market risk.\" \nNormally, one would not own the makeup of any index, but rather would have aunique combination of stocks in his portfolio. Such an investor may want to use \nfutures to hedge what he does own. \nOne reason why an investor who owned stocks would want to sell index prod\nucts against them might be that he has turned bearish and would prefer to sell futures \nrather than incur the costs involved with selling out his stock portfolio (and repur\nchasing it later). Commission charges are quite small on futures transactions as com-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:577", "doc_id": "ccd1bd29929b188d55724eee448433852bae5c97fb65d05068d6e82bfc502030", "chunk_index": 0}
{"text": "538 Part V: Index Options and Futures \npared to an equal dollar amount of stock. By selling the futures on an index - say, the \nS&P 500- he removes the \"market risk\" from his portfolio (assuming the S&P 500 \nrepresents the \"market\"). What is left over after selling the futures is the \"tracking \nerror.\" The discrepancy between the movement of the general stock market and any \nindividual portfolio is called \"tracking error.\" This investor will still make money if his \nportfolio outperforms the S&P 500, but he will find that he did not completely elim\ninate his losses if his portfolio underperforms the index. Note that if the market goes \nup, the investor will not make any money except for possible tracking error in his \nfavor. \nREMOVING THE MARKET RISK FROM A PORTFOLIO \nStock portfolios are diverse in nature, not :p.ecessarily reflecting the composition of \nthe index underlying the futures contracts. The characteristics of the individual \nstocks must be taken into account, for they may move more quickly or more slowly \nthan \"the market.\" Let us spend amoment to define this characteristic of stocks that \nis so important. \nVOLATILITY VERSUS BETA \nRecall that when we originally defined volatility for use in the Black-Scholes model, \nwe stated that Beta was not acceptable because it was strictly ameasure of the cor\nrelation of astock'sperformance to that of the stock market and was not ameasure \nof how fast the stock changed in price. Now we are concerned with how the stock'smovement relates to the market'sas awhole. This is the Beta. \nUnfortunately, Beta is not as readily available to the option strategist as is \nvolatility. Many option traders merely have to punch abutton on their quote \nmachines and they can receive estimates of volatility. However, Beta estimates are \nmore difficult to obtain, and the ones that are available are often for very long time \nperiods, such as several years. These long-term Betas cannot be used for the pur\nposes of the index hedging discussed in this chapter. Therefore, if one does not have \naccess to shorter-term Beta calculations, then he can approximate Beta by compar\ning an individual stock'svolatility with the market'svolatility. \nExample: XYZ is arelatively volatile stock, having both an implied and historical \nvolatility of 36%. The overall stock market has avolatility of 15%. Therefore, one \ncould approximate the Beta of XYZ as \nBeta approximation = 36/15 = 2.40", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:578", "doc_id": "e342a4941b44de2812b6098d229e92c8b23a0d6e97a2cc6db350e2d5e3488f0c", "chunk_index": 0}
{"text": "Chapter 30: Stock Index Hedging Strategies 541 \nor adjusted capitalization, in order to compensate for the higher volatility of the port\nfolio. \nAsimilar process can be used for far larger portfolios. The estimate of volatili\nty is, of course, crucial in these calculations, but as long as one is consistent in the \nsource from which he is extracting his volatilities, he should have areasonable hedge. \nThere is no way to judge the future performance of aportfolio of stocks versus the \nZYX Index. Thus, one has to expect arather large tracking error. In this type of \nhedge, one hopes to keep the tracking error down to afew percent, which could be \nseveral points in the futures contracts over along enough period of time. Of course, \nthe tracking error can work in one'sfavor also. The main point to recognize here is \nthat the vast majority of the risk of owning the portfolios has been eliminated by sell\ning the futures contracts. The upside profit potential of the portfolios has been elim\ninated as well, but the premise was that the investor was bearish on the market. \nNote that if the futures are overpriced when one enacts his bearishly-oriented \nportfolio hedge, he will gain an additional advantage. This will act to offset some neg\native tracking error, should such tracking error occur. However, there is no guaran\ntee that overpriced futures will be available at the time that the investor or portfolio \nmanager decides to tum bearish. It is better to sell the futures and establish the \nhedge at the time one turns bearish, rather than to wait and hope that they will \nacquire alarge premium before one sells them. \nHEDGING PORTFOLIOS WITH INDEX OPTIONS \nAs mentioned earlier, one could substitute options for futures wherever appropriate. \nIf he were going to sell futures, he could sell calls and buy puts instead. In this sec\ntion, we are also going to take amore sophisticated look at using index options against \nstock portfolios. \nFirst, let us examine how the investor from the previous example might use \nindex options to hedge his portfolio. \nExample: Suppose that an investor owns the same portfolio as in the previous exam\nple: 3,000 COCO, 5,000 UTIL, and 2,000 OIL. He decides to hedge with index \nUVX, which has options worth $100 per point. Assume that the volatility of the UVX \nis 15%. This investor would then compute his total adjusted capitalization in the same \nmanner as in the previous example, again arriving at afigure of $720,000. \nSuppose that the UVX Index is at 175.60. This investor would want to hedge his \n$720,000 of adjusted capitalization with 4,100 \"shares\" of UVX ($720,000 + 175.60). \nSince a 1-point move in UVX options is worth $100, this means that one would sell \n41 UVX calls and buy 41 UVX puts. He would probably use the 175 strike or possi-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:581", "doc_id": "6666c88472542f30b471e26fef8e84ac0de7265998cf12ac50314dc7fb1d6059", "chunk_index": 0}
{"text": "542 Part V: Index Options and Futures \nbly the 180 strike, since those strikes are the ones whereby the calls have the least \nchance for early assignment. \nWhere short options are involved, as with the calls in the above example, one \nmust be aware of the possibility of early assignment exposing the portfolio. \nConsequently, if the marketplace has an equal premium on the futures and the \"syn\nthetic\" UVX, one should sell the futures in that case, because there is no possibility \nof unwanted assignment. However, if the options represent asynthetic price that is \nmore expensive than the futures, then using the options may be more attractive. \nExample: Suppose that our same investor has decided to hedge his portfolio with its \n$720,000 of adjusted capitalization. He is indifferent as to whether to use the ZYX \nfutures or the UV:Xoptions. He will use whichever one affords him the better oppor\ntunity. The following table depicts the prices of the securities that he is considering, \nas well as their fair values. \nCurrent Fair Index \nSecurity Price Value Price \nZYX Jun Future 180.50 180.65 178.65 \nUVX Jun 175 Call 5 5 175.60 \nUVX Jun 175 Put 2 21/2 175.60 \nUVX Jun 180 Call 21/2 21/2 175.60 \nUVX Jun 1 80 Put 41/2 5 175.60 \nThis investor essentially has three choices: (1) to use the ZYX futures, (2) to use \nthe UVX options with the 175 strike, or (3) to use the UV:Xoptions with the 180 \nstrike. Notice that the ZYX future is trading 15 cents below its fair value (180.50 vs. \n180.65). The UV:X Index fair value, as shown by the fair values of the options, is \n177.50. This can be computed by adding the call price to the strike and subtracting \nthe put price. In the case of either strike, the fair values indicate a UV:X Index fair \nvalue of 177.50. \nHowever, the actual markets are slightly out of line. When using the actual \nprices, one sees that he can sell the UV:X Index synthetically for 178.00 whether he \nuses the l 75'sor the 180's. Thus, by using the UV:Xoptions he can sell the UVX \n\"future\" synthetically for ½ point over fair value, while the ZYX futures would have \nto be sold at 15 cents under fair value. Thus, the options appear to be abetter choice \nsince 65 cents ( the 50 cents that the UV:Xoptions are overvalued plus the 15 cents \nthat the futures are undervalued) is probably enough of an edge to offset the possi\nbility of early assignment.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:582", "doc_id": "8c010afbe30059c68630a6ad61219818b284632905ea0d54191c83e929ffa198", "chunk_index": 0}
{"text": "Chapter 30: Stock Index Hedging Strategies 543 \nWith the futures having been eliminated as apossibility, the investor must now \nchoose which strike to use. Since he will be selling calls and buying puts, and since \neither strike allows him to synthetically sell the UVX \"future\" at 178, he should \nchoose the 180 strike. This should be his choice because the 180 calls are out-of-the\nmoney and thus less likely to be the object of an early assignment. \nHEDGING WITH INDEX PUTS \nLet us now move on to discuss ways of hedging in which acomplete hedge is not \nestablished, but rather some risk is taken. The main difference between options and \nfutures is that futures lock in aprice, while options lock in aworst-case price (at \ngreater cost) but leave room for further profit potential. To see this, consider along \nstock portfolio hedged by short futures. In this case, one eliminates his upside profit \npotential except for positive tracking error. However, if he buys put options instead, \nhe expends money - thereby incurring agreater cost to himself than if he had used \nfutures - but he still has profit potential if the market rallies. \nOne could hedge along stock portfolio with options by either buying index puts \nor selling index calls. Buying the puts is generally the more attractive strategy, espe\ncially if the puts are cheap. In order to properly establish the hedge, it is not only nec\nessary to adjust the dollars of stock in accordance with the Beta, but the deltas of the \noptions must be taken into account as well. The following example will demonstrate \nthe use of puts to hedge aportfolio of diverse stocks. \nExample: Assume that an investor has the same portfolio of three stocks that was \nused in aprevious example: 3,000 GOGO, 5,000 UTIL, and 2,000 OIL. He has \nbecome somewhat bearish on the market in general and would like to hedge some of \nhis downside risk. However, he decides to use puts for the hedge just in case there is \nafurther rally in the market. \nThe table from the earlier example is reprinted below, showing the adjusted \nvolatilities and capitalizations for each stock in the portfolio. The total adjusted cap\nitalization of the portfolio is $720,000, as before. \nAdjusted Adjusted \nVolatility Quantity Capitalization \nStock Volatility (Step l) Price Owned (Step 2) \nGOGO .60 4.00 25 3,000 $300,000 \nUTIL .12 0.80 60 5,000 240,000 \nOIL .30 2.00 45 2,000 180,000 \nTotal adjusted capitalization: $720,000 (step 3)", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:583", "doc_id": "72c42413e8bdf77924c4d902eba6a095e651fc6b7696cc79c8ab20c94cabebea", "chunk_index": 0}
{"text": "Chapter 30: Stock Index Hedging Strategies 545 \nIn this case, the number of puts is determined by using the same formula as in \nthe above example and then also dividing by the absolute value of the delta: \nPuts to buy = $720,000 / (100 X 180) / 0.60 \n= 67 \nCost of protection: 67 x $450 = $30,150 \nIn this case, the portfolio manager is spending much more for the puts, but for \nhis additional expense, he acquires immediate protection for his portfolio. \nFurthermore, there is some intrinsic value to the puts he bought (2 points, or $13,400 \non 67 of them). If the UVX Index drops at all, these puts will immediately begin to \nhedge his entire portfolio against loss. Of course, if the market rises, he loses his \nmuch more expensive insurance cost. \nWhen one uses options instead of futures to hedge his position, he must make \nadjustments when the deltas of the options change. This was not the case when futures \nwere used; perhaps with futures, one might recalculate the adjusted capitalization of \nthe portfolio occasionally, but that would not be expected to affect the quantity of \nfutures to any great degree. With put options, however, the changing delta can make \nthe position delta short when the market declines, or can make it delta long if the mar\nket rises. This situation is akin to being long astraddle the position becomes delta \nshort as the market declines and becomes delta long as the market rises. \nBasically, the adjustments would be same as those that along straddle holder \nwould make. If the market rallied, the position would be delta long because the delta \nof the puts would have shrunk and they would not be providing the portfolio with as \nmuch adjusted dollar protection as it needs. The investor might roll the puts up to ahigher strike, amove that essentially locks in some of his stock profits. Alternatively, \nhe could buy more puts at the current (low) strike to increase his protection. \nConversely, if the market had declined immediately after the position was \nestablished, the investor will find himself delta short. The delta of the long puts will \nhave increased and there will actually be too much protection in place. His adjust\nment alternatives are still the same as those of along straddle holder - he might sell \nsome of the puts and thereby take aprofit on them while still providing the required \nprotection for the stock portfolio. Also, he might roll the puts down to alower strike, \nalthough that is aless desirable alternative. \nHEDGING WITH INDEX CALLS \nAnother strategy to protect astock portfolio is to establish aratio write using short \ncalls against the long stock. This is the opposite of using puts for protection, in that \nit is more equivalent to being short astraddle.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:585", "doc_id": "fa98948153b758458414a1365f1e9880ab78279ff73a148109ad4e7180cf649d", "chunk_index": 0}
{"text": "546 Part V: Index Options and Futures \nExample: In the last example, the March 180 put had adelta of -0.60. The March \n180 call should then have adelta of 0.40. If the portfolio manager wanted to hedge \nhis portfolio by ratio writing calls against it, he could use the same formula as in the \nprevious example: \nCalls to sell = $720,000 I (100 x 180) I 0.40 = 100 \nHe would sell 100 calls to hedge his portfolio. \nAdjustments would be made in much the same manner as those that astraddle \nseller would make. If the market rises, the delta of the calls will increase and the posi\ntion will be delta short. One would probably buy calls in that case. Follow-up action \nfor an actual short straddle might dictate buying in some of the underlying security \nrather than buying the calls, but that is not arealistic alternative in this case, since the \nsample portfolio is probably stable. \nIf, on the other hand, the market declined after the short calls were sold against \nthe portfolio, the position would become delta long as the delta of the calls shrinks. \nThe normal action in that case would be to roll the calls down and reestablish the \nproper amount of protection for the portfolio. \nOverall, hedging the portfolio with short index calls does not present as attrac\ntive aposition as hedging with long index puts. This is due mostly to the nature of \nwhat the portfolio manager is trying to accomplish, as opposed to the relative merits \nof long and short straddles. As was pointed out in previous chapters, straddle selling, \nwhile risky, is an excellent strategy on astatistical basis. However, in this section we \nare not dealing with astrategist who is going to go out and buy stocks and then write \nindex calls against them. Rather, we have an existing portfolio and the portfolio man\nager is becoming bearish on the market. Thus, the stock portfolio is afixed entity and \nthe index options or futures are being built around it for protection. \nLong puts serve the purpose of protection far better than short calls, for the fol\nlowing reasons. First, the types of adjustments that need to be made by astraddle \nseller often involve buying stock or at least buying relatively deep in-the-money calls. \nAportfolio manager or investor holding aportfolio stock may not need or want to get \ninvolved in amulti-optioned position. Second, with calls there is large risk to the \nupside in case of alarge market rally. Someone holding aportfolio of stocks might be \nwilling to forego upside profits ( as in the sale of futures), but generally would be quite \nupset to sustain large losses on the upside. Using puts, of course, leaves room for \nupside profit potential. Third, there is risk of early assignment with short index calls, \nalthough that is of minor significance in this case since the portfolio of stocks would \nhave been long in any case. Other calls could be written immediately on the day after \nthe assignment. The only real drawback to using the puts is that premium dollars are", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:586", "doc_id": "75dd5e27915297a24bb582076fc67a5c3f6db0425e948705e078626191803b0b", "chunk_index": 0}
{"text": "Cbapter 30: Stock Index Hedging Strategies 547 \npaid out and, if the market stabilizes, the time value decay will cause aloss on the \nputs. If one actually suspects that such astabilization might occur, he should use \nfutures against his position instead of puts or calls. \nINDEX ARBITRAGE \nAs previously stated, index arbitrage consists of buying virtually all of the stocks in an \nindex and selling futures against them, or vice versa. Whenever the futures on an \nindex are mispriced, as determined by comparing their actual value with their fair \nvalue, there may be opportunities for arbitrage if the mispricing is large enough. \nWhen futures are extremely overpriced: buy stocks, sell futures; or when futures are \nunderpriced: sell stocks, buy futures. In either case, the arbitrageur is attempting to \ncapture the differential between the fair value price of the futures contract and the \nprice at which he actually buys or sells the index. First, we will examine fully hedged \nsituations - ones in which the entire index is bought or sold. After that, we will exam\nine smaller sets of stocks that are designed to simulate the performance of the entire \nindex. \nHedging indices which contain fewer stocks is easier than hedging larger \nindices. Hedging aprice-weighted index is probably the simplest type of hedge. As \nexamples, the same sample indices that were constructed in the previous chapter will \nbe used. \nWhenever futures or index options trade on an index, it is possible to set up \nmarket baskets for arbitrage. The trader should determine, in advance, how many \nshares of each stock he will buy or sell in order to duplicate the index. In aprice\nweighted index, of course, he will buy the same number of shares of each stock. In acapitalization-weighted index, he will be buying different numbers of shares of each \nstock. Let us first look at how the number of shares to buy is determined. Then we \nwill discuss some of the nuances, such as monitoring bids and offers of the indices, \norder execution, and others. \nHOW MANY SHARES TO BUY \nIn advance of actually trading the stocks and futures or options, one should deter\nmine exactly how many shares of each stock he will be buying in each index he plans \nto arbitrage. Normally, one would decide in advance how many futures contracts or \noption contracts he will trade at one time. Then the number of shares of stock to be \nbought as ahedge can be determined as well. Essentially, one is going to hedge equal \ndollar amounts - that is, he will buy enough stocks to offset the total dollar amount \nrepresented by the index.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:587", "doc_id": "4dda4da51cad20e76a00f4ca38d58b9f26ea5d39a3e98d37dbeb072a4255714b", "chunk_index": 0}
{"text": "Chapter 30: Stock Index Hedging Strategies S49 \nActually he would probably buy 15,100 shares of each stock against the index, \nand on every fourth \"round\" (100 futures vs. stock) would buy 15,000 shares. This \nwould be avery close approximation without dealing in odd lots. \nThe trader might also use index options as his hedge instead of futures. The \nstriking price of the options does not come into play in this situation. Typically, one \nwould fully hedge his position with the index options - that is, if he bought stock, he \nwould then sell calls and buy puts against that stock. Both the puts and the calls \nwould have the same strike and expiration month. This creates ariskless position. \nThis position is aconversion. \nExample: Suppose that cash-based options trade on this index, and that these \noptions are worth $100 per point as are normal stock options - that is, an option is \nessentially an option on 100 shares of the index. The trader is going to synthetically \nshort the index by buying 100 June 105 puts and selling 100 June 105 calls. Assume \nthat the index data is the same as in the previous example, that 0.60298 shares of each \nstock comprise the index. How many shares would one hedge these 100 option syn\nthetics with? \nNumber of shares = .60298 x 100 contracts x 100 shares/contract \n= 6029.8 shares \nNote that in the case of aprice-weighted index, neither the current index value \nnor the striking price of the options involved (if options are involved) affects the \nnumber of shares of stock to buy. Both of the above examples demonstrate the fact \nthat the number of shares to buy is strictly afunction of the divisor of the price\nweighted index and the unit of trading of the option or future. \nHedging acapitalization-weighted index is more complicated, although the \ntechnique revolves around determining the makeup of the index in terms of shares \nof stock, just as the price-weighted examples above did. Recall that we could deter\nmine the number of shares of stock in acapitalization-weighted index by dividing the \nfloat of each stock by the divisor of the index. The general formula for the number of \nshares of each stock to buy is: \nShares of stock N Shares of N F . Futures unit \n= . . xutures quantity x . to buy mmdex of trading \nWe will use the fictional capitalization-weighted index from the previous chap\nter to illustrate these points. \nExample: The following table identifies the pertinent facts about the fictional index, \nincluding the important data: number of shares of each stock in the index.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:589", "doc_id": "649649b90457ce7bd1a185880ca3032ef6d520cb43d47f461b1f6279e3732d1f", "chunk_index": 0}
{"text": "554 Part V: Index Options and Futures \nCommissions on futures are generally charged only when the position is closed \nout. Generally, afutures commission on an S&P 500 contract might be reduced to \nsomething like $10 per contract for this type of hedging. Since 185.00, the index \nvalue, represents 11500th of the value of the futures contract, we can reduce the \nfutures commission to an index-related number by dividing the actual dollar com\nmission by 500. Thus, the futures commission is, in index terms, 10/500, or .02. The \ntotal commission for entering and exiting the position is thus 0.266 of index value, \n0.123 each for the purchase and sale of the stocks and .02 for the futures. \nNet profit = Futures \nprice \nFutures fair Commission \nvalue costs \n= 188.50 - 187.00 - 0.27 \n= 1.23 \nThis absolute net profit number can be converted into arate of return by annualiz\ning the profit and dividing by the current index price. Suppose that there are \ntwo months exactly remaining until expiration. Then the rate of return is computed \nas follows: \nIncremental = Net profit x ( 1/Time remaining) \nrate of return Index price \n1.23 X ( 12/2) \n185.00 \n= 3.99% \nFor the two-month time period, his return is about 2h of one percent. \nAt first glance, arate of return of almost 4% does not seem like much. But what \nwe have computed here is an incremental rate of return. That is, this return is over \nand above whatever rate we used in determining the fair value of the futures. Thus, \nif an institution were going to invest its cash at the prevailing short-term rate, and that \nrate were used to determine the futures fair value in the above example, then the \ninstitution could earn an additional 4%, annualized, if it arbitraged the futures rather \nthan put its money in the short-term money market. \nTRADE EXECUTION \nMost customers are not concerned with how the trades are executed, for they give \nthe order to their broker and let him work out the details. However, for those who \nare interested in the actual trade execution, ashort section dealing with that topic is \nin order.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:594", "doc_id": "bccd6e49b6901356275a34e27ebea16732ad36e80df1ee7b04649ea8e4d7c0eb", "chunk_index": 0}
{"text": "558 Part V: Index Options and Futures \nThat is, he would buy back the ones he is short and sell the next series of futures. For \nS&P 500 futures, this would mean rolling out 3 months, since that index has futures \nthat expire every 3 months. For the XMI futures and OEX index options, there are \nmonthly expirations, so one would only have to roll out 1 month if so desired. \nIt is asimple matter to determine if the roll is feasible: Simply compare the fair \nvalue of the spread between the two futures in question. If the current market is \ngreater than the theoretical value of the spread, then aroll makes sense if one is long \nstocks and short futures. If an arbitrageur had initially established his arbitrage when \nfutures were underpriced, he would be short stocks and long futures. In that case he \nwould look to roll forward to another month if the current market were less than the \ntheoretical value of the spread. \nExample: With the S&P 500 Index at 416.50, the hedger is short the March future \nthat is trading at 417.50. The June future is trading at 421.50. Thus, there is a 4-point \nspread between the March and June futures contracts. \nAssume that the fair value formula shows that the fair value premium for the \nMarch series is 35 cents and for the June series is 3.25. Thus, the fair value of the \nspread is 2.90, the difference in the fair values. \nConsequently, with the current market making the spread available at 4.00, one \nshould consider buying back his March futures and selling the June futures. The \nrolling forward action may be accomplished via aspread order in the futures, much \nlike aspread order in options. This roll would leave the hedge established for anoth\ner 3 months at an overpriced level. \nAnother way to close the position is to hold it to expiration and then sell out the \nstocks as the cash-based index products expire. If one were to sell his entire stock \nholding at the time the futures expire, he would be getting out of his hedge at exact\nly parity. That is, he sells his stocks at exactly the last sale of the index, and the futures \nexpire, being marked also to the last sale of the index. \nFor settlement purposes of index futures and options, the S&P 500 Index and \nmany other indices calculate the \"last sale\" from the opening prices of each stock on \nthe last day of trading. For some other indices, the last sale uses the closing price of \neach stock. \nExample: In anormal situation, if the S&P 500 index is trading at 415, say, then that \nrepresents the index based on last sales of the stocks in the index. If one were to \nattempt to buy all the stocks at their current offering price, however, he would prob\nably be paying approximately another 50 cents, or 415.50, for his market basket. \nSimilarly, if he were to sell all the stocks at the current bid price, then he would sell \nthe market basket at the equivalent of approximately 414.50.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:598", "doc_id": "0a5c69b2316dc79e867c68454eebd3d8dd4e39310066cb97621bd62011b9bbe6", "chunk_index": 0}
{"text": "Chapter 30: Stock Index Hedging Strategies 559 \nHowever, on the last day of trading, the cash-based index product will expire at \nthe opening price of the index. If one were to sell out his entire market basket of \nstocks at the current bid prices at the exact opening of trading on that day, he would \nsell his market basket at the calculated last sale of the index. That is, he would actu\nally be creating the last sale price of the index himself, and would thereby be remov\ning his position at parity. \nThe problem with this is that it is correct theory, but difficult to put into prac\ntice. For example, if one has several million dollars of stocks to sell, he cannot expect \nthe marketplace to absorb them easily when they are all being sold at the last minute \non a Friday afternoon. We will discuss this more fully momentarily, when we look at \nthe impact of stock index arbitrage on the stock market in general. \nThere is another interesting facet of the arbitrage strategy that combines the \nspread between the near-term future and the next longest one with the idea of exe\ncuting the stock portion of the arbitrage at the close of trading on the day the index \nproducts expire. Use of this strategy actually allows one to enter and exit the hedge \nwithout having to lose the spread between last sale and bid or last sale and offer in \neither case. Suppose that one feels that he would set up the arbitrage for 3 months if \nhe could establish it at anet price of 1.50 over fair value. Furthermore, if the fair \nvalue of the 3-month spread is 2.10, but it is currently trading at 3.60, then that rep\nresents 1.50 over fair value. One initiates the position by buying the near-term future \nand selling the longer-term future for anet credit of 3.60 points. At expiration of the \nnear-term future, rather than close out the spread, one buys the stocks that comprise \nthe index at the last sale of the trading day, thereby establishing his long stock posi\ntion at the last sale price of the index at the same moment that his long futures expire. \nThe resultant position is long stocks and short futures that expire in 3 months at apremium of 3.60. Since the fair value of such a 3-month future should be 2.10, the \nhedge is established at 1.50 over fair value. The position can be removed at expira\ntion in the same manner as described in the previous paragraph, again saving the dif\nferential between last sale and the bids of the stocks in the index. Note that this strat\negy creates buying pressure on the stock market at expiration of the near-term side \nof the spread, and selling pressure at the latter expiration. \nThe final way to exit from one'sposition is to remove it before expiration. \nSometimes, there are opportunities during the last two or three weeks before the \nfutures expire. If one hedged with long stock and short futures, the opportunities \nto remove the hedge arise when the futures trade below fair value - perhaps even \nat an actual discount to parity. If the futures never trade below fair value, but \ninstead continue to remain expensive, then rolling to the next expiration series is \noften warranted.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:599", "doc_id": "9a71e9f3a4efe9c74ac8a744fa1a6e935aa96062230525642af40903d052364b", "chunk_index": 0}
{"text": "Cbapter 30: Stock Index Hedging Strategies 561 \nAnother risk that the arbitrageur faces is that of changes in the dividend payout \nof the stocks in the index. Suppose that he is long stocks and short futures. If there \nare enough cuts in dividend payout, or dividend payments are delayed past the expi\nration date of the futures, then he will lose some of his return. Arbitrageurs who are \nshort stocks and long futures would have similar problems if dividend payout were \nincreased especially if alarge special dividend were declared by acompany that ,is \namajor component of the index - or payment dates were accelerated. \nIf one holds the arbitrage until expiration, he will be able to unwind it at parity. \nHowever, if he decides to remove the arbitrage before expiration, he might incur \nincreased costs that would harm his projected return. Instead of selling his stocks at \nthe last sale of the index, as he is able to do on expiration day, he would have to sell \nthem on their bids, afact that could cost him asignificant portion of his profit. \nIn alater section, where we discuss hedging the futures with amarket basket of \nstocks that does not exactly represent the entire index, we will be concerned with the \ngreatest risk of all, \"tracking error\" - the difference between the performance of the \nindex and the performance of the market basket of stocks being purchased. \nIMPACT ON THE STOCK MARKET \nThe act of establishing and removing these hedge positions affects the stock market \non ashort-term basis. It is affected both before expiration and also at expiration of \nthe index products. We will examine both cases and will also address how the strate\ngist can attempt to benefit from his knowledge of this situation. \nIMPACT BEFORE EXPIRATION \nWhen bullish speculators drive the price of futures too high, arbitrageurs will attempt \nto move in to establish positions by buying stock and selling futures. This action will \ncause the stock market to jump higher, especially since positions are normally estab\nlished with great speed and stocks are bought at offering prices. Such acceleration on \nthe upside can move the market up by agreat deal in terms of the Dow-Jones \nIndustrials in amatter of minutes. \nConversely, if futures become cheap there is also the possibility that arbi\ntrageurs can drive the market downward. If positions are already established from \nthe long side (long stock, short futures), then arbitrageurs might decide to unwind \ntheir positions if futures become too cheap. They would do this if futures were so \ncheap that it becomes more profitable to remove the position, even though stocks \nmust be sold on their bid, rather than hold it to expiration or roll it to another series.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:601", "doc_id": "a91f72bc99bbf3c085bf5d0cb012d5571bb28481c39d235bafb1f534edab0edd", "chunk_index": 0}
{"text": "S64 Part V: Index Options and Futures \nHowever, the concept is still avalid one, and it is now generally being practiced \nwith the purchase of put options. The futures strategy was, in theory, superior to buy\ning puts because the portfolio manager was supposed to be able to collect the pre\nmium from selling the futures. However, its breakdown came during the crash in that \nit was impossible to buy the insurance when it was most needed - similar to attempt\ning to buy fire insurance while your house is burning down. \nCurrently, the portfolio manager buys puts to protect his portfolio. Many of \nthese puts are bought directly over-the-counter from major banks or brokerage hous\nes, for they can be tailored directly to the portfolio manager'sliking. This practice \nconcerns regulators somewhat, because the major banks and brokerage houses that \nare selling the puts are taking some risk, of course. They hedge the sales (with futures \nor other puts), but regulators are concerned that, if another crash occurred, it would \nbe the writers of these puts who would be in the market selling futures. in amad fren\nzy to protect their short put positions. Hopefully, the put sellers will be able to hedge \ntheir positions properly without disturbing the stock market to any great degree. \nIMPACT AT EXPIRATION - THE RUSH TO EXIT \nSome traders persist in attempting to get out of their positions on the last day, at the \nlast minute. These traders are not normally professional arbitrageurs, but institu\ntional clients who are large enough to practice market basket hedging. Moreover, \nthey have positions in indices whose options expire at the close of trading (OEX, for \nexample). If these hedgers have stock to sell, what generally happens is that some \ntraders begin to sell before the close, figuring they will get better prices by beating \nthe crowd to the exit. Thus, about an hour before the close, the market may begin to \ndrift down and then accelerate as the closing bell draws nearer. Finally, right on the \nbell that announces the end of trading for the day, whatever stock has not yet been \nsold will be sold on blocks - normally significantly lower than the previous last sale. \nThese depressed sales will make the index decline in price dramatically at the last \nminute, when there is no longer an opportunity to trade against it. \nThese blocks are often purchased by large trading houses that advance their \nown capital to take the hedgers out of their positions. The hedgers are generally cus\ntomers of the block trading houses. Normally, on Monday, the market will rebound \nsomewhat and these blocks of stock can be sold back into the market at aprofit. \nWhatever happens on Monday, though, is of little solace to the trader trapped \nin the aftermath of the Friday action. For example, if one happened to be short puts \nand the index was near the strike as the close of trading was drawing near on Friday \nafternoon, he might decide to do nothing and merely allow the puts to expire, figur\ning that he would buy them back for asmall cost when he was assigned at expiration.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:604", "doc_id": "0498df2e297bf7c232592139e48b5a9e271dc9bbb274e08bfedae6c0a262fcf4", "chunk_index": 0}
{"text": "Cbapter 30: Stock Index Hedging Strategies 565 \nHowever, this flurry of block prints on the close might drive the index down by 2 or \n3 points! This is an extremely large move for the index, and the option trader has no \nrecourse as the options cease trading. An index composed of only afew stocks, such \nas the Dow-Jones 30 Industrials, will fall most dramatically when these events occur, \nalthough the OEX will drop heavily as well. \nWe have also previously seen that the late market action on expiration day might \nbe bullish. If institutional arbitrageurs have established the futures spread by being \nlong the short-term futures and short the next series, then they will be buyers of \nstocks at the close of trading on expiration day. Additionally, if the only remaining \narbitrage positions at expiration are short stocks versus long futures, then there might \nalso be buying pressure at expiration. \nAs might be expected, these events have not gone unnoticed and have caused \nsome consternation among both regulators and traders. There have been accusations \nthat some traders particularly those with foreknowledge of the block prints to come \nbuy very cheap index options on the last afternoon of trading and then force those \noptions to become profitable by selling their clients' portfolios in the manner \ndescribed above. \nThe strategist cannot be concerned with whether someone is acting irrationally \nor worse. Rather, he must decide how he will handle the situation should it occur. \nThe key is to try to determine the direction that the market will move at the close of \nexpiration day, if that is discernible. If futures have had alarge premium for along \nperiod of time, then one must assume that many hedgers have long stock versus short \nfutures. Furthermore, even if futures subsequently trade below fair value, there will \nstill be some hedgers who have stubbornly kept their positions, waiting to roll. The \nstrategist should recognize that fact and take appropriate action late on the last day \nof trading: Don'testablish bullish positions at that time and don'tallow positions that \nare expiring that day to become too bullish. That is, if one is short puts and the index \nis trading near the striking price of the puts, then buy them back. \nThus, the strategist must be aware of how the futures have traded during the \nlast 3 months in order to determine how he will address his positions on the last day. \nEven with this information, there is no guarantee that one can exactly predict what \nwill happen at expiration unless one is privy to the actual stock buy and sell orders. \nThis order flow information is closely guarded and known only to the firms that will \nbe executing the orders, generally on behalf of institutions. Consequently, it is avery \nrisky strategy to attempt to apply this information for establishing positions on expi\nration day itself. That is, if one expects stock buy orders at expiration, he might \ndecide to buy some cheap, expiring calls for himself on the last afternoon of trading. \nConversely, if he expects stock selling, he might buy puts. Given the fact that such \nmovements are hard to predict, such aggressive strategies are not warranted.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:605", "doc_id": "d4a7a698f7e32a00ffd400a731184647df0fbf12af268a966642f60217c6dc46", "chunk_index": 0}
{"text": "566 Part V: Index Options and Futures \nSIMULATING AN INDEX \nThe discussion in the previous section assumed that one bought enough stocks to \nduplicate the entire index. This is unfeasible for many investors for avariety of rea\nsons, the most prominent being that the execution capability and capital required \nprevent one from being able to duplicate the indices. Still, these traders obviously \nwould like to take advantage of theoretical pricing discrepancies in the futures con\ntracts. The way to do this, in ahedged manner, would be to set up amarket basket \nof asmall number of stocks, in order to have some sort of hedge against the futures \nposition. \nIn this section, we will demonstrate approaches that can be taken to hedge the \nfutures position with asmall number of stocks. This is different from when we looked \nat how to hedge individualized portfolios with index futures or options, because we \nare now going to try to duplicate the performance of the entire index, but do it with \nasubset of stocks in the index. In either of these cases, amathematical technique \ncalled regression analysis can be used to measure the performance of these portfo\nlios or small market baskets. However, we will take asimpler approach that does not \nrequire such sophisticated calculations, but will produce the desired results. \nUSING THE HIGH-CAPITALIZATION STOCKS \nRecall that in acapitalization-weighted index, the stocks with the largest capitaliza\ntions (price times float) have the most weight. In many such indices, there are ahandful of stocks that carry much more weight than the other stocks. Therefore, it is \noften possible to try to create amarket basket of just those stocks as ahedge against \nafutures position. While this type of basket will certainly not track the index exactly, \nit will have adefinite positive correlation to the index. \nWhat one essentially tries to accomplish with the smaller market basket is to \nhedge dollars represented by the index with the same dollar amount of stocks. No \nhedge works in which the total dollars involved are not nearly equal. Listed below are \nthe steps necessary to compute how many shares of each stock to buy in order to cre\nate a \"mini-index\" to hedge futures or options on alarger index: \n1. Determine the percent of the large index to be hedged (OEX, NYSE, S&P 500, \netc.) that each stock comprises. This information is readily available from the \nexchange on which the futures or options trade or can be calculated by the meth\nods shown in Chapter 29. \n2. Determine the percent of the mini-index to be constructed that each stock com\nprises, by inflating their relative percentages to total 100%.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:606", "doc_id": "e92202e36adf2f3aefda4d145966eeec01597363d31a237180bdf2c7a3218388", "chunk_index": 0}
{"text": "568 Part V: Index Options and Futures \nRecall how these items are calculated: The number of shares of astock in the \nindex is that stock'sfloat divided by the divisor of the index. Also, the percent of the \nindex is the stock'scapitalization (float times price) divided by the total capitalization \nof the index (this is step 1 above). Finally, the index value is the index'stotal capital\nization divided by the index divisor. \nWith this information, we can now construct amini-index that could be used to \nhedge the UVX itself. Notice that these four stocks alone comprise 28.4% of the \nentire UVX index. We would want each of these four stocks to have the same relative \nweight within our mini-index as they do within the UVX itself. The sum of the capi\ntalizations of the four stocks in the above table as well as their relative percentages \nare given in the following table. \nPct of Pct of \nIndex Mini-Index \nStock Copitolizotion (Step 1) (Step 2) \nIBM 78,000,000 13.1% 46.2% \nXON 34,000,000 5.7% 20.1% \nGE 31,500,000 5.3% 18.6% \nGM 25,500,000 4.3% 15.1% \nTotal: 169,000,000 28.4% 100.0% \nThe percent of the mini-index is each of the four stocks' capitalizations as aper\ncent of the sum of their capitalizations (step 2 from above). There are two ways to \ncompute step 2. First, for IBM one would divide 78 million (its capitalization) by 169 \nmillion (the total capitalization). Second, using the percentages from step 1, divide \nIBM'spercent, 13.1, by 28.4, the total percent. Either method gives the answer of \n46.2 percent. We have now constructed the relative percentages of the mini-index \nthat each stock comprises. Note that they are in the same relationship to each other \nas they are in the UVX itself. Now it is asimple matter to convert that percent into \nshares of stock, once we decide how many futures contracts to trade against our mini\nindex. \nWhen we know the total dollar amount of futures to hedge and we know the \npercent of the mini-index that each stock comprises, we can compute each stock'scapitalization within the mini-index. Finally, we divide by that stock'sprice to see how \nmany shares of each stock to buy. Assume that we are going to use UVX options, \nwhich are worth $100 per point, in lots of 50 options. The total dollar amount of the \nindex with the UVX at 170.25 would then be $851,250 (170.25 x 100 x 50). This \naccomplishes step 3. The following table shows the calculations necessary to deter\nmine how many shares of stock to buy against these 50 option contracts.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:608", "doc_id": "71c9df31e1c0e0f2c0f76ecae29cbd39474549c9430cabfa1d99f9484c96b078", "chunk_index": 0}
{"text": "574 Part V: Index Options and Futures \ntion. He would both sell calls and buy puts with the same striking price in order to \ncreate the hedge. This is similar to aconversion arbitrage. \nWhen attempting to hedge the S&P 500, one could use the S&P 500 futures \noptions or the S&P 500 cash options, but that would not necessarily present amore \nattractive situation than using the futures. On the other hand, there is not aliquid \nS&P 100 (OEX) futures contract, so that when hedging that contract, one generally \nuses the OEX options. As mentioned earlier, inter-index option spreads between var\nious indices, including the S&P 100 and 500, will be discussed in the next chapter. \nThere is not normally much difference as to which of the two is better at any \none time. However, since afull option hedge requires two executions (both selling \nthe call and buying the put), the futures probably have aslight advantage in that they \ninvolve only asingle execution. \nIn order to substitute options for futures in any of the examples in these chap\nters on indices, one merely has to use the appropriate number of options as com\npared to the futures. If one were going to sell OEX calls instead of S&P 500 futures, \nhe would multiply the futures quantity by 5. Five is the multiple because S&P 500 \nfutures are worth $250 per point while OEX options are worth $100 per point, and \nbecause the S&P 500 Index (SPX) trades at twice the price of OEX (OEX split 2-for\nlin November 1997). Thus, if an example calls for the sale of 20 S&P 500 futures, \nthen an equivalent hedge with OEX options would require 100 short calls and 100 \nlong puts. \nOne could attempt to create less fully hedged positions by using the options \ninstead of the futures. For example, he might buy stocks and just write in-the-money \ncalls instead of selling futures. This would create acovered call write. He would still \nuse the same techniques to decide how much of each stock to buy, but he would have \ndownside risk if he decided not to buy the puts. Such aposition would be most attrac\ntive when the calls are very overpriced. \nSimilarly, one might try to buy the stocks and buy slightly in-the-money puts \nwithout selling the calls. This position is asynthetic long call; it would have upside \nprofit potential and would lose if the index fell, but would have limited risk. Such aposition might be established when puts are cheap and calls are expensive. \nTRADING THE TRACKING ERROR \nAnother reason that one might sell futures against aportfolio of stocks is to actually \nattempt to capture the tracking error. If one were bullish on oil drilling stocks, for \nexample, and expected them to outperform the general market, he might buy sever-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:614", "doc_id": "88b785c80dddd1a1b76ba03e60e15e8d94ae2f3c4e11a376f8b1f60ff3bdd1bf", "chunk_index": 0}
{"text": "Chapter 30: Stock Index Hedging Strategies 577 \nthat leads the investor to believe that the group no longer has the potential to out\nperform the market. \nIf the futures are underpriced when one begins to investigate this strategy, he \nshould not establish the position. What is gained in tracking error could be lost in \ntheoretical value of the futures. Since one is establishing both sides of the hedge \n(stocks and futures) at essentially the same time, he can afford to wait until the \nfutures are attractively priced. This is not to say that the futures must be overpriced \nwhen the position is established, although that fact would be an enhancement to the \nposition. \nIf one thinks that aparticular group will underperform the market, he merely \nneeds to decide how many shares of each stock to sell short and then can determine \nhow many futures to buy against the short sales in order to try to capture the track\ning error. If one decides to capture the negative tracking error in this manner, he \nmust be careful not to buy overpriced futures. Rather, he should wait for the futures \nto be near fair value in order to establish the position. \nCOLLATERAL REQUIREMENTS \nIn any of the portfolio hedging strategies that we have discussed in this section, there \nis no reduction in margin requirements for either the futures or the options. That is, \nthe stocks must be paid for in full or margined as if they had no protection against \nthem, and the hedging security - the futures or options - must be margined fully as \nwell. Long puts would have to be paid for in full, short futures would require their \nnormal margin and would be marked to the market via variation margin, and short \ncalls would have to be margined as naked and would also be marked to the market. \nAtrader who has not margined his stocks could use them as collateral for the naked \ncall requirements if he so desired. \nSUMMARY \nThere have been two major impacts of index futures and options. One is that they \nallow atrader to \"buy the market\" without having to select individual stocks. This is \nimportant because many traders have some idea of the direction in which the mar\nket is heading, but may not be able to pick individual stocks well. The other, perhaps \nmore major, impact is that large holders of stocks can now hedge their portfolios \nwithout nearly as much difficulty. The use of these futures and options against actu\nal stock indices - real or simulated - has introduced astrategy into the marketplace \nthat did not previously exist. The versatility of these derivative securities is evidenced", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:617", "doc_id": "de919d013850f39670eb169471527caccf7446a28688b440cd5c36f9130a7527", "chunk_index": 0}
{"text": "574 Part V: Index Options and Futures \ntion. He would both sell calls and buy puts with the same striking price in order to \ncreate the hedge. This is similar to aconversion arbitrage. \nWhen attempting to hedge the S&P 500, one could use the S&P 500 futures \noptions or the S&P 500 cash options, but that would not necessarily present amore \nattractive situation than using the futures. On the other hand, there is not aliquid \nS&P 100 (OEX) futures contract, so that when hedging that contract, one generally \nuses the OEX options. As mentioned earlier, inter-index option spreads between var\nious indices, including the S&P 100 and 500, will be discussed in the next chapter. \nThere is not normally much difference as to which of the two is better at any \none time. However, since afull option hedge requires two executions (both selling \nthe call and buying the put), the futures probably have aslight advantage in that they \ninvolve only asingle execution. \nIn order to substitute options for futures in any of the examples in these chap\nters on indices, one merely has to use the appropriate number of options as com\npared to the futures. If one were going to sell OEX calls instead of S&P 500 futures, \nhe would multiply the futures quantity by 5. Five is the multiple because S&P 500 \nfutures are worth $250 per point while OEX options are worth $100 per point, and \nbecause the S&P 500 Index (SPX) trades at twice the price of OEX (OEX split 2-for\nlin November 1997). Thus, if an example calls for the sale of 20 S&P 500 futures, \nthen an equivalent hedge with OEX options would require 100 short calls and 100 \nlong puts. \nOne could attempt to create less fully hedged positions by using the options \ninstead of the futures. For example, he might buy stocks and just write in-the-money \ncalls instead of selling futures. This would create acovered call write. He would still \nuse the same techniques to decide how much of each stock to buy, but he would have \ndownside risk if he decided not to buy the puts. Such aposition would be most attrac\ntive when the calls are very overpriced. \nSimilarly, one might ti:yto buy the stocks and buy slightly in-the-money puts \nwithout selling the calls. This position is asynthetic long call; it would have upside \nprofit potential and would lose if the index fell, but would have limited risk. Such aposition might be established when puts are cheap and calls are expensive. \nTRADING THE TRACKING ERROR \nAnother reason that one might sell futures against aportfolio of stocks is to actually \nattempt to capture the tracking error. If one were bullish on oil drilling stocks, for \nexample, and expected them to outperform the general market, he might buy sever-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:620", "doc_id": "94176eb28893769373ac36efd7f90129d7245bf12fff9d20740887c90f0e5e14", "chunk_index": 0}
{"text": "Cbapter 30: Stock Index Hedging Strategies 577 \nthat leads the investor to believe that the group no longer has the potential to out\nperform the market. \nIf the futures are underpriced when one begins to investigate this strategy, he \nshould not establish the position. What is gained in tracking error could be lost in \ntheoretical value of the futures. Since one is establishing both sides of the hedge \n(stocks and futures) at essentially the same time, he can afford to wait until the \nfutures are attractively priced. This is not to say that the futures must be overpriced \nwhen the position is established, although that fact would be an enhancement to the \nposition. \nIf one thinks that aparticular group will underperform the market, he merely \nneeds to decide how many shares of each stock to sell short and then can determine \nhow many futures to buy against the short sales in order to try to capture the track\ning error. If one decides to capture the negative tracking error in this manner, he \nmust be careful not to buy overpriced futures. Rather, he should wait for the futures \nto be near fair value in order to establish the position. \nCOLLATERAL REQUIREMENTS \nIn any of the portfolio hedging strategies that we have discussed in this section, there \nis no reduction in margin requirements for either the futures or the options. That is, \nthe stocks must be paid for in full or margined as if they had no protection against \nthem, and the hedging security - the futures or options - must be margined fully as \nwell. Long puts would have to be paid for in full, short futures would require their \nnormal margin and would be marked to the market via variation margin, and short \ncalls would have to be margined as naked and would also be marked to the market. \nAtrader who has not margined his stocks could use them as collateral for the naked \ncall requirements if he so desired. \nSUMMARY \nThere have been two major impacts of index futures and options. One is that they \nallow atrader to \"buy the market\" without having to select individual stocks. This is \nimportant because many traders have some idea of the direction in which the mar\nket is heading, but may not be able to pick individual stocks well. The other, perhaps \nmore major, impact is that large holders of stocks can now hedge their portfolios \nwithout nearly as much difficulty. The use of these futures and options against actu\nal stock indices - real or simulated has introduced astrategy into the marketplace \nthat did not previously exist. The versatility of these derivative securities is evidenced", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:623", "doc_id": "1305dfee818700b10155606d2f3220f324858d27a2074109d3805c2203dbd4ba", "chunk_index": 0}
{"text": "CHAPTER 31 \nIndex Spreading \nIn this chapter, we will look at strategies oriented toward spreading one index against \nanother. This may be done with either futures or options. In some cases, this is almost \nan arbitrage because the indices track each other quite well. In others, it is ahigh\nrisk venture because the indices bear little relationship to each other. In any case, if \nthe futures relationship between the two indices is out of line, one may have an extra \nadvantage. \nINTER-INDEX SPREADING \nThere are general relationships between many stock indices, both in the United \nStates and worldwide. The idea behind inter-index spreading is often to capitalize on \none'sview of the relationships between the two indices without having to actually \npredict the direction of the stock market. Note that this is often the philosophy \nbehind many option spreads as well. \nSometimes an analyst will say that he expects small-cap stocks to outperform \nlarge-cap stocks. This analyst should consider using an inter-index spread between \nthe S&P 500 Index and the Value Line Index (which contains many small stocks), or \nperhaps between the S&Pand a NASDAQ-based index. If he buys the index that is \ncomprised of smaller stocks and sells the S&P 500 Index, he will make money if his \nanalysis is right, regardless of whether the stock market goes up or down. All he wants \nis for the index he is long to outperform the index he is short. \nOccasionally, the futures or options on these indices are mispriced in compar\nison to the way the indices are priced. When this happens, one may be able to cap\nitalize on the pricing discrepancy. At times, the spread between the index products \n579", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:625", "doc_id": "1164c8b2372c62dc276dff2739ac921c42c122402506a99c536857a0692b465a", "chunk_index": 0}
{"text": "580 Part V: Index Options and Futures \non two indices can trade at significantly different price levels from the spread \nbetween the two indices themselves. When this happens, an inter-index spread \nbecomes feasible. \nThe margin requirements for these spreads are often reduced because margin \nrules recognize that futures on one index can be hedged by futures on another index. \nThe general rule of thumb as far as selecting afutures spread to establish \nbetween two indices is to compare the price difference in the respective futures to \nthe actual price difference in the indices themselves. If the difference in the futures \nis substantially different from the difference in the cash prices of the indices, then \none would sell the more expensive future and buy the cheaper one. Several specific \nspreads are discussed in this chapter. \nRegardless of whether one is entering into the spread because he is trying to \npredict the relationships between the cash indices, or because he knows the two \nrespective futures are out of line, he must decide in what ratio he wants to establish \nthe spread. There are two lines of thinking on this subject. The first is to merely buy \none future and sell one future (on two different indices, of course). Many chart books \nand spread history charts are graphed in this manner - they compare one index to \nanother index on aone-for-one basis. \nExample: Aspreader wants to buy the ZYX Index futures and sell ABX futures \nagainst them. They are both trading in units of $500 per point, but ZYX is currently \nat 175.00 while ABX is at 130.00. Thus, the current differential is 45.00 points. This \nspreader would want the spread to widen to something larger in order to make \nmoney. The following profit table shows how he could make a $2,500 profit if the \nspread widens to 50.00 points, no matter which way the market goes. \nMarket ZYX ZYX ABX ABX Total \nDirection Price Profit Price Profit Profit \nup 185.00 +$5,000 135.00 -$2,500 +$2,500 \nneutral 177.00 + 1,000 127.00 + 1,500 + 2,500 \ndown 160.00 - 7,500 110.00 + 10,000 + 2,500 \nNotice that in each case, the difference in the prices of the indices ZYX and ABX is \n50.00 points. The profit is the same regardless of whether the general stock market \nrose, was relatively unchanged, or fell. \nThe $2,500 profit is the five points of profit that the spreader makes by buying \nthe spread of 45.00 and selling it at 50.00 (5.00 points x $500 per point = $2,500). \nThe second approach to index spreading is to use aratio of the two indices. This \napproach is often taken when the two indices trade at substantially different prices.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:626", "doc_id": "f95f6f5d51caaec11c4ea19c6710715acce90fb4807910ad82e296879ceddbe9", "chunk_index": 0}
{"text": "Chpt,r 31: Index Spreading 581 \nJ!\"<>rexample, if one index sells for twice the price of the other, and if both indices \nhave similar volatilities, then aone-to-one spread gives too much weight to the \nhigher-priced index. Atwo-to-one ratio would be better, for that would give equal \nweighting to the spread between the indices. \nExample: UVX is an index of stock prices that is currently priced at 100.00. ZYX, \nanother index, is priced at 200.00. The two indices have some similarities and, there\nfore, aspreader might want to trade one against the other. They also display similar \nvolatilities. \nIf one were to buy one UVX future and sell one ZYX future, his spread would \nbe too heavily oriented to ZYX price movement. The following table displays that, \nshowing that if both indices have similar percentage movements, the profit of the \none-by-one spread is dominated by the profit or loss in the ZYX future. Assume both \nfi1tures are worth $500 per point. \nMarket ZYX ZYX uvx uvx Total \nDirection Price Profit Price Profit Profit \nup 20% 240 -$20,000 120 +$10,000 -$10,000 \nup 10% 220 - 10,000 110 + 5,000 - 5,000 \ndown 10% 180 + 10,000 90 - 5,000 + 5,000 \ndown 20% 160 + 20,000 80 - 10,000 + 10,000 \nThis is not much of ahedge. If one wanted aposition that reflected the movement \nof the ZYX index, he could merely trade the ZYX futures and not bother with aspread. \nIf, however, one had used the ratio of the indices to decide how many futures \nto buy and sell, he would have amore neutral position. In this example, he would buy \ntwo UVX futures and sell one ZYX future. \nProponents of using the ratio of indices are attempting strictly to capture any \nperformance difference between the two indices. They are not trying to predict the \noverall direction of the stock market. \nTechnically, the proper ratio should also include the volatility of the two indices, \nbecause that is also afactor in determining how fast they move in relationship to each \nother.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:627", "doc_id": "bf513d0d63d4b3a558bd58f43b3eaed7e845b6f30ccb94061590e9b71b1245aa", "chunk_index": 0}
{"text": "Chapter 31: Index Spreading 583 \nslightly more volatile than these two larger indices, and also has more technology and \nless basic industry such as steel and chemicals. The OEX movement definitely has \ngood correlation to the S&P 500. The S&P 500 Index (SPX) currently trades at about \ntwice the \"speed\" of the OEX Index. This has been true since OEX split 2-for-lin \nNovember 1997. Aone-point move in SPX is approximately equal to amove of 7.5 \npoints in the Dow-Jones Industrial Average, while aone-point move in OEX is \napproximately equal to 15 Dow points. \nIn general, it is easier to spread the indices by using futures rather than options, \nalthough only the S&P 500 Index has liquid futures markets. (There is amini-Value \nLine futures market, as well as Dow-Jones futures - both of which are fairly illiq\nuid - but no futures trade on OEX.) One reason for this is liquidity - the index \nfutures markets have large open interest. Another reason is tightness of markets. \nFutures markets are normally 5 or 10 cents wide, while option markets are 10 cents \nwide or more. Moreover, an option position that is afull synthetic requires both aput \nand acall. Thus, the spread in the option quotes comes into play twice. \nThe Japanese stock market can be spread against the U.S. markets by spread\ning a U.S. index against Nikkei futures or futures options, traded on the Chicago \nMere, or against JPN options, traded on the AMEX. \nINTER-INDEX SPREADS USING OPTIONS \nAs mentioned before, it may not be as efficient to try to use options in lieu of the \nactual futures spreads since the futures are more liquid. However, there are still \nmany applications of the inter-index strategy using options. \nOEX versus S&P 500. The OEX cash-based index options are the most liquid \noption contracts. Thus, any inter-index spread involving the OEX and other indices \nmust include the OEX options. \nThe S&P 100 was first introduced in 1982 by the CBOE. It was originally \nintended to be an S&P 500 look-alike whose characteristics would allow investors \nwho did not want to trade futures ( S&P 500 futures) the opportunity to be able to \ntrade abroad index by offering options on the OEX. Initially, the index was known as \nthe CBOE 100, but later the CBOE and Standard and Poor's Corp. reached an \nagreement whereby the index would be added to S&P'sarray of indices. It was then \nrenamed the S&P 100. \nInitially, the two indices traded at about the same price. The OEX was the more \nexpensive of the two for awhile in the early 1980s. As the bull market of the 1980s \nmatured, the S&P 500 ground its way higher, eventually reaching aprice nearly 30 \npoints higher than OEX. As one can see, there is ample room for movement in the \nspread between the cash indices.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:629", "doc_id": "e92ac24eb0b095c992c87cb5510c665c007a9a787f0b302c1b97a0667b156953", "chunk_index": 0}
{"text": "584 Part V: Index Options and Futures \nThe S&P 500 has more stocks, and while both indices are capitalization-weight\ned, 500 stocks include many smaller stocks than the 100-stock index. Also, the OEX \nis more heavily weighted by technology issues and is therefore slightly more volatile. \nFinally, the OEX does not contain several stocks that are heavily weighted in the S&P \n500 because those stocks do not have options listed on the CBOE: Procter and \nGamble, Philip Morris, and Royal Dutch, to name afew. There are two ways to \napproach this spread - either from the perspective of the derivative products differ\nential or by attempting to predict the cash spread. \nIn actual practice, most market-makers in the OEX use the S&P 500 futures to \nhedge with. Therefore, if the futures have alarger premium - are overpriced - then \nthe OEX calls will be expensive and the puts will be cheap. Thus, there is not as much \nof an opportunity to establish an inter-index spread in which the derivative products \n(futures and options in this case) spread differs significantly from the cash spread. \nThat is, the derivative products spread will generally follow the cash spread very \nclosely, because of the number of people trading the spread for hedging purposes. \nNevertheless, the application does arise, albeit infrequently, to spread the \npremium of the derivative products in two indices on strictly ahedged basis with\nout trying to predict the direction of movement of the cash indices. In order to \nestablish such aspread, one would take aposition in futures and an opposite posi\ntion in both the puts and calls on OEX. Due to the way that options must be exe\ncuted, one cannot expect the same speed of execution that he can with the futures, \nunless he is trading from the OEX pit itself. Therefore, there is more of an execu\ntion risk with this spread. Consequently, most of this type of inter-index spreading \nis done by the market-makers themselves. It is much more difficult for upstairs \ntraders and customers. \nUSING OPTIONS IN INDEX SPREADS \nWhenever both indices have options, as most do, the strategist may find that he can \nuse the options to his advantage. This does not mean merely that he can use asyn\nthetic option position as asubstitute for the futures position (long call, short put at \nthe same strike instead of long futures, for example). There are at least two other \nalternatives with options. First, he could use an in-the-money option as asubstitute \nfor the future. Second, he could use the options' delta to construct amore leveraged \nspread. These alternatives are best used when one is interested in trading the spread \nbetween the cash indices - they are not really amenable to the short-term strategy of \nspreading the premiums between the futures. \nUsing in-the-money options as asubstitute for futures gives one an additional \nadvantage: If the cash indices move far enough in either direction, the spreader could", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:630", "doc_id": "61b0facb293c5f44fae6325f9493fa7de5ad8b3c0a7399f1872a576bfb234c74", "chunk_index": 0}
{"text": "O,apter 31: Index Spreading 585 \nstill make money, even if he was wrong in his prediction of the relationship of the \ncash indices. \nExample: The following prices exist: \nZYX: 175.00 \nUVX: 150.00 \nZYX Dec 185 put: 10½ \nUVX Dec 140 call: 11 \nSuppose that one wants to buy the UVX index and sell the ZYX index. He \nexpects the spread between the two - currently at 25 points - to narrow. He could \nbuy the UVX futures and sell the ZYX futures. However, suppose that instead he buys \nthe ZYX put and buys the UVX call. \nThe time value of the Dec 185 put is 1/2 point and that of the Dec 140 call is 1 \npoint. This is arelatively small amount of time value premium. Therefore, the com\nbination would have results very nearly the same as the futures spread, as long as \nboth options remain in-the-money; the only difference would be that the futures \nspread would outperform by the amount of the time premium paid. \nEven though he pays some time value premium for this long option combina\ntion, the investor has the opportunity to make larger profits than he would with the \nfutures spread. In fact, he could even make aprofit if the cash spread widens, if the \nindices are volatile. To see this, suppose that after alarge upward move by the over\nall market, the following prices exist: \nZYX: 200.00 \nUVX: 170.00 \nZYX Dec 185 put: 0 ( virtually worthless) \nUVX Dec 140 call: 30 \nThe combination that was originally purchased for 21 ½ points is now worth 30, \nso the spread has made money. But observe what has happened to the cash spread: \nIt has widened to 30 points, from the original price of 25. This is amovement in the \nopposite direction from what was desired, yet the option position still made money. \nThe reason that the option combination in the example was able to make \nmoney, even though the cash spread moved unfavorably, is because both indices rose \nso much in price. The puts that were owned eventually became worthless, but the \nlong call continued to make money as the market rose. This is asituation that is very \nsimilar to owning along strangle (long put and call with different strikes), except that", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:631", "doc_id": "e526e2986570187514971bbe6986ed745f3826c89022a6f092b19d9ed1b42442", "chunk_index": 0}
{"text": "586 Part V: Index Options and Futures \nthe put and call are based on different underlying indices. This concept is discussed \nin more detail in Chapter 35 on futures spreads. \nThe second way to use options in index spreading is to use options that are less \ndeeply in-the-money. In such acase, one must use the deltas of the options in order \nto accurately compute the proper hedge. He would calculate the number of options \nto buy and sell by using the formula given previously for the ratio of the indices, \nwhich incorporates both price and volatility, and then multiplying by afactor to \ninclude delta. \nwhere \nvi is the volatility of index i \nPi is the price of index iui is the unit of trading \nand di is the delta of the selected option on index i \nExample: The following data is known: \nZYX: 175.00, volatility= 20% \nUVX: 150.00, volatility = 15% \nZYX Dec 175 put: 7, delta= - .45, worth $500/pt. \nUVX Dec 150 call: 5, delta= .52, worth $100/pt \nSuppose one decides that he wants to set up aposition that will profit if the \nspread between the two cash indices shrinks. Rather than use the deeply in-the\nmoney options, he now decides to use the at-the-money options. He would use the \noption ratio formula to determine how many puts and calls to buy. (Ignore the put'snegative delta for the purposes of this formula.) \n.20 175.00 500 .45 Option Ratio= -x ---x - x - = 6 731 .15 150.00 100 .52 . \nHe would buy nearly 7 UVX calls for every ZYX put purchased. \nIn the previous example, using in-the-money options, one had avery small \nexpense for time value premium and could profit if the indices were volatile, even if \nthe cash spread did not shrink. This position has agreat deal of time value premium \ne:x--pense, but could make profits on smaller moves by the indices. Of course, either \none could profit if the cash indices moved favorably.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:632", "doc_id": "1db7b253676b64a6e2b0e9aaf7615a754422cd32197c8610d20235e4ad2ef38f", "chunk_index": 0}
{"text": "Cl,apter 31: Index Spreading 587 \nVolatility Differential. Atheoretical \"edge\" that sometimes appears is that of \nvolatility differential. If two indices are supposed to have essentially the same volatil\nity, or at least arelationship in their volatilities, then one might be able to establish \nan option spread if that relationship gets out ofline. In such acase, the options might \nactually show up as fair-valued on both indices, so that the disparity is in the volatili\nty differential, and not in the pricing of the options. \nOEX and SPX options trade with essentially the same implied volatility. \nThus, if one index'soptions are trading with ahigher implied volatility than the \nother's, apotential spread might exist. Normally, one would want the differential \nin implied volatilities to be at least 2% apart before establishing the spread for \nvolatility reasons. \nIn any case, whether establishing the spread because one thinks the cash index \nrelationship is going to change, or because the options on one index are expensive \nwith respect to the options on the other index, or because of the disparity in volatili\nties, the spreader must use the deltas of the options and the price ratio and volatili\nties of the indices in setting up the spread. \nStriking Price Differential. The index relationships can also be used by the \noption trader in another way. When an option spread is being established with \noptions whose strikes are not near the current index prices - that is, they are rela\ntively deeply in- or out-of-the-money- one can use the ratio between the indices to \ndetermine which strikes are equivalent. \nExample: ZYX is trading at 250 and the ZYX July 270 call is overpriced. An option \nstrategist might want to sell that call and hedge it with acall on another index. \nSuppose he notices that calls on the UVX Index are trading at approximately fair \nvalue with the UVX Index at 175. What UVX strike should he buy to be equivalent \nto the ZYX 270 strike? \nOne can multiply the ZYX strike, 270, by the ratio of the indices to arrive at the \nUVX strike to use: \nUVX strike= 270 x (175/250) \n= 189.00 \nSo he would buy the UVX July 190 calls to hedge. The exact number of calls to \nbuy would be determined by the formula given previously for option ratio.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:633", "doc_id": "5c84030fc0b31cfca072cfa75d588e1f285a6d04fe830324e47114c2a1e8ef9c", "chunk_index": 0}
{"text": "588 \nSUMMARY \nPart V: Index Options and Futures \nThis concludes the discussion of index spreading. The above examples are intended \nto be an overview of the most usable strategies in the complex universe of index \nspreading. The multitude of strategies involving inter-index and intra-index spreads \ncannot all be fully described. In fact, one'simagination can be put to good use in \ndesigning and implementing new strategies as market conditions change and as the \nemotion in the marketplace drives the premium on the futures contracts. \nOften one can discern ausable strategy by observation. Watch how two popu\nlar indices trade with respect to each other and observe how the options on the two \nindices are related. If, at alater time, one notices that the relationship is changing, \nperhaps aspread between the indices is warranted. One could use the NASDAQ\nbased indices, such as the NASDAQ-100 (NDX) or smaller indices based on it (QQQ \nor MNX). Sector indices can be used as well. This brings into play afairly large num\nber of indices with listed options (few, if any, of which have futures), such as the \nSemiconductor Index (SOX), the Oil & Gas Index (XOI), the Gold and Silver Index \n(XAU), etc. The key point to remember is that the index option and futures world is \nmore diverse than that of stock options. Stock option strategies, once learned or \nobserved, apply equally well to all stocks. Such is not the case with index spreading \nstrategies. The diversification means that there are more profit opportunities that are \nrecognized by fewer people than is the case with stock options. The reader is thus \nchallenged to build upon the concepts described in this part of the book.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:634", "doc_id": "d83bcf7a721592a98ebefda4e02d713bae191a7e7b3ee02ec6e0d446d3e1f0e3", "chunk_index": 0}
{"text": "590 Part V: Index Options and Futures \nThe discussion in this chapter concentrates on the structured products that are \nlisted and traded on the major stock exchanges. Abroader array of products -\ntypically called exotic options - is traded over-the-counter. These can be very com\nplicated, especially with respect to currency and bond options. It is not our intent to \ndiscuss exotic options, although the approaches to valuing the structured products \nthat are presented in this chapter can easily be applied to the overall valuation of \nmany types of exotic products. Also, the comments at the end of the chapter regard\ning where to find information about these products may prove useful for those seek\ning further information about either listed structured products or exotic options. \nPart I: \"Riskless\" Ownership \nof a Stock or Index \nTHE \"STRUCTURE\" OF A STRUCTURED PRODUCT \nAt many of the major institutional banks and brokerages, people are employed who \ndesign structured products. They are often called financial engineers because they \ntake existing financial products and build something new with them. The result is \npackaged as afund of sorts (or aunit trust, perhaps), and shares are sold to the pub\nlic. Not only that, but the shares are then listed on the American or New York Stock \nExchanges and can be traded just like any other stock. These attributes make the \nstructured product avery desirable investment. An example will show how ageneric \nindex structured product might look. \nExample: Let'slook at the structured index product to see how it might be designed \nand then how it might be sold to the public. Suppose that the designers believe there \nis demand for an index product that has these characteristics: \n1. This \"index product\" will be issued at alow price - say, $10 per share. \n2. The product will have amaturity date - say, seven years hence. \n3. The owner of these shares can redeem them at their maturity date for the \ngreater of either a) $10 per share orb) the percentage appreciation of the \nS&P 500 index over that seven-year time period. That is, if the S&Pdoubles \nover the seven years, then the shares can be redeemed for double their issue \nprice, or $20. \nThus, this product has no price risk! The holder gets his $10 back in the worst \ncase (except for credit risk, which will be addressed in aminute). \nMoreover, these shares will trade in the open market during the seven years, so \nthat if the holder wants to exit at any time, he can do so. Perhaps the S&Phas rallied", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:636", "doc_id": "9fc9028cf83ad8482cd9cc482b0ffc4bce520dafecfb0383e2d04f729a7ca150", "chunk_index": 0}
{"text": "O,apter 32: Structured Products 591 \ndramatically, or perhaps he needs cash for something else - both might be reasons \nthat the holder of the shares would want to sell before maturity. \nSuch aproduct has appeal to many investors. In fact, if one thought that the \nstock market was a \"long-term\" buy, this would be amuch safer way to approach it \nthan buying aportfolio of stocks that might conceivably be much lower in value seven \nyears hence. The risk of the structured product is that the underwriter might not be \nable to pay the $10 obligation at maturity. That is, if the major institutional bank or \nbrokerage firm who underwrote these products were to go out of business over the \ncourse of the next seven years, one might not be able to redeem them. In essence, \nthen, structured products are really forms of debt (senior debt) of the brokerage firm \nthat underwrote them. Fortunately, most structured products are underwritten by \nthe largest and best-capitalized institutions, so the chances of afailure to pay at matu\nrity would have to be considered relatively tiny. \nHow does the bank create these items? It might seem that the bank buys stock \nand buys aput and sells units on the combined package. In reality, the product is not \nnormally structured that way. Actually, it is not adifficult concept to grasp. This \nexample shows how the structure looks from the viewpoint of the bank: \nExample: Suppose that the bank wants to raise apool of $1,000,000 from investors \nto create astructured product based on the appreciation of the S&P 500 index over \nthe next seven years. The bank will use apart of that pool of money to buy U.S. zero\ncoupon bonds and will use the rest to buy call options on the S&P 500 index. \nSuppose that the U.S. government zero-coupon bonds are trading at 60 cents \non the dollar. Such bonds would mature in seven years and pay the holder $1.00. \nThus, the bank could take $600,000 and buy these bonds, knowing that in seven \nyears, they would mature at avalue of $1,000,000. The other $400,000 is spent to buy \ncall options on the S&P 500 index. Thus, the investors would be made whole at the \nend of seven years even if the options that were bought expired worthless. This is why \nthe bank can \"guarantee\" that investors will get their initial money back. \nMeanwhile, if the stock market advances, the $400,000 worth of call options will \ngain value and that money will be returned to the holders of the structured product \nas well. \nIn reality, the investment bank uses its own money ($1,000,000) to buy the secu\nrities necessary to structure this product. Then they make the product into alegal \nentity (often aunit trust) and sell the shares (units) to the public, marking them up \nslightly as they would do with any new stock brought to market. \nAt the time of the initial offering, the calls are bought at-the-money, meaning \nthe striking price of the calls is equal to the closing price of the S&P 500 index on the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:637", "doc_id": "bc8bc21c09e82b19f32bb62bf69a5defbadb32ec81b440cfb94e0297687bf072", "chunk_index": 0}
{"text": "592 Part V: Index Options and Futures \nday the products were sold to the public. Thus, the structured product itself has a \n\"strike price\" equal to that of the calls. It is this price that is used at maturity to deter\nmine whether the S&Phas appreciated over the seven-year period - an event that \nwould result in the holders receiving back more than just their initial purchase price. \nAfter the initial offering, the shares are then listed on the AMEX or the NYSE \nand they will begin to rise and fall as the value of the S&P 500 index fluctuates. \nSo, the structured product is not an index fund protected by aput option, but \nrather it is acombination of zero-coupon government bonds and acall option on an \nindex. These two structures are equivalent, just as the combination of owning stock \nprotected by aput option is equivalent to being long acall option. \nStructured products of this type are not limited to indices. One could do the \nsame thing with an individual stock, or perhaps agroup of stocks, or even create asimulated bull spread. There are many possibilities, and the major ones will be dis\ncussed in the following sections. In theory, one could construct products like this for \nhimself, but the mechanics would be too difficult. For example, where is one going \nto buy aseven-year option in small quantity? Thus, it is often worthwhile to avail one\nself of the product that is packaged (structured) by the investment banker. \nIn actuality, many of the brokerage firms and investment banks that undetwrite \nthese products give them names - usually acronyms, such as MITTS, TARGETS, \nBRIDGES, LINKS, DINKS, ELKS, and so on. If one looks at the listing, he may see \nthat they are called notes rather than stocks or index funds. Nevertheless, when the \nterms are described, they will often match the examples given in this chapter. \nINCOME TAX CONSEQUENCES \nThere is one point that should be made now: There is \"phantom interest\" on astruc\ntured product. Phantom interest is what one owes the government when abond is \nbought at adiscount to maturity. The IRS technically calls the initial purchase price \nan Original Issue Discount (OID) and requires you to pay taxes annually on apro\nportionate amount of that OID. For example, if one buys azero-coupon U.S. gov\nernment bond at 60 cents on the dollar, and later lets it mature for $1.00, the IRS \ndoes not treat the 40-cent profit as capital gains. Rather, the 40 cents is interest \nincome. Moreover, says the IRS, you are collecting that income each year, since you \nbought the bonds at adiscount. (In reality, of course, you aren'tcollecting athing; \nyour investment is simply worth alittle more each year because the discount decreas\nes as the bonds approach maturity.) However, you must pay income tax on the \"phan-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:638", "doc_id": "110d10f6b812aaad411df97cdda03045d4d4c11993bbe412000b89a34905886e", "chunk_index": 0}
{"text": "594 Part V: Index Options and Futures \nCash Surrender Value = $10 x Final Value/ 1,245.27 \nThis shortened version of the formula only works, though, when the participa\ntion rate is 100% of the increase in the Final Index Value above the striking price. \nOtherwise, the longer formula should be used. \nNot all structured products of this type offer the holder 100% of the appreci\nation of the index over the initial striking price. In some cases, the percentage is \nsmaller ( although in the early days of issuance, some products offered apercentage \nappreciation that was actually greater than 100%). After 1996, options in general \nbecame more expensive as the volatility of the stock market increased tremendous\nly. Thus, structured products issued after 1997 or 1998 tend to include an \"annual \nadjustment factor.\" Adjustment factors are discussed later in the chapter. \nTherefore, amore general formula for Cash Surrender Value - one that applies \nwhen the participation rate is afixed percentage of the striking price - is: \nCash Surrender Value = \nGuarantee + Guarantee x Participation Rate x (Final Index Value/ Striking Price - I) \nTHE COST OF THE IMBEDDED CALL OPTION \nFew structured products pay dividends. 1 Thus, the \"cost\" of owning one of these \nproducts is the interest lost by not having your money in the bank ( or money market \nfund), but rather having it tied up in holding the structured product. \nContinuing with the preceding example, suppose that you had put the $10 in \nthe bank instead of buying astructured product with it. Let'sfurther assume that the \nmoney in the bank earns 5% interest, compounded continuously. At the end of seven \nyears, compounded continuously, the $10 would be worth: \nMoney in the bank = Guarantee Price xert \n= $10 xe 0-05 x 7 = 14.191, in this case \nThis calculation usually raises some eyebrows. Even compounded annually, the \namount is 14.07. You would make roughly 40% (without considering taxes) just by \n1Some do pay dividends, though. Astructured product existed on acontrived index, called the Dow-Jones \nTop 10 Yield index (symbol: $XMT). This is asort of \"dogs of the Dow\" index. Since part of the reason for owning a \n\"dogs of the Dow\" product is that dividends are part of the performance, the creators of the structured product \n(Merrill Lynch) stated that the minimum price one would receive at maturity would be 12.40, not the 10 that was \nthe initial offering price. Thus, this particular structured product had a \"dividend\" built into it in the form of an ele\nvated minimum price at maturity.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:640", "doc_id": "8ac46a96faf34f45efa97b49ddf895a598d79356dccb83975d550d1b29086c82", "chunk_index": 0}
{"text": "Chapter 32: Structured Products 595 \nhaving your money in the bank. Forgetting structured products for amoment, this \nmeans that stocks in general would have to increase in value by over 40% during the \nseven-year period just for your performance to beat that of abank account. \nIn this sense, the cost of the imbedded call option in the structured product is \nthis lost interest - 4.19 or so. That seems like afairly expensive option, but if you con\nsider that it'saseven-year option, it doesn'tseem quite so expensive. In fact, one \ncould calculate the implied volatility of such acall and compare it to the current \noptions on the index in question. \nIn this case, with the stock at 10, the strike at 10, no dividends, a 5% interest \nrate, and seven years until expiration, the implied volatility of acall that costs $4.19 \nis 28.1 %. Call options on the S&P 500 index are rarely that expensive. So you can see \nthat you are paying \"something\" for this call option, even if it is in the form of lost \ninterest rather than an up-front cost. \nAs an aside, it is also unlikely that the underwriter of the structured product \nactually paid that high an implied volatility for the call that was purchased; but he is \nasking you to pay that amount. This is where his underwriting profit comes from. \nThe above example assumed that the holder of the structured product is par\nticipating in 100% of the upside gain of the underlying index over its striking price. \nIf that is not the case, then an adjustment has to be made when computing the price \nof the imbedded option. In fact, one must compute what value of the index, at matu\nrity, would result in the cash value being equal to the \"money in the bank\" calcula\ntion above. Then calculate the imbedded call price, using that value of the index. In \nthat way, the true value of the imbedded call can be found. \nYou might ask, \"Why not just divide the 'money in the bank' formula by the par\nticipation rate?\" That would be okay if the participation were always stated as aper\ncentage of the striking price, but sometimes it is not, as we will see when we look at \nthe more complicated examples. Further examples of structured products in this \nchapter demonstrate this method of computing the cost of the imbedded call. \nPRICE BEHAVIOR PRIOR TO MATURITY \nThe structured product cannot normally be \"exercised\" by the holder until it \nmatures. That is, the cash surrender value is only applicable at maturity. At any other \ntime during the life of the product, one can compute the cash surrender value, but \nhe cannot actually attain it. What you can attain, prior to maturity, is the market price, \nsince structured products trade freely on the exchange where they are listed. In actu\nal fact, the products generally trade at aslight discount to their theoretical cash sur\nrender value. This is akin to aclosed-end mutual fund selling at adiscount to net", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:641", "doc_id": "d8d237c98bfcb526c66eaf63c5e60ef271e616e039193793589940c4b776016f", "chunk_index": 0}
{"text": "596 Part V: Index Options and Futures \nasset value. Eventually, upon maturity, the actual price will be the cash surrender \nvalue price; so if you bought the product at adiscount, you would benefit, providing \nyou held all the way to maturity. \nExample: Assume that two years ago, astructured product was issued with an initial \noffering price of $10 and astrike price of 1,245.27, based upon the S&P 500 index. \nSince issuance, the S&P 500 index has risen to 1,522.00. That is an increase of \n22.22% for the S&P 500, so the structured product has atheoretical cash surrender \nvalue of 12.22. Isay \"theoretical\" because that value cannot actually be realized, since \nthe structured product is not exercisable at the current time - five years prior to \nmaturity. \nIn the real marketplace, this particular structured product might be trading at \naprice of 11. 75 or so. That is, it is trading at adiscount to its theoretical cash sur\nrender value. This is afairly common occurrence, both for structured products and \nfor closed-end mutual funds. If the discount were large enough, it should serve to \nattract buyers, for if they were to hold to maturity, they would make an extra 4 7 cents \n(the amount of this discount) from their purchase. That's 4% (0.47 divided by 11.75 \n= 4%) over five years, which is nothing great, but it'ssomething. \nWhy does the product trade at adiscount? Because of supply and demand. It is \nfree to trade at any price - premium or discount - because there is nothing to keep \nit fixed at the theoretical cash surrender value. If there is excess demand or supply in \nthe open market, then the price of the structured product will fluctuate to reflect that \nexcess. Eventually, of course, the discount will disappear, but five years prior to \nmaturity, one will often find that the product differs from its theoretical value by \nsomewhat significant amounts. If the discount is large enough, it will attract buyers; \nalternatively, if there should be alarge premium, that should attract sellers. \nSIS \nOne of the first structured products of this type that came to my attention was one \nthat traded on the AMEX, entitled \"Stock Index return Security\" or SIS. It also trad\ned under the symbol SIS. The product was issued in 1993 and matured in 2000, so \nwe have acomplete history of its movements. The terms were as follows: The under\nlying index was the S&P Midcap 400 index (symbol: $MID). Issued in June 1993, the \noriginal issue price was $10, and $MID was trading at 166.10 on the day of issuance, \nso that was the striking price. Moreover, buyers were entitled to 115% of the appre\nciation of $MID above the strike price. Thus, the cash value formula was:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:642", "doc_id": "914241ed599c1d63f608fb3b473d1ac665c0450a5ff9298d56106902606fc4e7", "chunk_index": 0}
{"text": "Gopter 32: Structured Products 597 \nCash value of SIS $10 + $10 x 1.15 x ($MID - 166.10) / 166.10 \nwhere \nGuarantee price = $10 \nUnderlying index: S&P Midcap 400 ($MID) \nStriking price: 166.10 \nParticipation rate: 115% of the increase of $MID above 166.10 \nSIS matured seven years later, on June 2, 2000. At the time of issuance, seven-year \ninterest rates were about 5.5%, so the \"money in the bank\" formula shows that one \ncould have made about 4.7 points on a $10 investment, just by utilizing risk-free gov\nernment securities: \nMoney in the bank= 10 xe0-055 x 7 = 14.70 \nWe can'tsimply say that the cost of the imbedded call was 4. 7 points, though, because \nthe participation rate is not 100% - it'sgreater. So we need to find out the Final Value \nof $MID that results in the cash value being equal to the \"money in the bank\" result. \nUsing the cash value formula and inserting all the terms except the final value of \n$MID, we have the following equation. Note: $MIDMIB stands for the value of $MID \nthat results in the \"money in the bank\" cash value, as computed above. \n14.70 = 10 + 10 X 1.15 X ($MIDMIB 166.10) I 166.10 \nSolving for $MIDMIB' we get avalue of 233.98. Now, convert this to apercent \ngain of the striking price: \nImbedded call price = 233.98 I 166.10 - 1 = 0.4087 \nHence, the imbedded call costs 40.87% of the guarantee price. In this example, \nwhere the guarantee price was $10, that means the imbedded call cost $4.087. \nThus, amore generalized formula for the value of the imbedded call can be \nconstrued from this example. This formula only works, though, where the participa\ntion rate is afixed percentage of the strike price. \nImbedded call value= Guarantee price x (Final Index ValueMIB / Striking Price - 1) \nFinal Index ValueMIB is the final index price that results in the cash value \nbeing equal to the \"money in the bank\" calculation, where \nMoney in the bank = Guarantee Price xert \nr = risk-free interest rate \nt = time to maturity \nThus, the calculated value of the imbedded call was approximately 4.087 points, \nwhich is an implied volatility of just over 26%. At the time, listed short-term options", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:643", "doc_id": "fa07c4fecb34c551e9bc03671d82a8d055461be27f1914c08e5867453225973a", "chunk_index": 0}
{"text": "600 Part V: Index Options and Futures \nSolving the following equation for $MID would give the desired answer: \nCash Value = 13 = 10 + 11.5 x ($MID/166.l - 1) \n3 = 11.5 x $MID/ 166.1 - 11.5 \n14.5 x 166.1 / 11.5 = $MID \n209.43 = $MID \nSo, if $MID were at 209.43, the cash value would be 13 - the price the investor \nis currently paying for SIS. This is protection of 12.2% down from the current price \nof 238.54. That is, $MID could decline 12.2% at maturity, from the current price of \n238.54 to aprice of 209.43, and the investor who bought SIS would break even \nbecause it would still have acash value of 13. \nOf course, this discount could have been computed using the SIS prices of 13 \nand 15.02 as well, but many investors prefer to view it in terms of the underlying \nindex - especially if the underlying is apopular and often-cited index such as the S&P \n500 or Dow-Jones Industrials. \nFrom Figure 32-1, it is evident that the discount persisted throughout the \nentire life of the product, shrinking more or less linearly until expiration. \nSIS TRADING AT A DISCOUNT TO THE GUARANTEE PRICE \nIn the previous example, the investor could have bought SIS at adiscount to its cash \nvalue computation, but if the stock market had declined considerably, he would still \nhave had exposure from his SIS purchase price of 13 down to the guarantee price of \n10. The discount would have mitigated his percentage loss when compared to the \n$MID index itself, but it would be aloss nevertheless. \nHowever, there are sometimes occasions when the structured product is trad\ning at adiscount not only to cash value, but also to the guarantee price. This situation \noccurred frequently in the early trading life of SIS. From Figure 32-1, you can see \nthat in 1995 the cash value was near 11, but SIS was trading at adiscount of more \nthan 2 points. In other words, SIS was trading below its guarantee price, while the \ncash value was actually above the guarantee price. It is a \"double bonus\" for an \ninvestor when such asituation occurs. \nExample: In February 1995, the following prices existed: \n$MID: 177.59 \nSIS: 8.75 \nFor amoment, set aside considerations of the cash value. If one were to buy SIS \nat 8. 75 and hold it for the 5.5 years remaining until maturity, he would make 1.25 \npoints on his 8.75 investment- areturn of 14.3% for the 5.5-year holding period. As \nacompounded rate of interest, this is an annual compound return of 2.43%.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:646", "doc_id": "2295c1579c8da54d47b1ef7d0bb059138f1c5eaca5cda41954cccf366aa2c374", "chunk_index": 0}
{"text": "Cl,apter 32: Structured Produds 601 \nNow, arate of return of 2.43% is rather paltry considering that the risk-free \nT•bill rate was more than twice that amount. However, in this case, you own acall \noption on the stock market and get to earn 2.43% per year while you own the call. In \nother words, \"they\" are paying you to own acall option! That'sasituation that \ndoesn'tarise too often in the world of listed options. \nIf we introduce cash value into this computation, the discrepancy is even larg\ner. Using the $MID price of 177.59, the cash value can be computed as: \nCash Value = 10 + 11.5 x (177.59/166.10 - 1) = 10.80 \nThus, with SIS trading at 8. 75 at that time, it was actually trading at awhopping \n19% discount to its cash value of 10.80. Even if the stock market declined, the guar\nantee price of 10 was still there to provide aminimal return. \nIn actual practice, astructured product will not normally trade at adiscount to its \nguarantee price while the cash value is higher than the guarantee price. There'sonly \nanarrow window in which that occurs. \nThere have been times when the stock market has declined rather substantial\nly while these products existed. We can observe the discounts at which they then \ntraded to see just how they might actually behave on the downside if the stock mar\nket declined after the initial offering date. Consider this rather typical example: \nExample: In 1997, Merrill Lynch offered astructured product whose underlying \nindex was Japan's Nikkei index. At the time, the Nikkei was trading at 20,351, so that \nwas the striking price. The participation rate was 140% of the increase of the Nikkei \nabove 20,351 - avery favorable participation rate. This structured product, trading \nunder the symbol JEM, was designed to mature in five years, on June 14, 2002. \nAs it turned out, that was about the peak of the Japanese market. By October of \n1998, when markets worldwide were having difficulty dealing with the Russian debt \ncrisis and the fallout from amajor hedge fund in the U.S. going broke, the Nikkei had \nplummeted to 13,300. Thus, the Nikkei would have had to increase in price by just \nover 50% merely to get back to the striking price. Hence, it would not appear that \nJEM was ever going to be worth much more than its guarantee price of 10. \nSince we have actual price histories of JEM, we can review how the market\nplace viewed the situation. In October 1998, JEM was actually trading at 8.75 - only \n1.25 points below its guarantee price. That discount equates to an annual com\npounded rate of 3.64%. In other words, if one were to buy JEM at 8.75 and it \nmatured at 10 about 40 months later, his return would have been 3.64% compound\ned annually. That by itself is arather paltry rate of return, but one must keep in mind \nthat he also would own acall option on the Nikkei index, and that option has a 140% \nparticipation rate on the upside.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:647", "doc_id": "e79e52fcb5d0c1a485b02309bf3866b6f3c6511bdf559a243821af18c0c4fbc4", "chunk_index": 0}
{"text": "602 Part V: Index Options and Futures \nCOMPUTING THE VALUE OF THE IMBEDDED CALL WHEN \nTHE UNDERLYING IS TRADING AT A DISCOUNT \nCan we compute the value of the imbedded call when the structured product itself \nis trading at adiscount to its guarantee price? Yes, the formulae presented earlier can \nalways be used to compute the value of the imbedded call. \nExample: Again using the example of JEM, the structured product on the Nikkei \nindex, recall that it was trading at 8. 75 with aguaranteed price of 10, with maturity \n40 months hence. Assume that the risk-free interest rate at the time was 5.5%. \nAssuming continuous compounding, $8.75 invested today would be worth $10.51 in \n40 months. \nMoney in the bank = 8. 75 xert \nwhere r = 0.05 and t = 3.33 years (40 months) \nMoney in the bank= 8.75 xe0-055 x 3-333 = 10.51 \nSince the structured product will be worth 10 at maturity, the value of the call \nis 0.51. \nThere is another, nearly equivalent way to determine the value of the call. It \ninvolves determining where the structured product would be trading if it were com\npletely azero-coupon debt of the underwriting brokerage. The difference between \nthat value and the actual trading price of the structured product is the value of the \nimbedded call. \nThe credit rating of the underwriter of the structured product is an important \nfactor in how large adiscount occurs. Recall that the guarantee price is only as good \nas the creditworthiness of the underwriter. The underwriter is the one who will pay \nthe cash settlement value at maturity - not the exchange where the product is listed \nnor any sort of clearinghouse or corporation. \nTHE ADJUSTMENT FACTOR \nIn recent years, some of the structured products have been issued with an adjustment \nfactor. The adjustment factor is generally anegative thing for investors, although the \nunderwriters try to couch it in language that makes it difficult to discern what is going \non. Simply put, the adjustment factor is amultiplier (less than 100%) applied to the \nunderlying index value before calculating the Final Cash Value. Adjustment factors \nseemed to come into being at about the time that index option implied volatility \nbegan to trade at much higher levels than it ever had (1997 onward).", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:648", "doc_id": "534ebfd347c412653cd28042c3538bcf4416d220ffebf127122e603d63210747", "chunk_index": 0}
{"text": "604 Part V: Index Options and Futures \nOr, thinking in the alternative, if the index triples, then the structured produc1 \n(before adjustment factor) would be triple its initial price, or 30. Then 30 x 91.25o/c \n== 27.375. \nThis example begins to demonstrate just how onerous the adjustment factor is. \nNotice that if the underlying doubles, you don'tmake \"double\" less 8.75% (the \nadjustment factor). No, you make \"double\" times the adjustment factor - 17.5% -\nless than double. In the case of tripling, you make 3 x 8.75%, or 26.25%, less than \ntriple (i.e., the structured product is worth 27.375, not 30, so the percentage increase \nwas 173. 75%, not 200% - adifference of 26.25%, stated in terms of the initial invest\nment). How can that be? It is aresult of the adjustment factor being applied to the \n$SPX price before your profit (cash settlement value) is computed. \nTHE BREAK-EVEN FINAL INDEX VALUE \nBefore discussing the adjustment factor in more detail, one more point should be \nmade: The owner of the structured product doesn'tget back anything more than the \nbase value unless the underlying has increased by at least afixed amount at maturi\nty. In others words, the underlying must appreciate to aprice large enough that the \nfinal price times the adjustment factor is greater than the striking price of the struc\ntured product. We'll call this price the break-even final index value. \nAn example will demonstrate this concept. \nExample: As in the preceding example, suppose tl1at the striking price of the struc\ntured product is 1,100 and the adjustment factor is 8.75%. At what price would the \nfinal cash settlement value be something greater than the base value of 10? That \nprice can be solved for with the following simple equation: \nBreak-even final index value== Striking price/ (1- Adjustment factor) \n= 1,100 / (0.9125) == 1,205.48. \nGenerally speaking, the underlying index must increase in value by aspecific \namount just to break even. In this case that amount is: \n1 / (1 -Adjustment factor) = 1 / 0.9175 = 1.0959 \nIn other words, the underlying index must increase in value by more than 9.5% \nby maturity just to overcome the weight of the adjustment factor. If the index increas\nes by alesser amount, then the structured product holder will merely receive back \nhis base value ( 10) at maturity. \nThe previous examples all show that the adjustment factor is not atrivial thing. \nAt first glance, one might not realize just how burdensome it is. After all, one might", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:650", "doc_id": "d660259b8f1e79b4c50fbe721714c291222b6f00d44768da3070196fd9fc4da2", "chunk_index": 0}
{"text": "605 \nhimself, what does 1.25% per year really matter? However, you can see that it \nmatter. In fact, our above examples did not even factor in the other cost that any \nInvestor has when his money is at risk - the cost of carry, or what he could have made \nhad he just put the money in the bank. \nMEASURING THE COST OF THE ADJUSTMENT FACTOR \nThe magnitude of the adjustment increases as the price of the underlying increases. \nlt is an unusual concept. We know that the structured product initially had an \nimbedded call option. Earlier in this chapter, we endeavored to price that option. \nHowever, with the introduction of the concept of an adjustment factor, it turns out \nthat the call option'scost is not afixed amount. It varies, depending on the final value \nof the underlying index. In fact, the cost of the option is apercentage of the final \nvalue of the index. Thus, we can'treally price it at the beginning, because we don'tknow what the final value of the index will be. In fact, we have to cease thinking of \nthis option'scost as afixed number. Rather, it is ageometric cost, if you will, for it \nincreases as the underlying does. \nPerhaps another way to think of this is to visualize what the cost will be in per\ncentage terms. Figure 32-2 compares how much of the percent increase in the index \nis captured by the structured product in the preceding example. The x-axis on the \ngraph is the percent increase by the index. The y-axis is the percent realized by the \nstructured product. The terms are the same as used in the previous examples: The \nstrike price is 1,100, the total adjustment factor is 8. 75%, and the guarantee price of \nthe structured product is 10. \nThe dashed line illustrates the first example that was shown, when adoubling \nof the index value (an increase of 100%) to 2,200 resulted in again of 83.5% in the \nprice of the structured. Thus, the point (100%, 83.5%) is on the line on the chart \nwhere the dashed lines meet. \nFigure 32-2 points out just how little of the percent increase one captures if the \nunderlying index increases only modestly during the life of the structured product. \nWe already know that the index has to increase by 9.59% just to get to the break-even \nfinal price. That point is where the curved line meets the x-axis in Figure 32-2. \nThe curved line in Figure 32-2 increases rapidly above the break-even price, \nand then begins to flatten out as the index appreciation reaches 100% or so. This \ndepicts the fact that, for small percentage increases in the index, the 8.75% adjust\nment factor - which is aflat-out downward adjustment in the index price - robs one \nof most of the percentage gain. It is only when the index has doubled in price or so \nthat the curve stops rising so quickly. In other words, the index has increased enough \nin value that the structured product, while not capturing all of the percentage gain \nby any means, is now capturing agreat deal of it.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:651", "doc_id": "1ea4cd06ccdffa24c9f00b0313845c65273f8af8349eac3cd4a958e1a0de419c", "chunk_index": 0}
{"text": "604 Part V: Index Options and Futures \nOr, thinking in the alternative, if the index triples, then the structured product \n(before adjustment factor) would be triple its initial price, or 30. Then 30 x 91.25% \n= 27.375. \nThis example begins to demonstrate just how onerous the adjustment factor is. \nNotice that if the underlying doubles, you don'tmake \"double\" less 8.75% (the \nadjustment factor). No, you make \"double\" times the adjustment factor - 17.5% -\nless than double. In the case of tripling, you make 3 x 8.75%, or 26.25%, less than \ntriple (i.e., the structured product is worth 27.375, not 30, so the percentage increase \nwas 173. 75%, not 200% - adifference of 26.25%, stated in terms of the initial invest\nment). How can that be? It is aresult of the adjustment factor being applied to the \n$SPX price before your profit (cash settlement value) is computed. \nTHE BREAK-EVEN FINAL INDEX VALUE \nBefore discussing the adjustment factor in more detail, one more point should be \nmade: The owner of the structured product doesn'tget back anything more than the \nbase value unless the underlying has increased by at least afixed amount at maturi\nty. In others words, the underlying must appreciate to aprice large enough that the \nfinal price times the adjustment factor is greater than the striking price of the struc\ntured product. We'll call this price the break-even final index value. \nAn example will demonstrate this concept. \nExample: As in the preceding example, suppose that the striking price of the struc\ntured product is 1,100 and the adjustment factor is 8.75%. At what price would the \nfinal cash settlement value be something greater than the base value of 10? That \nprice can be solved for with the following simple equation: \nBreak-even final index value = Striking price/ (1- Adjustment factor) \n= 1,100 / (0.9125) = 1,205.48. \nGenerally speaking, the underlying index must increase in value by aspecific \namount just to break even. In this case that amount is: \n1 / (1 - Adjustment factor) = 1 / 0.9175 = 1.0959 \nIn other words, the underlying index must increase in value by more than 9.5% \nby maturity just to overcome the weight of the adjustment factor. If the index increas\nes by alesser amount, then the structured product holder will merely receive back \nhis base value (10) at maturity. \nThe previous examples all show that the adjustment factor is not atrivial thing. \nAt first glance, one might not realize just how burdensome it is. After all, one might", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:652", "doc_id": "ecec40f9595a679a11bacb349ec1c04839c41c68e35655fbee87bd1252803958", "chunk_index": 0}
{"text": "605 \nhimself, what does 1.25% per year really matter? However, you can see that it \nmatter. In fact, our above examples did not even factor in the other cost that any \nhtvt?stor has when his money is at risk - the cost of carry, or what he could have made \nhe just put the money in the bank. \nMIASURING THE COST OF THE ADJUSTMENT FACTOR \nThe magnitude of the adjustment increases as the price of the underlying increases. \nIt is an unusual concept. We know that the structured product initially had an \nhnbedded call option. Earlier in this chapter, we endeavored to price that option. \nHowever, with the introduction of the concept of an adjustment factor, it turns out \nthat the call option'scost is not afixed amount. It varies, depending on the final value \nof the underlying index. In fact, the cost of the option is apercentage of the final \nvalue of the index. Thus, we can'treally price it at the beginning, because we don'tknow what the final value of the index will be. In fact, we have to cease thinking of \nthis option'scost as afixed number. Rather, it is ageometric cost, if you will, for it \nincreases as the underlying does. \nPerhaps another way to think of this is t.ovisualize what the cost will be in per\ncentage terms. Figure 32-2 compares how much of the percent increase in the index \nis captured by the structured product in the preceding example. The x-axis on the \ngraph is the percent increase by the index. The y-axis is the percent realized by the \nstructured product. The terms are the same as used in the previous examples: The \nstrike price is 1,100, the total adjustment factor is 8.75%, and the guarantee price of \nthe structured product is 10. \nThe dashed line illustrates the first example that was shown, when adoubling \nof the index value (an increase of 100%) to 2,200 resulted in again of 83.5% in the \nprice of the structured. Thus, the point (100%, 83.5%) is on the line on the chart \nwhere the dashed lines meet. \nFigure 32-2 points out just how little of the percent increase one captures if the \nunderlying index increases only modestly during the life of the structured product. \nWe already know that the index has to increase by 9.59% just to get to the break-even \nfinal price. That point is where the curved line meets the x-axis in Figure 32-2. \nThe curved line in Figure 32-2 increases rapidly above the break-even price, \nand then begins to flatten out as the index appreciation reaches 100% or so. This \ndepicts the fact that, for small percentage increases in the index, the 8.75% adjust\nment factor -which is aflat-out downward adjustment in the index price - robs one \nof most of the percentage gain. It is only when the index has doubled in price or so \nthat the curve stops rising so quickly. In other words, the index has increased enough \nin value that the structured product, while not capturing all of the percentage gain \nby any means, is now capturing agreat deal of it.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:653", "doc_id": "091567ac2a07a3f2ca213763db87ddf426dcde38647de16c8c3701cdd46556f0", "chunk_index": 0}
{"text": "608 Part V: Index Options and Future; \nFIGURE 32-4. \nComparison of adiusted and unadiusted cash values at maturity. \n50 \n40 \n20 \n0 1100 2200 3300 \nCost of the \nCall Option \n4400 5500 \nIndex Final Price (Unadjusted) \n6600 \nest. In this section, acouple of different constructs, ones that have been brought to \nthe public marketplace in the past, are discussed. \nTHE BUI.I. SPREAD \nSeveral structured products have represented abull spread, in effect. In some cases, \nthe structured product terms are stated just like those of acall spread in that the final \ncash value is defined with both aminimum and amaximum value. For example, it \nmight be described something like this: \n\"The final cash value of the (structured) product is equal to aminimum of abase \nprice of 10, plus any appreciation of the underlying index above the striking price, \nsubject to amaximum price of 20\" (where the striking price is stated elsewhere). \nIt'sfairly simple to see how this resembles abull spread: The worst you can do \nis to get back your $10, which is presumably the initial offering price, just as in any \nof the structured products described previously in this chapter. Then, above that, \nyou'dget some appreciation of the index price above the stated striking price - again", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:656", "doc_id": "08e24937417077389f94352a8112a02c989ba3e9933c1e23b55109e80065376a", "chunk_index": 0}
{"text": "609 \nthe products discussed earlier. However, in this case, there is amaximum that the \nc,1.,;hvalue can be worth: 20. In other words, there is aceiling on the value of this \n1tructured product at maturity. It is exactly like abull spread with two striking prices, \none at 10 and one at 20. In reality, this structured product would have to be evaluat-\nusing both striking prices. We'll get to that in aminute. \nThere is another way that the underwriter sometimes states the terms of the \nstructured product, but it is also abull spread in effect. The prospectus might say \nsomething to the effect that the structured product is defined pretty much in the \nstandard way, but that it is callable at acertain (higher) price on acertain date. In \nuther words, someone else can call your structured product away on that date. In \neffect, you have sold acall with ahigher striking price against your structured prod\nUt1:. Thus, you own an imbedded call via the usual purchase of the structured prod\nuct and you have written acall with ahigher strike. That, again, is the definition of abull spread. \nWhen analyzing aproduct such as this, one must be mindful that there are two \ncalls to price, not only in determining the final value, but more importantly in deter\nmining where you might expect the structured product to trade during its life, prior \nto maturity. An option strategist knows that abull spread doesn'twiden out to its max\nimum profit potential when there is still alot of time remaining before expiration, \nunless the underlying rises by asubstantial amount in excess of the higher striking \nprice of the spread. Thus, one would expect this type of structured product to behave \nin asimilar manner. \nThe example that will be used in the rest of this section is based on actual \"bull \nspread\" structured products of this type that trade in the open marketplace. \nExample: Suppose that astructured product is linked to the Internet index. The \nstrike price, based on index values, is 150. If the Internet index is below 150 at matu\nrity, seven years hence, then the structured product will be worth abase value of 10. \nThere is no adjustment factor, nor is there aparticipation rate factor. So far, this is \njust the same sort of definition that we've seen in the simpler examples presented \npreviously. The final cash value formula would be simply stated as: \nFinal cash value = 10 x (Final Internet index value/150) \nHowever, the prospectus also states that this structured product is callable at aprice of 25 during the last month of its life. \nThis call feature means that there is, in effect, acap on the price of the under\nlying. In actual practice, the call feature may be for alonger or shorter period of time, \nand may be callable well in advance of maturity. Those factors merely determine the \nexpiration date of the imbedded call that has been \"written.\"", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:657", "doc_id": "722960b58a5ed0bc444346ad7270e32853e98e4f97b142353b89ccf0af7fc4df", "chunk_index": 0}
{"text": "610 Part V: Index Options and Futures \nThe first thing one should do is to convert the striking price into an equivalent \nprice for the underlying index, so that he can see where the higher striking price is \nin relation to the index price. In this example, the higher striking price when stated \nin terms of the structured product is 2.5 times the base price. So the higher striking \nprice, in index terms, would be 2.5 times the striking price, or 375: \nIndex call price = ( Call price / Base price) x Striking price \n= (25 I 10) X 150 \n= 375 \nHence, if the Internet index rose above 375, the call feature would be \"in effect\" \n(i.e., the written call would be in-the-money). The value at which we can expect the \nstructured product to trade, at maturity, would be equal to the base price plus the \nvalue of the bull spread with strikes of 10 and 25. \nValuing the Bull Spread. Just as the single-strike structured products have \nan imbedded call option in them, whose cost can be inferred, so do double-strike \nstructured products. The same line of analysis leads to the following: \n\"Theoretical\" cash value = 10 + Value of bull spread - Cost of carry \nCost of carry refers to the cost of carry of the base price (10 in this example). \nBy using an option model and employing knowledge of bull spreads, one can \ncalculate atheoretical value for the structured product at any time during its life. \nMoreover, one can decide whether it is cheap or expensive - factors that would lead \nto adecision as to whether or not to buy. \nExample: Suppose that the Internet index is trading at aprice of 210. What price can \nwe expect the structured product to be trading at? The answer depends on how \nmuch time has passed. Let'sassume that two years have passed since the inception \nof the structured product (so there are still five years of life remaining in the option). \nWith the Internet index at 210, it is 40% above the structured product'slower \nstriking price of 150. Thus, the equivalent price for the structured product would be \n14. Another way to compute this would be to use the cash value formula: \nCash value= 10 x (210 / 150) = 14 \nNow, we could use the Black-Scholes (or some other) model to evaluate the two \ncalls - one with astriking price of 10 and the other with astriking price of 25. Using \navolatility estimate of 50%, and assuming the underlying is at 14, the two calls are \nroughly valued as follows: \nUnderlying price: 14", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:658", "doc_id": "f5f6dbf4320028b243e61abb5d94d7ce1ac99d9faf35010350932a29dce5a4a1", "chunk_index": 0}
{"text": "Cl,opter 32: Structured Products \nOption \n5-year call, strike = 10 \n5-year call, strike = 25 \nTheoretical Price \n7.30 \n3.70 \n611 \nThus, the value of the bull spread would be approximately 3.60 (7.30 minus \n3.70). The structured product would then be worth 13.60- the base price of 10, plus \nthe value of the spread: \n\"Theoretical\" cash value= 10 + 3.60 - Cost of carry= 13.60 - Cost of carry \nIt may seem strange to say that the value of the structured product is actually \nless than the cash value, but that is what the call feature does: It reduces the worth \nof the structured product to values below what the cash value formula would indi\ncate. \nGiven this information, we can predict where the structured product would trade at \nany price or at any time prior to maturity. Let'slook at amore extreme example, then, \none in which the Internet index has atremendously big run to the upside. \nExample: Suppose that the Internet index has risen to 525 with four years of life \nremaining until maturity of the structured product. This is well above the index\nequivalent call price of 375. Again, it is first necessary to translate the index price \nback to an equivalent price of the structured product, using either percentage gains \nor the cash value formula: \nCash value = 10 x (525/ 150) = 35 \nAgain, using the Black-Scholes model, we can determine the following theo\nretical values: \nUnderlying price: 35 \nOption \n3-year c~strike = 10 \n3-year call, strike = 25 \nTheoretical Price \n25.50 \n14.70 \nNow, the value of the bull spread is 10.80 (25.50 minus 14.70). The deepest in\nthe-money option is trading near parity, but the (written) option is only 10 points in\nthe-money and thus has quite abit of time value premium remaining, since there are \nthree years of life left: \n\"Theoretical\" cash value = 10 + 10.80 = 20.80 - Cost of carry", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:659", "doc_id": "44f49917d777b82fa516e5f465d7562b8b3cbce28183a6609848f286c1c99e2a", "chunk_index": 0}
{"text": "612 Part V: Index Options and Futures \nHence, even though the Internet index is at 525 - far above the equivalent cal \nprice of 375 - the structured product is expected to be trading at aprice well belo\\\\ \nits maximum price of 25. \nFigure 32-5 shows the values over abroad spectrum of prices and for various \nexpiration dates. One can clearly see that the structured product will not trade\"near \nits maximum price of 25 until time shrinks to nearly the maturity date, or until the \nunderlying index rises to very high prices. In particular, note where the theoretical \nvalues for the bull spread product lie when the index is at the higher striking price of \n375 (there is avertical line on the chart to aid in identifying those values). The struc\ntured product is not worth 20 in any of the cases, and for longer times to maturity, it \nisn'teven worth 15. Thus, the call feature tends to dampen the upside profit poten\ntial of this product in adramatic manner. \nThe curves in Figure 32-5 were drawn with the assumption that volatility is \n50%. Should volatility change materially during the life of the structured product, \nthen the values would change as well. Alower volatility would push the curves up \ntoward the \"at maturity\" line, while an increase in volatility would push the curves \ndown even further. \nFIGURE 32-5. \nValue of bull spread structured product. \nAt Maturity \n25 \n1 Year Left \n20 3Years Left \n15 \n5 \n100 150 200 250 300 350 400 450 500 550 600 \nPrice of Index", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:660", "doc_id": "4fe8c9c6cbcc9e78b2ef73256b1b68198731e05e84e1f3c1d31e24b992be8097", "chunk_index": 0}
{"text": "Gtpter 32: Structured Products \nMULTIPLE EXPIRATION DATES \n613 \nIn some cases, more than one expiration date is involved when the structured prod\nuct is issued. These products are very similar to the simple ones first discussed in this \nchapter. However, rather than maturing on aspecific date, the final index value -\nwhich is used to determine the final cash value of the structured product - is the \naverage of the underlying index price on two or three different dates. \nFor example, one such listed product was issued in 1996 and used the S&P 500 \nindex ($SPX) as the underlying index. The strike price was the price of $SPX on the \nday of issuance, as usual. However, there were three maturity dates: one each in April \n2001, August 2002, and December 2003. The final index value used to determine the \ncash settlement value was specified as the average of the $SPX closings on the three \nmaturity dates. \nIn effect, this structured product was really the sum of three separate struc\ntured products, each maturing on adifferent date. Hence, the values of the imbed\nded calls could each be calculated separately, using the methods presented earlier. \nThen those three values could be averaged to determine the overall value of the \nimbedded call in this structured product. \nOPTION STRATEGIES INVOLVING STRUCTURED PRODUCTS \nSince the structured products described previously are similar to well-known option \nstrategies (long call, bull spread, etc.), it is possible to use listed options in conjunc\ntion with the structured products to produce other strategies. These strategies are \nactually quite simple and would follow the same lines as adjustment strategies dis\ncussed in the earlier chapters of this book. \nExample: Assume that an investor purchased 15,000 shares of astructured product \nsome time ago. It is essentially acall option on the S&P 500 index ($SPX). The prod\nuct was issued at aprice of 10, and that is the guarantee price as well. The striking \nprice is 700, which is where $SPX was trading at the time. However, now $SPX is \ntrading at 1,200, well above the striking price. The cash value of the product is: \n)ox (1,2001100) = 11.14 \nFurthermore, assume that there are still two years remaining until maturity of \nthe structured product, and the investor is getting alittle nervous about the market. \nHe is thinking of selling or hedging his holding in the structured product. However, \nthe structured product itself is trading at 16.50, adiscount of 64 cents from its theo-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:661", "doc_id": "c005d80d958f4be3886bce5d5d85ff13677531559254ce1d9de56e1504428f64", "chunk_index": 0}
{"text": "614 Part V: Index Options and Futurei \nretical cash value. He is not too eager to sell at such adiscount, but he realizes tha \nhe has alot of exposure between the current price and the guarantee price of 10. \nHe might consider writing alisted call against his position. That would conver \nit into the equivalent of abull spread, since he already holds the equivalent of alonf \ncall via ownership of the structured product. Suppose that he quotes the $SP) \noptions that trade on the CBOE and finds the following prices for 6-month options \nexpiring in December: \n$SPX: 1,200 \nOption \nDecember 1,200 call \nDecember 1,250 call \nDecember 1,300 call \nPrice \n85 \n62 \n43 \nSuppose that he likes the sale of the December 1,250 call for 62 points. How \nmany should he sell against his position in order to have aproper hedge? \nFirst, one must compute amultiplier that indicates how many shares of the \nstructured product are equivalent to one \"share\" of the $SPX. That is done in the \nsimple case by dividing the striking price by the guarantee price: \nMultiplier = Striking price/ Base price \n= 700 / 10 = 70 \nThis means that buying 70 shares of the structured product is equivalent to \nbeing long one share of $SPX. To verify this, suppose that one had bought 70 shares \nof the structured product initially at aprice of 10, when $SPX was at 700. Later, \nassume that $SPX doubles to 1,400. With the simple structure of this product, which \nhas a 100% participation rate and no adjustment factor, it should also double to 20. \nSo 70 shares bought at 10 and sold at 20 would produce aprofit of $700. As for $SPX, \none \"share\" bought at 700 and later sold at 1,400 would also yield aprofit of $700. \nThis verifies that the 70-to-lratio is the correct multiplier. \nThis multiplier can then be used to figure out the current equivalent structured \nproduct position in terms of $SPX. Recall that the investor had bought 15,000 shares \ninitially. Since the multiplier is 70-to-l, these 15,000 shares are equivalent to: \n$SPX equivalent shares = Shares of structured product held/ Multiplier \n= 15,000 / 70 = 214.29 \nThat is, owning this structured product is the equivalent of owning 214+ shares \nof $SPX at current prices. Since an $SPX call option is an option on 100 \"shares\" of \n$SPX, one would write 2 calls (rounding off) against his structured profit position. \nSince the SPX December 1,250 calls are selling for 62, that would bring in $12,400 \nless commissions.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:662", "doc_id": "0d60963eda4747e28f7441ac34b984c286c0589f095042dd0fbc3bf63155f7ba", "chunk_index": 0}
{"text": "615 \nNote that the sale of these calls effectively puts acap on the profit potential of \ninvestor'soverall position until the December expiration of the listed calls. If $SPX \nwere to rise substantially above 1,250, his profits would be \"capped\" because the two \nwere sold. Thus, he has effectively taken his synthetic long call position and con\nverted it into abull spread (or acollared index fund, if you prefer that description). \nIn reality, any calls written against the structured product would have to be \nmargined as naked calls. In avirtual sense, the 15,000 shares of the structured prod\nUt't \"cover\" the sale of 2 $SPX calls, but margin rules don'tallow for that distinction. \nIn essence, the sale of two calls would create abull spread. Alternatively, if one thinks \nuf the structured product as along index fully protected by aput (which is another \nway to consider it), then the sale of the $SPX listed call produces a \"collar.\" \nOf course, one could write more than two $SPX calls, if he had the required \nmargin in his account. This would create the equivalent of acall ratio spread, and \nwould have the properties of that strategy: greatest profit potential at the striking \nprice of the written calls, limited downside profit potential, and theoretically unlim\nited upside risk if $SPX should rise quickly and by alarge amount. \nIn any of these option writing strategies, one might want to write out-of-the\nmoney, short-term calls against his structured product periodically or continuously. \nSuch astrategy would produce good results if the underlying index does not advance \nquickly while the written calls are in place. However, if the index should rise through \nthe striking price of the written calls, such astrategy would detract from the overall \nreturn of the structured product. \nChanging the Striking Price. Another strategy that the investor could use \nif he so desired is to establish avertical call spread in order to effectively change \nthe striking price of the (imbedded) call. For example, if the market had advanced \nby agreat deal since the product was bought, the imbedded call would theoreti\ncally have anice profit. If one could sell it and buy another, similar call at ahigh\ner strike, he would effectively ~olling his call up. This would raise the striking \nprice and would reduce downside risk greatly (at the cost of slightly reducing \nupside profit potential). \nExample: Using the same product as in the previous example, suppose that the \ninvestor who owns the structured product considers another alternative. In the pre\nvious example, he evaluated the possibility of selling aslightly out-of-the-money list\ned call to effectively produce acollared position, or abull spread. The problem with \nthat is that it limits upside profit potential. If the market were to continue to rise, he \nwould only participate up to the higher strike (plus the premium received).", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:663", "doc_id": "29d54b6fa8c4363ea6aca0eeba16423c3984365c969b2aa08b5869f8ec07c45d", "chunk_index": 0}
{"text": "616 Part V: Index Options and Futu, \nAbetter alternative might be to roll his imbedded call up, thereby taking s01 \nmoney out of the position but still retaining upside profit potential. Recall that tstructured product had these terms: \nGuarantee price: 10 \nUnderlying index: S&P 500 index ($SPX) \nStriking price: 700 \nAs in the earlier example, the investor owns 15,000 shares of the structun \nproduct. Furthermore, assume that there are about two years remaining until mat \nrity of the structured product, and that the current prices are the same as in the pr \nvious example: \nCurrent price of structured product: 16.50 \nCurrent price of $SPX: 1,200 \nFor purposes of simplicity, let'sassume that there are listed two-year LEAP \noptions available for the S&Pindex, whose prices are: \nS&P 2-year LEAPS, striking price 700: 550 \nS&P 2-year LEAPS, striking price 1,200: 210 \nIn reality, S&P LEAPS options are normally reduced-value options, meanin. \nthat they are for one-tenth the value of the index and thus sell for one-tenth the pricE \nHowever, for the purposes of this theoretical example, we will assume that the full \nvalue LEAPS shown here exist. \nIt was shown in the previous example that the investor would trade two of thest \ncalls as an equivalent amount to the quantity of calls imbedded in his structurec \nproduct. So, this investor could buy two of the 1,200 calls and sell two of the 700 calli \nand thereby roll his striking price up from 700 to 1,200. This roll would bring in 34( \npoints, two times; or $68,000 less commissions. \nSince the difference in the striking prices is 500 points, you can see that he is \nleaving something \"on the table\" by receiving only 340 points for the roll-up. This is \ncommon when rolling up: One loses the time value premium of the vertical spread. \nHowever, when viewed from the perspective of what has been accomplished, the \ninvestor might still find this roll worthwhile. He has now raised the striking price of \nhis call to 1,200, based on the S&Pindex, and has taken in $68,000 in doing so. Since \nhe owns 15,000 shares of the structured product, that means he has taken in 4.53 p~rshare (68,000 / 15,000). Now, for example, if the S&Pcrashes during the next two \nyears and plummets below 700 at the maturity date, he will receive $10 as the guar\nantee price plus the $4.53 he got from the roll - atotal \"guarantee\" of $14.53. Thus, \nhe has protected his downside.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:664", "doc_id": "e0d008e2f088b4d7bc6df598da199be1398c3af8c9b25151c1b0171a57b24f18", "chunk_index": 0}
{"text": "Otpt,r 32: Structured Products 617 \nNote that his downside risk is not completely eliminated, though. The current \nprke of the structured product is 16.50 and the cash value at the current S&Pprice \n11117.14 (see the previous example for this calculation), so he has risk from these lev\ndown to aprice of $14.53. \nHis upside is still unlimited, because he is net long two calls - the S&P 2-year \n1,,EAPS calls, struck at 1,200. The two LEAPS calls that he sold, struck at 700, effec\ntively offsets the call imbedded in the structured product, which is also struck at 700. \nThis example showed how one could effectively roll the striking price of his \nstructured product up to ahigher price after the underlying had advanced. The indi\nvidual investor would have to decide if the extra downside protection acquired is \nworth the profit potential sacrificed. That depends heavily, of course, on the prices of \nthe listed S&Poptions, which in turn depend on things such as volatility and time \nremaining until expiration. \nOf course, one other alternative exists for aholder of astructured product who \nhas built up agood profit, as in the previous two examples: He could sell the prod\nuct he owns and buy another one with astriking price closer to the current market \nvalue of the underlying index. This is not always possible, of course, but as long as \nthese products continue to be brought to market every few months or so by the \nunderwriters, there will be awide variety of striking prices to choose from. Apossi\nble drawback to rolling to another structured product is that one might have to \nextend his holding'smaturity date, but that is not necessarily abad thing. \nAdifferent scenario exists when the underlying index drops after the structured \nproduct is bought. In that case, one would own asynthetic call option that might be \nquite far out-of the-rrwney. Alisted call spread could be used to theoretically lower \nthe call'sstriking price, so that upside movement might more readily produce prof\nits. In such acase, one would sell alisted call option with astriking price equal to the \nstriking price of the structured product and would buy alisted call option with alower striking price - one more in line with current market values. In other words, \nhe would buy alisted call bull spread to go along with his structured product. \nWhatever debit he pays for this call bull spread will increase his downside risk, of \ncourse. However, in return he ~sthe ability to make profits more quickly if the \nunderlying index rises above the new, lower striking price. \nMany other strategies involving listed options and the structured product could \nbe constructed, of course. However, the ones presented here are the primary strate\ngies that an investor should consider. All that is required to analyze any strategy is to \nremember that this type of structured product is merely asynthetic long call. Once \nthat concept is in mind, then any ensuing strategies involving listed options can easily \nbe analyzed. For example, the purchase of alisted put with astriking price essential-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:665", "doc_id": "99b27d1d4a06a034a13687d2691dbdfde3477e0c81cc5691d373eca4696c7145", "chunk_index": 0}
{"text": "618 Part V: Index Options and Future \nly equal to that of the structured product would produce aposition similar to a 101 \nstraddle. The reader is left to interpret and analyze other such strategies on his OWI \nLISTS OF STRUCTURED PRODUCTS \nThe descriptions provided so far encompass the great majority of listed structure \nproducts. There are many similar ones involving individual stocks instead ofJndice \n(often called equity-linked notes). The concepts are the same; merely substitute \nstock price for an index price in the previous discussions in this chapter. \nSome large insurance companies offer similar products in the form of annuities \nThey behave in exactly the same way as the products described above, except tha \nthere is no continuous market for them. However, they still afford one the opportu\nnity to own an index fund with no risk Many of the insurance company products, in \nfact, pay interest to the annuity holder - something that most of the products listed \non the stock exchanges do not. \nBoth the CBOE and American Exchange Web sites (www.cboe.com and \nwww.amex.com) contain details of the structured products listed on their respective \nexchanges. Asampling at the time of this writing showed the following breakdowns \nof listed structured products: \nUnderlying Index Percent of Listed Products \nBroad-based index (S&P 500, e.g.) 23% \nSector index \nStocks \n43% \n34% \nIf you browse those lists, an investor may find indices or stocks that are of particular \ninterest to him. In addition, it may be possible to find ones trading at asubstantial \ndiscount to cash settlement value, something astrategist might find attractive. \nPERCS \nPart II: Products Designed \nto Provide /,/Income\" \nAt the beginning of this chapter, it was stated that most listed structured products~ \nfall into one of two categories. The first category was the type of structured prod\nuct that resembled the ownership of acall option. The second portion, to be dis-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:666", "doc_id": "a27b4f39aad777d9b936ae91e0256e0d797b5c15e6bfc1a020ed81d97c91d29b", "chunk_index": 0}
{"text": "0.,t,r 32: Structured Products 619 \nt'Ussed in the remainder of this chapter, resembles the covered write of acall \noption. These often have names involving the term preferreds. Some are called \nTrust Preferreds; another popular term for them is Preferred Equity Redemption \nCumulative Stock (PERCS). We will use the term PERCS in the following exam\nples, but the reader should understand that it is being used in ageneric sense - that \nany of the similar types of products could be substituted wherever the term PERCS \nis used. \nA PERCS is astructured product, issued with amaturity date and tied to an \nindividual stock. At the time of issuance, the PERCS and the common stock are usu\nally about the same price. The PERCS pays ahigher dividend than the common \nstock, which may pay no dividend at all. If the underlying common should decline in \nprice, the PERCS should decline by alesser amount because the higher dividend \npayout will provide ayield floor, as any preferred stock does. \nThere is alimited life span with PERCS that is spelled out in the prospectus at \nthe time it is issued. Typically, that life span is about three years. At the end of that \ntime, the PERCS becomes ordinary common stock. \nA PERC Smay be called at any time by the issuing corporation if the company'scommon stock exceeds apredetermined call price. In other words, this PERCS stock \nis callable. The call price is normally higher than the price at which the common is \ntrading when the PERCS is issued. \nWhat one has then, if he owns a PERCS, is aposition that will eventually \nbecome common stock unless it is called away. In order to compensate him for the \nfact that it might he called away, the owner receives ahigher dividend. What if one \nsubstitutes the word \"premium\" for \"higher dividend\"? Then the last statement \nreads: In order to compensate him for the fact that it might be called away, the owner \nreceives apremium. This is exactly the definition of acovered call option write. \nMoreover, it is an out-of-the-money covered write of along-term call option, since \nthe call price of the PERCS is akin to astriking price and is higher than the initial \nstock price. \nExample: XYZ is selling at $35 per share. XYZ common stock pays $1 ayear in div\nidends. The company decides to issue a PERCS. \nThe PERCS will have athree~ life and will be callable at $39. Moreover, the \nPERCS will pay an annual dividend of $2.50. \nThe PERCS annual dividend rate is 7% as compared to 2.8% for the common \nstock. \nIf XYZ were to rise to 39 in exactly three years, the PERCS would be called. \nThe total return that the PERCS holder would have made over that time would be:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:667", "doc_id": "b0ce4632ef496dbc54fc5b915f1de35f410e942b47d4b4661c9b11b31d2f2b86", "chunk_index": 0}
{"text": "620 \nStock price appreciation 139 - 35): \nDividends over 3 years: \nTotal gain \nTotal return: \nAnnualized return: \nPart V: Index Options and Future. \n4 \n7.50 \n11.50 \n11.50/35 = 32.9% \n32.9%/3 = 11% \nIf the PERCS were called at an earlier time, the annualized return might be ever \nhigher. · \nCALL FEATURE \nThe company will most likely call the PER CS if the common is above the call price \nfor even ashort period of time. The prospectus for the PERCS will describe any \nrequirements regarding the call. Atypical one might be that the common must close \nabove the call price for five consecutive trading days. If it does, then the company \nmay call the PERCS, although it does not have to. The decision to call or not is strict\nly the company's. The PERCS holder has no choice in the matter of when or if his \nshares are called. This is the same situation in which the writer of acovered call finds \nhimself: He cannot control when the exercise will occur, although there are often \nclues, including the disappearance of time value premium in the written listed call \noption. The PERCS holder is more in the dark, because he cannot actually see the \nseparate price of the imbedded call within the PERCS. Still, as will be shown later, \nhe may be able to use several clues to determine whether acall is imminent. \nMost PERCS may be called for either cash or common stock. This does not \nchange the profitability from the strategist'sstandpoint. He either receives cash in \nthe amount of the call price, or the same dollar amount of common stock. The only \ndifference between the two is that, in order to completely close his position, he would \nhave to sell out any common stock received via the call feature. If he had received \ncash instead, he wouldn'thave to bother with this final stock transaction. \nIn the case of most PERCS, the call feature is more complicated than that pre\nsented in the preceding example. Recall that the company that issued the PERCS \ncan call it at any time during the three years, as long as the common is above the call \nprice. The holder of the XYZ PERCS in the example would not be pleased to find \nthat the PER CS was called before he had received any of the higher dividends that \nthe PERCS pays. Therefore, in order to give a PERCS holder essentially the same \nreturn no matter when the PERCS is called, there is a \"sliding scale\" of call prices. -\nAt issuance, the call price will be the highest. Then it will drop to aslightly \nlower level after some of the dividends have been paid (perhaps after the first year).", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:668", "doc_id": "d798d483664aece3f78d2894f472ad299c4a4e288b057609b7de157b264681c0", "chunk_index": 0}
{"text": "621 \nThis lowering of the call price continues as more dividends are paid, until it finally \nreaches the final call price at maturity. The PERCS holder should not be confused \nthis sliding scale of call prices. The sliding call feature is designed to ensure that \nPERC Sholder is compensated for not receiving all his \"promised\" dividends if the \nPERCS should be called prior to maturity. \nExample: As before, XYZ issues a PERCS when the common is at 35. The PERCS \npays an annual dividend of $2.50 per share as compared to $1 per share on the com\nmon stock. The PERCS has afinal call price of 39 dollars per share in three years. \nIf XYZ stock should undergo asudden price advance and rise dramatically in avery short period of time, it is possible that the PERCS could be called before any \ndividends are paid at all. In order to compensate the PERCS holder for such an \nc>ecurrence, the initial call price would be set at 43.50 per share. That is, the PERCS \ncan'tbe called unless XYZ trades to aprice over 43.50 dollars per share. Notice that \nthe difference between the eventual call price of 39 and the initial call price of 43.50 \nis 4.50 points, which is also the amount of additional dividends that the PERCS \nwould pay over the three-year period. The PER CS pays $2.50 per year and the com\nmon $1 per year, so the difference is $1.50 per year, or $4.50 over three years. \nOnce the PERCS dividends begin to be paid, the call price will be reduced to \nreflect that fact. For example, after one year, the call price would be 42, reflecting \nthe fact that if the PERCS were not called until ayear had passed, the PERCS hold\ner would be losing $3 of additional dividends as compared to the common stock \n($1.50 per year for the remaining two years). Thus, the call price after one year is set \nat the eventual call price, 39, plus the $3 of potential dividend loss, for atotal call \nprice of 42. \nThis example shows how the company uses the sliding call price to compensate \nthe PERCS holder for potential dividend loss if the PERCS is called before the \nthree-year time to maturity has elapsed. Thus, the PER CS holder will make the same \ndollars of profit - dividends and price appreciation combined - no matter when the \nPERCS is called. In the case of the XYZ PERCS in the example, that total dollar \nprofit is $11.50 (see the prior example). Notice that the investor'sannualized rate of \nreturn would be much higher if he were called prior to the eventual maturity date. \nOne final point: The call price §lides on ascale as set forth in the prospectus for \nthe PERCS. It may be every time adividend is paid, but more likely it will be daily! \nThat is, the present worth of the remaining dividends is added to the final call price \nto calculate the sliding call price daily. Do not be overwhelmed by this feature. \nRemember that it is just ameans of giving the PERCS holder his entire \"dividend \npremium\" if the PERCS is called before maturity.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:669", "doc_id": "ab4d0ab4593b9d0f33288540f498006ea0ffe939f6716ba08c4190bc664c09da", "chunk_index": 0}
{"text": "622 Part V: Index Options and Futures \nFor the remainder of this chapter, the call price of the PERCS will be referrea \nto as the redemption price. Since much of the rest of this chapter will be concemec \nwith discussing the fact that a PERCS is related to acall option, there could be somE \nconfusion when the word call is used. In some cases, call could refer to the price at \nwhich the PER CS can be called; in other cases, it could refer to acall option - either \nalisted one or one that is imbedded within the PERCS. Hence, the word redemp\ntion will be used to refer to the action and price at which the issuing compa:J)ly may \ncall the PERCS. \nA PERCS IS A COVERED CALL WRITE \nIt was stated earlier that a PER CS is like acovered write. However, that has not yet \nbeen proven. It is known that any two strategies are equivalent if they have the same \nprofit potential. Thus, if one can show that the profitability of owning a PER CS is the \nsame as that of having established acovered call write, then one can conclude that \nthey are equivalent. \nExample: For the purposes of this example, suppose that there is athree-year listed \ncall option with striking price 39 available to be sold on XYZ common stock. Also, \nassume that there is a PERCS on XYZ that has aredemption price of 39 in three \nyears. The following prices exist: \nXYZ common: 35 \nXYZ PERCS: 35 \n3-year call on XYZ common with striking price of 39: 4.50 \nFirst, examine the XYZ covered call write'sprofitability from buying 100 XY2 and \nselling one call. It was initially established at adebit of 30.50 (35 less the 4.50 \nreceived from the call sale). The common pays $1 per year in dividends, for atotal of \n$3 over the life of the position. \nXYZ Price Price of a Profit/loss on Total Profit/loss \nin 3 Years 3-Year Call Securities Incl. Dividend \n25 0 -$550 -$250 \n30 0 -50 +250 \n35 0 +450 +750 \n39 0 +850 + 1,150 \n45 6 +850 + 1,150 \n50 11 +850 + 1,150", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:670", "doc_id": "56c5c56bce6a210efc0fda2541a6754cb9b6ebe6d6981dd859635483f393cc1e", "chunk_index": 0}
{"text": "O.,,ter 32: Structured Products 623 \nTI1is is the typical picture of the total return from acovered write - potential losses on \nthe downside with profit potential limited above the striking price of the written call. \nNow look at the profitability of buying the PER CS at 35 and holding it for three \n(Assume that it is not called prior to maturity.) The PER CS holder will earn atotal of $750 in dividends over that time period. \nXYZ Price Profit/Loss on Total Profit/Loss \nin 3 Years PERCS Incl. Dividend \n25 -$1,000 -$250 \n30 -500 +250 \n35 0 +750 \n>=39 +400 + 1, 150 \nThis is exactly the same profitability as the covered call write. Therefore, it can be \nconcluded with certainty that a PERCS is equivalent to acovered call write. Note \nthat the PER CS potential early redemption feature does not change the truth of this \nstatement. The early redemption possibility merely allows the PERCS holder to \nreceive the same total dollars at an earlier point in time if the PERCS is demanded \nprior to maturity. The covered call writer could theoretically be facing asimilar situ\nation if the written call option were assigned before expiration: He would make the \nsame total profit, but he would realize it in ashorter period of time. \nThe PERCS is like acovered write of acall option with striking price equal to \nthe redemption price of the PERCS, except that the holder does not receive acall \noption premium, but rather receives additional dividends. In essence, the PERCS \nhas acall option imbedded within it. The value of the imbedded call is really the \nvalue of the additional dividends to be paid between the current date and maturity. \nThe buyer of a PERCS is, in effect, selling acall option and buying common \nstock. He should have some idea of whether or not he is selling the option at area\nsonably fair price. The next section of this chapter addresses the problem of valuing \nthe call option that is imbedded in the PERCS. \nPRICE BEHAVIOR \nThe way that a PERCS price is often discussed is in relationship to the common \nstock. One may hear that the PERCS is trading at the same price as the common or \nat apremium or discount to the common. As an option strategist who understands \ncovered call writing, it should be asimple matter to picture how the PERCS price \nwill relate to the common price.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:671", "doc_id": "f3fa7918d228f87dfb59e2a0727db1999837a675c5ad5d64e84eec6a39c607f6", "chunk_index": 0}
{"text": "Oapter 32: Structured Products 625 \nAnother observation that can be made from the figure is that the PERCS pric\ning curves level off at the redemption price. They cannot sell for more than that \nprice. \nNow look on the left-hand side of the figure. Notice that the more time remain\nIng until maturity, the higher the PERCS will trade above the common stock. This is \nbecause of the extra dividends that the PER CS pay. Obviously, the PERCS with three \nyears until maturity has the potential to pay more dividends than the one with three \nmonths remaining, so the three-year PERCS will sell for more than the six-month \nPERCS when the common is below the issue price. Since either PERCS pays more \ndividends than the common, they both trade for higher prices than the common. \nWhen the common trades above the issue price (point 'T'), the opposite is true. \nThe six-month PERCS trades for aslightly higher price than the three-year PERCS, \nbut both sell for significantly less than the common, which has no limit on its poten\ntial price. \nOne other observation can be made regarding the situation in which the com\nmon trades well below the issue price: After the last additional dividend has been \npaid by the PERCS, it will trade for approximately the same price as the common in \nthat situation. · \nViewed strictly as asecurity, a PERCS may not appear all that attractive to some \ninvestors. It has much, but not all, of the downside risk of the common stock, and not \nnearly the upside potential. It does provide abetter dividend, however, so if the com\nmon is relatively unchanged from the issue price when the PERCS matures, the \nPERCS holder will have come out ahead. If this description of the PER CS does not \nappeal to you, then neither should covered call writing, for it is the same strategy; acall option premium is merely substituted for the higher dividend payout. \nPERCS STRATEGIES \nSince the PERCS is equivalent to acovered write, strategies that have covered writes \nas part of their makeup are amenable to having PERCS as part of their makeup as \nwell. Covered writing is part of ratio writing. Other modifications to the covered writ\ning strategy itself, such as the protected covered write, can also be applied to the \nPERCS. \nPROTECTING THE PERCS WITH LISTED OPTIONS \n~ \nThe safest way to protect the PERC Sholding with listed options is to buy an out-of \nthe-nwney put. The resultant position - long PERCS and long put - is aprotected \ncovered write, or a \"collar.\" The long put prevents large losses on the downside, but \nit costs the PERCS holder something. He won'tmake as much from his extra divi\ndend payout, because he is spending money for the listed put. Still, he may want the \ndownside comfort.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:673", "doc_id": "85286bf59ba72c58cfe1334ecc9616a43b8328505ce2dc4617bb2a8e88d9f654", "chunk_index": 0}
{"text": "626 Part V: Index Options and Futures \nOnce one realizes that a PERCS is equivalent to acovered write, he can easily \nextend that equivalence to other positions as well. For example, it is known that acovered call write is equivalent to the sale of anaked put. Thus, owning a PERCS is \nequivalent to the sale of anaked put. Obviously, the easiest way to hedge anaked put \nis to buy another put, preferably out-of-the-money, as protection. \nDo not be deluded into thinking that selling alisted call against the PERCS is \nasafe way of hedging. Such acall option sale does add amodicum of downside pro\ntection, but it exposes the upside to large losses and therefore introduces apotential \nrisk into the position. It is really aratio write. The subject is covered later in this \nchapter. \nREMOVING THE REDEMPTION FEATURE \nAt issuance, the imbedded call is athree-year call, so it is not possible to exactly \nduplicate the PERCS strategy in the listed market. However, as the PERCS nears \nmaturity, there will be listed calls that closely approximate the call that is imbedded \nin the PERCS. Consequently, one may be able to use the listed call or the underly\ning stock to his advantage. \nIf one were to buy alisted call with features similar to the imbedded call in a \nPERCS that he owned, he would essentially be creating long common stock. Not that \none would necessarily need to go to all that trouble to create long common stock, but \nit might provide opportunities for arbitrageurs. \nIn addition, it might appeal to the PERCS holder if the common stock has \ndeclined and the imbedded call is now inexpensive. If one covers the equivalent of \nthe imbedded call in the listed market, he would be able to more fully participate in \nupside participation if the common were to rally later. This is not always aprofitable \nstrategy, however. It may be better to just sell out the PERCS and buy the common \nif one expects alarge rally. \nExample: XYZ issued a PERCS some time ago. It has aredemption price of 39; the \ncommon pays adividend of $1 per year, while the PER CS pays $2.50 per year. \nXYZ has fallen to aprice of 30 and the PERCS holder thinks arally may be \nimminent. He knows that the imbedded call in the PERCS must be relatively inex\npensive, since it is 9 points out-of-the-money (the PERCS is redeemable at 39, while \nthe common is currently 30). Ifhe could buy back this call, he could participate more \nfully in the upward potential of the stock. \nSuppose that there is aone-year LEAPS call on XYZ with astriking price of 40. \nIf one were to buy that call, he would essentially be removing the redemption fea-\nture from his PERCS. \nAssume the following prices exist:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:674", "doc_id": "60bf5bcaf8bae5f36c2d4f4eabe25eb0c36e31a9e6bffcbdef007a6e9d45fb00", "chunk_index": 0}
{"text": "Gapter 32: Structured Products \nXYZ Common: 30 \nXYZ PERCS: 31 \nXYZ January 40 LEAPS call: 2 \n627 \nIf one buys this LEAPS call and holds it until maturity of the PERCS one year \nfrom now, the profit picture of the long PERCS plus long call position will be the fol\nlowing: \nTotal Value \nXYZ Price in PERCS January 40 of long PERCS \nJanuary Next Year Price LEAPS + long LEAPS \n25 25 0 25 \n30 30 0 30 \n35 35 0 35 \n40 39 0 39 \n45 39 5 44 \n50 39 10 49 \nThus, the PE RCS + long call position is worth almost exactly what the common \nstock is after one year. The PERCS holder has regained his upside profit potential. \nWhat did it cost the investor to reacquire his upside? He paid out 2 points for \nthe call, thereby more than negating his $1.50 dividend advantage over the course of \nthe year (the common pays a $1 dividend;'the PERCS $2.50). Thus, it may not actu\nally be worth the bother. In fact, notice that if the PERCS holder really wanted to \nreacquire his upside profit potential, he would have been better off selling his \nPERCS at 31 and buying the common at 30. If he had done this, he would have taken \nin 1 point from the sale and purchase, which is slightly smaller than the $1.50 divi\ndend he is forsaking. In either case, he must relinquish his dividend advantage and \nthen some in order to reacquire his upside profit potential. This seems fair, however, \nfor there must be some cost involved with reacquiring the upside. \nRemember that an arbitrageur might be able to find atrade involving these sit\nuations. He could buy a PERCS, sell the common short, and buy alisted call. If there \nwere price discrepancies, he could profit. It is actions such as these that are required \nto keep prices in their proper relationship. \n1 \nCHANGING THE REDEMPTION PRICE OF THE PERCS \nWhen covered writing was discussed as astrategy, it was shown that the writer may \nwant to buy back the call that was written and sell another one at adifferent strike.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:675", "doc_id": "f086e589e48c6846e1bc3add94edbfe3eee621d896a90541fb5f4c366aab73cf", "chunk_index": 0}
{"text": "628 Part V: Index Options and Futu, \nIf the action results in alower strike, it is known as rolling down; if it results in ahi§ \ner strike, it is rolling up. \nThis rolling action changes the profit potential of the position. If one rolls dov; \nhe gets more downside protection, but his upside is even more limited than it prei \nously was. Still, if he is worried about the stock falling lower, this may be aprop \naction to take. Conversely, if the common is rallying, and the covered writer is mo \nbullish on the stock, he can roll up in order to increase his upside profit potenti~( \ncourse, by rolling up, he creates more downside risk if the common stock should sue \ndenly reverse direction and fall. \nThe PERCS holder can achieve the same results as the covered writer. He ca \neffectively roll his redemption price down or up if he so chooses. His reasons fc \ndoing so would be substantially the same as the covered writer's. For example, if th \ncommon were dropping in price, the PERCS holder might become worried that hi \nextra dividend income would not be enough to protect him in the case of furthe \ndecline. Therefore, he would want to take in even more premium in exchange fo \nallowing himself to be called away at alower price. \nExample: XYZ issued PERCS when both were trading at 35. Now, XYZ has fallen t< \n30 with only ayear remaining until maturity, and the PERCS holder is nervous abou \nfurther declines. He could, of course, merely sell his stock; but suppose that ht: \nprefers to keep it and attempt to modify his position to more accurately reflect hb \nattitude about future price movements. \nAssume the following prices exist: \nXYZ Common: 30 \nXYZ PERCS: 31 \nXYZ January 40 call: 2 \nXYZ January 35 call: 4 \nIfhe buys the January 40 call and sells the January 35 call, he will have accomplished \nhis purpose. This is the same as selling acall bear spread. As shown in the previous \nexample, buying the January 40 call is essentially the same as removing the redemp\ntion feature from the PERCS. Then, selling the January 35 call will reinstate aredemption feature at 35. Thus, the PERCS holder has taken in apremium of 2 \npoints and has lowered the redemption price. \nIf XYZ is below 35 when the options expire, he will have an extra $200 profit \nfrom the option trades. If XYZ rallies and is above 35 at expiration, he will be effec\ntively called away at 37 (the striking price of 35 plus the two points from the rollr, \ninstead of at the original demand price of 39. In actual practice, if the January 35 call", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:676", "doc_id": "79d7b68752ec12fc036c11f4ed160e482c4de940ec145b6f85a7439bb67086f0", "chunk_index": 0}
{"text": "629 \nwere assigned, the trader could then be simultaneously long the PERCS and short \ncommon stock, with along January 40 call in addition. He would have to unwind \npieces separately, an action that might include exercising the January 40 call (if \nIt were in-the-money at expiration) to cover the short common stock. \nThe conclusion that can be drawn is that in order to roll down the redemption \nfiature of a PERCS, one must sell avertical call spread. In asimilar manner, if he \nwanted to roll the strike up, he would buy avertical call spread. Using the same \nexample, one would still buy the January 40 call ( this effectively removes the redemp\ntion feature of the PERCS) and would then sell a January 45 call in order to raise the \nredemption price. Thus, buying avertical call spread raises the effective redemption \nprice of a PERCS. \nThere is nothing magic about this strategy. Covered writers use it all the time. \nIt merely evolves from thinking of a PERCS as acovered write. \nSELLING A CALL AGAINST A LONG PERCS IS A RATIO WRITE \nIt is obvious to the strategist that if one owns a PERCS and also sells acall against it, \nhe does not have acovered write. The PERCS is already acovered write. What he \nhas when he sells another call is aratio write. His equivalent position is long the com\nmon and short two calls. \nThere is nothing inherently wrong with this, as long as the PERCS holder \nunderstands that he has exposed himself to potentially large upside losses by selling \nthe extra call. If the common stock were to rally heavily, the PERCS would stop ris\ning when it reached its redemption price. However, the additional call that was sold \nwould continue to rise in price, possibly inflicting large losses if no defensive action \nwere taken. \nThe same strategies that apply to ratio writing or straddle writing would have to \nbe used by someone who owns a PERCS and sells acall against it. He could buy com\nmon stock if the position were in danger on the upside, or he could roll the call(s) up. \nAdifference between ordinary ratio writing and selling alisted call option \nagainst a PERCS is that the imbedded call in the PERCS may be avery long-term \ncall (up to three years). The listed call probably wouldn'tbe of that duration. So the \nratio writer in this case has two different expiration dates for his options. This does \nnot change the overall strategy, but it does mean that the imbedded long-term call \nwill not diminish much in price due to thepssage of time, until the PERCS is near\ner maturity. \nNeutrality is normally an important consideration for aratio writer. If one is \nlong a PERCS and short alisted call, he is by definition aratio writer, so he should", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:677", "doc_id": "dbdba7d522796bb06d39cf9feaa8fdde720d791f64300cef8536f066ea869d83", "chunk_index": 0}
{"text": "630 Part V: Index Options and Futures \nbe interested in neutrality. The key to determining one'sneutrality, of course, is tc \nuse the delta of the option. In the case of the PERCS stock, one would have to usE \nthe delta of the imbedded call. \nExample: An investor is long 1,000 shares ofXYZ PERCS maturing in two years. He \nthinks XYZ is stuck in atrading range and does not expect much volatility in the near \nfuture. Thus, aratio write appeals to him. How many calls should he sell in order to \ncreate aneutral position against his 1,000 shares? \nFirst, he needs to compute the delta of the imbedded option in the PER CS, and \ntherefore the delta of the PERCS itself. The delta of a PERCS is not 1.00, as is the \ndelta of common stock. \nAssume the XYZ PERCS matures in two years. It is redeemable at 39 at that \ntime. XYZ common is currently trading at 33. The delta of atwo-year call with strik\ning price 39 and common stock at 33 can be calculated (the dividends, short-term \ninterest rate, and volatility all play apart). Suppose that the delta of such an option is \n0.30. Then the delta of the PER CS can be computed: \nPERCS delta= 1.00- Delta of imbedded call \n= 1.00 - 0.30 = 0.70 in this example \nAssume the following data is known: \nSecurity \nXYZ Common \nXYZ PERCS \nXYZ October 40 call \nPrice \n33 \n34 \n2 \nDelta \n1.00 \n0.70(!) \n0.35 \nBeing long 1,000 PER CS shares is the equivalent of being long 700 shares of \ncommon (ESP= 1,000 x 0.70 = 700). In order to properly hedge that ESP with the \nOctober 40 call, one would need to sell 20 October 40 calls. \nQuantity to sell = ESP of PER CS/ESP of October 40 call \n= 700/(100 shares per option x 0.35) \n= 700/35 = 20 \nThus, the position - long 1,000 PER CS, short 20 October 40 calls - is aneutral one \nand it is aratio write. \nOne may not want to have such asteep ratio, since the result of this example is \nthe equivalent of being long 1,000 common and short 30 calls in total (10 are imbed\nded in the long PERCS). Consequently, he could look at other options - perhaps \nwriting in-the-money October calls - that have higher deltas and won'trequire so \nmany to be sold in order to produce aneutral position.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:678", "doc_id": "563fa3ae22f2c0584e37147f786ae94518f8485ea907b5b37a2c7478de6de20a", "chunk_index": 0}
{"text": "Cl,apter 32: Structured Produds 631 \nTo remain neutral, one would have to keep computing the deltas of the options, \nboth listed and imbedded, as time passes, because stock movements or the passage \nof time could change the deltas and therefore affect the neutrality of the position. \nHEDGING PERCS WITH COMMON STOCK \nSome traders may want to use the common stock to hedge the purchase of PERCS. \nThese would normally be market-makers or block traders who acquire the PERCS in \norder to provide liquid markets or because they think they are slightly mispriced. The \nsimplest way for these traders to hedge their long PERCS would be with common \nstock. \nThis strategy might also apply to an individual who holds PERCS, if he wants to \nhedge them from apotential price decline but does not actually want to sell them (for \ntax reasons, perhaps). \nIn either case, it is not correct to sell 100 shares of common against each 100 \nshares of PERCS owned. That is not atrue hedge. In fact, what one accomplishes by \ndoing that is to create anaked call option. A PERCS is acovered write; if one sells \n100 shares of common stock from acovered write, he is left with anaked call. This \ncould cause large losses if the common rallies. \nRather, the proper way to hedge the PERCS with common stock is to calculate \nthe equivalent stock position of the PERC Sand hedge with the calculated amount of \ncommon stock. The example showed how to calculate the ESP of the PERCS: One \nmust calculate the delta of the imbedded call option, which may be along-term one. \nThen the delta of the PERCS can be computed, and the equivalent stock position can \nbe determined. \nExample: Vsing the same prices from the previous example, one can see how much \nstock he would have to sell in order to properly hedge his PERCS holding of 1,000 \nshares. \nAssume XYZ is trading at 33, and the PE RCS has two years until maturity. If the \nPERCS is redeemable at 39 at maturity, one can determine that the delta of the \nimbedded option is 0.30 (see previous example). Then: \nDelta of PE RCS = 1 - Delta of imbedded call \n= 1- 0.30 \n= 0.70 \nHence, the equivalent stock position of 1,000 PERCS is 700 shares (1,000 x \n0.10). 1 Consequently, one would sell short 700 shares of XYZ common in order to \nhedge this long holding of 1,000 PERCS.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:679", "doc_id": "686a661f2ab5316e72bc1c218f450241940e68f373540cef709473e509a05300", "chunk_index": 0}
{"text": "632 Part V: Index Options and Futures \nThis is not astatic situation. If XYZ changes in price, the delta of the imbedded \noption will change as well, so that the proper amount of stock to sell as ahedge will \nchange. The deltas will change with the passage of time as well. Achange in volatili\nty of the common stock can affect the deltas, too. Consequently, one must constant\nly recalculate the amount of stock needed to hedge the PERCS. \nWhat one has actually created by selling some common stock against his long \nPERCS holding is another ratio write. Consider the fact that being long 1,000 \nPE RCS shares is the equivalent of being long 1,000 common and short 10 imbedded, \nlong-term calls. If one sells 700 common, he will be left with an equivalent position \nof long 300 common and short 10 imbedded calls - aratio write. \nThe person who chooses to hedge his PER CS holding with apartial sale of com\nmon stock, as in the example, would do well to visualize the resulting hedged posi\ntion as aneutral ratio write. Doing so will help him to realize that there is both upside \nand downside risk if the underlying common stock should become very volatile (ratio \nwrites have risk on both the upside and the downside). If the common remains fair\nly stable, the value of the imbedded call will decrease and he will profit. However, if \nit is along-term imbedded call (that is, if there is along time until maturity of the \nPER CS), the rate of time decay will be quite small; the hedger should realize that \nfact as well. \nIn summary, the sale of some common against along holding of PERCS is aviable way to hedge the position. When one hedges in this manner, he must contin\nue to monitor the position and would be best served by viewing it as aratio write at \nall times. \nSELLING PERCS SHORT \nCan it make sense to sell PER CS short? The payout of the large dividend seems to \nbe adeterrent against such ashort sale. However, if one views it as the opposite of along-term, out-of-the-money covered write, it may make some sense. \nAcovered write is long stock, short call; it is also equivalent to being long a \nPERCS. The opposite of that is short stock, long call - asynthetic put. Therefore, along put is the equivalent of being short a PERCS. Profit graph Hin Appendix Dshows the profit potential of being short stock and long acall. There is large down\nside profit potential, but the upside risk is limited by the presence of the long call. \nThe amount of premium paid for the long call is awasting asset. If the stock does not \ndecline in price, the long call premium may be lost, causing an overall loss. \nShorting a PERCS would result in aposition with those same qualities. The \nupside risk is limited by the redemption feature of the PERCS. The downside prof\nit potential is large, because the PER CS will trade down in price if the common stoek", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:680", "doc_id": "b91ab6a78efbe654187670ec52661470bbe5c73a31e4d1a049b499dd49a78602", "chunk_index": 0}
{"text": "Chapter 32: Structured Products 633 \ndoes. The problem for the short seller of the PER CS is that he has to pay alot for \nthe imbedded call that affords him the protection from upside risk. The actual price \nthat he has to pay is the dividends that he, as ashort seller, must pay out. But this can \nalso be thought of as having purchased along-term call out-of-the-money as protec\ntion for ashort sale of common stock. The long-term call is bound to be expensive, \nsince it has agreat deal of time premium remaining; moreover, the fact that it is out\nof-the-money means that one is also assuming the price risk from the current com\nmon price up to the strike of the call. Hence, this out-of-the-money amount plus the \ntime value premium of the imbedded call can add up to asubstantial amount. \nThis discussion mainly pertains to shorting a PERCS near its issuance price and \ndate. However, one is free to short PERCS at any time if they can be borrowed. They \nmay be amore attractive short when they have less time remaining until the maturi\nty date, or when the underlying common is closer to the redemption price. \nOverall, one would not normally expect the short sale of a PERCS to be vastly \nsuperior to asynthetic put constructed with listed options. Arbitrageurs would be \nexpected to eliminate such aprice discrepancy if one exists. However, if such asitu\nation does present itself, the short seller of the PERCS should realize he has aposi\ntion that is the equivalent of owning aput, and plan his strategy accordingly. \nDETERMINING THE ISSUE PRICE \nAn investor might wonder how it is always possible for the PERCS and the common \nto be at the same price at the issue date. In fact, the issuing company has two vari\nables to work with to ensure that the common price and the PERCS issue price are \nthe same. One variable is the amount of the additional dividend that the PERCS will \npay. The other is the redemption price of the PER CS. By altering these two items, \nthe value of the covered write (i.e., the PERCS) can be made to be the same as the \ncommon on the issue date. \nFigure 32-7 shows the values that are significant in determining the issue price \nof the PE RCS. The line marked Final Value is the shape of the profit graph of acov\nered write at expiration. This is the PERCS'sfinal value at its maturity. The curved \nline is the value of the covered write at the current time, well before expiration. Of \ncourse, these two are linked together. \nThe line marked Common Stock is merely the profit or loss of owning stock. \nThe curved line (present PERCS value) crosses the Common Stock line at the issue \nprice. \nAt the time of issuance, the difference between the current stock price and the \neventual maturity value of the PER CS is the present value of all the additional divi\ndends to be paid. That amount is marked a1/11e vertical line on the graph. Therefore,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:681", "doc_id": "cc85412beb4789bdc900e9fcda6290f01e552a7e8d17f210cb0d8fabb977fd36", "chunk_index": 0}
{"text": "G,pter 32: Strudured Products 635 \nSuch discrepancies will be most notable when there is not alisted option that \nhas terms near the terms of the PERCS'simbedded call. If there is such alisted \noption, then arbitrageurs should be able to use it and the common stock to bring the \nPERCS into line. However, if there is not any such listed option available, there may \nbe opportunities for theoretical value traders. \nModels used for pricing call options, such as the Black-Scholes model, are dis\ncussed in Chapter 28 on mathematical applications. These models can be used to \nvalue the imbedded call in the PERCS as well. If the strategist determines the \nimplied value of the imbedded call is out of line, he may be able to make aprofitable \ntrade. It is afairly simple matter to determine the implied value of the imbedded call. \nThe formula to be used is: \nImbedded call implied value = Current stock price \n+ Present value of dividends - Current PERCS price \nThe validity of this formula can be seen by referring again to Figure 32-7. The \ndifference between the Final Value (that is, the profit of the covered write at expira\ntion) and the Issue Value or current value of the PERCS is the imbedded call price. \nThat is, the difference between the curved line and the line at expiration is merely \nthe present time value of the imbedded call. Since this formula is describing an out\nof-the-money situation, then the time value of the imbedded call is its entire price. \nIt is also known that the Final Value line differs from the current stock price by the \npresent value of all the additional dividends to be paid by the PERCS until maturity. \nThus, the four variables are related by the simple formula given above. \nExample: XYZ has fallen to 32 after the PERCS was issued. The PERCS is current\nly trading at 34 and, as in previous examples, the PERCS pays an additional $1.50 per \nyear in dividends. If there are two years remaining until maturity of the PERCS, what \nis the value of the imbedded call option? \nFirst, calculate the present value of the additional dividends. One should calcu\nlate the present value of each dividend. Since they are paid quarterly, there will be \neight of them between now and maturity. \nAssume the short-term interest rate is 6%. Each additional quarterly dividend \nis $0.375 ($1.50 divided by 4). Thus, the present value of the dividend to be paid in \nthree months is: \npw = 0.375/(1 + .06)114 = $0.3696 \nThe present value of the dividend to be paid two years from now is: \npw = 0.375/(1 + .06)2 = $0.338 \ni", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:683", "doc_id": "f2edd4e4ab1ea73c44e604f26d84a86077b321357a4429937c75d2c669dd40af", "chunk_index": 0}
{"text": "636 Part V: Index Options and Futures \nAdding up all eight of these, it is determined that the present worth of all the \nremaining additional dividends is $2.81. Note that this is less than the actual amount \nthat will eventually be paid over the two years, which is $3.00. \nNow, using the simple formula given earlier, the value of the imbedded call can \nbe determined: \nXYZ: 32 \nPERCS: 34 \nPresent worth of additional dividends: 2.81 \nImbedded call = Stock price + pw divs - PERCS price \n= 32 + 2.81 - 34 \n= 0.81 \nOnce this call value is determined, the strategist can use amodel to see if this call \nappears to be cheap or expensive. In this case, the call looks cheap for atwo-year call \noption that is 7 points out-of-the-money. Of course, one would need to know how \nvolatile XYZ stock is, in order to draw adefinitive conclusion regarding whether the \nimbedded call is undervalued or not. \nAbasic relationship can be drawn between the PER CS price and the calculated value \nof the imbedded call: If the imbedded call is undervalued, then the PERCS is too \nexpensive; if the imbedded call is overpriced, then the PERCS is cheap. In this exam\nple, the value of the imbedded call was only 81 cents. If XYZ is astock with average \nor above average volatility, then the call is certainly cheap. Therefore, the PERCS, \ntrading at 34, is too expensive. \nOnce this determination has been made, the strategist must decide how to use \nthe information. Abuyer of PER CS will need to know this information to determine \nif he is paying too much for the PER CS; alternatively stated, he needs to know if he \nis selling the imbedded call too cheaply. Ahedger might establish atrue hedge by \nbuying common and selling the PERCS, using the proper hedge ratio. It is possible \nfor a PER CS to remain expensive for quite some time, if investors are buying it for \nthe additional dividend yield alone and are not giving proper consideration to the \nlimited profit potential. Nevertheless, both the outright buyer and the strategist \nshould calculate the correct value of the PER CS in order to make rational decisions. \nPERCS SUMMARY \nA PERCS is apreferred stock with ahigher dividend yield than the common, and it \nis demandable at apredetermined series of prices. The decision to demand is strict\nly at the discretion of the issuing company; the PER CS holder has no say in the deci-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:684", "doc_id": "3e69fdaec4cabe2f87c872d018007102a4a9ae352b97d3bf7a0ac2292823a63f", "chunk_index": 0}
{"text": "Cl,opter 32: Structured Products 637 \n:don. The PERCS is equivalent to acovered write of along-term call option, which is \nimbedded in the PERCS value. Although there are not many PERCS trading at the \ncurrent time, that number may grow substantially in the future. \nAny strategies that pertain to covered call writing will pertain to PER CS as well. \nConventional listed options can be used to protect the PERCS from downside risk, \nto remove the limited upside profit potential, or to effectively change the price at \nwhich the PERCS is redeemable. Ratio writes can be constructed by selling alisted \ncall. Shorting PERCS creates asecurity that is similar to along put, which might be \nquite expensive if there is asignificant amount of time remaining until maturity of \nthe PERCS. \nNeutral traders and hedgers should be aware that a PERCS has adelta of its \nown, which is equal to one minus the delta of the imbedded call option. Thus, hedg\ning PERCS with common stock requires one to calculate the PERCS delta. \nFinally, the implied value of the call option that is imbedded with the PERCS \ncan be calculated quite easily. That information is used to determine whether the \nPERCS is fairly priced or not. The serious outright buyer as well as the option strate\ngist should make this calculation, since a PERCS is asecurity that is option-related. \nEither of these investors needs to know if he is making an attractive investment, and \ncalculating the valuation of the imbedded call is the only way to do so. \nOTHER STRUCTURED PRODUCTS \nEXCHANGE-TRADED FUNDS \nOther listed products exist that are simpler in nature than those already discussed, \nbut that the exchanges sometimes refer to as structured products. They often take \nthe form of unit trusts and mutual funds. The general term for these products is \nExchange-Traded Funds (ETFs). In aunit trust, an underwriter (Merrill Lynch, for \nexample) packages together 10 to 12 stocks that have similar characteristics; perhaps \nthey are in the same industry group or sector. The underwriter forms aunit trust with \nthese stocks. That is, the shares are held in trust and the resulting entity - the unit \ntrust - can actually be traded as shares of its own. The units are listed on an exchange \nand trade just like stocks. \nExample: One of the better-known and popular unit trusts is called the Standard & \nPoor's Depository Receipt{SPDR). It is aunit trust that exactly matches the S&P 500 \nindex, divided by 10. Th&-SPDR unit trust is affectionately called Spiders (or \nSpyders). It trades on the AMEX under the symbol SPY. If the S&P 500 index itself \nis at 1,400, for example, then SPY will be trading near 140. Unit trusts are very active, \nmostly because they allow any investor to buy an index fund, and to move in and out \nof it at will. The bid-asked spread differential is very tight, due to the liquidity of the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:685", "doc_id": "0a51542688750f13f8dc0de8191d1c373b3ac2ccd0dd6279dcef16f630b1f0ac", "chunk_index": 0}
{"text": "Chapter 32: Structured Products 639 \nAnother major segment of ETFs are called Holding Company Depository \nReceipts (HOLDRS). They were created by Merrill Lynch and are listed on the \nAMEX. \nOptions on ETFs. Options are listed on many ETFs. QQQ options, for example, \nare listed on all of the option exchanges and are some of the most liquid contracts in \nexistence. Things can always change, of course: Witness OEX, which at one time \ntraded amillion contracts aday and now barely trades one-thirtieth of that on most \ndays. \nThe options on ETFs can be used as substitutes for many expensive indices. \nThis brings index option trading more into the realm of reasonable cost for the small \nindividual investor. \nExample: The PHLX Semiconductor index ($SOX) has been apopular index since \nits inception, especially during the time that tech stocks were roaring. The index, \nwhose options are expensive because of its high statistical volatility, traded at prices \nbetween 500 and 1,300 for several years. During that time, both implied and histor\nical volatility was near 70%. So, for example, if $SOX were at 1,000 and one wanted \nto buy athree-month at-the-money call, it would cost approximately 135 points. \nThat's $13,500 for one call option. For many investors, that'sout of the realm of fea\nsibility. \nHowever, there are HOLDRS known as Semiconductor HOLDRS (symbol: \nSMH). The Semiconductor HOLD RS are composed of 20 stocks (in differing quan\ntities, since it is acapitalization-weighted unit trust) that behave in aggregate in much \nthe same manner as the Semiconductor index ($SOX) does. However, SMH has trad\ned at prices between 40 and 100 over the same period of time that $SOX was trad\ning between 500 and 1,300. The implied volatility of SMH options is 70% - just like \n$SOX options - because the same stocks are involved in both indices. However, athree-month at-the-money call on the $100 SMH, say, would cost only 13.50 points \n($1,350) - amuch more feasible option cost for most investors and traders. \nThus, astrategy that most option traders should keep in mind is one in which ETFs \nare substituted when one has atrading signal or opinion on ahigh-priced index. \nSimilarities exist among many of them. For example, the Morgan Stanley High-Tech \nindex ($MSH) is well known for the7eliability of its put-call ratio sentiment signals. \nHowever, the index is high-priced and volatile, much like $SOX. Upon examination, \nthough, one can discover that QQQ trades almost exactly like $MSH. So QQQ \noptions and \"stock\" can be used as asubstitute when one wants to trade $MSH.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:687", "doc_id": "5ed4e78b5809fe34dcf1f4c1b6306e678c0a78aa425f07b5920277376f25da71", "chunk_index": 0}
{"text": "640 Part V: Index Options and Futures \nSTRUCTURED PRODUCT SUMMARY \nStructured products whether of the simple style of the Exchange-Traded Fund or \nthe more complicated nature of the PERCS, bull spreads, or protected index funds \n- can and should be utilized by investors looking for unique ways to protect long\nterm holdings in indices or individual stocks. \nThe number of these products is constantly evolving and changing. Thus, \nanyone interested in trading these items should check the Web sites of the exchanges \nwhere the shares are listed. Analytical tools are available on the Web as well. \nFor example, the site www.derivativesmodels.com has over 40 different models \nespecially designed for evaluating options and structured products. They range from \nthe simple Black-Scholes model to models that are designed to evaluate extremely \ncomplicated exotic options. \nAll of these products have aplace, but the most conservative seem to be the \nstructured products that provide upside market potential while limiting downside \nrisk- the products discussed at the beginning of the chapter. As long as the credit\nworthiness of the underwriter is not suspect, such products can be useful longer\nterm investments for nearly everyone who bothers to learn about and understand \nthem.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:688", "doc_id": "3d20c0d1cbf93f673720defe9da02c4355c9f597086b1d7f9ce6a6a4fa93133c", "chunk_index": 0}
{"text": "CHAPTER 33 \nMathetnatical Considerations \nfor Index Products \nIn this chapter, we look at some riskless arbitrage techniques as they apply to index \noptions. Then asummary of mathematical techniques, especially modeling, is pre\nsented. \nARBITRAGE \nMost of the normal arbitrage strategies have been described previously. We will \nreview them here, concentrating on specific techniques not described in previous \nchapters on hedging (market baskets) and index spreading. \nDISCOUNTING \nWe saw that discounting in cash-based options is done with in-the-money options as \nit is with stock options. However, since the discounter cannot exactly hedge the cash\nbased options, he will normally do his discounting near the close of the day so that \nthere is as little time as possible between the time the option is bought and the close \nof the market. This reduces the risk that the underlying index can move too far before \nthe close of trading. \nExample: OEX is trading at 673.53 7nd an arbitrageur can buy the June 690 puts for \n16. That is adiscount of 0.47 since,parity is 16.47. Is this enough of adiscount? That \nis, can the discounter buy this put, hold it unhedged until the close of trading, and \n641", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:689", "doc_id": "8aaff6b4fcd77ea483b372ca38c173cf31b92baa8d142528c0cae6abbb010a9a", "chunk_index": 0}
{"text": "642 Part V: Index Options and Futures \nexercise it; or is there too great achance that OEX will rally and wipe out his dis\ncount? \nIf he buys this put when there is very little time left in the trading day, it might \nbe enough of adiscount. Recall that aone-point move in OEX is roughly equivalent \nto 15 points on the Dow (while aone-point move in SPX is about 7.5 Dow points). \nThus, this O EX discount of 0.4 7 is about equal to 7 Dow points. Obviously, this is not \nalot of cushion, because the Dow can easily move that far in ashort period of time, \nso it would be sufficient only if there are just afew minutes of trading left and there \nwere not previous indications oflarge orders to buy \"market on close.\" \nHowever, if this situation were presented to the discounter at an earlier time in \nthe trading day, he might defer because he would have to hedge his position and that \nmight not be worth the trouble. If there were several hours left in the trading day, \neven adiscount of afull point would not be enough to allow him to remain unhedged \n(one full OEX point is about 15 Dow points). Rather, he would, for example, buy \nfutures, buy OEX calls, or sell puts on another index. At the end of the day, he could \nexercise the puts he bought at adiscount and reverse the hedge in the open market. \nCONVERSIONS AND REVERSALS \nConversions and reversals in cash-based options are really the market basket hedges \n(index arbitrage) described in Chapter 30. That is, the underlying security is actually \nall the stocks in the index. However, the more standard conversions and reversals can \nbe executed with futures and futures options. \nSince there is no credit to one'saccount for selling afuture and no debit for buy\ning one, most futures conversions and reversals trade very nearly at anet price equal \nto the strike. That is, the value of the out-of-the-money futures option is equal to the \ntime premium of the in-the-money option that is its counterpart in the conversion or \nreversal. \nExample: An index future is trading at 179.00. If the December 180 call is trading \nfor 5.00, then the December 180 put should be priced near 6.00. The time value pre\nmium of the in-the-money put is 5.00 (6.00 + 179.00 - 180.00), which is equal to the \nprice of the out-of-the-money call at the same strike. \nIf one were to attempt to do aconversion or reversal with these options, he \nwould have aposition with no risk of loss but no possibility of gain: Areversal would \nbe established, for example, at a \"net price\" of 180. Sell the future at 179, add the \npremium of the put, 6.00, and subtract the cost of the call, 5.00: 179 + 6.00 - 5.00 = \n180.00. As we know from Chapter 27 on arbitrage, one unwinds aconversion or \nreversal for a \"net price\" equal to the strike. Hence, there would be no gain or loss \nfrom this futures reversal.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:690", "doc_id": "6f2e611227df6023f06a64e1df9b75f84417cb434de91cd89f12dd791d8c8db6", "chunk_index": 0}
{"text": "Chapter 33: Mathematical Considerations for Index Products 643 \nFor index futures options, there is no risk when the underlying closes near the \nstrike, since they settle for cash. One is not forced to make achoice as to whether to \nexercise his calls. (See Chapter 27 on arbitrage for adescription of risks at expiration \nwhen trading reversals or conversions.) \nIn actual practice, floor traders may attempt to establish conversions in futures \noptions for small increments - perhaps 5 or 10 cents in S&Pfutures, for example. \nThe arbitrageur should note that futures options do actually create acredit or debit \nin the account. That is, they are like stock options in that respect, even though the \nunderlying instrument is not. This means that if one is using adeep in-the-money \noption in the conversion, there will actually be some carrying cost involved. \nExample: An index future is trading at 179.00 and one is going to price the \nDecember 190 conversion, assuming that December expiration is 50 days away. \nAssume that the current carrying cost of money is 10% annually. Finally, assume that \nthe December 190 call is selling for 1.00, and the December 190 put is selling for \n11.85. Note that the put has atime value premium of only 85 cents, less than the pre\nmium of the call. The reason for this is that one would have to pay acarrying cost to \ndo the December 190 conversion. \nIf one established the 190 conversion, he would buy the futures (no credit or \ndebit to the account), buy the put (adebit of 11.85), and sell the call (acredit of 1.00). \nThus, the account actually incurs adebit of 10.85 from the options. The carrying cost \nfor 10.85 at 10% for 50 days is 10.85 x 10% x 50/365 = 0.15. This indicates that the \nconverter is willing to pay 15 cents less time premium for the put (or conversely that \nthe reversal trader is willing to sell the put for 15 cents less time premium). Instead \nof the put trading with atime value premium equal to the call price, the put will trade \nwith apremium of 15 cents less. Thus, the time premium of the put is 85 cents, \nrather than being equal to the price of the call, 1.00. \nBOX SPREADS \nRecall that a \"box\" consists of abullish vertical spread involving two striking prices, \nand abearish vertical spread using the same two strikes. One spread is constructed \nwith puts and the other with calls. The profitability of the box is the same regardless \nof the price of the underlying security at expiration. \nBox arbitrage with equity options involves trying to buy the box for less than the \ndifference in the striking prices, for ~ple, trying to buy abox in which the strikes \nare 5 points apart for 4. 75. Selling the box for more than 5 points would represent \narbitrage as well. In fact, even selling the box at exactly 5 points would produce aprofit for the arbitrageur, since he earns interest on the credit from the sale.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:691", "doc_id": "d513b4daaa23053bc933c27fc82f1df8d7fcec488201f2fbe9db7dfc238eea90", "chunk_index": 0}
{"text": "644 Part V: Index Options and Futures \nThese same strategies apply to options on futures. However, boxes on cash\nbased options involve another consideration. It is often the case with cash-based \noptions that the box sells for more than the difference in the strikes. For example, abox in which the strikes are 10 points apart might sell for 10.50, asubstantial premi\num over the striking price differential. The reason that this happens is because of the \npossibility of early assignment. The seller of the box assumes that risk and, as aresult, \ndemands ahigher price for the box. \nIf he sells the box for half apoint more than the striking price differential, then \nhe has abuilt-in cushion of .50 point of index movement if he were to be assigned \nearly. In general, box strategies are not particularly attractive. However, if the pre\nmium being paid for the box is excessively high, then one should consider selling the \nbox. Since there are four commissions involved, this is not normally aretail strategy. \nMATHEMATICAL APPLICATIONS \nThe following material is intended to be acompanion to Chapter 28 on mathemati\ncal applications. Index options have afew unique properties that must be taken into \naccount when trying to predict their value via amodel. \nThe Black-Scholes model is still the model of choice for options, even for index \noptions. Other models have been designed, but the Black-Scholes model seems to \ngive accurate results without the extreme complications of most of the other models. \nFUTURES \nModeling the fair value of most futures contracts is adifficult task. The \nBlack-Scholes model is not usable for that task. Recall that we saw earlier that the \nfair value of afuture contract on an index could be calculated by computing the pres\nent value of the dividend and also knowing the savings in carrying cost of the futures \ncontract versus buying the actual stocks in the index. \nCASH-BASED INDEX OPTIONS \nThe futures fair value model for acapitalization-weighted index requires knowing the \nexact dividend, dividend payment date, and capitalization of each stock in the index \n(for price-weighted indices, the capitalization is unnecessary). This is the only way of \ngetting the accurate dividend for use in the model. The same dividend calculation \nmust be done for any other index before the Black-Scholes formula can be applied. \nIn the actual model, the dividend for cash-based index options is used in much \nthe same way that dividends are used for stock options: The present value of the div-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:692", "doc_id": "c034aa272c083bdc2e09b49d58f254b656b28d68ca7be7fc1007cb86589e847c", "chunk_index": 0}
{"text": "Chapter 33: Mathematical Considerations for Index Products 64S \nidend is subtracted from the index price and the model is evaluated using that adjust\ned stock price. With stock options, there was asecond alternative - shortening the \ntime to expiration to be equal to the ex-date - but that is not viable with index options \nsince there are numerous ex-dates. \nLet'slook at an example using the same fictional dividend information and index \nthat were used in Chapter 30 on stock index hedging strategies. \nExample: Assume that we have acapitalization-weighted index composed of three \nstocks: AAA, BBB, and CCC. The following table gives the pertinent information \nregarding the dividends and floats of these three stocks: \nDividend Days until \nStock Amount Dividend Float \nAAA 1.00 35 50,000,000 \nBBB 0.25 60 35,000,000 \nCCC 0.60 8 120,000,000 \nDivisor: 150,000,000 \nOne first computes the present worth of each stock'sdividend, multiplies that \namount by the float, and then divides by the index divisor. The sum of these compu\ntations for each stock gives the total dividend for the index. The present worth of the \ndividend for this index is $0.8667. \nAssume that the index is currently trading at 175.63 and that we want to evalu\nate the theoretical value of the July 175 call. Then, using the Black-Scholes model, \nwe would perform the following calculations: \n1. Subtract the present worth of the dividend, 0.8667, from the current index price \nof 175.63, giving an adjusted index price of 174.7633. \n2. Evaluate the call'sfair value using 17 4. 7633 as the stock price. All other variables \nare as they are for stocks, including the risk-free interest rate at its actual value \n(10%, for example). \nThe theoretical value for puts is computed in the same way as for equity \noptions, by using the arbitrage model. This is sufficient for cash-based index options \nbecause it is possible - albeit difficult to hedge these options by buying or selling \nthe entire index. Thus, the options should reflect the potential for such arbitrage. \nThe put value should, of course, reflect the potential for dividend arbitrage with the \nindex. The arbitrage valuation model p\"resented in Chapter 28 on modeling called for \nthe dividend to be used. For these index puts, one would use the present worth of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:693", "doc_id": "ba5ee1b61c09d96fa138b78a0b8751f043e40bc42197128807b813e695038516", "chunk_index": 0}
{"text": "646 Part V: Index Options and Futures \nthe dividend on the index - the same one that was used for the call valuation, as in \nthe last example. \nTHE IMPLIED DIVIDEND \nIf one does not have access to all of the dividend information necessary to make the \n\"present worth of the dividends\" calculation (i.e., if he is aprivate individual or pub\nlic customer who does not subscribe to acomputer-based dividend \"service\"), there \nis still away to estimate the present worth of the dividend. All one need do is make \nthe assumption that the market- makers know what the present worth of the dividend \nis, and are thus pricing the options accordingly. The individual public customer can \nuse this information to deduce what the dividend is. \nExample: OEX is trading at 700, the June options have 30 days of life remaining, the \nshort-term interest rate is 10%, and the following prices exist: \nJune 700 call: 18.00 \nJune 700 put: 14.50 \nOne can use iterations of the Black-Scholes model to determine what the OEX \n\"dividend\" is. In this case, it turns out to be something on the order of $2.10. \nBriefly, these are the steps that one would need to follow in order to determine \nthis dividend: \n1. Assume the dividend is $0.00. \n2. Using the assumed dividend, use the Black-Scholes model to determine the \nimplied volatility of the call option, whose price is known (18.00 in the above \nexample). \n3. Using the implied volatility determined from step 2 and the assumed dividend, \nis the arbitrage put value as derived from the Black-Scholes calculations at the \nend of step 2 roughly equal to the market value of the put (14.50 in the above \nexample)? If yes, you are done. If not, increase the assumed dividend by some \nnominal amount, say $0.10, and return to step 2. \nThus, without having access to complete dividend information, one can use the \ninformation provided to him by the marketplace in order to imply the dividend of an \nindex option. The only assumption one makes is that the market-makers know what \nthe dividend is (they most assuredly do). Note that the implied volatility of the \noptions is determined concurrently with the implied dividend (step 2 above). Aveiy \nuseful tool, this simple \"implied dividend calculator\" can be added to any software \nthat employs the Black-Scholes model.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:694", "doc_id": "b0d10ed61bfd1c89b625989ba026307ba036abe4be2958b2ea6fcd65225feec2", "chunk_index": 0}
{"text": "O,apter 33: Mathematical Considerations for Index Products \nEUROPEAN EXERCISE \n647 \nTo account for European exercise, one basically ignores the fact that an in-the-money \nput option'sminimum value is its intrinsic value. European exercise puts can trade at \nadiscount to intrinsic value. Consider the situation from the viewpoint of aconver\nsion arbitrage. If one buys stock, buys puts, and sells calls, he has aconversion arbi\ntrage. In the case of a European exercise option, he is forced to carry the position to \nexpiration in order to remove it: He cannot exercise early, nor can he be called early. \nTherefore, his carrying costs will always be the maximum value to expiration. These \ncarrying costs are the amount of the discount of the put value. \nFor adeeply in-the-money put, the discount will be equal to the carrying \ncharges required to carry the striking price to expiration: \nCarry = s Ji - 1 ] L (1+ r)t \nLess deeply in-the-money puts, that is, those with deltas less than - 1.00, would \nnot require the full discounting factor. Rather, one could multiply the discounting \nfactor by the absolute value of the put' sdelta to arrive at the appropriate discounting \nfactor. \nFUTURES OPTIONS \nAmodified Black-Scholes model, called the Black Model, can be used to evaluate \nfutures options. See Chapter 29 on futures for afutures discussion. Essentially, the \nadjustment is as follows: Use 0% as the risk-free rate in the Black-Scholes model and \nobtain atheoretical call value; then discount that result. \nBlack model: \nCall value= e-rt x Black-Scholes call value [using r = 0%] \nwhere \nris the risk-free interest rate \nand tis the time to expiration in years. \nThe relationship between afutures call theoretical value and that of aput can \nalso be discussed from the model: \nCall = Put + e-rf(J - s) \nwhere \nfis the futures price \nands is the striking price.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:695", "doc_id": "86a98bdbf06b0509bac171f5e5bd64d9b2711030b98c5224af0400ded217cdfe", "chunk_index": 0}
{"text": "648 Part V: Index Options and Futures \nExample: The following prices exist: \nZYX Cash Index: 17 4.49 \nZYX December future: 177.00 \nThere are 80 days remaining until expiration, the volatility of ZYX is 15%, and \nthe risk-free interest rate is 6%. \nIn order to evaluate the theoretical value of a ZYX December 185 call, the fol\nlowing steps would be taken: \nl. Evaluate the regular Black-Scholes model using 185 as the strike, 177.00 as the \nstock price, 15% as the volatility, 0.22 as the time remaining (80/365), and 0% as \nthe interest rate. Note that the futures price, not the index price, is input to the \nmodel as stock price. \nSuppose that this yields aresult of 2.05. \n2. Discount the result from step l: \nBlack Model call value = e-(.0 6 x 0-22) x 2.05 \n= 2.02 \nIn this case, the difference between the Black model and the Black-Scholes \nmodel is small (3 cents). However, the discounting factor can be large for longer-term \nor deeply in-the-money options. \nThe other items of amathematical nature that were discussed in Chapter 28 on \nmathematical applications are applicable, without change, to index options. Expected \nreturn and implied volatility have the same meaning. Implied volatility can be calcu\nlated by using the Black-Scholes formulas as specified above. \nNeutral positioning retains its meaning as well. Recall that any of the above the\noretical value computations gives the delta of the option as aby-product. These deltas \ncan be used for cash-based and futures options just as they are used for stock options \nto maintain aneutral position. This is done, of course, by calculating the equivalent \nstock position (or equivalent \"index\" or \"futures\" position, in these cases). \nFOLLOW-UP ACTION \nThe various types of follow-up action that were applicable to stock options are avail\nable for index options as well. In fact, when one has spread options on the same \nunderlying index, these actions are virtually the same. However, when one is doing \ninter-index spreads, there is another type of follow-up picture that is useful. The rea-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:696", "doc_id": "4dde12d3dbd60ff0b3f4a71e04c17bca9052480394c779f5e787f52baeb94ee8", "chunk_index": 0}
{"text": "Chapter 33: Mathematical Considerations for Index Products 649 \nson for this is that the spread will have different outcomes not only based on the price \nof one index, but also based on that index'srelationship to the other index. \nIt is possible, for example, that amildly bullish strategy implemented as an \ninter-index spread might actually lose money even if one index rose. This could hap\npen if the other index performed in amanner that was not desirable. If one could \nhave his computer \"draw\" apicture of several different outcomes, he would have abetter idea of the profit potential of his strategy. \nExample: Assume aput spread between the ZYX and the ABX indices was estab\nlished. An ABX June 180 put was bought at 3.00 and a ZYX June 175 put was sold at \n3.00, when the ZYX was at 175.00 and the ABX Index was at 178.00. This spread will \nobviously have different outcomes if the prices of the ZYX and the ABX move in dra\nmatically different patterns. \nOn the surface, this would appear to be abearish position - long aput at ahigh\ner strike and short aput at alower strike. However, the position could make money \neven in arising market if the indices move appropriately: If, at expiration, the ZYX \nand ABX are both at 179.00, for example, then the short option expires worthless and \nthe long option is still worth 1.00. This would mean that a 1-point profit, or $500, was \nmade in the spread ($1,500 profit on the short ZYX puts less a $1,000 loss on the one \nABX put). \nConversely, adownward movement doesn'tguarantee profits either. If the ZYX \nfalls to 170.00 while the ABX declines to 175.00, then both puts would be worth 5 at \nexpiration and there would be no gain or loss in the spread. \nWhat the strategist needs in order to better understand his position is a \"sliding scale\" \npicture. That is, most follow-up pictures give the outcome (say, at expiration) of the \nposition at various stock or index prices. That is still needed: One would want to see \nthe outcome for ZYX prices of, say, 165 up to 185 in the example. However, in this \nspread something else is needed: The outcome should also take into account how the \nZYX matches up with the ABX. Thus, one might need three (or more) tables of out\ncomes, each of which depicts the results as ZYX ranges from 165 up to 185 at expi\nration. One might first show how the results would look if ZYX were, say, 5 points \nbelow ABX; then another table would show ZYX and ABX unchanged from their \noriginal relationship (a 3-point differential); finally, another table would show the \nresults if ZYX and ABX were equal at expiration. \nIf the relationship between the two indices were at 3 points at expiration, such \natable might look like this:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:697", "doc_id": "782f9637c88cc1434c31d9b3913494f3d4b2555cc922e9c92dc0cd88980f534d", "chunk_index": 0}
{"text": "6S0 Part V: Index Options and Futures \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 168 173 178 183 188 \nZYX June 175P 10 5 0 0 0 \nABX June 1 80P 12 7 2 0 0 \nProfit +$1,000 +$1,000 +$1,000 0 0 \nThis picture indicates that the position is neutral to bearish, since it makes \nmoney even if the indices are unchanged. However, contrast this with the situation \nin which the ZYX falls to alevel 5 points below the ABX by expiration. \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 170 175 180 185 190 \nZYX June 175P 10 5 0 0 0 \nABX June l 80P 10 5 0 0 0 \nProfit 0 0 0 0 0 \nIn this case, the spread has no potential for profit at all, even if the market col\nlapses. Thus, even abearish spread like this might not prove profitable if there is an \nadverse movement in the relationship of the indices. \nFinally, observe what happens if the ZYX rallies so strongly that it catches up to \nthe ABX. \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 165 170 175 180 185 \nZYX June 175P 10 5 0 0 0 \nABX June 180P 15 10 5 0 0 \nProfit +$2,500 +$2,500 +$2,500 +$2,500 +$2,500 \nThese tables can be called \"sliding scale\" tables, because what one is actually \ndoing is showing adifferent set of results by sliding the ABX scale over slightly each \ntime while keeping the ZYX scale fixed. Note that in the above two tables, the ZYX \nresults are unchanged, but the ABX has been slid over slightly to show adifferent \nresult. Tables like this are necessary for the strategist who is doing spreads in options \nwith different underlying indices or is trading inter-index spreads.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:698", "doc_id": "2dd35596e5690bcd4944661214ff5e07f73d1ac24400b5e429024186f18aef06", "chunk_index": 0}
{"text": "650 Part V: Index Options and Futures \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 168 173 178 183 188 \nZYX June 175P 10 5 0 0 0 \nABX June 180P 12 7 2 0 0 \nProfit +$1,000 +$1,000 +$1,000 0 0 \nThis picture indicates that the position is neutral to bearish, since it makes \nmoney even if the indices are unchanged. However, contrast this with the situation \nin which the Z¥Xfalls to alevel 5 points below the ABX by expiration. \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 170 175 180 185 190 \nZYX June 175P 10 5 0 0 0 \nABX June 1 80P 10 5 0 0 0 \nProfit 0 0 0 0 0 \nIn this case, the spread has no potential for profit at all, even if the market col\nlapses. Thus, even abearish spread like this might not prove profitable if there is an \nadverse movement in the relationship of the indices. \nFinally, observe what happens if the ZYX rallies so strongly that it catches up to \nthe ABX. \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 165 170 175 180 185 \nZYX June 175P 10 5 0 0 0 \nABX June 1 80P 15 10 5 0 0 \nProfit +$2,500 +$2,500 +$2,500 +$2,500 +$2,500 \nThese tables can be called \"sliding scale\" tables, because what one is actually \ndoing is showing adifferent set of results by sliding the ABX scale over slightly each \ntime while keeping the Z¥Xscale fixed. Note that in the above two tables, the Z¥Xresults are unchanged, but the ABX has been slid over slightly to show adifferent \nresult. Tables like this are necessary for the strategist who is doing spreads in options \nwith different underlying indices or is trading inter-index spreads.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:699", "doc_id": "4a7ce645a50ab9931107984cced3b7ec4c0871db60165d4d9ad59a0568bba0c8", "chunk_index": 0}
{"text": "650 \nZYX \nABX \nZYX June 175P \nABX June 1 80P \nProfit \n165 \n168 \n10 \n12 \n+$1,000 \n170 \n173 \n5 \n7 \n+$1,000 \nPart V: Index Options and Futures \nPrice at Expiration \n175 180 185 \n178 183 188 \n0 0 0 \n2 0 0 \n+$1,000 0 0 \nThis picture indicates that the position is neutral to bearish, since it makes \nmoney even if the indices are unchanged. However, contrast this with the situation \nin which the ZYX falls to alevel 5 points below the ABX by expiration. \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 170 175 180 185 190 \nZYX June 175P 10 5 0 0 0 \nABX June 1 80P 10 5 0 0 0 \nProfit 0 0 0 0 0 \nIn this case, the spread has no potential for profit at all, even if the market col\nlapses. Thus, even abearish spread like this might not prove profitable if there is an \nadverse movement in the relationship of the indices. \nFinally, observe what happens if the ZYX rallies so strongly that it catches up to \nthe ABX. \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 165 170 175 180 185 \nZYX June 175P 10 5 0 0 0 \nABX June 1 80P 15 10 5 0 0 \nProfit +$2,500 +$2,500 +$2,500 +$2,500 +$2,500 \nThese tables can be called \"sliding scale\" tables, because what one is actually \ndoing is showing adifferent set of results by sliding the ABX scale over slightly each \ntime while keeping the ZYX scale fixed. Note that in the above two tables, the ZYX \nresults are unchanged, but the ABX has been slid over slightly to show adifferent \nresult. Tables like this are necessary for the strategist who is doing spreads in options \nwith different underlying indices or is trading inter-index spreads.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:700", "doc_id": "fe4d5c196639a912fa301c47ebab3a13ef10e48ed57af691cbe0c26231001ee0", "chunk_index": 0}
{"text": "Cl,apter 33: Mathematical Considerations for Index Products 651 \nThe astute reader will notice that the above example can be generalized by \ndrawing athree-dimensional graph. The Xaxis would be the price of ZYX; the Yaxis \nwould be the dollars of profit in the spread; and instead of \"sliding scales,\" the Zaxis \nwould be the price of ABX. There is software that can draw 3-dimensional profit \ngraphs, although they are somewhat difficult to read. The previous tables would then \nbe horizontal planes of the three-dimensional graph. \nThis concludes the chapter on riskless arbitrage and mathematical modeling. \nRecall that arbitrage in stock options can affect stock prices. The arbitrage \ntechniques outlined here do not affect the indices themselves. That is done by the \nmarket basket hedges. It was also known that no new models are necessary for \nevaluation. For index options, one merely has to properly evaluate the dividend for \nusage in the standard Black-Scholes model. Future options can be evaluated by set\nting the risk-free interest rate to 0% in the Black-Scholes model and discounting the \nresult, which is the Black model. \n)", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:701", "doc_id": "f18f86ef782bdf721cbd9b380563a4ed6a8885a9ccfef79ec05c65d7446e7bf1", "chunk_index": 0}
{"text": "CHAPTER 34 \nFutures and Futures Options \nIn the previous chapters on index trading, aparticular type of futures option - the \nindex option - was described in some detail. In this chapter, some background infor\nmation on futures themselves is spelled out, and then the broad category of futures \noptions is investigated. In recent years, options have been listed on many types of \nfutures as well as on some physical entities. These include options on things as diverse \nas gold futures and cattle futures, as well as options on currency and bond futures. \nMuch of the information in this chapter is concerned with describing the ways \nthat futures options are similar to, or different from, ordinary equity and index \noptions. There are certain strategies that can be developed specifically for futures \noptions as well. However, it should be noted that once one understands an option \nstrategy, it is generally applicable no matter what the underlying instrument is. That \nis, abull spread in gold options entails the same general risks and rewards as does abull spread in any stock'soptions - limited downside risk and limited upside profit \npotential. The gold bull spread would make its maximum profit if gold futures were \nabove the higher strike of the spread at expiration, just as an equity option bull spread \nwould do if the stock were above the higher strike at expiration. Consequently, it \nwould be awaste of time and space to go over the same strategies again, substituting \nsoybeans or orange juice futures, say, for XYZ stock in all the examples that have been \ngiven in the previous chapters of this book. Rather, the concentration will be on areas \nwhere there is truly anew or different strategy that futures options provide. \nBefore beginning, it should be pointed out that futures contracts and futures \noptions have far less standardization than equity or index options do. Most futures \ntrade in different units. Most options have different expiration months, expiration \ntimes, and striking price intervals. All the different contract specifications are not \nspelled out here. One should contact his broker or the exchange where the contracts \n652", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:702", "doc_id": "e86cb6475f6a95edb0ab4ab522236f664f425ab045891084f0663a775f2e5132", "chunk_index": 0}
{"text": "Cl,apter 34: Futures and Futures Options 6S3 \nare traded in order to receive complete details. However, whenever examples are \nused, full details of the contracts used in those examples are given. \nFUTURES CONTRACTS \nBefore getting into options on futures, afew words about futures contracts them\nselves may prove beneficial. Recall that afutures contract is astandardized contract \ncalling for the delivery of aspecified quantity of acertain commodity at some future \ntime. Future contracts are listed on awide variety of commodities and financial \ninstruments. In some cases, one must make or take delivery of aspecific quantity of \naphysical commodity (50,000 bushels of soybeans, for example). These are known as \nfutures on physicals. In others, the futures settle for cash as do the S&P 500 Index \nfutures described in aprevious chapter; there are other futures that have this same \nfeature (Eurodollar time deposits, for example). These types of futures are cash\nbased, or cash settlement, futures. \nIn terms of total numbers of contracts listed on the various exchanges, the more \ncommon type of futures contract is one with aphysical commodity underlying it. \nThese are sometimes broken down into subcategories, such as agricultural futures \n(those on soybeans, oats, coffee, or orange juice) and financial futures (those on U.S. \nTreasury bonds, bills, and notes). \nTraders not familiar with futures sometimes get them confused with options. \nThere really is very little resemblance between futures and options. Think of futures \nas stock with an expiration date. \nThat is, futures contracts can rise dramatically in price and can fall all the way \nto nearly zero (theoretically), just as the price of astock can. Thus, there is great \npotential for risk. Conversely, with ownership of an option, risk is limited. The only \nreal similarity between futures and options is that both have an expiration date. In \nreality, futures behave much like stock, and the novice should understand that con\ncept before moving on. \nHEDGING \nThe primary economic function of futures markets is hedging - taking afutures \nposition to offset the risk of actually owning the physical commodity. The physical \ncommodity or financial instrument is known as the \"cash.\" For index futures, this \nhedging was designed to remove the risk from owning stocks (the \"cash market\" that \nunderlies index futures). Aportfolio manager who owned alarge quantity of stocks \ncould sell index futures against the stock to remove much of the price risk of that", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:703", "doc_id": "4da6d6bcbc2472b6586e617de8ebd8e364705eec8237ee0874e60217d4668923", "chunk_index": 0}
{"text": "654 Part V: Index Options and Futures \nstock ownership. Moreover, he is able to establish that hedge at amuch smaller com\nmission cost and with much less work than would be required to sell thousands of \nshares of stock. Similar thinking applies to all the cash markets that underlie futures \ncontracts. The ability to hedge is important for people who must deal in the \"cash\" \nmarket, because it gives them price protection as well as allowing them to be more \nefficient in their pricing and profitability. Ageneral example may be useful to demon\nstrate the hedging concept. \nExample: An international businessman based in the United States obtains alarge \ncontract to supply a Swiss manufacturer. The manufacturer wishes to pay in Swiss \nfrancs, but the payment is not due until the goods are delivered six months from now. \nThe U.S. businessman is obviously delighted to have the contract, but perhaps is not \nso delighted to have the contract paid in francs six months from now. If the U.S. dol\nlar becomes stronger relative to the Swiss franc, the U.S. businessman will be receiv\ning Swiss francs which will be worth fewer dollars for his contract than he originally \nthought he would. In fact, if he is working on anarrow profit margin, he might even \nsuffer aloss if the Swiss franc becomes too weak with respect to the dollar. \nAfutures contract on the Swiss franc may be appropriate for the U.S. business\nman. He is \"long\" Swiss francs via his contract (that is, he will get francs in six months, \nso he is exposed to their fluctuations during that time). He might sell short a Swiss \nfranc futures contract that expires in six months in order to lock in his current profit \nmargin. Once he sells the future, he locks in aprofit no matter what happens. \nThe future'sprofit and loss are measured in dollars since it trades on a U.S. \nexchange. If the Swiss franc becomes stronger over the six-month period, he will lose \nmoney on the futures sale, but will receive more dollars for the sale of his products. \nConversely, if the franc becomes weak, he will receive fewer dollars from the Swiss \nbusinessman, but his futures contract sale will show aprofit. 111 either case, the \nfutures contract enables him to lock in afuture price (hence the name \"futures\") that \nis profitable to him at today'slevel. \nThe reader should note that there are certain specific factors that the hedger \nmust take into consideration. Recall that the hedger of stocks faces possible problems \nwhen he sells futures to hedge his stock portfolio. First, there is the problem of sell\ning futures below their fair value; changes in interest rates or dividend payouts can \naffect the hedge as well. The U.S. businessman who is attempting to hedge his Swiss \nfrancs may face similar problems. Certain items such as short-term interest rates, \nwhich affect the cost of carry, and other factors may cause the Swiss franc futures to \ntrade at apremium or discount to the cash price. That is, there is not necessarily acomplete one-to-one relationship between the futures price and the cash price.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:704", "doc_id": "e61cb94033f23ab86ea1af959d3176b2a8574497b1761cddc7721dc41e47aa64", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 655 \nHowever, the point is that the businessman is able to substantially reduce the cur\nrency risk, since in six months there could be alarge change in the relationship \nbetween the U.S. dollar and the Swiss franc. While his hedge might not eliminate \nevery bit of the risk, it will certainly get rid of avery large portion of it. \nSPECULATING \nWhile the hedgers provide the economic function of futures, speculators provide the \nliquidity. The attraction for speculators is leverage. One is able to trade futures with \nvery little margin. Thus, large percentages of profits and losses are possible. \nExample: Afutures contract on cotton is for 50,000 pounds of cotton. Assume the \nMarch cotton future is trading at 60 (that is, 60 cents per pound). Thus, one is con\ntrolling $30,000 worth of cotton by owning this contract ($0.60 per pound x 50,000 \npounds). However, assume the exchange minimum margin is $1,500. That is, one has \nto initially have only $1,500 to trade this contract. This means that one can trade cot\nton on 5% margin ($1,500/$30,000 = 5%). \nWhat is the profit or risk potential here? Aone-cent move in cotton, from 60 to \n61, would generate aprofit of $500. One can always determine what aone-cent move \nis worth as long as he knows the contract size. For cotton, the size is 50,000 pounds, \nso aone-cent move is 0.01 x 50,000 = $500. \nConsequently, if cotton were to fall three cents, from 60 to 57, this speculator \nwould lose 3 x $500, or $1,500 - his entire initial investment. Alternatively, a 3-cent \nmove to the upside would generate aprofit of $1,500, a 100% profit. \nThis example clearly demonstrates the large risks and rewards facing aspecula\ntor in futures contracts. Certain brokerage firms may require the speculator to place \nmore initial margin than the exchange minimum. Usually, the most active customers \nwho have asufficient net worth are allowed to trade at the exchange minimum mar\ngins; other customers may have to put up two or three times as much initial margin \nin order to trade. This still allows for alot of leverage, but not as much as the specu\nlator has who is trading with exchange minimum margins. Initial margin require\nments can be in the form of cash or Treasury bills. Obviously, if one uses Treasury \nbills to satisfy his initial margin requirements, he can be earning interest on that \nmoney while it serves as collateral for his initial margin requirements. If he uses cash \nfor the initial requirement, he will not earn interest. (Note: Some large customers do \nearn credit on the cash used for margin requirements in their futures accounts, but \nmost customers do not.) \nAspeculator will also be required to keep his account current daily through the \nuse of maintenance mar~is account is marked to market daily, so unrealized", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:705", "doc_id": "023741bcef7c6e8c8d5074181674870e23842792b4a275a3c21b7cb17492125b", "chunk_index": 0}
{"text": "656 Part V: Index Options and Futures \ngains and losses are taken into account as well as are realized ones. If his account \nloses money, he must add cash into the account or sell out some of his Treasury bills \nin order to cover the loss, on adaily basis. However, if he makes money, that unreal\nized profit is available to be withdrawn or used for another investment. \nExample: The cotton speculator from the previous example sees the price of the \nMarch cotton futures contract he owns fall from 60.00 to 59.20 on the first day he \nowns it. This means there is a $400 unrealized loss in his account, since his holding \nwent down in price by 0.80 cents and aone-cent move is worth $500. He must add \n$400 to his account, or sell out $400 worth of T-bills. \nThe next day, rumors of adrought in the growing areas send cotton prices much \nhigher. The March future closes at 60.90, up 1.70 from the previous day'sclose. That \nrepresents again of $850 on the day. The entire $850 could be withdrawn, or used as \ninitial margin for another futures contract, or transferred to one'sstock market \naccount to be used to purchase another investment there. \nWithout speculators, afutures contract would not be successful, for the specu\nlators provide liquidity. Volatility attracts speculators. If the contract is not trading \nand open interest is small, the contract may be delisted. The various futures \nexchanges can delist futures just as stocks can be delisted by the New York Stock \nExchange. However, when stocks are delisted, they merely trade over-the-counter, \nsince the corporation itself still exists. When futures are delisted, they disappear -\nthere is no over-the-counter futures market. Futures exchanges are generally more \naggressive in listing new products, and delisting them if necessary, than are stock \nexchanges. \nTERMS \nFutures contracts have certain standardized terms associated with them. However, \ntrading in each separate commodity is like trading an entirely different product. The \nstandardized terms for soybeans are completely different from those for cocoa, for \nexample, as might well be expected. The size of the contract (50,000 pounds in the \ncotton example) is often based on the historical size of acommodity delivered to \nmarket; at other times it is merely acontrived number ($100,000 face amount of U.S. \nTreasury bonds, for example). \nAlso, futures contracts have expiration dates. For some commodities (for exam\nple, crude oil and its products, heating oil and unleaded gasoline), there is afutures \ncontract for every month of the year. Other commodities may have expirations in only \n5 or 6 calendar months of the year. These items are listed along with the quotes in agood financial newspaper, so they are not difficult to discover.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:706", "doc_id": "c966512f1e2246e87dd1a4decc53b0c4d0c9f7f52e1fae0bd00ce8ccf7106303", "chunk_index": 0}
{"text": "Gapter 34: Futures and Futures Options 657 \nThe number of expiration months listed at any one time varies from one mar\nket to another. Eurodollars, for example, have futures contracts with expiration dates \nthat extend up to ten years in the future. T-bond and 10-year note contracts have \nexpiration dates for only about the next year or so. Soybean futures, on the other \nhand, have expirations going out about two years, as do S&Pfutures. \nThe day of the expiration month on which trading ceases is different for each \ncommodity as well. It is not standardized, as the third Friday is for stock and index \noptions. \nTrading hours are different, even for different commodities listed on the same \nfutures exchange. For example, U.S. Treasury bond futures, which are listed on the \nChicago Board of Trade, have very long trading hours (currently 8:20 A.M. to 3 P.M. \nand also 7 P.M. to 10:30 P.M. every day, Eastern time). But, on the same exchange, soy\nbean futures trade avery short day (10:30 A.M. to 2:15 P.M., Eastern time). Some mar\nkets alter their trading hours occasionally, while others have been fixed for years. For \nexample, as the foreign demand for U.S. Treasury bond futures increases, the trad\ning hours might expand even further. However, the grain markets have been using \nthese trading hours for decades, and there is little reason to expect them to change \nin the future. · \nUnits of trading vary for different futures contracts as well. Grain futures trade \nin eighths of apoint, 30-year bond futures trade in thirty-seconds of apoint, while \nthe S&P 500 futures trade in 10-cent increments (0.10). Again, it is the responsibili\nty of the trader to familiarize himself with the units of trading in the futures market \nif he is going to be trading there. \nEach futures contract has its own margin requirements as well. These conform \nto the type of margin that was described with respect to the cotton example above: \nAn initial margin may be advanced in the form of collateral, and then daily mark-to\nmarket price movements are paid for in cash or by selling some of the collateral. \nRecall that maintenance margin is the term for the daily mark to market. \nFinally, futures are subject to position limits. This is to prevent any one entity \nfrom attempting to comer the market in aparticular delivery month of acommodi\nty. Different futures have different position limits. This is normally only of interest to \nhedgers or very large speculators. The exchange where the futures trade establishes \nthe position limit. \nTRADING LIMITS \nMost futures contracts have some limit on their maximum daily price change. For \nindex futures, it was shown that the limits are designed to act like circuit breakers to \nprevent the stock market from crashing. Trading limits exist in many futures con-\n(", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:707", "doc_id": "e3e42ef42c1fdddf38df6d1a8319261ae67c4d511e3d264fd37342b747ac2262", "chunk_index": 0}
{"text": "658 Part V: Index Options and Futures \ntracts in order to help ensure that the market cannot be manipulated by someone \nforcing the price to move tremendously in one direction or the other. Another rea\nson for having trading limits is ostensibly to allow only afixed move, approximately \nequal to or slightly less than the amount covered by the initial margin requirement, \nso that maintenance margin can be collected if need be. However, limits have been \napplied to all futures, some of which don'treally seem to warrant alimit - U.S. \nTreasury bonds, for example. The bond issue is too large to manipulate, and there is \naliquid \"cash\" bond market to hedge with. \nRegardless, limits are afact of life in futures trading. Each individual commod\nity has its own limits, and those limits may change depending on how the exchange \nviews the volatility of that commodity. For example, when gold was trading wildly at \naprice of more than $700 per ounce, gold futures had alarger daily trading limit than \nthey do at more stable levels of $300 to $400 an ounce (the current limit is a $15 \nmove per day). If acommodity reaches its limit repeatedly for two or three days in arow, the exchange will usually increase the limit to allow for more price movement. \nThe Chicago Board of Trade automatically increases limits by 50% if afutures con\ntract trades at the limit three days in arow. \nWhenever limits exist there is always the possibility that they can totally destroy \nthe liquidity of amarket. The actual commodity underlying the futures contract is \ncalled the \"spot\" and trades at the \"spot price.\" The spot trades without alimit, of \ncourse. Thus, it is possible that the spot commodity can increase in price tremen\ndously while the futures contract can only advance the daily limit each day. This sce\nnario means that the futures could trade \"up or down the limit\" for anumber of days \nin arow. As aconsequence, no one would want to sell the futures if they were trad\ning up the limit, since the spot was much higher. In those cases there is no trading in \nthe futures - they are merely quoted as bid up the limit and no trades take place. This \nis disastrous for short sellers. They may be wiped out without ever naving the chance \nto close out their positions. This sometimes happens to orange juice futures when an \nunexpected severe freeze hits Florida. Options can help alleviate the illiquidity \ncaused by limit moves. That topic is covered later in this chapter. \nDELIVERY \nFutures on physical commodities can be assigned, much like stock options can be \nassigned. When afutures contract is assigned, the buyer of the contract is called upon \nto receive the full contract. Delivery is at the seller'soption, meaning that the owner \nof the contract is informed that he must take delivery. Thus, if acorn contract is \nassigned, one is forced to receive 5,000 bushels of corn. The old adage about this \nbeing dumped in your yard is untrue. One merely receives awarehouse receipt and", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:708", "doc_id": "af80b917ca925220214e32dd937dd4a3dc3a8116945aee987da0e21eb26640e3", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 659 \nis charged for storage. His broker makes the actual arrangements. Futures contracts \ncannot be assigned at any time during their life, as options can. Rather, there is ashort period of time before they expire during which one can take delivery. This is \ngenerally a 4- to 6-week period and is called the \"notice period\" - the time during \nwhich one can be notified to accept delivery. The first day upon which the futures \ncontract may be assigned is called the \"first notice day,\" for logical reasons. \nSpeculators close out their positions before the first notice day, leaving the rest of the \ntrading up to the hedgers. Such considerations are not necessary for cash-based \nfutures contracts (the index futures), since there is no physical commodity involved. \nIt is always possible to make amistake, of course, and receive an assignment \nwhen you didn'tintend to. Your broker will normally be able to reverse the trade for \nyou, but it will cost you the warehouse fees and generally at least one commission. \nThe terms of the futures contract specify exactly what quantity of the commod\nity must be delivered, and also specify what form it must be in. Normally this is \nstraightforward, as is the case with gold futures: That contract calls for delivery of 100 \ntroy ounces of gold that is at least 0.995 fine, cast either in one bar or in three one\nkilogram bars. \nHowever, in some cases, the commodity necessary for delivery is more compli\ncated, as is the case with Treasury bond futures. The futures contract is stated in \nterms of anominal 8% interest rate. However, at any time, it is likely that the pre\nvailing interest rate for long-term Treasury bonds will not be 8%. Therefore, the \ndelivery terms of the futures contract allow for delivery of bonds with other interest \nrates. \nNotice that the delivery is at the seller'soption. Thus, if one is short the futures \nand doesn'trealize that first notice day has passed, he has no problem, for delivery is \nunder his control. It is only those traders holding long futures who may receive asur\nprise delivery notice. \nOne must be familiar with the specific terms of the contract and its methods of \ndelivery if he expects to deal in the physical commodity. Such details on each futures \ncontract are readily available from both the exchange and one'sbroker. However, \nmost futures traders never receive or deliver the physical commodity; they close out \ntheir futures contracts before the time at which they can be called upon to make \ndelivery. \nPRICING OF FUTURES \nIt is beyond the scope of this book to describe futures arbitrage versus the cash com\nmodity. Suffice it to say that this arbitrage is done, more in some markets (U.S. \nTreasury bonds, for example) than others (soybeans). Therefore, futures can be over-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:709", "doc_id": "17a163e398590bbc7f08a7d7168ec957bddabddeb3441ab76fc5f0c2cf01bdd3", "chunk_index": 0}
{"text": "660 Part V: Index Options and Futures \npriced or underpriced as well. The arbitrage possibilities would be calculated in amanner similar to that described for index futures, the futures premium versus cash \nbeing the determining factor. \nOPTIONS ON FUTURES \nThe reader is somewhat familiar with options on futures, having seen many examples \nof index futures options. The commercial use of the option is to lock in aworst-case \nprice as opposed to afuture price. The U.S. businessman from the earlier example \nsold Swiss franc futures to lock in afuture price. However, he might decide instead \nto buy Swiss franc futures put options to hedge his downside risk, but still leave room \nfor upside profits if the currency markets move in his favor. \nDESCRIPTION \nAfutures option is an option on the futures contract, not on the cash commodity. \nThus, if one exercises or assigns afutures option, he buys or sells the futures contract. \nThe options are always for one contract of the underlying commodity. Splits and \nadjustments do not apply in the futures markets as they do for stock options. Futures \noptions generally trade in the same denominations as the future itself ( there are afew \nexceptions to this rule, such as the T-bond options, which trade in sixty-fourths while \nthe futures trade in thirty-seconds). \nExample: Soybean options will be used to illustrate the above features of futures \noptions. \nSuppose that March soybeans are selling at 575. \nSoybean quotes are in cents. Thus, 575 is $5.75 - soybeans cost $5.75 per \nbushel. Asoybean contract is for 5,000 bushels of soybeans, so aone-cent move is \nworth $50 (5,000 x .01). -\nSuppose the following option prices exist. The dollar cost of the options is also \nshown (one cent is worth $50). \nOption Price Dollar Cost \nMarch 525 put 5 $ 250 \nMarch 550 call 35 1/2 $1,775 \nMarch 600 call 81/4 $ 412.50 \nThe actual dollar cost is not necessary for the option strategist to determine the \nprofitability of acertain strategy. For example, if one buys the March 600 call, he", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:710", "doc_id": "72b0780e836125a7a1e44fa8870e5419e72350fed46bc4d7c6a06b81bcd17eec", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 661 \nneeds March soybean futures to be trading at 608.25 or higher at expiration in order \nto have aprofit at that time. This is the normal way in which acall buyer views his \nbreak-even point at expiration: strike price plus cost of the call. It is not necessary to \nknow that soybean options are worth $50 per point in order to know that 608.25 is \nthe break-even price at expiration. \nIf the future is acash settlement future (Eurodollar, S&P 500, and other \nindices), then the options and futures generally expire simultaneously at the end of \ntrading on the last trading day. (Actually, the S&P'sexpire on the next morning'sopening.) However, options on physical futures will expire before the first notice day \nof the actual futures contract, in order to give traders time to close out their positions \nbefore receiving adelivery notice. The fact that the option expires in advance of the \nexpiration of the underlying future has aslightly odd effect: The option often expires \nin the month preceding the month used to describe it. \nExample: Options on March soybean futures are referred to as \"March options.\" \nThey do not actually expire in March - however, the soybean futures do. \nThe rather arcane definition of the last trading day for soybean options is \"the \nlast Friday preceding the last business day of the month prior to the contract month \nby at least 5 business days\"! \nThus, the March soybean options actually expire in February. Assume that the \nlast Friday of February is the 23rd. If there is no holiday during the business week of \nFebruary 19th to 23rd, then the soybean options will expire on Friday, February \n16th, which is 5 business days before the last Friday of February. \nHowever, if President's Day happened to fall on Monday, February 19th, then \nthere would only be four business days during the week of the 19th to the 23rd, so \nthe options would have to expire one Friday earlier, on February 9th. \nNot too simple, right? The best thing to do is to have afutures and options expi\nration calendar that one can refer to. Futures Magazine publishes ayearly calendar \nin its December issue, annually, as well as monthly calendars which are published \neach month of the year. Alternatively, your broker should be able to provide you with \nthe information. \nIn any case, the March soybean futures options expire in February, well in \nadvance of the first notice day for March soybeans, which is the last business day of \nthe month preceding the expiration month (February 28th in this case). The futures \noption trader must be careful not to assume that there is along time between option \nexpiration and first notice day of the futures contract. In certain commodities, the \nfutures first notice day is the day after the options expire (live cattle futures, for \nexample). \n\\", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:711", "doc_id": "31eb4b98123eca75fcca27caf4b7ce45b2d35c41792fe7dea13ddaf7fd3c266e", "chunk_index": 0}
{"text": "662 Part V: Index Options and Futures \nThus, if one is long calls or short puts and, therefore, acquires along futures \ncontract via exercise or assignment, respectively, he should be aware of when the first \nnotice day of the futures is; he could receive adelivery notice on his longfutures posi\ntion unexpectedly if he is not paying attention. \nOTHER TERMS \nStriking Price Intervals. Just as futures on differing physical commodities have \ndiffering terms, so do options on those futures. Striking price intervals are aprime \nexample. Some options have striking prices 5 points apart, while others have strikes \nonly 1 point apart, reflecting the volatility of the futures contract. Specifically, S&P \n500 options have striking prices 5 points apart, while soybean options striking prices \nare 25 points (25 cents) apart, and gold options are 10 points ($10) apart. Moreover, \nas is often the case ,vith stocks, the striking price differential for aparticular com\nmodity may change if the price of the commodity itself is vastly different. \nExample: Gold is quoted in dollars per ounce. Depending on the price of the futures \ncontract, the striking price interval may be changed. The current rules are: \nStriking Price \nInterval \n$10 \n$20 \n$50 \nPrice of Futures \nbelow $500/oz. \nbetween $500 and $1,000/oz. \nabove $1,000/oz. \nThus, when gold futures are more expensive, the striking prices are further \napart. Note that gold has never traded above $1,000/oz., but the option exchanges are \nall set if it does. \nThis variability in the striking prices is common for many commodities. In fact, \nsome commodities alter the striking price interval depending on how much time is \nremaining until expiration, possibly in addition to the actual prices of the futures \nthemselves. \nRealizing that the striking price intervals may change - that is, that new strikes \nwill be added when the contract nears maturity - may help to plan some strategies, \nas it will give more choices to the strategist as to which options he can use to hedge \nor adjust his position. \nAutomatic Exercise. All futures options are subject to automatic exercise as are \nstock options. In general, afutures option will be exercised automatically, even if it is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:712", "doc_id": "f71e5c66f5827f207d8d9d79afe871c5f3a9cb0a58f341537558bf47a5e7caec", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 663 \none tick in the money. You can give instructions to not have afutures option auto\nmatically exercised if you wish. \nSERIAL OPTIONS \nSerial options are futures options whose expiration month is not the same as the expi\nration month of their corresponding underlying futures. \nExample: Gold futures expire in February, April, June, August, October, and \nDecember. There are options that expire in those months as well. Notice that these \nexpirations are spaced two months apart. Thus, when one gold contract expires, there \nare two months remaining until the next one expires. \nMost option traders recognize that the heaviest activity in an option series is in \nthe nearest-term option. If the nearest-term option has two months remaining until \nexpiration, it will not draw the trading interest that ashorter-term option would. \nRecognizing this fact, the exchange has decided that in addition to the regular \nexpiration, there will be an option contract that expires in the nearest non-cycle \nrrwnth, that is, in the nearest month that does not have an actual gold future expir\ning. So, if it were currently January 1, there might be gold options expiring in \nFebruary, March, April, etc. \nThus, the March option would be aserial option. There is no actual March gold \nfuture. Rather, the March options would be exercisable into Arpl futures. \nSerial options are exercisable into the nearest actual futures contract that exists \nafter the options' expiration date. The number of serial option expirations depends \non the underlying commodity. For example, gold will always have at least one serial \noption trading, per the definition highlighted in the example above. Certain futures \nwhose expirations are three months apart (S&P 500 and all currency options) have \nserial options for the nearest two months that are not represented by an actual \nfutures contract. Sugar, on the other hand, has only one serial option expiration per \nyear - in December - to span the gap that exists between the normal October and \nMarch sugar futures expirations. \nStrategists trading in options that may have serial expirations should be careful \nin how they evaluate their strategies. For example, June S&P 500 futures options \nstrategies can be planned with respect to where the underlying S&P 500 Index of \nstocks will be at expiration, for the June options are exercisable into the June futures, \nwhich settle at the same price as the Index itself on the last day of trading. However, \nif one is trading April S&P 500 options, he must plan his strategy on where the June \nfutures contract is going to be trading at April expiration. The April options are exer-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:713", "doc_id": "3d10923e8df9666b8c6302978b167b92c47cb47508c7b334ef5b2ab67b553d03", "chunk_index": 0}
{"text": "664 Part V: Index Options and Futures \ncisable into the June futures at April expiration. Since the June futures contract will \nstill have some time premium in it in April, the strategist cannot plan his strategy with \nrespect to where the actual S&P 500 Index will be in April. \nExample: The S&P 500 Stock Index (symbol SPX) is trading at 410.50. The follow\ning prices exist: \nCash (SPX): 410.50 \nJune futures: 415.00 \nOptions \nApril 415 coll: 5.00 \nJune 415 coll: 10.00 \nIf one buys the June 415 call for 10.00, he knows that the SPX Index will have \nto rise to 425.00 in order for his call purchase to break even at June expiration. Since \nthe SPX is currently at 410.50, arise of 14.50 by the cash index itself will be neces\nsary for break-even at June expiration. \nHowever, asimilar analysis will not work for calculating the break-even price for \nthe April 415 call at April expiration. Since 5.00 points are being paid for the 415 call, \nthe break-even at April expiration is 420. But exactly what needs to be at 420? The \nJune future, since that is what the April calls are exercisable into. \nCurrently, the June futures are trading at apremium of 4.50 to the cash index \n(415.00 - 410.50). However, by April expiration, the fair value of that premium will \nhave shrunk. Suppose that fair .value is projected to be 3.50 premium at April expi\nration. Then the SPX would have to be at 416.50 in order for the June futures to be \nfairly valued at 420.00 (416.50 + 3.50 = 420.00). \nConsequently, the SPX cash index would have to rise 6 points, from 410.50 to \n416.50, in order for the June futures to trade at 420 at April expiration. If this hap\npened, the April 415 call purchase would break even at expiration. \nQuote symbols for futures options have improved greatly over the years. Most \nvendors use the convenient method of stating the striking price as anumeric num\nber. The only \"code\" that is required is that of the expiration month. The codes for \nfutures and futures options expiration months are shown in Table 34-1. Thus, a \nMarch (2002) soybean 600 call would use asymbol that is something like SH2C600, \nwhere Sis the symbol for soybeans, His the symbol for March, 2 means 2002, Cstands for call option, and 600 is the striking price. This is alot simpler and more flex\nible than stock options. There is no need for assigning striking prices to letters of the \nalphabet, as stocks do, to everyone'sgreat consternation and confusion.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:714", "doc_id": "8cd56ca7b2db320f35f81102588a5719559f863424c61ce2b370a98a180066b5", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options \nTABLE 34-1. \nMonth symbols for futures or futures options. \nFutures or Futures Options \nExpiration Month Month Symbol \nJanuary F \nFebruary G \nMarch H \nApril J \nMay K \nJune M \nJuly N \nAugust Q \nSeptember u \nOctober V \nNovember X \nDecember z \n665 \nBid-Offer Spread. The actual markets - bids and offers - for most futures \noptions are not generally available from quote vendors ( options traded on the \nChicago Mere are usually apleasant exception). The same is true for futures con\ntracts themselves. One can always request a ~rket from the trading floor, but that \nis atime-consuming process and is impractic!al if one is attempting to analyze alarge \nnumber of options. Strategists who are used to dealing in stock or index options will \nfind this to be amajor inconvenience. The situation has persisted for years and shows \nno sign of improving. \nCommissions. Futures traders generally pay acommission only on the closing \nside of atrade. If aspeculator first buys gold futures, he pays no commission at that \ntime. Later, when he sells what he is long - closes his position - he is charged acom\nmission. This is referred to as a \"round-tum\" commission, for obvious reasons. Many \nfutures brokerage firms treat future options the same way - with around-tum com\nmission. Stock option traders are used to paying acommission on every buy and sell, \nand there are still afew futures option brokers who treat futures options that way, \ntoo. This is an important difference. Consider the following example. \nExample: Afutures option trader has been paying acommission of $15 per side -\nthat is, he pays acommission of $15 per contract each time he buys and sells. His bro-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:715", "doc_id": "e8f65e958b47f825b07f05fa9b0d7941f31caeb5bda11b85eda854a6b2b2f775", "chunk_index": 0}
{"text": "666 Part V: Index Options and Futures \nker informs him one day that they are going to charge him $30 per round tum, \npayable up front, rather than $15 per side. That is the way most futures option bro\nkerage firms charge their commissions these days. Is this the same thing, $15 per side \nor $30 round turn, paid up front? No, it is not! What happens if you buy an option \nand it expires worthless? You have already paid the commission for atrade that, in \neffect, never took place. Nevertheless, there is little you can do about it, for it has \nbecome the industry standard to charge round-turn commission on futures options. \nIn either case, commissions are negotiated to aflat rate by many traders. \nDiscount futures commission merchants (i.e., brokerage houses) often attract \nbusiness this way. In general, this method of paying commissions is to the customer'sbenefit. However, it does have ahidden effect that the option trader should pay \nattention to. This effect makes it potentially more profitable to trade options on some \nfutures than on others. \nExample: Acustomer who buys com futures pays $30 per round turn in option com\nmissions. Since corn options are worth $50 per one point (one cent), he is paying 0.60 \nof apoint every time he trades acorn option (30/50 = 0.60). \nNow, consider the same customer trading options on the S&P 500 futures. The \nS&P 500 futures and options are worth $250 per point. So, he is paying only 0.12 of \napoint to trade S&P 500 options (30/250 = .12). \nHe clearly stands amuch better chance of making money in an S&P 500 option \nthan he does in acorn option. He could buy an S&Poption at 5.00 and sell it at 5.20 \nand make .08 points profit. However, with com options, if he buys an option at 5, he \nneeds to sell it at 55/sto make money- asubstantial difference between the two con\ntracts. In fact, if he is participating in spread strategies and trading many options, the \ndifferential is even more important. \nPosition limits exist for futures options. While the limits for financial futures are \ngenerally large, other futures - especially agricultural ones - may have small limits. \nAlarge speculator who is doing spreads might inadvertently exceed asmaller limit. \nTherefore, one should check with his broker for exact limits in the various futures \noptions before acquiring alarge position. \n) \nOPTION MARGINS \nFutures option margin requirements are generally more logical than equity or index \noption requirements. For example, if one has aconversion or reversal arbitrage in \nplace, his requirement would be nearly zero for futures options, while it could be \nquite large for equity options. Moreover, futures exchanges have introduced abetter \nway of margining futures and futures option portfolios.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:716", "doc_id": "d46b203b30bc568980e73555126422708eab708cbb402fad9329b70ad14dadad", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 667 \nSPAN Margin. The SPAN margin system (Standard Portfolio ANalysis of Risk) \nis used by nearly all of the exchanges. SPAN is designed to determine the entire risk \nof aportfolio, including all futures and options. It is aunique system in that it bases \nthe option requirements on projected movements in the futures contracts as well as \non potential changes in implied volatility of the options in one'sportfolio. This cre\nates amore realistic measure of the risk than the somewhat arbitrary requirements \nthat were previously used (called the \"customer margin\" system) or than those used \nfor stock and index options. \nNot all futures clearing firms automatically put their customers on SPAN mar\ngin. Some use the older customer margin system for most of their option accounts. \nAs astrategist, it would be beneficial to be under SPAN margin. Thus, one should \ndeal with abroker who will grant SPAN margin. \nThe main advantages of SPAN margin to the strategist are twofold. First, \nnaked option margin requirements are generally less; second, certain long option \nrequirements are reduced as well. This second point may seem somewhat unusual \n- margin on long options? SPAN calculates the amount of along option'svalue that \nis at risk for the current day. Obviously, if there is time remaining until expiration, acall option will still have some value even if the underlying futures trade down the \nlimit. SPAN attempts to calculate this remaining value. If that value is less than the \nmarket price of the option, the excess can be applied toward any other requirement \nin the portfoliol Obviously, in-the-money options would have agreater excess value \nunder this system. \n~ \nHow SPAN Works. Certain basic requirements are determined by the futures \nexchange, such as the amount of movement by the futures contract that must be mar\ngined (maintenance margin). Once that is known, the exchange'scomputers gener\nate an array of potential gains and losses for the next day'strading, based on futures \nmovement within arange of prices and based on volatility changes. These results are \nstored in a \"risk array.\" There is adifferent risk array generated for each futures con\ntract and each option contract. The clearing member (your broker) or you do not \nhave to do any calculations other than to see how the quantities of futures and \noptions in your portfolio are affected under the gains or losses in the SPAN risk array. \nThe exchange does all the mathematical calculations needed to project the potential \ngains or losses. The results of those calculations are presented in the risk array. \nThere are 16 items in the risk array: For seven different futures prices, SPAN \nprojects again or loss for both increased and decreased volatility; that makes 14 \nitems. SPAN also projects aprofit or loss for an \"extreme\" upward move and an \n\"extreme\" downward move. The futures exchange determines the exact definition of \n\"extreme,\" and defines \"increased\" or \"decreased\" volatility.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:717", "doc_id": "c83a37744240d947810a23a5c599e76101dde577c67d59c68aa29b3c3d3d4f1c", "chunk_index": 0}
{"text": "668 Part V: Index Options and Futures \nSPAN \"margin\" applies to futures contracts as well, although volatility consid\nerations don'tmean anything in terms of evaluating the actual futures risk As afirst \nexample, consider how SPAN would evaluate the risk of afutures contract. \nExample: The S&P 500 futures will be used for this example. Suppose that the \nChicago Mercantile Exchange determines that the required maintenance margin for \nthe futures is $10,000, which represents a 20-point move by the futures (recall that \nS&Pfutures are worth $500 per point). Moreover, the exchange determines that an \n\"extreme\" move is 14 points, or $7,000 of risk \nScenario \nFutures unchanged; volatility up \nFutures unchanged; volatility down \nFutures up one-third of range; volatility up \nFutures up one-third of range; volatility down \nFutures down one-third of range; volatility up \nFutures down one-third of range; volatility down \nFutures up two-thirds of range; volatility up \nFutures up two-thirds of range; volatility down \nFutures down two-thirds of range; volatility up \nFutures down two-thirds of range; volatility down \nFutures up three-thirds of range; volatility up \nFutures up three-thirds of range; volatility down \nFutures down three-thirds of range; volatility up \nFutures down three-thirds of range; volatility down \nFutures up \"extreme\" move \nFutures down \"extreme\" move \nLong 1 \nFuture \nPotential \nPit/Loss \n0 \n0 \n+ 3,330 \n+ 3,330 \n- 3,330 \n- 3,330 \n+ 6,670 \n+ 6,670 \n- 6,670 \n- 6,670 \n+ 10,000 \n+ l 0,000 \n-10,000 \n- 10,000 \n+ 7,000 \n- 7,000 \nThe 16 array items are always displayed in this order. Note that since this array \nis for afutures contract, the \"volatility up\" and \"volatility down\" scenarios are always \nthe same, since the volatility that is referred to is the one that is used as the input to \nan option pricing model. \nNotice that the actual price of the futures contract is not needed in order to \ngenerate the risk array. The SPAN requirement is always the largest potential loss \nfrom the array. Thus, if one were long one S&P 500 futures contract, his SPAN mar\ngin requirement would be $10,000, which occurs under the \"futures down three\nthirds\" scenarios. This will always be the maintenance margin for afutures contract.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:718", "doc_id": "1e1460520c54ce0a862bcb0667a9a74565dd8b1816a311391e309b3091c2626e", "chunk_index": 0}
{"text": "Cl,apter 34: Futures and Futures Options 669 \nNow let us consider an option example. In this type of calculation, the exchange \nuses the same moves by the underlying futures contract and calculates the option \ntheoretical values as they would exist on the next trading day. One calculation is per\nformed for volatility increasing and one for volatility decreasing. \nExample: Using the same S&P 500 futures contract, the following array might depict \nthe risk array for along December 410 call. One does not need to know the option \nor futures price in order to use the array; the exchange incorporates that information \ninto the model used to generate the potential gains and losses. \nScenario \nFutures unchanged; volatility up \nFutures unchanged; volatility down \nFutures up one-third of range; volatility up \nFutures up one-third of range; volatility down \nFutures down one-third of range; volatility up \nFutures down one-third of range; volatility down \nFutures up two-thirds of range; volatility up \nFutures up two-thirds of range; volatility down \nFutures down two-thirds of range; volatility ur \nFutures down two-thirds of range; volatility /o:n \nFutures up three-thirds of range; volatility up \nFutures up three-thirds of range; volatility down \nFutures down three-thirds of range; volatility up \nFutures down three-thirds of range; volatility down \nFutures up \"extreme\" move \nFutures down \"extreme\" move \nLong 1 \nDec 410 call \nPotential \nPh/Loss \n+ 460 \n610 \n+ 2,640 \n+ 1,730 \n- 1,270 \n- 2,340 \n+ 5,210 \n+ 4,540 \n- 2,540 \n- 3,430 \n+ 8,060 \n+ 7,640 \n- 3,380 \n- 3,990 \n+ 3,130 \n- 1,500 \nThe items in the risk array are all quite logical: Upward futures movements pro\nduce profits and downward futures movements produce losses in the long call posi\ntion. Moreover, worse results are always obtained by using the lower volatility as \nopposed to the higher one. In this particular example, the SPAN requirement would \nbe $3,990 (\"futures down three-thirds; volatility down\"). That is, the SPAN system \npredicts that you could lose $3,990 of your call value if futures fell by their entire \nrange and volatility decreased - aworst-case scenario. Therefore, that is the amount \nof margin one is required to keep for this long option position.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:719", "doc_id": "7d507b8701e8320ae796141caa152379017059b71236d0e43d8741666a49ce82", "chunk_index": 0}
{"text": "670 Part V: Index Options and Futures \nWhile the exchange does not tell us how much of an increase or decrease it uses \nin terms of volatility, one can get something of afeel for the magnitude by looking at \nthe first two lines of the table. The exchange is saying that if the futures are \nunchanged tomorrow, but volatility \"increases,\" then the call will increase in value by \n$460 (92 cents); if it \"decreases,\" however, the call will lose $610 (1.22 points) of \nvalue. These are large piice changes, so one can assume that the volatility assump\ntions are significant. \nThe real ease of use of the SPAN iisk array is when it comes to evaluating the \niisk of amore complicated position, or even aportfolio of options. All one needs to \ndo is to combine the risk array factors for each option or future in the position in \norder to arrive at the total requirement. \nExample: Using the above two examples, one can see what the SPAN requirements \nwould be for acovered wiite: long the S&Pfuture and short the Dec 410 call. \nShort 1 \nLong Dec 410 call \n1 S&P Potential Covered \nScenario Future Pft/Loss Write \nFutures unchanged; vol. up 0 460 - 460 \nFutures unchanged; vol. down 0 + 610 + 610 \nFutures up 1 /3 of range; vol. up + 3,330 - 2,640 + 690 \nFutures up 1 /3 of range; vol. down + 3,330 - 1,730 + 1,600 \nFutures down 1 /3 of range; vol. up - 3,330 + 1,270 -2,060 \nFutures down 1 /3 of range; vol. down 3,330 + 2,340 - 990 \nFutures up 2/3 of range; vol. up + 6,670 - 5,210 + 1,460 \nFutures up 2/3 of range; vol. down + 6,670 - 4,540 +2, 130 \nFutures down 2/3 of range; vol. up 6,670 + 2,540 -4, 130 \nFutures down 2/3 of range; vol. down - 6,670 + 3,430 -3,240 \nFutures up 3/3 of range; vol. up + 10,000 - 8,060 + 1,940 \nFutures up 3/3 of range; vol. down + 10,000 - 7,640 +2,360 \nFutures down 3/3 of range; vol. up -10,000 + 3,380 -6,620 \nFutures down 3/3 of range; vol. down -10,000 + 3,990 -6,010 \nFutures up ,, extreme\" move + 7,000 - 3,130 +3\\870 \nFutures down \"extreme\" move - 7,000 + 1,500 -5,500 \nAs might be expected, the worst-case projection for acovered wiite is for the \nstock to drop, but for the implied volatility to increase. The SPAN system projects \nthat this covered wiiter would lose $6,620 if that happened. Thus, \"futures down 3/3 \nof range; volatility up\" is the SPAN requirement, $6,620.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:720", "doc_id": "eaa2ffd92bca331eae3e917a1d6ee9157620637a44ce4ac68af080caef9591b0", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 671 \nAs ameans of comparison, under the older \"customer margin\" option require\nments, the requirement for acovered write was the futures margin, plus the option \npremium, less one-half the out-of-the-money amount. In the above example, assume \nthe futures were at 408 and the call was trading at 8. The customer covered write \nmargin would then be more than twice the SPAN requirement: \nFutures margin \nOption premium \n1/2 out-of-money amount \n$10,000 \n+ 4,000 \n- 1,000 \n$13,000 \nObviously, one can alter the quantities in the use of the risk array quite easily. \nFor example, ifhe had aratio write oflong 3 futures and short 5 December 410 calls, \nhe could easily calculate the SPAN requirement by multiplying the projected futures \ngains and losses by 3, multiplying the projected option gains and losses by 5, and \nadding the two together to obtain the total requirement. Once he had completed this \ncalculation, his SPAN requirement would be the worst expected loss as projected by \nSPAN for the next trading day. \nIn actual practice, the SPAN calculations are even more sophisticated: They \ntake into account acertain minimum option margin (for deeply out-of-the-money \noptions); they account for spreads between futures contracts on the same commodi\nty (different expiration months); they add adelivery month charge (if you are hold\ning aposition past the first notice day); ~ they even allow for slightly reduced \nrequirements for related, but different, futures spreads (T-bills versus T-bonds, for \nexample). \nIf you are interested in calculating SPAN margin yourself, your broker may be \nable to provide you with the software to do so. More likely, though, he will provide \nthe service of calculating the SPAN margin on aposition prior to your establishing it. \nThe details for obtaining the SPAN margin requirements should thus be requested \nfrom your broker. \nPHYSICAL CURRENCY OPTIONS \nAnother group oflisted options on aphysical is the currency options that trade on the \nPhiladelphia Stock Exchange (PHLX). In addition, there is an even larger over-the\ncounter market in foreign currency options. Since the physical commodity underly\ning the option is currency, in some sense of the word, these are cash-based options \nas well. However, the cash that the options are based in is not dollars, but rather may \nbe deutsche marks, Swiss francs, British pounds, Canadian dollars, French francs, or", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:721", "doc_id": "95b8f89682d2e1f162ca4aba0358e80b2b5fa0fa84a0b708987e8640178fca5a", "chunk_index": 0}
{"text": "672 Part V: Index Options and Futures \nJapanese yen. Futures trade in these same currencies on the Chicago Mercantile \nExchange. Hence, many traders of the physical options use the Chicago-based \nfutures as ahedge for their positions. \nUnlike stock options, currency options do not have standardized terms - the \namount of currency underlying the option contract is not the same in each of the \ncases. The striking price intervals and units of trading are not the same either. \nHowever, since there are only the six different contracts and since their terms corre\nspond to the details of the futures contracts, these options have had much success. \nThe foreign currency markets are some of the largest in the world, and that size is \nreflected in the liquidity of the futures on these currencies. \nThe Swiss franc contract will be used to illustrate the workings of the foreign \ncurrency options. The other types of foreign currency options work in asimilar man\nner, although they are for differing amounts of foreign currency. The amount of for\neign currency controlled by the foreign currency contract is the unit of trading, just \nas 100 shares of stock is the unit of trading for stock options. The unit of trading for \nthe Swiss franc option on the PHLX is 62,500 Swiss francs. Normally, the currency \nitself is quoted in terms of U.S. dollars. For example, a Swiss franc quote of 0.50 \nwould mean that one Swiss franc is worth 50 cents in U.S. currency. \nNote that when one takes aposition in foreign currency options (or futures), he \nis simultaneously taking an opposite position in U.S. dollars. That is, if one owns a \nSwiss franc call, he is long the franc (at least delta long) and is by implication there\nfore short U.S. dollars. \nStriking prices in Swiss options are assigned in one-cent increments and are \nstated in cents, not dollars. That is, if the Swiss franc is trading at 50 cents, then there \nmight be striking prices of 48, 49, 50, 51, and 52. Given the unit of trading and the \nstriking price in U.S. dollars, one can compute the total dollars involved in aforeign \ncurrency exercise or assignment. \nExample: Suppose the Swiss franc is trading at 0.50 and there are striking prices of \n48, 50, and 52, representing U.S. cents per Swiss franc. If one were to exercise acall \nwith astrike of 48, then the dollars involved in the exercise would be 125,000 (the \nunit of trading) times 0.48 (the strike in U.S. dollars), or $60,000. \nOption premiums are stated in U.S. cents. That is, if a Swiss franc option is \nquoted at 0. 75, its cost is $.0075 times the unit of trading, 125,000, for atotal of \n$937.50. Premiums are quoted in hundredths of apoint. That is, the next \"tick\" from \n0.75 would be 0.76. Thus, for the Swiss franc options, each tick or hundredth of apoint is equal to $12.50 (.0001 x 125,000).", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:722", "doc_id": "5fc62798cef3ef21c501b8facdf2ff2f4f75e5b559c737e2eebc2c1214d04e5f", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 673 \nActual delivery of the security to satisfy an assignment notice must occur with\nin the country of origin. That is, the seller of the currency must make arrangements \nto deliver the currency in its country of origin. On exercise or assignment, sellers of \ncurrency would be put holders who exercise or call writers who are assigned. Thus, \nif one were short Swiss franc calls and he were assigned, he would have to deliver \nSwiss francs into abank in Switzerland. This essentially means that there have to be \nagreements between your firm or your broker and foreign banks if you expect to \nexercise or be assigned. The actual payment for the exercise or assignment takes \nplace between the broker and the Options Clearing Corporation (OCC) in U.S. dol\nlars. The OCC then can receive or deliver the currency in its country of origin, since \nOCC has arrangements with banks in each country. \nEXERCISE AND ASSIGNMENT \nThe currency options that trade on the PHLX (Philadelphia Exchange) have exercise \nprivileges similar to those for all other options that we have studied: They can be \nexercised at any time during their life. \nEven though PHLX currency options are \"cash\" options in the most literal \nsense of the word, they do not expose the writer to the same risks of early assignment \nthat cash-based index options do. \nExample: Suppose that acurrency trader has established the following spread on the \nPHLX: long Swiss franc December 50 puts, short Swiss franc December 52 puts - abullish spread. As in any one-to-one spread, there is limited risk. However, the dol\nlar rallies and the Swiss franc falls, pushing the exchange rate down to 48 cents (U.S.) \nper Swiss franc. Now the puts that were wri,tten - the December 52 contracts - are \ndeeply in-the-money and might be subject to early assignment, as would any deeply \nin-the-money put if it were trading at adiscount. \nSuppose the trader learns that he has indeed been assigned on his short puts. \nHe still has ahedge, for he is long the December 50 puts and he is now long Swiss \nfrancs. This is still ahedged position, and he still has the same limited risk as he did \nwhen he started (plus possibly some costs involved in taking physical delivery of the \nfrancs). This situation is essentially the same as that of aspreader in stock or futures \noptions, who would still be hedged after an assignment because he would have \nacquired the stock or future. Contrast this to the cash-based index option, in which \nthere is no longer ahedge after an assignment.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:723", "doc_id": "a7d99a0275f51e8ee14d63bcb79e1df1eb961755505a3ad936a668d59959b354", "chunk_index": 0}
{"text": "674 Part V: Index Options and Futures \nFUTURES OPTION TRADING STRATEGIES \nThe strategies described here are those that are unique to futures option trading. \nAlthough there may be some general relationships to stock and index option strate\ngies, for the most part these strategies apply only to futures options. It will also be \nshown - in the backspread and ratio spread examples - that one can compute the \nprofitability of an option spread in the same manner, no matter what the underlying \ninstrument is (stocks, futures, etc.) by breaking everything down into \"points\" and not \n\"dollars.\" \nBefore getting into specific strategies, it might prove useful to observe some \nrelationships about futures options and their price relationships to each other and to \nthe futures contract itself. Carrying cost and dividends are built into the price of stock \nand index options, because the underlying instrument pays dividends and one has to \npay cash to buy or sell the stock. Such is not the case with futures. The \"investment\" \nrequired to buy afutures contract is not initially acash outlay. Note that the cost of \ncarry associated with futures generally refers to the carrying cost of owning the cash \ncommodity itself. That carrying cost has no bearing on the price of afutures option \nother than to determine the futures price itself. Moreover, the future has no divi\ndends or similar payout. This is even true for something like U.S. Treasury bond \noptions, because the interest rate payout of the cash bond is built into the futures \nprice; thus, the option, which is based on the futures price and not directly on the \ncash price, does not have to allow for carry, since the future itself has no initial car\nrying costs associated with it. \nSimplistically, it can be stated that: \nFutures Call = Futures Put + Futures Price - Strike Price \nExample: April crude oil futures closed at 18.74 ($18.74 per barrel). The following \nprices exist: \nStrike April Call April Put Put + Futures \nPrice Price Price - Strike \n17 1.80 0.06 1.80 \n18 0.96 0.22 0.96 \n19 0.35 0.61 \\ 0.35 \n20 0.10 1.36 0.10 \nNote that, at every strike, the above formula is true (Call = Put + Futures -\nStrike). These are not theoretical prices; they were taken from actual settlement \nprices on aparticular trading day.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:724", "doc_id": "3b972ab06e11b193ca99fed93e87425ce7c9bf35be9890b7788da042f3824043", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 675 \nIn reality, where deeply in-the-money or longer-term options are involved, this \nsimple formula is not correct. However, for most options on aparticular nearby \nfutures contract, it will suffice quite well. Examine the quotes in today'snewspaper \nto verify that this is atrue statement. \nAsubcase of this observation is that when the futures contract is exactly at the \nstriking price, the call and put with that strike will both trade at the same price. Note \nthat in the above formula, if one sets the futures price equal to the striking price, the \nlast two terms cancel out and one is left with: Call price = Put price. \nOne final observation before getting into strategies: For aput and acall with the \nsame strike, \nNet change call - Net change put = Net change futures \nThis is atrue statement for stock and index options as well, and is auseful rule \nto remember. Since futures options bid and offer quotes are not always disseminat\ned by quote vendors, one is forced to use last sales. If the last sales don'tconform to \nthe rule above, then at least one of the last sales is probably not representative of the \ntrue market in the options. \nExample: April crude oil is up 50 cents to 19.24. Atrader punches up the following \nquotes on his machine and sees the following prices: \nOption \nApril 19 call: \nApril 19 put: \nLast Sale \n0.55 \n0.31 \nThese options conform to the abo~rule: \nNet change futures = Net change call - Net change put \n= +0.20 - (-0.30) \n= +0.50 \nNet Change \n+ 0.20 \n- 0.30 \nThe net changes of the call and put indicate the April future should be up 50 \ncents, which it is. \nSuppose that one also priced aless active option on his quote machine and saw \nthe following: \nOption \nApril 17 call: \nApril 17 put: \nLast Sale \n2.10 \n0.04 \nNet Change \n+ 0.30 \n- 0.02", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:725", "doc_id": "34f2cc576a3610bc4aa5bf067a37c717d04b82dcf048714d96eecdf084067192", "chunk_index": 0}
{"text": "676 Part V: Index Options and Futures \nIn this case, the formula yields an incorrect result: \nNet change futures= +0.30 - (-0.02) = +0.32 \nSince the futures are really up 50 cents, one can assume that one of the last sales \nis out of date. It is obviously the April 17 call, since that is the in-the-money option; \nif one were to ask for aquote from the trading floor, that option would probably be \nindicated up about 48 cents on the day. \nDELTA \nWhile we are on the subject of pricing, aword about delta may be in order as well. \nThe delta of afutures option has the same meaning as the delta of astock option: It \nis the amount by which the option is expected to increase in price for aone-point \nmove in the underlying futures contract. As we also know, it is an instantaneous meas\nurement that is obtained by taking the first derivative of the option pricing model. \nIn any case, the delta of an at-the-money stock or index option is greater than \n0.50; the more time remaining to expiration, the higher the delta is. In asimplified \nsense, this has to do with the cost of carrying the value of the striking price until the \noption expires. But part of it is also due to the distribution of stock price movements \n- there is an upward bias, and with along time remaining until expiration, that bias \nmakes call movements more pronounced than put movements. \nOptions on futures do not have the carrying cost feature to deal with, but they \ndo have the positive bias in their price distribution. Afutures contract, just like astock, can increase by more than 100%, but cannot fall more than 100%. \nConsequently, deltas of at-the-money futures calls will be slightly larger than 0.50. \nThe more time remaining until expiration of the futures option, the higher the at-the\nmoney call delta will be. \nMany traders erroneously believe that the delta of an at-the-money futures \noption is 0.50, since there is no carrying cost involved in the futures conversion or \nreversal arbitrage. That is not atrue statement, since the distribution of futures prices \naffects the delta as well. \nAs always, for futures options as well as for stock and index options, the delta of \naput is related to the delta of acall with the same striking price and expiration date: \nDelta of put = 1 - Delta of call \nFinally, the concept of equivalent stock position applies to futures opti<i>nstrate\ngies, except, of course, it is called the equivalent futures position (EFP). The EFP is \ncalculated by the simple formula: \nEFP = Delta of option x Option quantity", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:726", "doc_id": "c3a432c7c833b73bea0bbc10430377ad4ebbee056a336e8dd6732f73657b6dd2", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 677 \nThus, if one is long 8 calls with adelta of 0. 75, then that position has an EFP of \n6 (8 x 0.75). This means that being long those 8 calls is the same as being long 6 \nfutures contracts. \nNote that in the case of stocks, the equivalent stock position formula has anoth\ner factor shares per option. That concept does not apply to futures options, since \nthey are always options on one futures contract. \nMATHEMATICAL CONSIDERATIONS \nThis brief section discusses modeling considerations for futures options and options \non physicals. \nFutures Options. The Black model (see Chapter 33 on mathematical consider\nations for index options) is used to price futures options. Recall that futures don'tpay \ndividends, so there is no dividend adjustment necessary for the model. In addition, \nthere is no carrying cost involved with futures, so the only adjustment that one needs \nto make is to use 0% as the interest rate input to the Black-Scholes model. This is an \noversimplification, especially for deeply in-the-money options. One is tying up some \nmoney in order to buy an option. Hence, the Black model will discount the price \nfrom the Black-Scholes model price. Therefore, the actual pricing model to be used \nfor theoretical evaluation of futures options is the Black model, which is merely the \nBlack-Scholes model, using 0% as the interest rate, and then discounted: \nCall Theoretical Price = e-rt x Black-Scholes formula [r = O] \nRecall that it was stated above that: \nFutures call = Futures put + Future price - Strike price \nThe actual relationship is: ~ \nFutures call= Futures put+ e-rt (Futures price - Strike price) \nwhere \nr = the short-term interest rate, \nt = the time to expiration in years, and \ne-rt = the discounting factor. \nThe short-term interest rate has to be used here because when one pays adebit \nfor an option, he is theoretically losing the interest that he could earn if he had that \nmoney in the bank instead, earning money at the short-term interest rate. \nThe difference between these two formulae is so small for nearby options that \nare not deeply in-the-money that it is normally less than the bid-asked spread in the \noptions, and the first equation can be used.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:727", "doc_id": "40de0d4e6e6d2eeab7640270848e13de340b23734c451c0059826376f34a6da6", "chunk_index": 0}
{"text": "678 Part V: Index Options and Futures \nExample: The table below compares the theoretical values computed with the two \nformulae, where r = 6% and t = 0.25 (1/4 of ayear). Furthermore, assume the futures \nprice is 100. The strike price is given in the first column, and the put price is given \nin the second column. The predicted call prices according to each formula are then \nshown in the next two columns. \nPut Formula l Formula 2 \nStrike Price (Simple) ( Using e-rf) \n70 0.25 30.25 29.80 \n80 1.00 21.00 20.70 \n90 3.25 13.25 13.10 \n95 5.35 10.35 10.28 \n100 7.50 7.50 7.50 \n105 10.70 5.70 5.77 \n110 13.90 3.90 4.05 \n120 21.80 1.80 2.10 \nFor options that are 20 or 30 points in- or out-of-the-money, there is anotice\nable differential in these three-month options. However, for options closer to the \nstrike, the differential is small. \nIf the time remaining to expiration is shorter than that used in the example \nabove, the differences are smaller; if the time is longer, the differences are magnified. \nOptions on Physicals. Determining the fair value of options on physicals such \nas currencies is more complicated. The proper way to calculate the fair value of an \noption on aphysical is quite similar to that used for stock options. Recall that in the \ncase of stock options, one first subtracts the present worth of the dividend from the \ncurrent stock price before calculating the option value. Asimilar process is used for \ndetermining the fair value of currency or any other options on physicals. In any of \nthese cases, the underlying security bears interest continuously, instead of quarterly \nas stocks do. Therefore, all one needs to do is to subtract from the underlying price \nthe amount of interest to be paid until option expiration and then add the amount of \naccrued interest to be paid. All other inputs into the Black-Scholes model would \nremain the same, including the risk-free interest rate being equal to the 90-day T-bill \nrate. \nAgain, the practical option strategist has ashortcut available to him. If one \nassumes that the various factors necessary to price currencies have been assimilated \ninto the futures markets in Chicago, then one can merely use the futures price as the \nprice of the underlying for evaluating the physical delivery options in Philadelphia.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:728", "doc_id": "6974c367b8f6223cdf95ae13f4f58605715e9c63b08ad78d27db2cebb61441de", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 679 \nThis will not work well near expiration, since the future expires one week prior to the \nPHLX option. In addition, it ignores the early exercise value of the PHLX options. \nHowever, except for these small differentials, the shortcut will give theoretical values \nthat can be used in strategy-making decisions. \nExample: It is sometime in April and one desires to calculate the theoretical values \nof the June deutsche mark physical delivery options in Philadelphia. Assume that one \nknows four of the basic items necessary for input to the Black-Scholes formula: 60 \ndays to expiration, strike price of 68, interest rate of 10%, and volatility of 18%. But \nwhat should be used as the price of the underlying deutsche mark? Merely use the \nprice of the June deutsche mark futures contract in Chicago. \nSTRATEGIES REGARDING TRADING LIMITS \nThe fact that trading limits exist in most futures contracts could be detrimental to \nboth option buyers and option writers. At other times, however, the trading limit may \npresent aunique opportunity. The following section focuses on who might benefit \nfrom trading limits in futures and who would not.. \nRecall that atrading limit in afutures contract limits the absolute number of \npoints that the contract can trade up or down from the previous close. Thus, if the \ntrading limit in T-bonds is 3 points and they closed last night at 7 421132, then the high\nest they can trade on the next day is 7721132, regardless of what might be happening \nin the cash bond market. Trading limits exist in many futures contracts in order to \nhelp ensure that the market cannot be manipulated by someone forcing the price to \nmove tremendously in one direction or the other. Another reason for having trading \nlimits is ostensibly to allow only afixed move, approximately equal to the amount cov\nered by the initial margin, so that maintenance margin can be collected if need be. \nHowever, limits have been applied in case~which they are unnecessary. For exam\nple, in T-bonds, there is too much liquidity for anyone to be able to manipulate the \nmarket. Moreover, it is relatively easy to arbitrage the T-bond futures contract against \ncash bonds. This also increases liquidity and would keep the future from trading at aprice substantially different from its theoretical value. \nSometimes the markets actually need to move far quickly and cannot because of \nthe trading limit. Perhaps cash bonds have rallied 4 points, when the limit is 3 points. \nThis makes no difference when afutures contract has risen as high as it can go for \nthe day, it is bid there (asituation called \"limit bid\") and usually doesn'ttrade again \nas long as the underlying commodity moves higher. It is, of course, possible for afuture to be limit bid, only to find that later in the day, the underlying commodity \nbecomes weaker, and traders begin to sell the future, driving it down off the limit.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:729", "doc_id": "fcef6db1dff85ed4449cdf496e7774c8e22c97598731cefe3c7cb30e3d4f659a", "chunk_index": 0}
{"text": "680 Part V: Index Options and Futures \nSimilar situations can also occur on the downside, where, if the future has traded as \nlow as it can go, it is said to be \"limit offered.\" \nAs was pointed out earlier, futures options sometimes have trading limits \nimposed on them as well. This limit is of the same magnitude as the futures limit. \nMost of these are on the Chicago Board of Trade (all grains, U.S. Treasury bonds, \nMunicipal Bond Index, Nikkei stock index, and silver), although currency options on \nthe Chicago Mere are included as well. In other markets, options are free to trade, \neven though futures have effectively halted because they are up or down the limit. \nHowever, even in the situations in which futures options themselves have atrading \nlimit, there may be out-of-the-money options available for trading that have not \nreached their trading limit. \nWhen options are still trading, one can use them to imply the price at which the \nfutures would be trading, were they not at their trading limit. \nExample: August soybeans have been inflated in price due to drought fears, having \nclosed on Friday at 650 ($6.50 per bushel). However, over the weekend it rains heav\nily in the Midwest, and it appears that the drought fears were overblown. Soybeans \nopen down 30 cents, to 620, down the allowable 30-cent limit. Furthermore, there \nare no buyers at that level and the August bean contract is locked limit down. No fur\nther trading ensues. \nOne may be able to use the August soybean options as aprice discovery mech\nanism to see where August soybeans would be trading if they were open. \nSuppose that the following prices exist, even though August soybeans are not \ntrading because they are locked limit down: \nLost Sole Net Change \nOption Price for the Day \nAugust 625 call 19 - 21 \nAugust 625 put 31 +16 \nAn option strategist knows that synthetic long futures can be created by buying \nacall and selling aput, or vice versa for short futures. Knowing this, one can tell what \nprice futures are projected to be trading at: \nImplied Futures Price = Strike Price + Call Price - Put Price \n= 625 + 19 - 31 = 613 \nWith these options at the prices shown, one can create asynthetic futures posi\ntion at aprice of 613. Therefore, the implied price for August soybean futures in this \nexample is 613.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:730", "doc_id": "deecee45821d5a88f8527bf1a4cf60227739b2a5435c31659a751254aa44589e", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 681 \nNote that this formula is merely another version of the one previously present\ned in this chapter. \nIn the example above, neither of the options in question had moved the 30-\npoint limit, which applies to soybean options as well as to soybean futures. If they \nhad, they would not be useable in the formula for implying the price of the future. \nOnly options that are freely trading - not limit up or down - can be used in the above \nformula. \nAmore complete look at soybean futures options on the day they opened and \nstayed down the limit would reveal that some of them are not tradeable either: \nExample: Continuing the above example, August soybeans are locked limit down 30 \ncents on the day. The following list shows awider array of option prices. Any option \nthat is either up or down 30 cents on the day has also reached its trading limit, and \ntherefore could not be used in the process necessary to discover the implied price of \nthe August futures contract. \nlast Sale Net Change \nOption Price for the Day \nAugust 550 call 71 - 30 \nAugust 575 call 48 30 \nAugust 600 call 31 - 26 \nAugust 625 call 19 - 21 \nAugust 650 call 11 - 15 \nAugust 675 call 6 - 10 \nAugust 550 put 4 + 3 \nAugust 575 put 9 + 6 \nAugust 600 put 18 + 11 \nAugust 625 put -----------31 + 16 \nAugust 650 put 48 + 22 \nAugust 675 put 67 + 30 \nThe deeply in-the-money calls, August 550'sand August 575's, and the deeply in\nthe-money August 675 puts are all at the trading limit. All other options are freely trad\ning and could be used for the above computation of the August future'simplied price. \nOne may ask how the market-makers are able to create markets for the options \nwhen the future is not freely trading. They are pricing the options off cash quotes. \nKnowing the cash quote, they can imply the price of the future (613 in this case), and \nthey can then make option markets as well.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:731", "doc_id": "6b50913c67e39ef2cff81416d20939378643017b0ea5450e1f7bedd3ebee10f6", "chunk_index": 0}
{"text": "682 Part V: Index Options and Futures \nThe real value in being able to use the options when afuture is locked limit up \nor limit down, of course, is to be able to hedge one'sposition. Simplistically, if atrad\ner came in long the August soybean futures and they were locked limit down as in \nthe example above, he could use the puts and calls to effectively close out his posi\ntion. \nExample: As before, August soybeans are at 620, locked down the limit of 30 cents. \nAtrader has come into this trading day long the futures and he is very worried. He \ncannot liquidate his long position, and if soybeans should open down the limit again \ntomorrow, his account will be wiped out. He can use the August options to close out \nhis position. \nRecall that it has been shown that the following is true: \nLong put + Short call is equivalent to short stock. \nIt is also equivalent to short futures, of course. So if this trader were to buy aput and short acall at the same strike, then he would have the equivalent of ashort \nfutures position to offset his long futures position. \nUsing the following prices, which are the same as before, one can see how his \nrisk is limited to the effective futures price of 613. That is, buying the put and selling \nthe call is the same as selling his futures out at 613, down 37 cents on the trading day. \nCurrent prices: \nOption \nAugust 625 call \nAugust 625 put \nPosition: \nBuy August 625 put for 19 \nSell August 625 call for 31 \nAugust Futures \nat Option \nExpiration Put Price \n575 50 \n600 25 \n613 12 \n625 0 \n650 0 \nPut \nP/L \n+ $1,900 \n600 \n- 1,900 \n- 3,100 \n3,100 \nLast Sale \nPrice \n19 \n31 \nCall Price \n0 \n0 \n0 \n0 \n25 \nCall \nP/L \n+$1,900 \n+ 1,900 \n+ 1,900 \n+ 1,900 \n600 \nNet Change \nfor the Day \n-21 \n+16 \nNet Profit \nor loss on \nPosition \n+$3,800 \n+ 1,300 \n0 \n- 1,200 \n- 3,700", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:732", "doc_id": "03a5060445e7664e30e19e8eaff562250ba9fc3468b2383767df97dc7ef83faa", "chunk_index": 0}
{"text": "Otapter 34: Futures and Futures Options 683 \nThis profit table shows that selling the August 625 call at 19 and buying the \nAugust 625 put at 31 is equivalent to - that is, it has the same profit potential as -\nselling the August future at 613. So, if one buys the put and sells the call, he will \neffectively have sold his future at 613 and taken his loss. \nHis resultant position after buying the put and selling the call would be acon\nversion (long futures, long put, and short call). The margin required for aconversion \nor reversal is zero in the futures market. The margin rules recognize the riskless \nnature of such astrategy. Thus, any excess money that he has after paying for the \nunrealized loss in the futures will be freed up for new trades. \nThe futures trader does not have to completely hedge off his position ifhe does \nnot want to. He might decide to just buy aput to limit the downside risk. \nUnfortunately, to do so after the futures are already locked limit down may be too lit\ntle, too late. There are many kinds of partial hedges that he could establish - buy \nsome puts, sell some calls, utilize different strikes, etc. \nThe same or similar strategies could be used by anaked option seller who can\nnot hedge his position because it is up the limit. He could also utilize options that are \nstill in free trading to create asynthetic futures position. \nFutures options generally have enough out-of-the-money striking prices listed \nthat some of them will still be free trading, even if the futures are up or down the \nlimit. This fact is aboon to anyone who has alosing position that has moved the daily \ntrading limit. Knowing how to use just this one option trading strategy should be aworthwhile benefit to many futures traders. \nCOMMONPLACE MISPRICING STRATEGIES \nFutures options are sometimes prone to severe mispricing. Of course, any product'soptions may be subject to mispricing from time to time. However, it seems to appear \nin futures options more often than it does in stock options. The following discussion \nof strategies concentrates on aspecific pattern of futures options mispricing that \noccurs with relative frequency. It generally m{inifests itself in that out-of-the-money \nputs are too cheap, and out-of-the-money calls are too expensive. The proper term \nfor this phenomenon is \"volatility skewing\" and it is discussed further in Chapter 36 \non advanced concepts. In this chapter, we concentrate on how to spot it and how to \nattempt to profit from it. \nOccasionally, stock options exhibit this trait to acertain extent. Generally, it \noccurs in stocks when speculators have it in their minds that astock is going to expe\nrience asudden, substantial rise in price. They then bid up the out-of-the-money \ncalls, particularly the near-term ones, as they attempt to capitalize on their bullish \nexpectations. When takeover rumors abound, stock options display this mispricing", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:733", "doc_id": "eddfa966fbc2f49616fd1c104abe75bdae3e741ecaf44144a654f4ff6cc8db3b", "chunk_index": 0}
{"text": "684 Part V: Index Options and Futures \npattern. Mispricing is, of course, astatistically related term; it does not infer anything \nabout the possible validity of takeover rumors. \nAsignificant amount of discussion is going to be spent on this topic, because the \nfutures option trader will have ample opportunities to see and capitalize on this mis\npricing pattern; it is not something that just comes along rarely. He should therefore \nbe prepared to make it work to his advantage. \nExample: January soybeans are trading at 583 ($5.83 per bushel). The following \nprices exist: \nStrike \n525 \n550 \n575 \n600 \n625 \n650 \n675 \nJanuary beans: 583 \nCall \nPrice \n191/2 \n11 \n51/4 \n31/2 \n21/4 \nPut \nPrice \nSuppose one knows that, according to historic patterns, the \"fair values\" of these \noptions are the prices listed in the following table. \nStrike \n525 \n550 \n575 \n600 \n625 \n650 \n675 \nCall \nPrice \n191/2 \n11 \n53/4 \n31/2 \n21/4 \nCall \nTheo. \nValue \n21.5 \n10.4 \n4.3 \n1.5 \n0.7 \nPut \nPut Theo. \nPrice Value \n1/2 1.6 \n31/4 5.4 \n12 13.7 \n28 27.6 \nNotice that the out-of-the-money puts are priced well below their theoretical \nvalue, while the out-of-the-money calls are priced above. The options at the 575 and \n600 strikes are much closer in price to their theoretical values than are the out-of\nthe-money options.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:734", "doc_id": "58b8a6af1c49adf42780dfad257a76f1fb112a7009bb292b2671f3c96b08c0d0", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 685 \nThere is another way to look at this data, and that is to view the options' implied \nvolatility. Implied volatility was discussed in Chapter 28 on mathematical applica\ntions. It is basically the volatility that one would have to plug into his option pricing \nmodel in order for the model'stheoretical price to agree with the actual market price. \nAlternatively, it is the volatility that is being implied by the actual marketplace. The \noptions in this example each have different implied volatilities, since their mispricing \nis so distorted. Table 34-2 gives those implied volatilities. The deltas of the options \ninvolved are shown as well, for they will be used in later examples. \nThese implied volatilities tell the same story: The out-of-the-money puts have \nthe lowest implied volatilities, and therefore are the cheapest options; the out-of-the\nmoney calls have the highest implied volatilities, and are therefore the most expen\nsive options. \nSo, no matter which way one prefers to look at it - through comparison of the \noption price to theoretical price or by comparing implied volatilities - it is obvious \nthat these soybean options are out of line with one another. \nThis sort of pricing distortion is prevalent in many commodity options. \nSoybeans, sugar, coffee, gold, and silver are all subject to this distortion from time to \ntime. The distortion is endemic to some - soybeans, for example - or may be pres\nent only when the speculators tum extremely bullish. \nThis precise mispricing pattern is so prevalent in futures options that strategists \nshould constantly be looking for it. There are two major ways to attempt to profit \nfrom this pattern. Both are attractive strategies, since one is buying options that are \nrelatively less expensive than the options that are being sold. Such strategies, if \nimplemented when the options are mispriced, tilt the odds in the strategist'sfavor, \ncreating apositive expected return for the position. \nTABLE 34-2. \nVolatility skewing of soybean options. \nStrike \n525 \n550 \n575 \n600 \n625 \n650 \n675 \nCall \nPrice \n19 1/2 \n11 \n53/4 \n31/2 \n21/4 \nPut \nPrice \n1/2 \n31/4 ; \n12 \n28 \nImplied Delta \nVolatility Call/Put \n12% /-0.02 \n13% /-0.16 \n15% 0.59/-0.41 \n17% 0.37 /-0.63 \n19% 0.21 \n21% 0.13 \n23% 0.09", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:735", "doc_id": "25f158d23493dccdb1cfbc369bad55f1da9218b2e0f4e76f38f0609bd631f3e6", "chunk_index": 0}
{"text": "686 Part V: Index Options and Futures \nThe two theoretically attractive strategies are: \n1. Buy out-of-the-money puts and sell at-the-money puts; or \n2. Buy at-the-money calls and sell out-of-the-money calls. \nOne might just buy one cheap and sell one expensive option - abear spread \nwith the puts, or abull spread with the calls. However, it is better to implement these \nspreads with aratio between the number of options bought and the number sold. \nThat is, the first strategy involving puts would be abackspread, while the second \nstrategy involving calls would be aratio spread. By doing the ratio, each strategy is amore neutral one. Each strategy is examined separately. \nBACKSPREAD/NG THE PUTS \nThe backspread strategy works best when one expects alarge degree of volatility. \nImplementing the strategy with puts means that alarge drop in price by the under\nlying futures would be most profitable, although alimited profit could be made if \nfutures rose. Note that amoderate drop in price by expiration would be the worst \nresult for this spread. \nExample: Using prices from the above example, suppose that one decides to estab\nlish abackspread in the puts. Assume that aneutral ratio is obtained in the following \nspread: \nBuy 4 January bean 550 puts 31/4 \nSell 1 January bean 600 put at 28 \nNet position: \n13 DB \n28 CR \n15 Credit \nThe deltas (see Table 34-2) of the options are used to compute this neutral ratio. \nFigure 34-1 shows the profit potential of this spread. It is the typical picture for \naput backspread - limited upside potential with agreat deal of profit potential for \nlarge downward moves. Note that the spread is initially established for acredit of 15 \ncents. If January soybeans have volatile movements in either direction, the position \nshould profit. Obviously, the profit potential is larger to the downside, where there \nare extra long puts. However, if beans should rally instead, the spreader could still \nmake up to 15 cents ($750), the initial credit of the position. \nNote that one can treat the prices of soybean options in the same manner as he \nwould treat the prices of stock options in order to determine such things as break\neven points and maximum profit potential. The fact that soybean options are worth", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:736", "doc_id": "ce32c753c9c8fd01a82b24f3856d718d8a3bac85cbce0a336368ff4170ae9449", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 687 \nFIGURE 34-1. \nJanuary soybean, backspread. \n60 \n50 \n40 \n30 ..... \ne 20 a.. \n0 10 ~ r::: \n~ 550 600 625 \n-20 \n-30 \nFutures Price \n$50 per point ( which is cents when referring to soybeans) and stock options are worth \n$100 per point do not alter these calculations for aput backspread. \nMaximum upside profit potential= Initial debit or credit of position \n= 15 points \nMaximum risk = Maximum upside Distance between strikes \nx Number of puts sold short \n= 15-50 X 1 \n= -35 points \nDownside break-even point = Lower strike \n- Points of risk/Number of excess puts \n= 550- 35/3 \n= 538.3 \nThus, one is able to analyze afutures option p~tion or astock option position \nin the same manner - by reducing everything to be in terms of points, not dollars. \nObviously, one will eventually have to convert to dollars in order to calculate his prof\nits or losses. However, note that referring to everything in \"points\" works very well.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:737", "doc_id": "6fcfe8db09cc0f3ed5a4258c919de4ae3af2bf686d70b7f343d3a652188a79e8", "chunk_index": 0}
{"text": "688 Part V: Index Options and Futures \nLater, one can use the dollars per point to obtain actual dollar cost. Dollars per point \nwould be $50 for soybeans options, $100 for stock or index options, $400 for live cat\ntle options, $375 for coffee options, $1,120 for sugar options, etc. In this way, one \ndoes not have to get hung up in the nomenclature of the futures contract; he can \napproach everything in the same fashion for purposes of analyzing the position. He \nwill, of course, have to use proper nomenclature to enter the order, but that comes \nafter the analysis is done. \nRATIO SPREADING THE CALLS \nReturning to the subject at hand - spreads that capture this particular mispricing \nphenomenon of futures options - recall that the other strategy that is attractive in \nsuch situations is the ratio call spread. It is established with the maximum profit \npotential being somewhat above the current futures price, since the calls that are \nbeing sold are out-of-the-money. \nExample: Again using the January soybean options of the previous few examples, \nsuppose that one establishes the following ratio call spread. Using the calls' deltas \n(see Table 34-2), the following ratio is approximately neutral to begin with: \nBuy 2 January bean 600 calls at 11 \nSell 5 January bean 650 calls at 31/2 \nNet position: \n22 DB \n171/2 CR \n41/2 Debit \nFigure 34-2 shows the profit potential of the ratio call spread. It looks fairly typ\nical for aratio spread: limited downside exposure, maximum profit potential at the \nstrike of the written calls, and unlimited upside exposure. \nSince this spread is established with both options out-of-the-money, one needs \nsome upward movement by January soybean futures in order to be profitable. \nHowever, too much movement would not be welcomed (although follow-up strate\ngies could be used to deal with that). Consequently, this is amoderately bullish strat\negy; one should feel that the underlying futures have achance to move somewhat \nhigher before expiration. \nAgain, the analyst should treat this position in terms of points, not dollars or \ncents of soybean movement, in order to calculate the significant profit and loss \npoints. Refer to Chapter 11 on ratio call spreads for the original explanation of these \nformulae for ratio call spreads: \nMaximum downside loss = Initial debit or credit \n= -4½ (it is adebit)", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:738", "doc_id": "0c78c56505ad62208c3b1c6fa603ad5a1e62bba382f1f9ef587b72e23f3bcb85", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options \nFIGURE 34-2. \nJanuary soybean, ratio spread. \n90 \n80 \n70 \n60 \n50 \n:!:: \n40 0 ... a.. 30 \n0 20 .le \nC 10 \n~ 0 \n-10 \n-20 \n-30 \n575 625 650 \nAt Expiration \nFutures Price \nPoints of maximum profit = Maximum downside loss \n+ Difference in strikes \nx Number of calls owned \n=-4½ + 50 X 2 \n=95½ \nUpside break-even price = Higher striking price \n700 \n+ Maximum profit/Net number of naked calls \n= 650 + 95½/3 \n= 681.8 \n689 \nThese are the significant points of profitability at expiration. One does not care \nwhat the unit of trading is (for example, cents for soybeans) or how many dollars are \ninvolved in one unit of trading ($50 for soybeans and soybean options). He can con\nduct his analysis strictly in terms of points, and he should do so. \nBefore proceeding into the comparisons beleen the backspread and the ratio \nspread as they apply to mispriced futures options, it should be pointed out that the seri\nous strategist should analyze how his position will perform over the short term as well \nas at expiration. These analyses are presented in Chapter 36 on advanced concepts.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:739", "doc_id": "440d76572a525de843190ab6ad86c15b6ff213d08ed1a2c26642f3bc61758989", "chunk_index": 0}
{"text": "690 Part V: Index Options and Futures \nWHICH STRATEGY TO USE \nThe profit potential of the put backspread is obviously far different from that of the \ncall ratio spread. They are similar in that they both offer the strategist the opportu\nnity to benefit from spreading mispriced options. Choosing which one to implement \n(assuming liquidity in both the puts and calls) may be helped by examining the tech\nnical picture ( chart) of the futures contract. Recall that futures traders are often more \ntechnically oriented than stock traders, so it pays to be aware of basic chart patterns, \nbecause others are watching them as well. If enough people see the same thing and \nact on it, the chart pattern will be correct, if only from a \"self-fulfilling prophecy\" \nviewpoint if nothing else. \nConsequently, if the futures are locked in a (smooth) downtrend, the put strat\negy is the strategy of choice because it offers the best downside profit. Conversely, if \nthe futures are in asmooth uptrend, the call strategy is best. \nThe worst result will be achieved if the strategist has established the call ratio \nspread, and the futures have an explosive rally. In certain cases, very bullish rumors \n- weather predictions such as drought or El Nifio, foreign labor unrest in the fields \nor mines, Russian buying of grain - will produce this mispricing phenomenon. The \nstrategist should be leery of using the call ratio spread strategy in such situations, \neven though the out-of-the-money calls look and are ridiculously expensive. If the \nrumors prove true, or if there are too many shorts being squeezed, the futures can \nmove too far, too fast and seriously hurt the spreader who has the ratio call spread in \nplace. His margin requirements will escalate quickly as tl1e futures price moves high\ner. The option premiums will remain high or possibly even expand if the futures rally \nquickly, thereby overriding the potential benefit of time decay. Moreover, if the fun\ndamentals change immediately - it rains; the strike is settled; no grain credits are \noffered to the Russians - or rumors prove false, the futures can come crashing back \ndown in ahurry. \nConsequently, if rumors of fundamentals have introduced volatility in the \nfutures rnarket, implement the strategy with the put backspread. The put backspread \nis geared to taking advantage of volatility, and this fundamental situation as described \nis certainly volatile. It may seem that because the market is exploding to the upside, \nit is awaste of time to establish the put spread. Still, it is the wisest choice in avolatile \nmarket, and there is always the chance that an explosive advance can turn into aquick \ndecline, especially when the advance is based on rumors or fundamentals that could \nchange overnight. \nThere are afew \"don'ts\" associated with the ratio call spread. Do not be tempt\ned to use the ratio spread strategy in volatile situations such as those just described; \nit works best in aslowly rising market. Also, do not implement the ratio spread with", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:740", "doc_id": "be6ee80948d755bd92f41e51e25cf311ac783bb1fa2294539720b6e0e26c334b", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 691 \nridiculously far out-of-the-money options, as one is wasting his theoretical advantage \nif the futures do not have arealistic chance to climb to the striking price of the writ\nten options. Finally, do not attempt to use overly large ratios in order to gain the most \ntheoretical advantage. This is an important concept, and the next example illustrates \nit well. \nExample: Assume the same pricing pattern for January soybean options that has \nbeen the basis for this discussion. January beans are trading at 583. The (novice) \nstrategist sees that the slightly in-the-money January 575 call is the cheapest and the \ndeeply out-of-the-money January 675 call is the most expensive. This can be verified \nfrom either of two previous tables: the one showing the actual price as compared to \nthe \"theoretical\" price, or Table 34-2 showing the implied volatilities. \nAgain, one would use the deltas (see Table 34-2) to create aneutral spread. Aneutral ratio of these two would involve selling approximately six calls for each one \npurchased. \nBuy 1 January bean 575 call at 191/z \nSell 6 January bean 675 calls at 21/4 \nNet position: \n191/z DB \n131/z CR \n6 Debit \nFigure 34-3 shows the possible detrimental effects of using this large ratio. \nWhile one could make 94 points of profit if beans were at 675 at January expiration, \nhe could lose that profit quickly if beans shot on through the upside break-even \npoint, which is only 693.8. The previous formulae can be used to verify these maxi\nmum profit and upside break-even point calculations. The upside break-even point \nis too close to the striking price to allow for reasonable follow-up action. Therefore, \nthis would not be an attractive position from apractical viewpoint, even though at \nfirst glance it looks attractive theoretically. \nIt would seem that neutral spreading could get one into trouble if it \"recom\nmends\" positions like the 6-to-lratio spread. In reality, it is the strategist who is get\nting into trouble if he doesn'tlook at the whole picture. The statistics are just an aid \n- atool. The strategist must use the tools to his advantage. It should be pointed out \nas well that there is atool missing from the toolkit at this point. There are statistics \nthat will clearly show the risk of this type of high-rati<,Yspread. In this case, that tool \nis the gamma of the option. Chapter 40 covers the -Lise of gamma and other more \nadvanced statistical tools. This same example is expanded in that chapter to include \nthe gamma concept.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:741", "doc_id": "0cad2c0437862ab21aa4d3b7e7462a721a492cf03b64a8c8c64d74c9409675f6", "chunk_index": 0}
{"text": "692 Part V: Index Options and Futures \nFIGURE 34-3. \nJanuary soybean, heavily ratioed spread. \n90 \n60 \n30 \n- 0 \ne 575 625 650 675 725 a. -30 0 \n.1!l -60 C \n~ \n-90 \n-120 At Expiration \n-150 \n-180 \nFutures Price \nFOLLOW-UP ACTION \nThe same follow-up strategies apply to these futures options as did for stock options. \nThey will not be rehashed in detail here; refer to earlier chapters for broader expla\nnations. This is asummary of the normal follow-up strategies: \nRatio call spread: \nFollow-up action in strategies with naked options, such as this, generally involves \ntaking or limiting losses. Arising market will produce anegative EFP. \nNeutralize anegative EFP by: \nBuying futures \nBuying some calls \nLimit upside losses by placing buy stop orders for futures at or near the upside \nbreak-even point. \nPut backspread: \nFollow-up action in strategies with an excess of long options generally involves \ntaking or protecting profits. Afalling market will produce anegative EFP. \nNeutralize anegative EFP by: \nBuying futures \nSelling some puts", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:742", "doc_id": "e296542cc115d7a6cadf2ab2635b026575ac93b62745243343491fdc705e46c1", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 693 \nThe reader has seen these follow-up strategies earlier in the book. However, \nthere is one new concept that is important: The mispricing continues to propagate \nitself no matter what the price of the underlying futures contract. The at-the-money \noptions will always be about fairly priced; they will have the average implied volatility. \nExample: In the previous examples, January soybeans were trading at 583 and the \nimplied volatility of the options with striking price 575 was 15%, while those with a \n600 strike were 17%. One could, therefore, conclude that the at-the-money January \nsoybean options would exhibit an implied volatility of about 16%. \nThis would still be true if beans were at 525 or 675. The mispricing of the other \noptions would extend out from what is now the at-the-money strike. Table 34-3 shows \nwhat one might expect to see if January soybeans rose 75 cents in price, from 583 to \n658. \nNate that the same mispricing properties exist in both the old and new situa\ntions: The puts that are 58 points out-of-the-money have an implied volatility of only \n12%, while the calls that are 92 points out-of-the-money have an implied volatility of \n23%. \nTABLE 34-3. \nPropagation of volatility skewing. \nOriginal Situation \nJanuary beans: 583 \nImplied \nStrike Volatility \n525 12% \n550 13% \n575 15% \n600 17% \n625 19% \n650 21% \n675 23% \nNew Situation \nJanuary beans: 658 \nStrike \n600 \n625 \n650 \n675 \n700 \n725 \n750 \nThis example is not meant to infer that the volatility of an at-the-money soybean \nfutures option will always be 16%. It could be anything, depending on the historical \nand implied volatility of the futures contract itself. However, the volatility skewing \nwill still persist even if the futures rally or decline. \nThis fact will affect how these strategies behave as the(linderlying futures con\ntract moves. It is abenefit to both strategies. First, look at the put backspread when \nthe stock falls to the striking price of the purchased puts.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:743", "doc_id": "4dd7367cbce91eebc736237eeeedec2984ee33aca1dec9c7f30ed6162b3b6d90", "chunk_index": 0}
{"text": "694 Part V: Index Options and Futures \nExample: The put backspread was established under the following conditions: \nStrike \n550 \n600 \nPut \nPrice \nTheoretical \nPut Price \n5.4 \n27.6 \nImplied \nVolatility \n13% \n17% \nIf January soybean futures should fall to 550, one would expect the implied \nvolatility of the January 550 puts that are owned to be about 16% or 17%, since they \nwould be at-the-money at that time. This makes the assumption that the at-the\nmoney puts will have about a 17% implied volatility, which is what they had when the \nposition was established. \nSince the strategy involves being long alarge quantity of January 550 puts, this \nincrease in implied volatility as the futures drop in price will be of benefit to the \nspread. \nNote that the implied volatility of the January 600 puts would increase as well, \nwhich would be asmall negative aspect for the spread. However, since there is only \none put short and it is quite deeply in the money with the futures at 550, this nega\ntive cannot outweigh the positive effect of the expansion of volatility on the long \nJanuary 550 puts. \nIn asimilar manner, the call spread would benefit. The implied volatility of the \nwritten options would actually drop as the futures rallied, since they would be less far \nout-of-the-money than they originally were when the spread was established. While \nthe same can be said of the long options in the spread, the fact that there are extra, \nnaked, options means the spread will benefit overall. \nIn summary, the futures option strategist should be alert to mispricing situations \nlike those described above. They occur frequently in afew commodities and occa\nsionally in others. The put backspread strategy has limited risk and might therefore \nbe attractive to more individuals; it is best used in downtrending and/or volatile mar\nkets. However, if the futures are in asmooth uptrend, not avolatile one, aratio call \nspread would be better. In either case, the strategist has established aspread that is \nstatistically attractive because he has sold options that are expensive in relation to the \nones that he has bought.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:744", "doc_id": "870b0f3eae0e7ee89595ec4b1fe84ed55d4aa30999ba793bc5b757ce943d0505", "chunk_index": 0}
{"text": "Chapter 34: Futures and Futures Options 695 \nSUMMARY \nThis chapter presented the basics of futures and futures options trading. The basic \ndifferences between futures options and stock or index options were laid out. In acertain sense, afutures option is easier to utilize than is astock option because the \neffects of dividends, interest rates, stock splits, and so forth do not apply to futures \noptions. However, the fact that each underlying physical commodity is completely \ndifferent from most other ones means that the strategist is forced to familiarize him\nself with avast array of details involving striking prices, trading units, expiration \ndates, first notice days, etc. \nMore details mean there could be more opportunities for mistakes, most of \nwhich can be avoided by visualizing and analyzing all positions in terms of points and \nnot in dollars. \nFutures options do not create new option strategies. However, they may afford \none the opportunity to trade when the futures are locked limit up. Moreover, the \nvolatility skewing that is present in futures options will offer opportunities for put \nbackspreads and call ratio spreads that are not normally present in stock options. \nChapter 35 discusses futures spreads and how one can use futures options with \nthose spreads. Calendar spreads are discussed as well. Calendar spreads with futures \noptions are different from calendar spreads using stock or index options. These are \nimportant concepts in the futures markets - distinctly different from an option \nspread - and are therefore significant for the futures option trader.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:745", "doc_id": "d1b1813edcf1698516fef6d7f8237928e80f370c039e3259704092b5b92d79a0", "chunk_index": 0}
{"text": "Futures Option Strategies for \nFutures Spreads \nAspread with futures is not the same as aspread with options, except that one item \nis bought while another is simultaneously sold. In this manner, one side of the spread \nhedges the risk of the other. This chapter describes futures spreading and offers ways \nto use options as an adjunct to those spreads. \nThe concept of calendar spreading with futures options is covered in this chap\nter as well. This is the one strategy that is very different when using futures options, \nas opposed to using stock or index options. \nFUTURES SPREADS \nBefore getting into option strategies, it is necessary to define futures spreads and to \nexamine some common futures spreading strategies. \nFUTURES PRICING DIFFERENTIALS \nIt has already been shown that, for any paiticular physical commodity, there are, at \nany one time, several futures that expire in different months. Oil futures have month\nly expirations; sugar futures expire in only five months of any one calendar year. The \nfrequency of expiration months depends on which futures contract one is discussing. \nFutures on the same underlying commodity will trade at different prices. The \ndifferential is due to several factors, not just time, as is the case with stock options. Amajor factor is carrying costs - how much one would spend to buy and hold the phys-\n696", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:746", "doc_id": "24ce3063bcdbeba8a2a7cf411e033fce5481a511b91f107b426f7dff0c5b8dc6", "chunk_index": 0}
{"text": "Chapter 35: Futures Option Strategies for Futures Spreads 697 \nical commodity until futures expiration. However, other factors may enter in as well, \nincluding supply and demand considerations. In anormal carrying cost market, \nfutures that expire later in time are more expensive than those that are nearer-term. \nExample: Gold is acommodity whose futures exhibit forward or normal carry. \nSuppose it is March 1st and spot gold is trading at 351. Then, the futures contracts \non gold and their respective prices might be as follows: \nExpiration Month Price \nApril 352.50 \nJune 354.70 \nAugust 356.90 \nDecember 361.00 \nJune 366.90 \nNotice that each successive contract is more expensive than the previous one. \nThere is a 2.20 differential between each of the first three expirations, equal to 1.10 \nper month of additional expiration time. However, the differential is not quite that \ngreat for the December, which expires in 9 months, or for the June contract, which \nexpires in 15 months. The reason for this might be that longer-term interest rates are \nslightly lower than the short-term rates, and so the cost of carry is slightly less. \nHowever, prices in all futures don'tline up this nicely. In some cases, different \nmonths may actually represent different products, even though both are on the same \nunderlying physical commodity. For example, wheat is not always wheat. There is asummer crop and awinter crop. While the two may be related in general, there could \nbe asubstantial difference between the July wheat futures contract and the \nDecember contract, for example, that has very little to do with what interest rates are. \nSometimes short-term demand can dominate the interest rate effect, and aseries of futures contracts can be aligned such that the short-term futures are more \nexpensive. This is known as areverse carrying charge market, or contango. \nINTRAMARKET FUTURES SPREADS \nSome futures traders attempt to predict the relationships between various expiration \nmonths on the same underlying physical commodity. That is, one might buy July \nsoybean futures and sell September soybean futures. When one both buys and sells \ndiffering futures contracts, he has aspread. When both contracts are on the same \nunderlying physical commodity, he has an intramarket spread. \n~", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:747", "doc_id": "6a9648dc3923ade76d12d0aee157301f3edc227e20376c35b99622f9420d6885", "chunk_index": 0}
{"text": "698 Part V: Index Options and Futures \nThe spreader is not attempting to predict the overall direction of prices. Rather, \nhe is trying to predict the differential in prices between the July and September con\ntracts. He doesn'tcare if beans go up or down, as long as the spread between July and \nSeptember goes his way. \nExample: Aspread trader notices that historic price charts show that if September \nsoybeans get too expensive with respect to July soybeans, the differential usually dis\nappears in amonth or two. The opportunity for establishing this trade usually occurs \nearly in the year - February or March. \nAssume it is February 1st, and the following prices exist: \nJuly soybean futures: 600 ($6.00/bushel) \nSeptember soybean futures: 606 \nThe price differential is 6 cents. It rarely gets worse than 12 cents, and often revers\nes to the point that July futures are more expensive than soybean futures - some \nyears as much as 100 cents more expensive. \nIf one were to trade this spread from ahistorical perspective, he would thus be \nrisking approximately 6 cents, with possibilities of making over 100 cents. That is \ncertainly agood risk/reward ratio, if historic price patterns hold up in the current \nenvironment. \nSuppose that one establishes the spread: \nBuy one July future @ 600 \nSell one September future @ 606 \nAt some later date, the following prices and, hence, profits and losses, exist. \nFutures Price \nJuly: 650 \nSeptember: 630 \nTotal Profit: \nProfit/Loss \n+50 cents \n-24 cents \n26 cents ($1,300) \nThe spread has inverted, going from an initial state in which September was 6 \ncents more expensive than July, to asituation in which July is 20 cents more expen\nsive. The spreader would thus make 26 cents, or $1,300, since 1 cent in beans is \nworth $50.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:748", "doc_id": "6decd412addc18439c5b0a3f919cf06b28805412e4df6c3a6d0e0c5abc0d582b", "chunk_index": 0}
{"text": "Chapter 35: Futures Option Strategies for Futures Spreads 699 \nNotice that the same profit would have been made at any of the following pairs \nof prices, because the price differential between July and September is 20 cents in \nall cases (with July being the more expensive of the two). \nJuly Futures September Futures July Profit September Profit \n420 400 -180 +206 \n470 450 -130 +156 \n550 530 -50 +76 \n600 580 0 +26 \n650 630 +50 -24 \n700 680 +100 -74 \n800 780 +200 -174 \nTherefore, the same 26-cent profit can be made whether soybeans are in asevere bear market, in arousing bull market, or even somewhat unchanged. The \nspreader is only concerned with whether the spread widens from a 6-cent differen\ntial or not. \nCharts, some going back years, are kept of the various relationships between \none expiration month and another. Spread traders often use these historical charts to \ndetermine when to enter and exit intramarket spreads. These charts display the sea\nsonal tendencies that make the relationships between various contracts widen or \nshrink. Analysis of the fundamentals that cause the seasonal tendencies could also be \nmotivation for establishing intramarket spreads. \nThe margin required for intramarket spread trading (and some other types of \nfutures spreads) is smaller than that required for speculative trading in the futures \nthemselves. The reason for this is that spreads are considered less risky than outright \npositions in the futures. However, one can still make or lose agood deal of money in \naspread - percentage-wise as well as in dollars - so it cannot be considered conser\nvative; it'sjust less risky than outright futures speculation. \nExample: Using the soybean spread from the example above, assume the speculative \ninitial margin requirement is $1,700. Then, the spread margin requirement might be \n$500. That is considerably less than one would have to put up as initial margin if each \nside of the spread had to be margined separately, asituation that would require \n$3,400. \nIn the previous example, it was shown that the soybean spread had the poten\ntial to widen as much as 100 points ($1.00), amove that would be worth $5,000 if it", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:749", "doc_id": "be250674c94e5b44a74235c91d57cd537acede0647ce0a2243c6d9f6c5e7992f", "chunk_index": 0}
{"text": "700 Part V: Index Options and Futures \noccurred. While it is unlikely that the spread would actually widen to historic highs, \nit is certainly possible that it could widen 25 or 30 cents, aprofit of $1,250 to $1,500. \nThat is certainly high leverage on a $500 investment over ashort time period, \nso one must classify spreading as arisk strategy. \nINTERMARKET FUTURES SPREADS \nAnother type of futures spread is one in which one buys futures contracts in one mar\nket and sells futures contracts in another, probably related, market. When the futures \nspread is transacted in two different markets, it is known as an intermarket spread. \nIntermarket spreads are just as popular as intramarket spreads. \nOne type of intermarket spread involves directly related markets. Examples \ninclude spreads between currency futures on two different international currencies; \nbetween financial futures on two different bond, note, or bill contracts; or between acommodity and its products - oil, unleaded gasoline, and heating oil, for example. \nExample: Interest rates have been low in both the United States and Japan. As aresult, both currencies are depressed with respect to the European currencies, where \ninterest rates remain high. Atrader believes that interest rates will become more uni\nform worldwide, causing the Japanese yen to appreciate with respect to the German \nmark. \nHowever, since he is not sure whether Japanese rates will move up or German \nrates will move down, he is reluctant to take an outright position in either currency. \nRather, he decides to utilize an intermarket spread to implement his trading idea. \nAssume he establishes the spread at the following prices: \nBuy I June yen future: 77.00 \nSell I June mark future: 60.00 \nThis is an initial differential of 17.00 between the two currency futures. He is \nhoping for the differential to get larger. The dollar trading terms are the same for \nboth futures: One point of movement (from 60.00 to 61.00, for example) is worth \n$1,250. His profit and loss potential would therefore be: \nSpread Differential \nal a Later Date Profit/Loss \n14.00 $3,750 \n16.00 - $1,250 \n18.00 + 1,250 \n20.00 + 3,750", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:750", "doc_id": "61f94bcb2771ba05547fb396d5fa32c363bed9f4b1f8d29385e9267241014d51", "chunk_index": 0}
{"text": "Chapter 35: Futures Option Strategies for Futures Spreads 701 \nIn some cases, the exchanges recognize frequently traded intermarket spreads \nas being eligible for reduced margin requirements. That is, the exchange recognizes \nthat the two futures are hedges against one another if one is sold and the other is \nbought. \nThese spreads between currencies, called cross-currency spreads, are so heavi\nly traded that there are other specific vehicles - both futures and warrants - that \nallow the speculator to trade them as asingle entity. Regardless, they serve as aprime \nexample of an intermarket spread when the two futures are used. \nIn the example above, assume the outright speculative margin for aposition in \neither currency future is $1,700 per contract. Then, the margin for this spread would \nprobably be nearly $1,700 as well, equal to the speculative margin for one side of the \nspread. This position is thus recognized as aspread position for margin purposes. The \nmargin treatment isn'tas favorable as for the intramarket spread (see the earlier soy\nbean example), but the spread margin is still only one-half of what one would have to \nadvance as initial margin if both sides of the spread had to be margined separately. \nOther intermarket spreads are also eligible for reduced margin requirements, \nalthough at first glance they might not seem to be as direct ahedge as the two cur\nrencies above were. \nExample: Acommon intermarket spread is the TED spread, which consists of \nTreasury bill futures on one side and Eurodollar futures on the other. Treasury bills \nrepresent the safest investment there is; they are guaranteed. Eurodollars, however, \nare not insured, and therefore represent aless safe investment. Consequently, \nEurodollars yield more than Treasury bills. How much more is the key, because as \nthe yield differential expands or shrinks, the spread between the prices of T-bill \nfutures and Eurodollar futures expands or shrinks as well. In essence, the yield dif\nferential is small when there is stability and confidence in the financial markets, \nbecause uninsured deposits and insured deposits are not that much different in times \nof financial certainty. However, in times of financial uncertainty and instability, the \nspread widens because the uninsured depositors require acomparatively higher yield \nfor the higher risk they are taking. \nAssume the outright initial margin for either the T-bill future or the Eurodollar \nfuture is $800 per contract. The margin for the TED spread, however, is only $400. \nThus, one is able to trade this spread for only one-fourth of the amount of margin \nthat would be required to margin both sides separately. \nThe reason that the margin is more favorable is that there is not alot of volatil\nity in this spread. Historically, it has ranged between about 0.30 and 1.70. In both \nfutures contracts, one cent (0.01) of movement is worth $25. Thus, the entire 140-\ncent historic range of the spread only represents $3,500 (140 x $25). \n(", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:751", "doc_id": "5c0782dcebbb8749406494b1bf0288441f1d137952772ace7bde29e4b6c205f0", "chunk_index": 0}
{"text": "702 Part V: Index Options and Futures \nMore will be said later about the TED spread when the application of futures \noptions to intermarket spreads is discussed. Since there is aliquid option market on \nboth futures, it is sometimes more logical to establish the spread using options \ninstead of futures. \nOne other comment should be made regarding the TED spread: It has carry\ning cost. That is, if one buys the spread and holds it, the spread will shrink as time \npasses, causing asmall loss to the holder. When interest rates are low, the carrying \ncost is small (about 0.05 for 3 months). It would be larger if short-term rates rose. \nThe prices in Table 35-1 show that the spread is more costly for longer-term con\ntracts. \nTABLE 35-1. \nCarrying costs of the TED spread. \nMonth T-Bill Future \nMarch 96.27 \nJune 96.15 \nSeptember 95.90 \nEurodollar Future \n95.86 \n95.69 \n95.39 \nTED Spread \n0.41 \n0.46 \n0.51 \nMany intermarket spreads have some sort of carrying cost built into them; the \nspreader should be aware of that fact, for it may figure into his profitability. \nOne final, and more complex, example of an intermarket spread is the crack \nspread. There are two major areas in which abasic commodity is traded, as well as \ntwo of its products: crude oil, unleaded gasoline, and heating oil; or soybeans, soy\nbean oil, and soybean meal. Acrack spread involves trading all three - the base com\nmodity and both byproducts. \nExample: The crack spread in oil consists of buying two futures contracts for crude \noil and selling one contract each for heating oil and unleaded gasoline. \nThe units of trading are not the same for all three. The crude oil future is acon\ntract for 1,000 barrels of oil; it is traded in units of dollars per barrel, so a $1 increase \nin oil prices from $18.00 to $19.00, say - is worth $1,000 to the futures contract. \nHeating oil and unleaded gasoline futures contracts have similar terms, but they are \ndifferent from crude oil. Each of these futures is for 42,000 gallons of the product, \nand they are traded in cents. So, aone-cent move - gasoline going from 60 cents agallon to 61 cents agallon - is worth $420. This information is summarized in Table \n35-2 by showing how much aunit change in price is worth.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:752", "doc_id": "bdca5dc2c6051497bf76fcd23c847e17a9d3645d546d818099e003f11a9bbb4c", "chunk_index": 0}
{"text": "Chapter 35: Futures Option Strategies for Futures Spreads \nTABLE 35-2. \nTerms of oil production contract. \nContract \nCrude Oil \nUnleaded Gasoline \nHeating Oil \nInitial \nPrice \n18.00 \n.6000 \n.5500 \nSubsequent \nPrice \n19.00 \n.6100 \n.5600 \nThe following formula is generally used for the oil crack spread: \nCrack= (Unleaded gasoline + Heating oil) x 42 - 2 x Crude \n2 \n(.6000 + .5500) X 42 - 2 X 18.00 = \n2 \n= (48.3 - 36)/2 \n= 6.15 \n703 \nGain in \nDollars \n$1,000 \n$ 420 \n$ 420 \nSome traders don'tuse the divisor of 2 and, therefore, would arrive at avalue \nof 12.30 with the above data. \nIn either case, the spreader can track the history of this spread and will attempt \nto buy oil and sell the other two, or vice versa, in order to attempt to make an over\nall profit as the three products move. Suppose aspreader felt that the products were \ntoo expensive with respect to crude oil prices. He would then implement the spread \nin the following manner: \nBuy 2 March crude oil futures @ 18.00 \nSell 1 March heating oil future @ 0.5500 \nSell l March unleaded gasoline future @ 0.6000 \nThus, the crack spread was at 6.15 when he entered the position. Suppose that \nhe was right, and the futures prices subsequently changed to the following: \nMarch crude oil futures: 18.50 \nMarch unleaded gas futures: .6075 \nMarch heating oil futures: .5575 \nThe profit is shown in Table 35-3.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:753", "doc_id": "b2abb413b5824d773f1ab3f9ab789fd7850103ba49e25ad1ced0c03481208903", "chunk_index": 0}
{"text": "704 \nTABLE 35-3. \nProfit and loss of crack spread. \nContract \n2 March Crude \n1 March Unleaded \n1 March Heating Oil \nNet Profit (before commissions) \nInitial \nPrice \n18.00 \n.6000 \n.5500 \nPart V: Index Options and Futures \nSubsequent \nPrice \n18.50 \n.6075 \n.5575 \nGain in \nDollars \n+ $1,000 \n- $ 315 \n- $ 315 \n+ $ 370 \nOne can calculate that the crack spread at the new prices has shrunk to 5.965. \nThus, the spreader was correct in predicting that the spread would narrow, and he \nprofited. \nMargin requirements are also favorable for this type of spread, generally being \nslightly less than the speculative requirement for two contracts of crude oil. \nThe above examples demonstrate some of the various intermarket spreads that \nare heavily watched and traded by futures spreaders. They often provide some of the \nmost reliable profit situations without requiring one to predict the actual direction of \nthe market itself. Only the differential of the spread is important. \nOne should not assume that all intermarket spreads receive favorable margin \ntreatment. Only those that have traditional relationships do. \nUSING FUTURES OPTIONS IN FUTURES SPREADS \nAfter viewing the above examples, one can see that futures spreads are not the same \nas what we typically know as option spreads. However, option contracts may be use\nful in futures spreading strategies. They can often provide an additional measure of \nprofit potential for very little additional risk. This is true for both intramarket and \nintermarket spreads. \nThe futures option calendar spread is discussed first. The calendar spread with \nfutures options is not the same as the calendar spread with stock or index options. In \nfact, it may best be viewed as an alternative to the intramarket futures spread rather \nthan as an option spread strategy. \nCALENDAR SPREADS \nAcalendar spread with futures options would still be constructed in the familiar \nmanner - buy the May call, sell the March call with the same striking price. However,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:754", "doc_id": "58c59d4b12aafdd64464bbdd06cbc301aeda3f8d4adfacb576482c4301729d25", "chunk_index": 0}
{"text": "Chapter 35: Futures Option Strategies for Futures Spreads 705 \nthere is amajor difference between the futures option calendar spread and the stock \noption calendar spread. That difference is that acalendar spread using futures \noptions involves two separate underlying instruments, while acalendar spread using \nstock options does not. When one buys the May soybean 600 call and sells the March \nsoybean 600 call, he is buying acall on the May soybean futures contract and selling \nacall on the March soybean futures contract. Thus, the futures option calendar \nspread involves two separate, but related, underlying futures contracts. However, if \none buys the IBM May 100 call and sells the IBM March 100 call, both calls are on \nthe same underlying instrument, IBM. This is amajor difference between the two \nstrategies, although both are called \"calendar spreads.\" \nTo the stock option trader who is used to visualizing calendar spreads, the \nfutures option variety may confound him at first. For example, astock option trader \nmay conclude that if he can buy afour-month call for 5 points and sell atwo-month \ncall for 2 points, he has agood calendar spread possibility. Such an analysis is mean\ningless with futures options. If one can buy the May soybean 600 call for 5 and sell \nthe March soybean 600 call for 3, is that agood spread or not? It'simpossible to tell, \nunless you know the relationship between May and March soybean futures contracts. \nThus, in order to analyze the futures option calendar spread, one must not only ana\nlyze the options' relationship, but the two futures contracts' relationship as well. \nSimply stated, when one establishes afutures option calendar spread, he is not only \nspreading time, as he does with stock options, he is also spreading the relationship \nbetween the underlying futures. \nExample: Atrader notices that near-term options in soybeans are relatively more \nexpensive than longer-term options. He thinks acalendar spread might make sense, \nas he can sell the overpriced near-term calls and buy the relatively cheaper longer\nterm calls. This is agood situation, considering the theoretical value of the options \ninvolved. He establishes the spread at the following prices: \nSoybean Trading \nContract Initial Price Position \nMarch 600 call 14 Sell 1 \nMay 600 call 21 Buy 1 \nMarch future 594 none \nMay future 598 none \nThe May/March 600 call calendar spread is established for 7 points debit. \nMarch expiration is two months away. At the current time, the May futures are trad\ning at a 4-point premium to March futures. The spreader figures that if March", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:755", "doc_id": "90acddf8b51baa65884a1db37c260bd62f170b2864c475d4b38d6422733dd2c8", "chunk_index": 0}
{"text": "706 Part V: Index Options and Futures \nfutures are approximately unchanged at expiration of the March options, he should \nprofit handsomely, because the March calls are slightly overpriced at the current \ntime, plus they will decay at afaster rate than the May calls over the next two months. \nSuppose that he is correct and March futures are unchanged at expiration of the \nMarch options. This is still no guarantee of profit, because one must also determine \nwhere May futures are trading. If the spread between May and March futures \nbehaves poorly (May declines with respect to March), then he might still lose money. \nLook at the following table to see how the futures spread between March and May \nfutures affects the profitability of the calendar spread. The calendar spread cost 7 \ndebit when the futures spread was +4 initially. \nFutures Calendar \nFutures Prices Spread May 600 Call Spread \nMarch/May Price Price Profit/Loss \n594/570 -24 4 -3 cents \n594/580 -14 61/2 _1/2 \n594/590 -4 10 +3 \n594/600 +6 141/2 +71/2 \nThus, the calendar spread could lose money even with March futures \nunchanged, as in the top two lines of the table. It also could do better than expected \nif the futures spread widens, as in the bottom line of the table. \nThe profitability of the calendar spread is heavily linked to the futures spread \nprice. In the above example, it was possible to lose money even though the March \nfutures contract was unchanged in price from the time the calendar spread was \ninitially established. This would never happen with stock options. If one placed acalendar spread on IBM and the stock were unchanged at the expiration of the near\nterm option, the spread would make money virtually all of the time ( unless implied \nvolatility had shrunk dramatically). \nThe futures option calendar spreader is therefore trading two spreads at once. \nThe first one has to do with the relative pricing differentials (implied volatilities, for \nexample) of the two options in question, as well as the passage of time. The second \none is the relationship between the two underlying futures contracts. As aresult, it is \ndifficult to draw the ordinary profit picture. Rather, one must approach the problem \nin this manner: \n1. Use the horizontal axis to represent the futures spread price at the expiration of \nthe near-term option.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:756", "doc_id": "5aeca2e1e93f20a0d5f709af6f64674557a5a0798b4008e2eb00419a4797f75c", "chunk_index": 0}
{"text": "Chapter 35: Futures Option Strategies for Futures Spreads 707 \n2. Draw several profit curves, one for each price of the near-term future at near\nterm expiration. \nExample: Expanding on the above example, this method is demonstrated here. \nFigure 35-1 shows how to approach the problem. The horizontal axis depicts \nthe spread between March and May soybean futures at the expiration of the March \nfutures options. The vertical axis represents the profit and loss to be expected from \nthe calendar spread, as it always does. \nThe major difference between this profit graph and standard ones is that there \nare now several sets of profit curves. Aseparate one is drawn for each price of the \nMarch futures that one wants to consider in his analysis. The previous example \nshowed the profitability for only one price of the March futures - unchanged at 594. \nHowever, one cannot rely on the March futures to remain unchanged, so he must \nview the profitability of the calendar spread at various March futures prices. \nThe data that is plotted in the figure is summarized in Table 35-4. Several things \nare readily apparent. First, if the futures spread improves in price, the calendar \nspread will generally make money. These are the points on the far right of the figure \nand on the bottom line of Table 35-4. Second, if the futures spread behaves miser-\nFIGURE 35-1. \nSoybean futures calendar spreads, at March expiration. \ngj \n20 \n16 \n12 \n.3 8 \n::.: \n0 \nct 4 \n0 \n-8 \nMarch/May Spread \nMarch =604 \nMarch =594 \nMarch= 614 \nMarch =584 \nMarch= 574", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:757", "doc_id": "49eed3bef60455452e24c2e40f55b1d63186d51fa843aac6d93ac966cc2ac984", "chunk_index": 0}
{"text": "708 Part V: Index Options and Futures \nably, the calendar spread will almost certainly lose money (points on the left-hand \nside of the figure, or top line of the table). \nThird, if March futures rise in price too far, the calendar spread could do poor\nly. In fact, if March futures rally and the futures spread worsens, one could lose more \nthan his initial debit (bottom left-hand point on figure). This is partly due to the fact \nthat one is buying the March options back at aloss if March futures rally, and may \nalso be forced to sell his May options out at aloss if May futures have fallen at the \nsame time. \nFourth, as might be expected, the best results are obtained if March futures \nrally slightly or remain unchanged and the futures spread also remains relatively \nunchanged (points in the upper right-hand quadrant of the figure). \nIn Table 35-4, the far right-hand column shows how afutures spreader would \nhave fared if he had bought May and sold March at 4 points May over March, not \nusing any options at all. \nTABLE 35-4. \nProfit and loss from soybean call calendar. \nAll Prices at March Option Expiration \nFutures Future \nSpread Calendar Spread Profit Spread \n(May-March) March Future Price: 574 584 594 604 614 Profit \n-24 -5.5 - 4.5 -3 -4.5 -11.5 -28 \n-14 -4.5 3 -0.5 -1 -7 -18 \n-4 -2.5 0 +3 +3.5 -1 - 8 \n6 0 + 3 +7.5 +9 +5.5 + 2 \n16 +7 + 11 +17 +19 +13 +12 \nThis example demonstrates just how powerful the influence of the futures \nspread is. The calendar spread profit is predominantly afunction of the futures \nspread price. Thus, even though the calendar spread was attractive from the theo\nretical viewpoint of the option'sprices, its result does not seem to reflect that theo\nretical advantage, due to the influence of the futures spread. Another important \npoint for the calendar spreader used to dealing with stock options to remember is \nthat one can lose more than his initial debit in afutures calendar spread if the spread \nbetween the underlying futures inverts. \nThere is another way to view acalendar spread in futures options, however, and \nthat is as asubstitute or alternative to an intramarket spread in the futures contracts \nthemselves. Look at Table 35-4 again and notice the far right-hand column. This is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:758", "doc_id": "4a34ca1927c0eddec6e5a7040410209d970f3609d7a86ca62861d5850dc68acd", "chunk_index": 0}
{"text": "Chapter 35: Futures Option Strategies for Futures Spreads 709 \nthe profit or loss that would be made by an intramarket soybean spreader who bought \nMay and sold March at the initial prices of 598 and 594, respectively. The calendar \nspread generally outperforms the intramarket spread for the prices shown in this \nexample. This is where the true theoretical advantage of the calendar spread comes \nin. So, if one is thinking of establishing an intrarnarket spread, he should check out \nthe calendar spread in the futures options first. If the options have atheoretical pric\ning advantage, the calendar spread may clearly outperform the standard intramarket \nspread. \nStudy Table 35-4 for amoment. Note that the intramarket spread is only better \nwhen prices drop but the spread widens (lower left comer of table). In all other \ncases, the calendar spread strategy is better. One could not always expect this to be \ntrue, of course; the results in the example are partly due to the fact that the March \noptions that were sold were relatively expensive when compared with the May \noptions that were bought. \nIn summary, the futures option calendar spread is more complicated when \ncompared to the simpler stock or index option calendar spread. As aresult, calendar \nspreading with futures options is aless popular strategy than its stock option coun\nterpart. However, this does not mean that the strategist should overlook this strate\ngy. As the strategist knows, he can often find the best opportunities in seemingly \ncomplex situations, because there may be pricing inefficiencies present. This strate\ngy'smain application may be for the intramarket spreader who also understands the \nusage of options. \nLONG COMBINATIONS \nAnother attractive use of options is as asubstitute for two instruments that are being \ntraded one against the other. Since intermarket and intramarket futures spreads \ninvolve two instruments being traded against each other, futures options may be able \nto work well in these types of spreads. You may recall that asimilar idea was pre\nsented with respect to pairs trading, as well as certain risk arbitrage strategies and \nindex futures spreading. \nIn any type of futures spread, one might be able to substitute options for the \nactual futures. He might buy calls for the long side of the spread instead of actually \nbuying futures. Likewise, he could sell calls or buy puts instead of selling futures for \nthe other side of the spread. In using options, however, he wants to avoid two prob\nlems. First, he does not want to increase his risk. Second, he does not want to pay alot of time value premium that could waste away, costing him the profits from his \nspread.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:759", "doc_id": "182f46388a0309dc0fee83fcd9e463db4354e4f7392910ae5d8076cbfcad5462", "chunk_index": 0}
{"text": "710 Part V: Index Options and Futures \nLet'sspend ashort time discussing these two points. First, he does not want to \nincrease his risk. In general, selling options instead of utilizing futures increases one'srisk. If he sells calls instead of selling futures, and sells puts instead of buying futures, \nhe could be increasing his risk tremendously if the futures prices moved alot. If the \nfutures rose tremendously, the short calls would lose money, but the short puts would \ncease to make money once the futures rose through the striking price of the puts. \nTherefore, it is not arecommended strategy to sell options in place of the futures in \nan intramarket or intennarket spread. The next example will show why not. \nExample: Aspreader wants to trade an intramarket spread in live cattle. The con\ntract is for 40,000 pounds, so aone-cent move is worth $400. He is going to sell April \nand buy June futures, hoping for the spread to narrow between the two contracts. \nThe following prices exist for live cattle futures and options: \nApril future: 78.00 \nJune future: 74.00 \nApril 78 call: 1.25 \nJune 74 put: 2.00 \nHe decides to use the options instead of futures to implement this spread. He \nsells the April 78 call as an alternative to selling the April future; he also sells the June \n74 put as an alternative to buying the June future. \nSometime later, the following prices exist: \nApril future: 68.00 \nJune future: 66.00 \nApril 78 call: 0.00 \nJune 74 put: 8.05 \nThe futures spread has indeed narrowed as expected - from 4.00 points to 2.00. \nHowever, this spreader has no profit to show for it; in fact he has aloss. The call that \nhe sold is now virtually worthless and has therefore earned aprofit of 1.25 points; \nhowever, the put that was sold for 2.00 is now worth 8.05 - aloss of 6.05 points. \nOverall, the spreader has anet loss of 4.80 points since he used short options, instead \nof the 2.00-point gain he could have had if he had used futures instead. \nThe second thing that the futures spreader wants to ensure is that he does not \npay for alot of time value premium that is wasted, costing him his potential profits. \nIf he buys at- or out-of-the-money calls instead of buying futures, and if he buys at-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:760", "doc_id": "2fdfa492a1b6a840c339e3cb77e8b84e5ab8bc054b71b270a5b7fd7e9d59db00", "chunk_index": 0}
{"text": "Chapter 35: Futures Option Strategies for Futures Spreads 711 \nor out-of-the-money puts instead of selling futures, he could be exposing his spread \nprofits to the ravages of time decay. Do not substitute at- or out-of-the-rrwney options \nfor the futures in intramarket or intennarket spreads. The next example will show \nwhy not. \nExample: Afutures spreader notices that afavorable situation exists in wheat. He \nwants to buy July and sell May. The following prices exist for the futures and options: \nMay futures: 410 \nJuly futures: 390 \nMay 410 put: 20 \nJuly 390 call: 25 \nThis trader decides to buy the May 410 put instead of selling May futures; he \nalso buys the July 390 call instead of buying July futures. \nLater, the following prices exist: \nMay futures: 400 \nJuly futures: 400 \nMay 410 put: 25 \nJuly 390 call: 30 \nThe futures spread would have made 20 points, since they are now the same \nprice. At least this time, he has made money in the option spread. He has made 5 \npoints on each option for atotal of 10 points overall - only half the money that could \nhave been made with the futures themselves. Nate that these sample option prices \nstill show agood deal of time value premium remaining. If more time had passed and \nthese options were trading closer to parity, the result of the option spread would be \nworse. \nIt might be pointed out that the option strategy in the above example would \nwork better if futures prices were volatile and rallied or declined substantially. This \nis true to acertain extent. If the market had moved alot, one option would be very \ndeeply in-the-money and the other deeply out-of-the-money. Neither one would \nhave much time value premium, and the trader would therefore have wasted all the \nmoney spent for the initial time premium. So, unless the futures moved so far as to \noutdistance that loss of time value premium, the futures strategy would still outrank \nthe option strategy. \nHowever, this last point of volatile futures movement helping an option position \nis avalid one. It leads to the reason for the only favorable option strategy that is asub-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:761", "doc_id": "f4a098e13938dc4761d93ee2f42e48a010d99a296998c9eef14efa6113ab4b28", "chunk_index": 0}
{"text": "712 Part V: Index Options and Futures \nstitute for futures spreads - that is, using in-the-money options. If one buys in-the\nrnoney calls instead of buying futures, and buys in-the-money puts instead of selling \nfutures, he can often create aposition that has an advantage over the intramarket or \nintermarket futures spread. In-the-money options avoid most of the problems \ndescribed in the two previous examples. There is no increase of risk, since the options \nare being bought, not sold. In addition, the amount of money spent on time value \npremium is small, since both options are in-the-money. In fact, one could buy them \nso far in the money as to virtually eliminate any expense for time value premium. \nHowever, that is not recommended, for it would negate the possible advantage of \nusing moderately in-the-money options: If the underlyingfutures behave in avolatile \nmanner, it might be possible for the option spread to make money, even if the futures \nspread does not behave as expected. \nIn order to illustrate these points, the TED spread, an intermarket spread, will \nbe used. Recall that in order to buy the TED spread, one would buy T-bill futures \nand sell an equal quantity of Eurodollar futures. \nOptions exist on both T-bill futures and Eurodollar futures. If T-bill calls were \nbought instead of T-bill futures, and if Eurodollar puts were bought instead of sell\ning Eurodollar futures, asimilar position could be created that might have some \nadvantages over buying the TED spread using futures. The advantage is that if T-bills \nand/or Eurodollars change in price by alarge enough amount, the option strategist \ncan make money, even if the TED spread itself does not cooperate. \nOne might not think that short-term rates could be volatile enough to make this \naworthwhile strategy. However, they can move substantially in ashort period of time, \nespecially if the Federal Reserve is active in lowering or raising rates. For example, \nsuppose the Fed continues to lower rates and both T-bills and Eurodollars substan\ntially rise in price. Eventually, the puts that were purchased on the Eurodollars will \nbecome worthless, but the T-bill calls that are owned will continue to grow in value. \nThus, one could make money, even if the TED spread was unchanged or shrunk, as \nlong as short-term rates dropped far enough. \nSimilarly, if rates were to rise instead, the option spread could make money as \nthe puts gained in value (rising rates mean T-bills and Eurodollars will fall in price) \nand the calls eventually became worthless. \nExample: The following prices for June T-bill and Eurodollar futures and options \nexist in January. All of these products trade in units of 0.01, which is worth $25. So awhole point is worth $2,500. \nJune T-bill futures: 94.75 \nJune Euro$ futures: 94.15", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:762", "doc_id": "9e42fe39eeb2b53d87f0d32b5a155e5ccc2073b81fc6db3679a6bd676f441db1", "chunk_index": 0}
{"text": "Chapter 35: Futures Option Strategies for Futures Spreads \nJune T-bill 9450 calls: 0.32 \nJune Euro$ 9450 puts: 0.40 \n713 \nThe TED spread, basis June, is currently at 0.60 (the difference in price of the \ntwo futures). Both futures have in-the-money options with only asmall amount of \ntime value premium in them. \nThe June T-bill calls with astriking price of 94.50 are 0.25 in the money and are \nselling for 0.32. Their time value premium is only 0.07 points. Similarly, the June \nEurodollar puts with astriking price of 94.50 are 0.35 in the money and are selling \nfor 0.40. Hence, their time value premium is 0.05. \nSince the total time value premium - 0.12 ($300) - is small, the strategist \ndecides that the option spread may have an advantage over the futures intermarket \nspread, so he establishes the following position: \nBuy one June T-bill call @ 0.40 \nBuy one June Euro$ put @ 0.32 \nTotal cost: \nCost \n$1,000 \n$ 800 \n$1,800 \nLater, financial conditions in the world are very stable and the TED spread \nbegins to shrink. However, at the same time, rates are being lowered in the United \nStates, and T-bill and Eurodollar prices begin to rally substantially. In May, when the \nJune T-bill options expire, the following prices exist: \nJune T-bill futures: 95.50 \nJune Euro$ futures: 95.10 \nJune T-bill 9450 calls: 1.00 \nJune Euro$ 9450 puts: 0.01 \nThe TED spread has shrunk from 0.60 to only 0.40. Thus, any trader attempt\ning to buy the TED spread using only futures would have lost $500 as the spread \nmoved against him by 0.20. \nHowever, look at the option position. The options are now worth acombined \nvalue of 1.01 points ($2,525), and they were bought for 0.72 points ($1,800). Thus, \nthe option strategy has turned aprofit of $725, while the futures strategy would have \nlost money. \nAny traders who used this option strategy instead of using futures would have \nenjoyed profits, because as the Federal Reserve lowered rates time after time, the \nprices of both T-bills and Eurodollars rose far enough to make the option strategist's", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:763", "doc_id": "4554f141465869b6948983c270b4846e56189ecfd7c7d048a166b0542a4a3eea", "chunk_index": 0}
{"text": "714 Part V: Index Options and Futures \ncalls more profitable than the loss in his puts. This is the advantage of using in-the\nmoney options instead of futures in futures spreading strategies. \nIn fairness, it should be pointed out that if the futures prices had remained rel\natively unchanged, the 0.12 points of time value premium ($300) could have been \nlost, while the futures spread may have been relatively unchanged. However, this \ndoes not alter the reasoning behind wanting to use this option strategy. \nAnother consideration that might come into play is the margin required. Recall \nthat the initial margin for implementing the TED spread was $400. However, if one \nuses the option strategy, he must pay for the options in full - $1,800 in the above \nexample. This could conceivably be adeterrent to using the option strategy. Of \ncourse, if by investing $1,800, one can make money instead of losing money with the \nsmaller investment, then the initial margin requirement is irrelevant. Therefore, the \nprofit potential must be considered the more important factor. \nFOLLOW-UP CONSIDERATIONS \nWhen one uses long option combinations to implement afutures spread strategy, he \nmay find that his position changes from aspread to more of an outright position. This \nwould occur if the markets were volatile and one option became deeply in-the\nmoney, while the other one was nearly worthless. The TED spread example above \nshowed how this could occur as the call wound up being worth 1.00, while the put \nwas virtually worthless. \nAs one side of the option spread goes out-of-the-money, the spread nature \nbegins to disappear and amore outright position takes its place. One can use the \ndeltas of the options in order to calculate just how much exposure he has at any one \ntime. The following examples go through aseries of analyses and trades that astrate\ngist might have to face. The first example concerns establishing an intermarket \nspread in oil products. \nExample: In late summer, aspreader decides to implement an intermarket spread. \nHe projects that the coming winter may be severely cold; furthermore, he believes \nthat gasoline prices are too high, being artificially buoyed by the summer tourist sea\nson, and the high prices are being carried into the future months by inefficient mar\nket pricing. \nTherefore, he wants to buy heating oil futures or options and sell unleaded \ngasoline futures or options. He plans to be out of the trade, if possible, by early \nDecember, when the market should have discounted the facts about the winter. \nTherefore, he decides to look at January futures and options. The following prices \nexist:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:764", "doc_id": "440c216500549bd59b13af3b38ce05d02a9bfe88db57ff9355f3d7fa464de262", "chunk_index": 0}
{"text": "Chapter 35: Futures Option Strategies for Futures Spreads \nFuture or Option \nJanuary heating oil futures: \nJanuary unleaded gasoline futures: \nJanuary heating oil 60 call: \nJanuary unleaded gas 62 put: \nPrice \n.6550 \n.5850 \n6.40 \n4.25 \n715 \nTime Value \nPremium \n0.90 \n0.75 \nThe differential in futures prices is .07, or 7 cents per gallon. He thinks it could \ngrow to 12 cents or so by early winter. However, he also thinks that oil and oil prod\nucts have the potential to be very volatile, so he considers using the options. One cent \nis worth $420 for each of these items. \nThe time value premium of the options is 1.65 for the put and call combined. If \nhe pays this amount ($693) per combination, he can still make money if the futures \nwiden by 5.00 points, as he expects. Moreover, the option spread gives him the \npotential for profits if oil products are volatile, even if he is wrong about the futures \nrelationship. \nTherefore, he decides to buy five combinations: \nPosition \nBuy 5 January heating oil 60 calls @ 6.40 \nBuy 5 January unleaded 62 puts @ 4.25 \nTotal cost: \nCost \n$13,440 \n8,925 \n$22,365 \nThis initial cost is substantially larger than the initial margin requirement for \nfive futures spreads, which would be about $7,000. Moreover, the option cost must \nbe paid for in cash, while the futures requirement could be taken care of with \nTreasury bills, which continue to earn money for the spreader. Still, the strategist \nbelieves that the option position has more potential, so he establishes it. \nNotice that in this analysis, the strategist compared his time value premium cost \nto the profit potential he expected from the futures spread itself This is often agood \nway to evaluate whether or not to use options or futures. In this example, he thought \nthat, even if futures prices remained relatively unchanged, thereby wasting away his \ntime premium, he could still make money - as long as he was correct about heating \noil outperforming unleaded gasoline. \nSome follow-up actions will now be examined. If the futures rally, the position \nbecomes long. Some profit might have accrued, but the whole position is subject to \nlosses if the futures fall in price. The strategist can calculate the extent to which his", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:765", "doc_id": "02f97db7f5b9f5de28e6eadfd1f34a7798beafa63a3b137a5914fc4e989b7f98", "chunk_index": 0}
{"text": "716 Part V: Index Options and Futures \nposition has become long by using the delta of the options in the strategy. He can \nthen use futures or other options in order to make the position more neutral, if he \nwants to. \nExample: Suppose that both unleaded gasoline and heating oil have rallied some and \nthat the futures spread has widened slightly. The following information is known: \nFuture or Option \nJanuary heating oil futures: \nJanuary unleaded gasoline futures: \nJanuary heating oil 60 call: \nJanuary unleaded gas 62 put: \nTotal profit: \nPrice \n.7100 \n.6300 \n11.05 \n1.50 \nNet \nChange \n+ .055 \n+ .045 \n+ 4.65 \n- 2.75 \nProfit/loss \n+$9,765 \n- 5,775 \n+$3,990 \nThe futures spread has widened to 8 cents. If the strategist had established the \nspread with futures, he would now have aone-cent ( $420) profit on five contracts, or \na $2,100 profit. The profit is larger in the option strategy. \nThe futures have rallied as well. Heating oil is up 5½ cents from its initial price, \nwhile unleaded is up 4½ cents. This rally has been large enough to drive the puts out\nof-the-money. When one has established the intermarket spread with options, and \nthe futures rally this much, the profit is usually greater from the option spread. Such \nis the case in this example, as the option spread is ahead by almost $4,000. \nThis example shows the most desirable situation for the strategist who has \nimplemented the option spread. The futures rally enough to force the puts out-of\nthe-money, or alternatively fall far enough to force the calls to be out-of-the-money. \nIf this happens in advance of option expiration, one option will generally have almost \nall of its time value premium disappear (the calls in the above example). The other \noption, however, will still have some time value ( the puts in the example). \nThis represents an attractive situation. However, there is apotential negative, \nand that is that the position is too long now. It is not really aspread anymore. If \nfutures should drop in price, the calls will lose value quickly. The puts will not gain \nmuch, though, because they are out-of-the-money and will not adequately protect \nthe calls. At this juncture, the strategist has the choice of taking his profit - closing \nthe position - or making an adjustment to make the spread more neutral once again. \nHe could also do nothing, of course, but astrategist would normally want to protect \naprofit to some extent.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:766", "doc_id": "083b10d6a5c2cae50aed106f40b81e6027ebd144fe873a53e83345c83b61a640", "chunk_index": 0}
{"text": "Chapter 35: Futures Option Strategies for Futures Spreads 717 \nExample: The strategist decides that, since his goal was for the futures spread to \nwiden to 12 cents, he will not remove the position when the spread is only 8 cents, \nas it is now. However, he wants to take some action to protect his current profit, while \nstill retaining the possibility to have the profit expand. \nAs afirst step, the equivalent futures position (EFP) is calculated. The pertinent \ndata is shown in Table 35-5. \nTABLE 35-5. \nEFP of long combination. \nFuture or Option \nJanuary heating oil futures: \nJanuary unleaded gasoline futures: \nJanuary heating oil 60 call: Long 5 \nJanuary unleaded gas 62 put: Long 5 \nPrice \n.7100 \n.6300 \n11.05 \n1.50 \nDelta \n0.99 \n-0.40 \nEFP \n+4.95 \n-2.00 \nTotal EFP: +2.95 \nOverall, the position is long the equivalent of about three futures contracts. The \nposition'sprofitability is mostly related to whether the futures rise or fall in price, not \nto how the spread between heating oil futures and unleaded gas futures behaves. \nThe strategist could easily neutralize the long delta by selling three contracts. \nThis would leave room for more profits if prices continue to rise ( there are still two \nextra long calls). It would also provide downside protection if prices suddenly drop, \nsince the 5 long puts plus the 3 short futures would offset any loss in the 5 in-the\nmoney calls. \nWhich futures should the strategist short? That depends on how confident he is \nin his original analysis of the intermarket spread widening. If he still thinks it will \nwiden further, then he should sell unleaded gasoline futures against the deeply in\nthe-money heating oil calls. This would give him an additional profit or loss opportu\nnity based on the relationship of the two oil products. However, ifhe decides that the \nintermarket spread should have widened more than this by now, perhaps he will just \nsell 3 heating oil futures as adirect hedge against the heating oil calls. \nOnce one finds himself in aprofitable situation, as in the above example, the \nrrwst conservative course is to hedge the in-the-rrwney option with its own underly\ning future. This action lessens the further dependency of the profits on the inter\nmarket spread. There is still profit potential remaining from futures price action. \nFurthermore, if the futures should fall so far that both options return to in-the\nmoney status, then the intermarket spread comes back into play. Thus, in the above", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:767", "doc_id": "8aff124fb36fce8a8701868dfc9af3d1392b8a489fd4bd59c61f5a09304573c3", "chunk_index": 0}
{"text": "718 Part V: Index Options and Futures \nexample, the conservative action would be to sell three heating oil futures against the \nheating oil calls. \nThe more aggressive course is to hedge the in-the-money option with the future \nunderlying the other side of the intermarket spread. In the above example, that \nwould entail selling the unleaded gasoline futures against the heating oil calls. \nSuppose that the strategist in the previous example decides to take the conser\nvative action, and he therefore shorts three heating oil futures at .7100, the current \nprice. This action preserves large profit potential in either direction. It is better than \nselling out-of-the-money options against his current position. \nHe would consider removing the hedge if futures prices dropped, perhaps \nwhen the puts returned to an in-the-money status with aput delta of at least -0. 75 \nor so. At that point, the position would be at its original status, more or less, except \nfor the fact that he would have taken anice profit in the three futures that were sold \nand covered. \nEpilogue. The above examples are taken from actual price movements. In reality, \nthe futures fell back, not only to their original price, but far below it. The funda\nmental reason for this reversal was that the weather was warm, hurting demand for \nheating oil, and gasoline supplies were low. By the option expiration in December, \nthe following prices existed: \nJanuary heating oil futures: .5200 \nJanuary unleaded gas futures: .5200 \nNot only had the futures prices virtually crashed, but the intermarket spread \nhad been decimated as well. The spread had fallen to zero! It had never reached any\nthing near the 12-cent potential that was envisioned. Any spreader who had estab\nlished this spread with futures would almost certainly have lost money; he probably \nwould not have held it until it reached this lowly level, but there was never much \nopportunity to get out at aprofit. \nThe strategist who established the spread with options, however, most certain\nly would have made money. One could safely assume that he covered the three \nfutures sold in the previous example at anice profit, possibly 7 points or so. One \ncould also assume that as the puts became in-the-money options, he established asimilar hedge and bought three unleaded gasoline futures when the EFP reached \n-3.00. This probably occurred with unleaded gasoline futures around .5700-5 cents \nin the money. \nAssuming that these were the trades, the following table shows the profits and \nlosses.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:768", "doc_id": "19be3ef043555c0579fe896eaeee76c7e881e6f58bf1d0fec32938a05ae8fc92", "chunk_index": 0}
{"text": "Chapter 35: Futures Option Strategies for Futures Spreads 719 \nInitial Final Net Profit/ \nPosition Price Price Loss \nBought 5 calls 6.40 0 -$13,440 \nBought 5 puts 4.25 10.00 + 12,075 \nSold 3 heating oil futures .7100 .6400 + 8,820 \nBought 3 unleaded gas futures .5700 .5200 - 6,300 \nTotal profit: +$ 1,155 \nIn the final analysis, the fact that the intermarket spread collapsed to zero actu\nally aided the option strategy, since the puts were the in-the-money option at expira\ntion. This was not planned, of course, but by being long the options, the strategist was \nable to make money when volatility appeared. \nINTRAMARKET SPREAD STRATEGY \nIt should be obvious that the same strategy could be applied to an intramarket spread \nas well. If one is thinking of spreading two different soybean futures, for example, he \ncould substitute in-the-money options for futures in the position. He would have the \nsame attributes as shown for the intermarket spread: large potential profits if volatil\nity occurs. Of course, he could still make money if the intramarket spread widens, but \nhe would lose the time value premium paid for the options. \nSPREADING FUTURES AGAINST STOCK SECTOR INDICES \nThis concept can be carried one step further. Many futures contracts are related to \nstocks - usually to asector of stocks dealing in aparticular commodity. For example, \nthere are crude oil futures and there is an Oil & Gas Sector Index (XOI). There are \ngold futures and there is a Gold & Silver Index (XAU). If one charts the history of \nthe commodity versus the price of the stock sector, he can often find tradeable pat\nterns in terms of the relationship between the two. That relationship can be traded \nvia an intermarket spread using options. \nFor example, if one thought crude oil was cheap with respect to the price of oil \nstocks in general, he could buy calls on crude oil futures and buy puts on the Oil & \nGas (XOI) Index. One would have to be certain to determine the number of options \nto trade on each side of the spread, by using the ratio that was presented in Chapter \n31 on inter-index spreading. (In fact, this formula should be used for futures inter\nmarket spreading if the two underlying futures don'thave the same terms.) Only now, \nthere is an extra component to add if options are used - the delta of the options:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:769", "doc_id": "0d85456cf6a529a93ee90da2435c381f5382593753d5b24bc5664e6b922890b9", "chunk_index": 0}
{"text": "720 Part V: Index Options and Futures \nwhere vi = volatility \nPi = price of the underlying \nui = unit of trading of the option \nLli = delta of the option \nExample: Suppose that one indeed wants to buy crude oil calls and also buy puts on \nthe XOI Index because he thinks that crude oil is cheap with respect to oil stocks. \nThe following prices exist: \nJuly crude futures: 16.35 \nCrude July 1550 call: 1.10 \nVolatility: 25% \nCall delta: O. 7 4 \n$XOI: 256.50 \nJune 265 put: 14½ \nVolatility: 17% \nPut delta: 0. 73 \nThe unit of trading for XOI options is $100 per point, as it is with nearly all stock and \nindex options. The unit of trading for crude oil futures and options is $1,000 per \npoint. With all of this information, the ratio can be computed: \nCrude= 1,000 x 0.25 x 16.35 x 0.74 \nXOI = 100 x 0.17 x 256.50 x 0.73 \nRatio = Crude/ XOI = 0.91 \nTherefore, one would buy 0.91 XOI put for every 1 crude oil call that he bought. For \nsmall accounts, this is essentially a 1-to-lratio, but for large accounts, the exact ratio \ncould be used (for example, buy 91 XOI puts and 100 crude oil calls). The resultant \nquantities encompass the various differences in these two markets - mainly the price \nand volatility of the underlyings, plus the large differential in their units of trading \n(100 vs. 1,000). \nSUMMARY \nFutures spreading is avery important and potentially profitable endeavor. Utilizing \noptions in these spreads can often improve profitability to the point that an originally \nmistaken assumption can be overcome by volatility of price movement.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:770", "doc_id": "d483cca1aadd6e66abca580451f0770731346b5b2d0b3a620f4e9a7b576c09a9", "chunk_index": 0}
{"text": "Chapter 35: Futures Option Strategies for Futures Spreads 721 \nFutures spreads fall into two categories - intermarket and intramarket. They \nare important strategies because many futures exhibit historic and/or seasonal ten\ndencies that can be traded without regard to the overall movement of futures prices. \nOptions can be used to enhance these futures spreading strategies. The futures \ncalendar spread is closely related to the intramarket spread. It is distinctly different \nfrom the stock or index option calendar spread. \nUsing in-the-money long option combinations in lieu of futures can be avery \nattractive strategy for either intermarket or intramarket spreads. The option strategy \ngives the spreader two ways to make money: ( 1) from the movement of the underly\ning futures in the spread; or (2) if the futures prices experience abig move, from the \nfact that one option can continually increase in value while the other can drop only \nto zero. The option strategy also affords the strategist the opportunity for follow-up \naction based on the equivalent futures position that accumulates as prices rise or fall. \nThe concepts introduced in this chapter apply not only to futures spreads, but \nto intermarket spreads between any two entities. An example was given of an inter\nmarket spread between futures and astock sector index, but the concept can be gen\neralized to apply to any two related markets of any sort. \nTraders who utilize futures spreads as part of their trading strategy should give \nserious consideration to substituting options when applicable. Such an alternative \nstrategy will often improve the chances for profit.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:771", "doc_id": "bbb269c66259b254b5b496b88479b9d7a65ecc60fd0bd052afdfb92b376cba97", "chunk_index": 0}
{"text": "724 Part VI: Measuring and Trading Volatility \nEven though amyriad of strategies and concepts have been presented so far, acom\nmon thread among them is lacking. The one thing that ties all option strategies \ntogether and allows one to make comparative decisions is volatility. In fact, volatility \nis the most important concept in option trading. Oh, sure, if you're agreat picker of \nstocks, then you might be able to get by without considering volatility. Even then, \nthough, you'dbe operating without full consideration of the main factor influencing \noption prices and strategy. For the rest of us, it is mandatory that we consider volatil\nity carefully before deciding what strategy to use. In this section of the book, an \nextensive treatment of volatility and volatility trading is presented. The first part \ndefines the terms and discusses some general concepts about how volatility can - and \nshould - be used. Then, anumber of the more popular strategies, described earlier \nin the book, are discussed from the vantage point of how they perform when implied \nvolatilities change. After that, volatility trading strategies are discussed - and these \nare some of the most important concepts for option traders. Adiscussion is present\ned of how stock prices actually behave, as opposed to how investors perceive them to \nbehave, and then specific criteria and methodology for both buying and selling \nvolatility are introduced. \nThe information to be presented here is not overly theoretical. All of the con\ncepts should be understandable by most option traders. Whether or not one chooses \nto actually \"trade volatility,\" it is nevertheless important for an option trader to under\nstand the concepts that underlie the basic principles of volatility trading. \nWHY TRADE \n11\nTHE MARKET\"? \nThe \"game\" of stock market predicting holds appeal for many because one who can \ndo it seems powerful and intelligent. Everyone has his favorite indicators, analysis \ntechniques, or \"black box\" trading systems. But can the market really be predicted? \nAnd if it can't, what does that say about the time spent trying to predict it? The \nanswers to these questions are not clear, and even if one were to prove that the mar\nket can'tbe predicted, most traders would refuse to believe it anyway. In fact, there \nmay be more than one way to \"predict\" the market, so in acertain sense one has to \nqualify exactly what he is talking about before it can be determined if the market can \nbe predicted or not. \nThe astute option trader knows that market prediction falls into two categories: \n(1) the prediction of the short-term movement of prices, and (2) the prediction of \nvolatility of the underlying. These are not independent predictions. For example, \nanyone who is using a \"target\" is trying to predict both. That'spretty hard. Not only \ndo you have to be right about the direction of prices, but you also have to be able to", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:774", "doc_id": "c3f5c066004f18927772eaf1a21ee7012bf1eba435e2252caff3f28e20d774fe", "chunk_index": 0}
{"text": "CHAPTER 36 \nThe Basics of \nVolatility Trading \nVolatility trading first attracted mathematically oriented traders who noticed that the \nmarket'sprediction of forthcoming volatility - for example, implied volatility - was \nsubstantially out of line with what one might reasonably expect should happen. \nMoreover, many of these traders (market-makers, arbitrageurs, and others) had \nfound great difficulties with keeping a \"delta neutral\" position neutral. Seeking abet\nter way to trade without having amarket opinion on the underlying security, they \nturned to volatility trading. This is not to suggest that volatility trading eliminates all \nmarket risk, turning it all into volatility risk, for example. But it does suggest that acertain segment of the option trading population can handle the risk of volatility with \nmore deference and aplomb than they can handle price risk \nSimply stated, it seems like amuch easier task to predict volatility than to pre\ndict prices. That is said notwithstanding the great bull market of the 1990s, in which \nevery investor who strongly participated certainly feels that he understands how to \npredict prices. Remember not to confuse brains with abull market. Consider the chart \nin Figure 36-1. This seems as if it might be agood stock to trade: Buy it near the lows \nand sell it near the highs, perhaps even selling it short near the highs and covering \nwhen it later declines. It appears to have been in atrading range for along time, so \nthat after each purchase or sale, it returns at least to the midpoint of its trading range \nand sometimes even continues on to the other side of the range. There is no scale on \nthe chart, but that doesn'tchange the fact that it appears to be atradable entity. In \nfact, this is achart of implied volatility of the options on amajor U.S. corporation. It \nreally doesn'tmatter which one (it's IBM), because the implied volatility chart of near\nly every stock, index, or futures contract has asimilar pattern - atrading range. The \nonly time that implied volatility will totally break out of its \"normal\" range is if some\nthing material happens to change the fundamentals of the way the stock moves - atakeover bid, for example, or perhaps amajor acquisition or other dilution of the stock \n727", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:777", "doc_id": "ba171e24b2aa79d55944e14507ac9773b3e669c37196c78d7559db49df1ab42b", "chunk_index": 0}
{"text": "728 Part VI: Measuring and Trading Volatility \nFIGURE 36-1. \nAsample chart. \nBuy at these points. \nSo, many traders observed this pattern and have become adherents of trying to \npredict volatility. Notice that if one is able to isolate volatility, he doesn'tcare where \nthe stock price goes he is just concerned with buying volatility near the bottom of \nthe range and selling it when it gets back to the middle or high end of the range, or \nvice versa. In real life, it is nearly impossible for apublic customer to be able to iso\nlate volatility so specifically. He will have to pay some attention to the stock price, but \nhe still is able to establish positions in which the direction of the stock price is irrel\nevant to the outcome of the position. This quality is appealing to many investors, who \nhave repeatedly found it difficult to predict stock prices. Moreover, an approach such \nas this should work in both bull and bear markets. Thus, volatility trading appeals to \nagreat number of individuals. Just remember that, for you personally to operate astrategy properly, you must find that it appeals to your own philosophy of trading. \nTrying to use astrategy that you find uncomfortable will only lead to losses and frus\ntration. So, if this somewhat neutral approach to option trading sounds interesting to \nyou, then read on. \nDEFINITIONS OF VOLATILITY \nVolatility is merely the term that is used to describe how fast astock, future, or index \nchanges in price. When one speaks of volatility in connection with options, there are \ntwo types of volatility that are important. The first is historical volatility, which is ameasure of how fast the underlying instrument has been changing in price. The other \nis implied volatility, which is the option market'sprediction of the volatility of the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:778", "doc_id": "8a24d580fc14eee16f8820d256ade65b4a4bb1e3d74d7eb9b158c8a6198773d0", "chunk_index": 0}
{"text": "Chapter 36: The Basics of Volatility Trading 729 \nunderlying over the life of the option. The computation and comparison of these two \nmeasures can aid immensely in predicting the forthcoming volatility of the underly\ning instrument - acrucial matter in determining today'soption prices. \nHistorical volatility can be measured with aspecific formula, as shown in the · \nchapter on mathematical applications. It is merely the formula for standard deviation \nas contained in most elementary books on statistics. The important point to under\nstand is that it is an exact calculation, and there is little debate over how to compute \nhistorical volatility. It is not important to know what the actual measurement means. \nThat is, if one says that acertain stock has ahistorical volatility of 20%, that by itself \nis arelatively meaningless number to anyone but an ardent statistician. However, it \ncan be used for comparative purposes. \nThe standard deviation is expressed as apercent. One can determine that the \nhistorical volatility of the broad stock market has usually been in the range of 15% to \n20%. Avery volatile stock might have an historical volatility in excess of 100%. These \nnumbers can be compared to each other, so that one might say that astock with the \nlatter historical volatility is five times more volatile that the \"stock market.\" So, the \nhistorical volatility of one instrument can be compared with that of another instru\nment in order to determine which one is more volatile. That in itself is auseful func\ntion of historical volatility, but its uses go much farther than that. \nHistorical volatility can be measured over different time periods to give one asense of how volatile the underlying has been over varying lengths of time. For exam\nple, it is common to compute a 10-day historical volatility, as well as a 20-day, 50-day, \nand even 100-day. In each case, the results are annualized so that one can compare \nthe figures directly. \nConsider the chart in Figure 36-2. It shows astock (although it could be afutures contract or index, too) that was meandering in arather tight range for quite \nsome time. At the point marked \"A\" on the chart, it was probably at its least volatile. \nAt that time, the 10-dayvolatility might have been something quite low, say 20%. The \nprice movements directly preceding point Ahad been very small. However, prior to \nthat time the stock had been more volatile, so longer-term measures of the historical \nvolatility would shown higher numbers. The possible measures of historical volatility, \nthen at point A, might have been something like: \n10-day historical volatility: 20% \n20-day historical volatility: 23% \n50-day historical volatility: 35% \n100-day historical volatility: 45% \nApattern of historical volatilities of this sort describes astock that has been \nslowing down lately.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:779", "doc_id": "1129b6dd300631b79fe79e045b79faecf89697caf5e3e651be1b7c86b19fac8e", "chunk_index": 0}
{"text": "730 \nFIGURE 36-2. \nSample stock chart. \n:::::::::r;~.w· r \nI \n, .. ~ \nn \nIll•• ~N \nIT \nPart VI: Measuring and Trading Volatllity \n: \nI \nIjj \n~ \nJI \n• I' \n'Vn ~- A \nIts price movements have been less extreme in the near term. \nAgain referring to Figure 36-2, note that shortly after point A, the stock jumped \nmuch higher over ashort period of time. Price action like this increases the implied \nvolatility dramatically. And, at the far right edge of the chart, the stock had stopped \nrising but was swinging back and forth in far more rapid fashion than it had been at \nmost other points on the chart. Violent action in aback-and-forth manner can often \nproduce ahigher historical volatility reading that straight-line move can; it'sjust the \nway the numbers work out. So, by the far right edge of the chart, the 10-day histori\ncal volatility would have increased rather dramatically, while the longer-term meas\nures wouldn'tbe so high because they would still contain the price action that \noccurred prior to point A. \nAt the far right edge of Figure 36-2, these figures might apply: \nl 0-day historical volatility: 80% \n20-day historical volatility: 75% \n50-day historical volatility: 60% \nl 00-day historical volatility: 55% \nWith this alignment of historical volatilities, one can see that the stock has been \nmore volatile recently than in the more distant past. In Chapter 38 on the distribu\ntion of stock prices, we will discuss in some detail just which one, if any, of these his\ntorical volatilities one should use as \"the\" historical volatility input into option and", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:780", "doc_id": "a2511dc8fa933f0fce8dd873419a61eb6a24ec4d47dcc6a490df02004a697b8f", "chunk_index": 0}
{"text": "Chapter 36: The Basics of Volatility Trading 731 \nprobability models. We need to be able to make volatility estimates in order to deter\nmine whether or not astrategy might be successful, and to determine whether the \ncurrent option price is arelatively cheap one or arelatively expensive one. For exam\nple, one can'tjust say, \"Ithink XYZ is going to rise at least 18 points by February expi\nration.\" There needs to be some basis in fact for such astatement and, lacking inside \ninformation about what the company might announce between now and February, \nthat basis should be statistics in the form of volatility projections. \nHistorical volatility is, of course, useful as an input to the (Black-Scholes) option \nmodel. In fact, the volatility input to any model is crucial because the volatility com\nponent is such amajor factor in determining the price of an option. Furthermore, \nhistorical volatility is useful for more than just estimating option prices. It is neces\nsary for making stock price projections and calculating distributions, too, as will be \nshown when those topics are discussed later. Any time one asks the question, \"What \nis the probability of the stock moving from here to there, or of exceeding aparticu\nlar target price?\" the answer is heavily dependent on the volatility of the underlying \nstock (or index or futures). \nIt is obvious from the above example that historical volatility can change dra\nmatically for any particular instrument. Even if one were to stick with just one \nmeasure of historical volatility ( the 20-day historical is commonly the most popular \nmeasure), it changes with great frequency. Thus, one can never be certain that bas\ning option price predictions or stock price distributions on the current historical \nvolatility will yield the \"correct\" results. Statistical volatility may change as time \ngoes forward, in which case your projections would be incorrect. Thus, it is impor\ntant to make projections that are on the conservative side. \nANOTHER APPROACH: GARCH \nGARCH stands for Generalized Autoregressive Conditional Heteroskedasticity, \nwhich is why it'sshortened to GARCH. It is atechnique for forecasting volatility that \nsome analysts say produces better projections than using historical volatility alone or \nimplied volatility alone. GARCH was created in the 1980s by specialists in the field of \neconometrics. It incorporates both historical and implied volatility, plus one can throw \nin aconstant (\"fudge factor\"). In essence, though, the user of GARCH volatility mod\nels has to make some predictions or decisions about the weighting of the factors used \nfor the estimate. By its very nature, then, it can be just as vague as the situations \ndescribed in the previous section. \nThe model can \"learn,\" though, if applied correctly. That is, if one makes avolatility prediction for today (using GARCH, let'ssay), but it turns out that the actu-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:781", "doc_id": "e4116ea97449ebc9041a3c8eef1a0fc922129958bec046f3533ba3ca169efda3", "chunk_index": 0}
{"text": "732 Part VI: Measuring and Trading Volatility \nal volatility was lower, then when you make the volatility prediction for tomorrow, \nyou'll probably want to adjust it downward, using the experience of the real world, \nwhere you see volatility declining. This also incorporates the common-sense notion \nthat volatility tends to remain the same; that is, tomorrow'svolatility is likely to be \nmuch like today's. Of course, that'salittle bit like saying tomorrow'sweather is likely \nto be the same as today's (which it is, two-thirds of the time, according to statistics). \nIt'sjust that when atornado hits, you have to realize that your forecast could be wrong. \nThe same thing applies to GAR CH volatility projections. They can be wrong, too. \nSo, GARCH does not do aperfect job of estimating and forecasting volatility. In \nfact, it might not even be superior, from astrategist'sviewpoint, to using the simple \nminimum/maximum techniques outlined in the previous section. It is really best \ngeared to predicting short-term volatility and is favored most heavily by dealers in \ncurrency options who must adjust their markets constantly. For longer-term volatility \nprojections, which is what aposition trader of volatility is interested in, GARCH may \nnot be all that useful. However, it is considered state-of-the-art as far as volatility pre\ndicting goes, so it has afollowing among theoretically oriented traders and analysts. \nMOVING AVERAGES \nSome traders try to use moving averages of daily composite implied volatility read\nings, or use asmoothing of recent past historical volatility readings to make volatility \nestimates. As mentioned in the chapter on mathematical applications, once the com\nposite daily implied volatility has been computed, it was recommended that asmoothing effect be obtained by taking amoving average of the 20 or 30 days' \nimplied volatilities. In fact, an exponential moving average was recommended, \nbecause it does not require one to keep accessing the last 20 or 30 days' worth of data \nin order to compute the moving average. Rather, the most recent exponential mov\ning average is all that'sneeded in order to compute the next one. \nIMPLIED VOLATILITY \nImplied volatility has been mentioned many times already, but we want to expand on \nits concept before getting deeper into its measure and uses later in this section. \nImplied volatility pertains only to options, although one can aggregate the implied \nvolatilities of the various options trading on aparticular underlying instrument to \nproduce asingle number, which is often referred to as the implied volatility of the \nunderlying.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:782", "doc_id": "087fb1f482a72e2513d3f3f854de06195fbc95946c055133666f247518293c31", "chunk_index": 0}
{"text": "732 Part VI: Measuring and Trading Volatility \nal volatility was lower, then when you make the volatility prediction for tomorrow, \nyou'll probably want to adjust it downward, using the experience of the real world, \nwhere you see volatility declining. This also incorporates the common-sense notion \nthat volatility tends to remain the same; that is, tomorrow'svolatility is likely to be \nmuch like today's. Of course, that'salittle bit like saying tomorrow'sweather is likely \nto be the same as today's (which it is, two-thirds of the time, according to statistics). \nIt'sjust that when atornado hits, you have to realize that your forecast could be wrong. \nThe same thing applies to GARCH volatility projections. They can be wrong, too. \nSo, GARCH does not do aperfect job of estimating and forecasting volatility. In \nfact, it might not even be superior, from astrategist'sviewpoint, to using the simple \nminimum/maximum techniques outlined in the previous section. It is really best \ngeared to predicting short-term volatility and is favored most heavily by dealers in \ncurrency options who must adjust their markets constantly. For longer-term volatility \nprojections, which is what aposition trader of volatility is interested in, GAR CH may \nnot be all that useful. However, it is considered state-of-the-art as far as volatility pre\ndicting goes, so it has afollowing among theoretically oriented traders and analysts. \nMOVING AVERAGES \nSome traders try to use moving averages of daily composite implied volatility read\nings, or use asmoothing of recent past historical volatility readings to make volatility \nestimates. As mentioned in the chapter on mathematical applications, once the com\nposite daily implied volatility has been computed, it was recommended that asmoothing effect be obtained by taking amoving average of the 20 or 30 days' \nimplied volatilities. In fact, an exponential moving average was recommended, \nbecause it does not require one to keep accessing the last 20 or 30 days' worth of data \nin order to compute the moving average. Rather, the most recent exponential mov\ning average is all that'sneeded in order to compute the next one. \nIMPLIED VOLATILITY \nImplied volatility has been mentioned many times already, but we want to expand on \nits concept before getting deeper into its measure and uses later in this section. \nImplied volatility pertains only to options, although one can aggregate the implied \nvolatilities of the various options trading on aparticular underlying instrument to \nproduce asingle number, which is often referred to as the implied volatility of the \nunderlying.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:783", "doc_id": "06461c2493807b7a02a40cde6f5301464d8e9fe59d22dfdea6e35daa1ea0ba9f", "chunk_index": 0}
{"text": "732 Part VI: Measuring and Trading Volatility \nal volatility was lower, then when you make the volatility prediction for tomorrow, \nyou'll probably want to adjust it downward, using the experience of the real world, \nwhere you see volatility declining. This also incorporates the common-sense notion \nthat volatility tends to remain the same; that is, tomorrow'svolatility is likely to be \nmuch like today's. Of course, that'salittle bit like saying tomorrow'sweather is likely \nto be the same as today's (which it is, two-thirds of the time, according to statistics). \nIt'sjust that when atornado hits, you have to realize that your forecast could be wrong. \nThe same thing applies to GARCH volatility projections. They can be wrong, too. \nSo, GAR CH does not do aperfect job of estimating and forecasting volatility. In \nfact, it might not even be superior, from astrategist'sviewpoint, to using the simple \nminimum/maximum techniques outlined in the previous section. It is really best \ngeared to predicting short-term volatility and is favored most heavily by dealers in \ncurrency options who must adjust their markets constantly. For longer-term volatility \nprojections, which is what aposition trader of volatility is interested in, GARCH may \nnot be all that useful. However, it is considered state-of-the-art as far as volatility pre\ndicting goes, so it has afollowing among theoretically oriented traders and analysts. \nMOVING AVERAGES \nSome traders try to use moving averages of daily composite implied volatility read\nings, or use asmoothing of recent past historical volatility readings to make volatility \nestimates. As mentioned in the chapter on mathematical applications, once the com\nposite daily implied volatility has been computed, it was recommended that asmoothing effect be obtained by taking amoving average of the 20 or 30 days' \nimplied volatilities. In fact, an exponential moving average was recommended, \nbecause it does not require one to keep accessing the last 20 or 30 days' worth of data \nin order to compute the moving average. Rather, the most recent exponential mov\ning average is all that'sneeded in order to compute the next one. \nIMPLIED VOLATILITY \nImplied volatility has been mentioned many times already, but we want to expand on \nits concept before getting deeper into its measure and uses later in this section. \nImplied volatility pertains only to options, although one can aggregate the implied \nvolatilities of the various options trading on aparticular underlying instrument to \nproduce asingle number, which is often referred to as the implied volatility of the \nunderlying.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:784", "doc_id": "3098cc6a3dcd8c8caf5afa899b86b51ee2ceced075cd71da295b2f3c15a2c2d7", "chunk_index": 0}
{"text": "Chapter 36: The Basics of Volatility Trading 733 \nAt any one point in time, atrader knows for certain the following items that \naffect an option'sprice: stock price, strike price, time to expiration, interest rate, and \ndividends. The only remaining factor is volatility - in fact, implied volatility. It is the \nbig \"fudge factor\" in option trading. If implied volatility is too high, options will be \noverpriced. That is, they will be relatively expensive. On the other hand, if implied \nvolatility is too low, options will be cheap or underpriced. The terms \"overpriced\" and \n\"underpriced\" are not really used by theoretical option traders much anymore, \nbecause their usage implies that one knows what the option should be worth. In the \nmodem vernacular, one would say that the options are trading with a \"high implied \nvolatility\" or a \"low implied volatility,\" meaning that one has some sense of where \nimplied volatility has been in the past, and the current measure is thus high or low in \ncomparison. \nEssentially, implied volatility is the option market'sguess at the forthcoming sta\ntistical volatility of the underlying over the life of the option in question. If traders \nbelieve that the underlying will be volatile over the life of the option, then they will \nbid up the option, making it more highly priced. Conversely, if traders envision anon\nvolatile period for the stock, they will not pay up for the option, preferring to bid \nlower; hence the option will be relatively low-priced. The important thing to note is \nthat traders normally do not know the future. They have no way of knowing, for sure, \nhow volatile the underlying is going to be during the life of the option. \nHaving said that, it would be unrealistic to assume that inside information does \nnot leak into the marketplace. That is, if certain people possess nonpublic knowledge \nabout acompany'searnings, new product announcement, takeover bid, and so on, \nthey will aggressively buy or bid for the options and that will increase implied volatil\nity. So, in certain cases, when one sees that implied volatility has shot up quickly, it is \nperhaps asignal that some traders do indeed know the future - at least with respect \nto aspecific corporate announcement that is about to be made. \nHowever, most of the time there is not anyone trading with inside information. \nYet, every option trader - market-maker and public alike - is forced to make a \n\"guess\" about volatility when he buys or sells an option. That is true because the price \nhe pays is heavily influenced by his volatility estimate ( whether or not he realizes that \nhe is, in fact, making such avolatility estimate). As you might imagine, most traders \nhave no idea what volatility is going to be during the life of the option. They just pay \nprices that seem to make sense, perhaps based on historic volatility. Consequently, \ntoday'simplied volatility may bear no resemblance to the actual statistical volatility \nthat later unfolds during the life of the option. \nFor those who desire amore mathematical definition of implied volatility, con\nsider this.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:785", "doc_id": "6558d417443c43fa072cf2bf108fe9c8759cb4132344186d1233897ee1ace102", "chunk_index": 0}
{"text": "734 Part VI: Measuring and Trading Volatillty \nOpt price = f(Stock price, Strike price, Time, Risk-free rate, Volatility, Dividends) \nFurthermore, suppose that one knows the following information: \nXYZ price: 52 \nApril 50 call price: 6 \nTime remaining to April expiration: 36 days \nDividends: $0.00 \nRisk-free interest rate: 5% \nThis information, which is available for every option at any time, simply from an \noption quote, gives us everything except the implied volatility. So what volatility \nwould one have to plug in the Black-Scholes model ( or whatever model one is using) \nto make the model give the answer 6 (the current price of the option)? That is, what \nvolatility is necessary to solve the equation? \n6 = f(52, 50, 36 days, 5%, Volatility, $0.00) \nWhatever volatility is necessary to make the model yield the current market price (6) \nas its value, is the implied volatility for the XYZ April 50 call. In this case, if you're \ninterested, the implied volatility is 75.4%. The actual process of determining implied \nvolatility is an iterative one. There is no formula, per se. Rather, one keeps trying var\nious volatility estimates in the model until the answer is close enough to the market \nvalue. \nTHE VOLATILITY OF VOLATILITY \nIn order to discuss the implied volatility of aparticular entity - stock, index, or \nfutures contract one generally refers to the implied volatility of individual options \nor perhaps the composite implied volatility of the entire option series. This is gener\nally good enough for strategic comparisons. However, it turns out that there might be \nother ways to consider looking at implied volatility. In paiticular, one might want to \nconsider how wide the range of implied volatility is - that is, how volatile the indi\nvidual implied volatility numbers are. \nIt is often conventional to talk about the percentile of implied volatility. That is \naway to rank the current implied volatility reading with past readings for the same \nunderlying instrument. \nHowever, afairly important ingredient is missing when percentiles are involved. \nOne can'treally tell if \"cheap\" options are cheap as apractical matter. That'sbecause \none doesn'tknow how tightly packed together the past implied volatility readings are. \nFor example, if one were to discover that the entire past range of implied volatility \nfor XYZ stretched only from 39% to 45%, then acurrent reading of 40%, while low,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:786", "doc_id": "c1293a9ddd6740721bcaa86a0da07a89d6ee8a16ac271e255c4ed6f928259725", "chunk_index": 0}
{"text": "Chapter 36: The Basics of Volatility Trading 135 \nmight not seem all that attractive. That is, if the first percentile of XYZ options were \nat an implied volatility reading of 39% and the 100th percentile were at 45%, then areading of 40% is really quite mundane. There just wouldn'tbe much room for \nimplied volatility to increase on an absolute basis. Even if it rose to the 100th per\ncentile, an individual XYZ option wouldn'tgain much value, because its implied \nvolatility would only be increasing from about 40% to 45%. \nHowever, if the distribution of past implied volatility is wide, then one can truly \nsay the options are cheap if they are currently in alow percentile. Suppose, rather \nthan the tight range described above, that the range of past implied volatilities for \nXYZ instead stretched from 35% to 90% - that the first percentile for XYZ implied \nvolatility was at 35% and the 100th percentile was at 90%. Now, if the current read\ning is 40%, there is alarge range above the current reading into which the options \ncould trade, thereby potentially increasing the value of the options if implied volatil\nity moved up to the higher percentiles. \nWhat this means, as apractical matter, is that one not only needs to know the \ncurrent percentile of implied volatility, but he also needs to know the range of num\nbers over which that percentile was derived. If the range is wide, then an extreme \npercentile truly represents acheap or expensive option. But if the range is tight, then \none should probably not be overly concerned with the current percentile of implied \nvolatility. \nAnother facet of implied volatility that is often overlooked is how it ranges with \nrespect to the time left in the option. This is particularly important for traders of \nLEAPS (long-term) options, for the range of implied volatility of a LEAPS option will \nnot be as great as that of ashort-term option. In order to demonstrate this, the \nimplied volatilities of $OEX options, both regular and LEAPS, were charted over \nseveral years. The resulting scatter diagram is shown in Figure 36-3. \nTwo curved lines are drawn on Figure 36-3. They contain most of the data \npoints. One can see from these lines that the range of implied volatility for near-term \noptions is greater than it is for longer-term options. For example, the implied volatil\nity readings on the far left of the scatter diagram range from about 14% to nearly 40% \n(ignore the one outlying point). However, for longer-term options of 24 months or \nmore, the range is about 17% to 32%. While $0EX options have their own idiosyn\ncracies, this scatter diagram is fairly typical of what we would see for any stock or \nindex option. \nOne conclusion that we can draw from this is that LEAPS option implied \nvolatilities just don'tchange nearly as much as those of short-term options. That can \nbe an important piece of information for a LEAPS option trader especially if he is \ncomparing the LEAPS implied volatility with acomposite implied volatility or with \nthe historical volatility of the underlying.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:787", "doc_id": "af9ed559dd1ad0dc7b8bdef5f3abb537c87b7c3707789c2a1490fdbfd27e7d66", "chunk_index": 0}
{"text": "736 Part VI: Measuring and Trading Volatility \nOnce again, consider Figure 36-3. While it is difficult to discern from the graph \nalone, the 10th percentile of $OEX composite implied volatility, using all of the data \npoints given, is 17%. The line that marks this level (the tenth percentile) is noted on \nthe right side of the scatter diagram. It is quite easy to see that the LEAPS options \nrarely trade at that low volatility level. \nIn Figure 36-3, the distance between the curved lines is much greater on the \nleft side (i.e., for shorter-term options) than it is on the right side (for longer-term \noptions). Thus, it'sdifficult for the longer-term options to register either an extreme\nly high or extremely low implied volatility reading, when all of the options are con\nsidered. Consequently, LEAPS options will rarely appear \"cheap\" when one looks at \ntheir percentile of implied volatility, including all the short-term options, too: \nOne might say that, if he were going to buy long-term options, he should look \nonly at the size of the volatility range on the right side of the scatter diagram. Then, \nhe could make his decision about whether the options are cheap or not by only com\nparing the current reading to past readings of long-term options. This line of think\ning, though, is somewhat fallacious reasoning, for acouple of reasons: First, if one \nholds the option for any long period of time, the volatility range will widen out and \nthere is achance that implied volatility could drop substantially. Second, the long\nterm volatility range might be so small that, even though the options are initially \ncheap, quick increase in implied volatility over several deciles might not translate into \nmuch of again in price in the short term. \nFIGURE 36-3. Implied volatilities of $OEX options over several \nyears. \n50 \n45 \n40 \n~ 35 \n~ 30 \ng 25 \"O \n.91 20 C. \nE 15 -0th \n10 \n5 \n0 \n0 10 20 30 40 \nTime to Expiration (months)", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:788", "doc_id": "31da06068e414e7c21d8316d6c2625ab5103174f615a0d79967d422522a2cce0", "chunk_index": 0}
{"text": "Chapter 36: The Basics ol Volatility Trading 737 \nIt'simportant for anyone using implied volatility in his trading decisions to \nunderstand that the range of past implied volatilities is important, and to realize that \nthe volatility range expands as time shrinks. \nIS IMPLIED VOLATILITY A GOOD PREDICTOR OF ACTUAL VOLATILITY? \nThe fact that one can calculate implied volatility does not mean that the calculation \nis agood estimate of forthcoming volatility. As stated above, the marketplace does not \nreally know how volatile an instrument is going to be, any more than it knows the \nforthcoming price of the stock. There are clues, of course, and some general ways of \nestimating forthcoming volatility, but the fact remains that sometimes options trade \nwith an implied volatility that is quite abit out of line with past levels. Therefore, \nimplied volatility may be considered to be an inaccurate estimate of what is really \ngoing to happen to the stock during the life of the option. Just remember that implied \nvolatility is aforward-looking estimate, and since it is based on traders' suppositions, \nit can be wrong - just as any estimate of future events can be in error. \nThe question posed above is one that should probably be asked more often than \nit is: \"Is implied volatility agood predictor of actual volatility?\" Somehow, it seems \nlogical to assume that implied and historical (actual) volatility will converge. That'snot really true, at least not in the short term. Moreover, even if they do converge, \nwhich one was right to begin with - implied or historical? That is, did implied volatil\nity move to get more in line with actual movements of the underlying, or did the \nstock'smovement speed up or slow down to get in line with implied volatility? \nTo illustrate this concept, afew charts will be used that show the comparison \nbetween implied and historical volatility. Figure 36-4 shows information for the \n$0EX Index. In general, $0EX options are overpriced. See the discussion in \nChapter 29. That is, implied volatility of $0EX options is almost always higher than \nwhat actual volatility turns out to be. Consider Figure 36-4. There are three lines in \nthe figure: (a) implied volatility, (b) actual volatility, and (c) the difference between \nthe two. There is an important distinction here, though, as to what comprises these \ncurves: \n(a) The implied volatility curve depicts the 20-day moving average of daily compos\nite implied volatility readings for $0EX. That is, each day one number is com\nputed as acomposite implied volatility for $0EX for that day. These implied \nvolatility figures are computed using the averaging formula shown in the chapter \non mathematical applications, whereby each option'simplied volatility is weight\ned by trading volume and by distance in- or out-of-the-money, to arrive at asin\ngle composite implied volatility reading for the trading day. To smooth out those \ndaily readings, a 20-day simple moving average is used. This daily implied volatil-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:789", "doc_id": "d7277b0eabc25b40db92f8b23caf3bb6123a4a057ae5d7b2bc88d2f9c8d5056d", "chunk_index": 0}
{"text": "738 Part VI: Measuring and Trading Volatility \nFIGURE 36-4. \n$OEX implied versus historical volatility. \n10 \nImplied minus Actual 1999 Date \nity of $OEX options encompasses all the $OEX options, so it is different from the \nVolatility Index ($VIX), which uses only the options closest to the money. By \nusing all of the options, aslightly different volatility figure is arrived at, as com\npared to $VIX, but achart of the two would show similar patterns. That is, peaks \nin implied volatility computed using all of the $OEX options occur at the same \npoints in time as peaks in $VIX. \n(b) The actual volatility on the graph is alittle different from what one normally \nthinks of as historical volatility. It is the 20-day historical volatility, computed 20 \ndays later than the date of the implied volatility calculation. Hence, points on the \nimplied volatility curve are matched with a 20-day historical volatility calculation \nthat was made 20 days later. Thus, the two curves more or less show the predic\ntion of volatility and what actually happened over the 20-day period. These actu\nal volatility readings are smoothed as well, with a 20-day moving average. \n(c) The difference between the two is quite simple, and is shown as the bottom \ncurve on the graph. A \"zero\" line is drawn through the difference. \nWhen this \"difference line\" passes through the zero line, the projection of \nvolatility and what actually occurred 20 days later were equal. If the difference line \nis above the zero line, then implied volatility was too high; the options were over\npriced. Conversely, if the difference line is below the zero line, then actual volatility \nturned out to be greater than implied volatility had anticipated. The options were \nunderpriced in that case. Those latter areas are shaded in Figure 36-4. Simplistically, \nyou would want to own options during the shaded periods on the chart, and would \nwant to be aseller of options during the non-shaded areas.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:790", "doc_id": "57a94a0956480eeda158e8c5f944df6688cd14e55e5ff79efd940356e91c0179", "chunk_index": 0}
{"text": "Chapter 36: The Basics of Volatility Trading 739 \nNote that Figure 36-4 indeed confirms the fact that $OEX options are consis\ntently overpriced. Very few charts are as one-dimensional as the $OEX chart, where \nthe options were so consistently overpriced. Most stocks find the difference line \noscillating back and forth about the zero mark. Consider Figures 36-5 and 36-6. \nFigure 36-5 shows achart similar to Figure 36-4, comparing actual and implied \nvolatility, and their difference, for aparticular stock. Figure 36-6 shows the price \ngraph of that same stock, overlaid on implied volatility, during the period up to and \nincluding the heavy shading. \nThe volatility comparison chart (Figure 36-5) shows several shaded areas, dur\ning which the stock was more volatile than the options had predicted. Owners of \noptions profited during these times, provided they had amore or less neutral outlook \non the stock. Figure 36-6 shows the stock'sperformance up to and including the \nMarch-April 1999 period - the largest shaded area on the chart. Note that implied \nvolatility was quite low before the stock made the strong move from 10 to 30 in little \nmore than amonth. These graphs are taken from actual data and demonstrate just \nhow badly out of line implied volatility can be. In February and early March 1999, \nimplied volatility was at or near the lowest levels on these charts. Yet, by the end of \nMarch, amajor price explosion had begun in the stock, one that tripled its value in \njust over amonth. Clearly, implied volatility was apoor predictor of forthcoming \nactual volatility in this case. \nWhat about later in the year? In Figure 36-5, one can observe that implied and \nactual volatility oscillated back and forth quite afew times during the rest of 1999. It \nmight appear that these oscillations are small and that implied volatility was actually \ndoing apretty good job of predicting actual volatility, at least until the final spike in \nDecember 1999. However, looking at the scale on the left-hand side of Figure 36-5, \none can see that implied volatility was trying to remain in the 50% to 60% range, but \nactual volatility kept bolting higher rather frequently. \nOne more example will be presented. Figures 36-7 and 36-8 depict another \nstock and its volatilities. On the left half of each graph, implied volatility was quite \nhigh. It was higher than actual volatility turned out to be, so the difference line in \nFigure 36-7 remains above the zero line for several months. Then, for some reason, \nthe option market decided to make an adjustment, and implied volatility began to \ndrop. Its lowest daily point is marked with acircle in Figure 36-8, and the same point \nin time is marked with asimilar circle in Figure 36-7. At that time, options traders \nwere \"saying\" that they expected the stock to be very tame over the ensuing weeks. \nInstead, the stock made two quick moves, one from 15 down to 11, and then anoth\ner back up to 17. That movement jerked actual volatility higher, but implied volatili\nty remained rather low. After aperiod of trading between 13 and 15, during which \ntime implied volatility remained low, the stock finally exploded to the upside, as evi\ndenced by the spikes on the right-hand side of both Figures 36-7 and 36-8. Thus,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:791", "doc_id": "f92977d7665be03be4da417b664400e5e752521c12b35933228d3986c5e998f6", "chunk_index": 0}
{"text": "742 Part VI: Measuring and Trading Volatility \nimplied volatility was apoor predictor of actual volatility for most of the time on these \ngraphs. Moreover, implied volatility remained low at the right-hand side of the charts \n(January 2000) even though the stock doubled in the course of amonth. \nThe important thing to note from these figures is that they clearly show that \nimplied volatility is really not avery good predictor of the actual volatility that is to \nfollow. If it were, the difference line would hover near zero most of the time. Instead, \nit swings back and forth wildly, with implied volatility over- or underestimating actu\nal volatility by quite wide levels. Thus, the current estimates of volatility by traders \n(i.e., implied volatility) can actually be quite wrong. \nConversely, one could also say that historical volatility is not agreat predictor of \nvolatility that is to follow, either, especially in the short term. No one really makes any \nclaims that it is agood predictor, for historical volatility is merely areflection of what \nhas happened in the past. All we can say for sure is that implied and historical volatil\nity tend to trade within arange. \nOne thing that does stand out on these charts is that implied volatility seems to \nfluctuate less than actual volatility. That seems to be anatural function of the volatil\nity predictive process. For example, when the market collapses, implied volatilities of \noptions rise only modestly. This can be observed by again referring to Figure 36-4, \nthe $0EX option example. The only shaded area on the graph occurred when the \nmarket had arather sharp sell-off during October 1999. In previous years, when \nthere had been even more severe market declines (October 1997 or August-October \n1998) $0EX actual volatility had briefly moved above implied volatility (this data for \n1997 and 1998 is shown in Figure 36-9). In other words, option traders and market\nmakers are predicting volatility when they price options, and one tends to make a \nFIGURE 36-9. \n$OEX implied versus historical volatility, 1997-1998. \nActual \n40 \n30 \n10 \n0 \nD J F M A \n-20 1997 1998", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:794", "doc_id": "8d3a55c66e8c1fe8594fcf3619140fc13dfb66caefcefb7882dea8705631195f", "chunk_index": 0}
{"text": "Chapter 36: The Basics of Volatility Trading 743 \nprediction that is somewhat \"middle of the road,\" since an extreme prediction is \nmore likely to be wrong. Of course, it turns out to be wrong anyway, since actual \nvolatility jumps around quite rapidly. \nThe few charts that have been presented here don'tconstitute arigorous study \nupon which to draw the conclusion that implied volatility is apoor predictor of actu\nal volatility, but it is this author'sfirm opinion that that statement is true. Agraduate \nstudent looking for amaster'sthesis topic could take it from here. \nVOLATILITY TRADING \nAs aresult of the fact that implied volatility can sometimes be at irrational extremes, \noptions may sometimes trade with implied volatilities that are significantly out of line \nwith what one would normally expect. For example, suppose astock is in arelatively \nnonvolatile period, like the price of the stock in Figure 36-2, just before point Aon \nthe graph. During that time, option sellers would probably become more aggressive \nwhile option buyers, who probably have been seeing their previous purchases decay\ning with time, become more timid. As aresult, option prices drop. Alternatively stat\ned, implied volatility drops. When implied volatilities are decreasing, option sellers \nare generally happy (and may often become more aggressive), while option buyers \nare losing money (and may often tend to become more timid). This is just afunction \nof looking at the profit and loss statements in one'soption account. But anyone who \ntook alonger backward look at the volatility of the stock in Figure 36-2 would see that \nit had been much more volatile in the past. Consequently, he might decide that the \nimplied volatility of the options had gotten too low and he would be abuyer of \noptions. \nIt is the volatility trader'sobjective to spot situations when implied volatility is \npossibly or probably erroneous and to take aposition that would profit when the \nerror is brought to light. Thus, the volatility trader'smain objective is spotting situa\ntions when implied volatility is overvalued or undervalued, irrespective of his outlook \nfor the underlying stock itself. In some ways, this is not so different from the funda\nmental stock analyst who is attempting to spot overvalued or undervalued stocks, \nbased on earnings and other fundamentals. \nFrom another viewpoint, volatility trading is also acontrarian theory of invest\ning. That is, when everyone else thinks the underlying is going to be nonvolatile, the \nvolatility trader buys volatility. When everyone else is selling options and option buy\ners are hard to find, the volatility trader steps up to buy options. Of course, some rig\norous analysis must be done before the volatility trader can establish new positions, \nbut when those situations come to light, it is most likely that he is taking positions \nopposite to what \"the masses\" are doing. He will be buying volatility when the major-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:795", "doc_id": "9fd54374d227b8678a4298eadbafab6917eefa249a4cbf1c600eeb8b432ee529", "chunk_index": 0}
{"text": "744 Part VI: Measuring and Trading Volatility \nity has been selling it (or at least, when the majority is refusing to buy it), and he will \nbe selling volatility when everyone else is panicking to buy options, making them \nquite expensive. \nWHY DOES VOLATILITY REACH EXTREMES? \nOne can'tjust buy every option that he considers to be cheap. There must be some \nconsideration given to what the probabilities of stock movement are. Even more \nimportant, one can'tjust sell every option that he values as expensive. There may be \nvalid reasons why options become expensive, not the least of which is that someone \nmay have inside information about some forthcoming corporate news (atakeover or \nan earnings surprise, for example). \nSince options off er agood deal of leverage, they are an attractive vehicle to any\none who wants to make aquick trade, especially if that person believes he knows \nsomething that the general public doesn'tknow. Thus, if there is aleak of atakeover \nrumor - whether it be from corporate officers, investment bankers, printers, or \naccountants - whoever possesses that information may quite likely buy options \naggressively, or at least bid for them. Whenever demand for an option outstrips sup\nply - in this case, the major supplier is probably the market-maker - the options \nquickly get more expensive. That is, implied volatility increases. \nIn fact, there are financial analysts and reporters who look for large increases in \ntrading volume as aclue to which stocks might be ready to make abig move. \nInvariably, if the trading volume has increased and if implied volatility has increased \nas well, it is agood warning sign that someone with inside information is buying the \noptions. In such acase, it might not be agood idea to sell volatility, even though the \noptions are mathematically expensive. \nSometimes, even more minor news items are known in advance by asmall seg\nment of the investing community. If those items will be enough to move the stock \neven acouple of points, those who possess the information may try to buy options in \nadvance of the news. Such minor news items might include the resignation or firing \nof ahigh-ranking corporate officer, or perhaps some strategic alliance with another \ncompany, or even anew product announcement. \nThe seller of volatility can watch for two things as warning signs that perhaps \nthe options are \"predicting\" acorporate event (and hence should be avoided as a \n\"volatility sale\"). Those two things are adramatic increase in option volume or asud\nden jump in implied volatility of the options. One or both can be caused by traders \nwith inside information trying to obtain aleveraged instrument in advance of the \nactual corporate news item being made public.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:796", "doc_id": "6d5f35520ae2d4d418c708b457fc5aa3535f918fc7292d905cf9a6cd42ca5085", "chunk_index": 0}
{"text": "Chapter 36: The Basics of Volatility Trading 745 \nA SUDDEN INCREASE IN OPTION VOLUME OR IMPLIED VOLATILITY \nThe symptoms of insider trading, as evidenced by alarge increase in option trading \nactivity, can be recognized. Typically, the majority of the increased volume occurs in \nthe near-term option series, particularly the at-the-money strike and perhaps the next \nstrike out-of-the-money. The activity doesn'tcease there, however. It propagates out \nto other option series as market-makers (who by the nature of their job function are \nshort the near-term options that those with insider knowledge are buying) snap up \neverything on the books that they can find. In addition, the market-makers may try \nto entice others, perhaps institutions, to sell some expensive calls against aportion of \ntheir institutional stock holdings. Activity of this sort should be awarning sign to the \nvolatility seller to stand aside in this situation. \nOf course, on any given day there are many stocks whose options are extraordi\nnarily active, but the increase in activity doesn'thave anything to do with insider trad\ning. This might include alarge covered call write or maybe alarge put purchase \nestablished by an institution as ahedge against an existing stock position, or arela\ntively large conversion or reversal arbitrage established by an arbitrageur, or even alarge spread transaction initiated by ahedge fund. In any of these cases, option vol\nume would jump dramatically, but it wouldn'tmean that anyone had inside knowl\nedge about aforthcoming corporate event. Rather, the increases in option trading \nvolume as described in this paragraph are merely functions of the normal workings \nof the marketplace. \nWhat distinguishes these arbitrage and hedging activities from the machina\ntions of insider trading is: (1) There is little propagation of option volume into other \nseries in the \"benign\" case, and (2) the stock price itself may languish. However, \nwhen true insider activity is present, the market-makers react to the aggressive \nnature of the call buying. These market-makers know they need to hedge themselves, \nbecause they do not want to be short naked call options in case atakeover bid or \nsome other news spurs the stock dramatically higher. As mentioned earlier, they try \nto buy up any other options offered in \"the book,\" but there may not be many of \nthose. So, as alast result, the way they reduce their negative position delta is to buy \nstock. Thus, if the options are active and expensive, and if the stock is rising too, you \nprobably have areasonably good indication that \"someone knows something.\" \nHowever, if the options are expensive but none of the other factors are present, espe\ncially if the stock is declining in price - then one might feel more comfortable with astrategy of selling volatility in this case. \nHowever, there is acase in which options might be the object of pursuit by \nsomeone with insider knowledge, yet not be accompanied by heavy trading volume. \nThis situation could occur with illiquid options. In this case, afloor broker holding", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:797", "doc_id": "a42aa4b770b963fdf81750a85339873155b8c9c9b54aa013411f15e276c3a0be", "chunk_index": 0}
{"text": "746 Part VI: Measuring and Trading Volatility \nthe order of those with insider information might come into the pit to buy options, \nbut the market-makers may not sell them many, preferring to raise their offering \nprice rather than sell alarge quantity. If this happens afew times in arow, the options \nwill have gotten very expensive as the floor broker raises his bid price repeatedly, but \nonly buys afew contracts each time. Meanwhile, the market-maker keeps raising his \noffering price. \nEventually, the floor broker concludes that the options are too expensive to \nbother with and walks away. Perhaps his client then buys stock. In any case, what has \nhappened is that the options have gotten very expensive as the bids and offers were \nrepeatedly raised, but not much option volume was actually traded because of the \nilliquidity of the contracts. Hence the normal warning light associated with asudden \nincrease in option volume would not be present. In this case, though, avolatility sell\ner should still be careful, because he does not want to step in to sell calls right before \nsome major corporate news item is released. The clue here is that implied volatility \nliterally exploded in ashort period of time (one day, or actually less time), and that \nalone should be enough warning to avolatility seller. \nThe point that should be taken here is that when options suddenly become very \nexpensive, especially if accompanied by strong stock price movement and strong \nstock volume, there may very well be agood reason why that is happening. That rea\nson will probably become public knowledge shortly in the form of anews event. In \nfact, amajor market-maker once said he believed that rrwst increases in implied \nvolatility were eventually justified - that is, some corporate news item was released \nthat made the stock jump. Hence, avolatility seller should avoid situations such as \nthese. Any sudden increase in implied volatility should probably be viewed as apotential news story in the making. These situations are not what aneutral volatility \nseller wants to get into. \nOn the other hand, if options have become expensive as aresult of corporate \nnews, then the volatility seller can feel more comfortable making atrade. Perhaps the \ncompany has announced poor earnings and the stock has taken abeating while \nimplied volatility rose. In this situation, one can assess the information and analyze it \nclearly; he is not dealing with some hidden facts known to only afew insider traders. \nWith clear analysis, one might be able to develop avolatility selling strategy that is \nprudent and potentially profitable. \nAnother situation in which options become expensive in the wake of market \naction is during abear market in the underlying. This can be true for indices, stocks, \nand futures contracts. The Crash of '87 is an extreme example, but implied volatility \nshot through the roof during the crash. Other similar sharp market collapses - such \nas October 1989, October 1997, and August-September 1998 - caused implied \nvolatility to jump dramatically. In these situations, the volatility seller knows why", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:798", "doc_id": "54c8e658717674ef5c9f9d21a776902443ff469e14a62858e5fa4a855d20d8b4", "chunk_index": 0}
{"text": "Chapter 31,: 1be Basics of Volatility Trading 747 \nimplied volatility is high. Given that fact, he can then construct positions around aneutral strategy or around his view of the future. The time when the volatility seller \nmust be careful is when the options are expensive and no one seems to know why. \nThat'swhen insider trading may be present, and that'swhen the volatility seller \nshould defer from selling options. \nCHEAP OPTIONS \nWhen options are cheap, there are usually far less discernible reasons why they have \nbecome cheap. An obvious one may be that the corporate structure of the company \nhas changed; perhaps it is being taken over, or perhaps the company· has acquired \nanother company nearly its size. In either case, it is possible that the combined enti\nty'sstock will be less volatile than the original company'sstock was. As the takeover \nis in the process of being consummated, the implied volatility of the company'soptions will drop, giving the false impression that they are cheap. \nIn asimilar vein, acompany may mature, perhaps issuing more shares of stock, \nor perhaps building such a.., good earnings stream that the stock is considered less \nvolatile than it formerly was. Some of the Internet companies will be classic cases: In \nthe beginning they were high-flying stocks with plenty of price movement, so the \noptions traded with arelatively high degree of implied volatility. However, as the com\npany matures, it buys other Internet companies and then perhaps even merges with alarge, established company (America Online and Time-Warner Communications, for \nexample). In these cases, actual (statistical) volatility will diminish as the company \nmatures, and implied volatility will do the same. On the surface, abuyer of volatility \nmay see the reduced volatility as an attractive buying situation, but upon further \ninspection he may find that it is justified. If the decrease in implied volatility seems \njustified, abuyer of volatility should ignore it and look for other opportunities. \nAll volatility traders should be suspicious when volatility seems to be extreme -\neither too expensive or too cheap. The trader should investigate the possibilities as to \nwhy volatility is trading at such extreme levels. In some cases, the supply and demand \nof the public just pushes the options to extreme levels; there is nothing more involved \nthan that. Those are the best volatility trading situations. However, if there is ahint \nthat the volatility has gotten to an extreme reading because of some logical (but per\nhaps nonpublic) reason, then the volatility trader should be suspicious and should \nprobably avoid the trade. Typically this happens with expensive options. \nBuyers of volatility really have little to fear if they miscalculate and thus buy an \noption that appears inexpensive but turns out not to be, in reality. The volatility buyer \nmight lose money if he does this, and overpaying for options constantly will lead to \nruin, but an occasional mistake will probably not be fatal.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:799", "doc_id": "4f165124ace0be2a942e7b5ded07f7755855fe061385a370a8fd53949d124e48", "chunk_index": 0}
{"text": "748 Part VI: Measuring and Trading Volatility \nSellers of volatility, however, have to be alot more careful. One mistake could \nbe the last one. Selling naked calls that seem terrifically expensive by historic stan\ndards could be ruinous if atakeover bid subsequently emerges at alarge premium to \nthe stock'scurrent price. Even put sellers must be careful, although alot of traders \nthink that selling naked puts is safe because it'sthe same as buying stock. But who \never said buying stock wasn'trisky? If the stock literally collapses - falling from 80, \nsay, to 15 or 20, as Oxford Health did, or from 30 to 2 as Sunrise Technology did -\nthen aput seller will be buried. Since the risk of loss from naked option selling is \nlarge, one could be wiped out by ahuge gap opening. That'swhy it'simperative to \nstudy why the options are expensive before one sells them. If it'sknown, for exam\nple, that asmall biotech company is awaiting FDA trial results in two weeks,~and all \nthe options suddenly become expensive, the volatility seller should not attempt to be \nahero. It'sobvious that at least some traders believe that there is achance for the \nstock to gap in price dramatically. It would be better to find some other situation in \nwhich to sell options. \nThe seller of futures options or index options should be cautious too, although \nthere can'tbe takeovers in those markets, nor can there be ahuge earnings surprise \nor other corporate event that causes abig gap. The futures markets, though do have \nthings like crop reports and government economic data to deal with, and those can \ncreate volatile situations, too. The bottom line is that volatility selling - even hedged \nvolatility selling - can be taxing and aggravating if one has sold volatility in front of \nwhat turns out to be anews item that justifies the expensive volatility. \nSUMMARY \nVolatility trading is apredictable way to approach the market, because volatility \nalmost invariably trades in arange and therefore its value can be estimated with agreat deal more precision than can the actual prices of the underlyings. Even so, one \nmust be careful in his approach to volatility trading, because diligent research is \nneeded to determine if, in fact, volatility is \"cheap\" or \"expensive.\" As with any sys\ntematic approach to the market, if one is sloppy about his research, he cannot expect \nto achieve superior results. In the next few chapters, agood deal of time will be spent \nto give the reader agood understanding of how volatility affects positions and how it \ncan be used to construct trades with positive expected rates of return.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:800", "doc_id": "644f22e7852fdb1e28046e5e31fa6933e0e7b8f071ae6b2f5905c6a9fc527093", "chunk_index": 0}
{"text": "· GHAR:f ER :8'7 . . -\nHow Volatility Affects \nPopular Strategies \nThe previous chapter addressed the calculation or interpretation of implied volatili\nty, and how to relate it to historic volatility. Another, related topic that is important is \nhow implied volatility affects aspecific option strategy. Simplistically, one might think \nthat the effect of achange in implied volatility on an option position would be asim\nple matter to discern; but in reality, most traders don'thave acomplete grasp of the \nways that volatility affects option positions. In some cases, especially option spreads \nor more complex positions, one may not have an intuitive \"picture\" of how his posi\ntion is going to be affected by achange in implied volatility. In this chapter, we'll \nattempt arelatively thorough review of how implied volatility changes affect most of \nthe popular option strategies. \nThere are ways to use computer analysis to \"draw\" apicture of this volatiiity \neffect, of course, and that will be discussed momentarily. But an option strategist \nshould have some idea of the general changes that aposition will undergo if implied \nvolatility changes. Before getting into the individual strategies, it is important that \none understands some of the basics of the effect of volatility on an option'sprice. \nVEGA \nTechnically speaking, the term that one uses to quantify the impact of volatility \nchanges on the price of an option is called the vega of the option. In this chapter, the \nreferences will be to vega, but the emphasis here is on practicality, so the descriptions \n749", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:801", "doc_id": "99b5296bdbb6af52742d1aba85c537724e3934c2482abe866b92382fd077659d", "chunk_index": 0}
{"text": "750 Part VI: Measuring and Trading Volatility \nof how volatility affects option positions will be in plain English as well as in the more \nmathematical realm of vega. Having said that, let'sdefine vega so that it is understood \nfor later use in the chapter. \nSimply stated, vega is the amount by which an option'sprice changes when \nvolatility changes by one percentage point. \nExample: XYZ is selling at 50, and the July 50 call is trading at 7.25. Assume that \nthere is no dividend, that short-term interest rates are 5%, and that July expiration is \nexactly three months away. With this information, one can determine that the implied \nvolatility of the July 50 call is 70%. That'safairly high number, so one can surmise \nthat XYZ is avolatile stock. What would the option price be if implied volatility were \nrise to 71 %? Using amodel, one can determine that the July 50 call would theoreti\ncally be worth 7.35 if that happened. Hence, the vega of this option is 0.10 (to two \ndecimal places). That is, the option price increased by 10 cents, from 7.25 to 7.35, \nwhen volatility rose by one percentage point. (Note that \"percentage point\" here \nmeans afull point increase in volatility, from 70% to 71 %.) \nWhat if implied volatility had decreased instead? Once again, one can use the \nmodel to determine the change in the option price. In this case, using an implied \nvolatility of 69% and keeping everything else the same, the option would then theo\nretically be worth 7.15- again, a 0.10 change in price (this time, adecrease in price). \nThis example points out an interesting and important aspect of how volatility \naffects acall option: If implied volatility increases, the price of the option will \nincrease, and if implied volatility decreases, the price of the option will decrease. \nThus, there is adirect relationship between an option'sprice and its implied volatili-\nty. \nMathematically speaking, vega is the partial derivative of the Black-Scholes \nmodel (or whatever model you're using to price options) with respect to volatility. In \nthe above example, the vega of the July 50 call, with XYZ at 50, can be computed to \nbe 0.098 - very near the value of 0.10 that one arrived at by inspection. \nVega also has adirect relationship with the price of aput. That is, as implied \nvolatility rises, the price of aput will rise as well. \nExample: Using the same criteria as in the last example, suppose that XYZ is trading \nat 50, that July is three months away, that short-term interest rates are 5%, and that \nthere is no dividend. In that case, the following theoretical put and call prices would \napply at the stated implied volatilities:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:802", "doc_id": "0a3b3710a7da3bf29d06f92cd5fcea76a972a49eac2f65a17376e5eb560da86c", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies 751 \nStock Price July 50 call July 50 put Implied Volatility Put's Vega \n50 7.15 6.54 69% 0.10 \n7.25 6.64 70% 0.10 \n7.35 6.74 71% 0.10 \nThus, the put'svega is 0.10, too - the same as the call'svega was. \nIn fact, it can be stated that acall and aput with the same terms have the same \nvega. To prove this, one need only refer to the arbitrage equation for aconversion. If \nthe call increases in price and everything else remains equal - interest rates, stock \nprice, and striking price - then the put price must increase by the same amount. Achange in implied volatility will cause such achange in the call price, and asimilar \nchange in the put price. Hence, the vega of the put and the call must be the same. \nIt is also important to know how the vega changes as other factors change, par\nticularly as the stock price changes, or as time changes. The following examples con\ntain several tables that illustrate the behavior of vega in atypically fluctuating envi\nronment. \nExample: In this case, let the stock price fluctuate while holding interest rate (5% ), \nimplied volatility (70%), time (3 months), dividends (0), and the strike price (50) con\nstant. See Table 37-1. \nIn these cases, vega drops when the stock price does, too, but it remains fairly \nconstant if the stock rises. It is interesting to note, though, that in the real world, \nwhen the underlying drops in price especially if it does so quickly, in apanic mode \n- implied volatility can increase dramatically. Such an increase may be of great ben\nefit to acall holder, serving to mitigate his losses, perhaps. This concept will be dis\ncussed further later in this chapter. \nTABLE 37-1 \nImplied Volatility Theoretical \nStock Price July 50 Call Price Coll Price Vega \n30 70% 0.47 0.028 \n40 2.62 0.073 \n50 7.25 0.098 \n60 14.07 0.092 \n70 22.35 0.091", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:803", "doc_id": "962159b799d5e106d284fe79cf067c85cc86e81163e09267a7ee8b788290f538", "chunk_index": 0}
{"text": "752 Part VI: Measuring and Trading Volatility \nThe above example assumed that the stock was making instantaneous changes \nin price. In reality, of course, time would be passing as well, and that affects the vega \ntoo. Table 37-2 shows how the vega changes when time changes, all other factors \nbeing equal. \nExample: In this example, the following items are held fixed: stock price (50), strike \nprice (50), implied volatility (70%), risk-free interest rate (5%), and dividend\\(0). But \nnow, we let time fluctuate. \nTable 37-2 clearly shows that the passage of time results not only in adecreas\ning call price, but in adecreasing vega as well. This makes sense, of course, since one \ncannot expect an increase in implied volatility to have much of an effect on avery \nshort-term option - certainly not to the extent that it would affect a LEAPS option. \nSome readers might be wondering how changes in implied volatility itself would \naffect the vega. This might be called the \"vega of the vega,\" although I've never actu\nally heard it referred to in that manner. The next table explores that concept. \nExample: Again, some factors will be kept constant - the stock price (50), the time \nto July expiration (3 months), the risk-free interest rate (5%), and the dividend (0). \nTable 37-3 allows implied volatility to fluctuate and shows what the theoretical price \nof a July 50 call would be, as well as its vega, at those volatilities. \nThus, Table 37-3 shows that vega is surprisingly constant over awide range of \nimplied volatilities. That'sthe real reason why no one bothers with \"vega of the vega.\" \nVega begins to decline only if implied volatility gets exceedingly high, and implied \nvolatilities of that magnitude are relatively rare. \nOne can also compute the distance astock would need to rise in order to over\ncome adecrease in volatility. Consider Figure 37-1, which shows the theoretical price \nTABLE 37-2 \nImplied Time Theoretical \nStock Price Volatility Remaining Call Price Vega \n50 70% One year 14.60 0.182 \nSix months 10.32 0.135 \nThree months 7.25 0.098 \nTwo months 5.87 0.080 \nOne month 4.16 0.058 \nTwo weeks 2.87 0.039 \nOne week 1.96 0.028 \nOne day 0.73 0.010", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:804", "doc_id": "12f928e15ef2b3d1323dcb63408636fd1f788b2787f15809757ca0158203654e", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affeds Popular Strategies \nTABLE 37-3 \nImplied \nStock Price Volatility \n50 10% \n30% \n50% \n70% \n100% \n150% \n200% \nTheoretical \nColl Price \n1.34 \n3.31 \n5.28 \n7.25 \n10.16 \n14.90 \n19.41 \n753 \nVega \n0.097 \n0.099 \n0.099 \n0.098 \n0.096 \n0.093 \n0.088 \nof a 6-month call option with differing implied volatilities. Suppose one buys an \noption that currently has implied volatility of 170% (the top curve on the graph). \nLater, investor perceptions of volatility diminish, and the option is trading with an \nimplied volatility of 140%. That means that the option is now \"residing\" on the sec\nond curve from the top of the list. Judging from the general distance between those \ntwo curves, the option has probably lost between 5 and 8 points of value due to the \ndrop in implied volatility. \nHere'sanother way to think about it. Again, suppose one buys an at-the-money \noption (stock price = 100) when its implied volatility is 170%. That option value is \nmarked as point Aon the graph in Figure 37-1. Later, the option'simplied volatility \ndrops to 140%. How much does the stock have to rise in order to overcome the loss \nof implied volatility? The horizontal line from point Ato point Bshows that the \noption value is the same on each line. Then, dropping avertical line from Bdown to \npoint C, we see that point Cis at astock price of about 109. Thus, the stock would \nhave to rise 9 points just to keep the option value constant, if implied volatility drops \nfrom 170% to 140%. \nIMPLIED VOLATILITY AND DELTA \nFigure 37-1 shows another rather unusual effect: When implied volatility gets very \nhigh, the delta of the option doesn'tchange much. Simplistically, the delta of an \noption measures how much the option changes in price when the stock moves one \npoint. Mathematically, the delta is the first partial derivative of the option model with \nrespect to stock price. Geometrically, that means that the delta of an option is the \nslope of aline drawn tangent to the curve in the preceding chart.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:805", "doc_id": "ad72b7ee3efa6bb8c1fe9678d4e713032ac2ceab52c9724467869ea743e5f5aa", "chunk_index": 0}
{"text": "754 Part VI: Measuring and Trading Volatility \nFIGURE 37-1. \nTheoretical option prices at differing implied \nvolatilities (6-month calls). \n80 \n70 \nQ) 60 \n(.) \n·;::: \nCl.. 50 \nC: \n0 \n·a 40 \n0 \n30 \n20 \n10 \nStock Price \n60 80 100 C 120 140 \n_JY.._ \n170% \n140% \n110% \n80% \n50% \n20% \nThe bottom line in Figure 37-1 (where implied volatility= 20%) has adistinct \ncurvature to it when the stock price is between about 80 and 120. Thus the delta \nranges from afairly low number (when the stock is near 80) to arather high number \n(when the stock is near 120). Now look at the top line on the chart, where implied \nvolatility= 170%. It'salmost astraight line from the lower left to the upper right! The \nslope of astraight line is constant. This tells us that the delta (which is the slope) \nbarely changes for such an expensive option - whether the stock is trading at 60 or \nit'strading at 150! That fact alone is usually surprising to many. \nIn addition, the value of this delta can be measured: It's 0. 70 or higher from astock price of 80 all the way up to 150. Among other things, this means that an out~ \nof-the-money option that has extremely high implied volatility has afairly high delta \n- and can be expected to mirror stock price movements more closely than one might \nthink, were he not privy to the delta. \nFigure 37-2 follows through on this concept, showing how the delta of an option \nvaries with implied volatility. From this chart, it is clear how much the delta of an \noption varies when the implied volatility is 20%, as compared to how little it varies \nwhen implied volatility is extremely high. \nThat data is interesting enough by itself, but it becomes even more thought-pro\nvoking when one considers that achange in the implied volatility of his option (vega) \nalso can mean asignificant change in the delta of the option. In one sense, it explains \nwhy, in the first chart (Figure 37-1), the stock could rise 9 points and yet the option \nholder made nothing, because implied volatility declined from 170% to 140%.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:806", "doc_id": "11670eb8738ec642af3259b630a873cbc2ea5dca061321c74088dc1d1e73a6b6", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies \nEFFECTS ON NEUTRALITY \n755 \nApopular concept that uses delta is the \"delta-neutral\" spread aspread whose prof\nitability is supposedly ambivalent to market movement, at least for short time frames \nand limited stock price changes. Anything that significantly affects the delta of an \noption can affect this neutrality, thus causing adelta-neutral position to become \nunbalanced ( or, more likely, causing one'sintuition to be wrong regarding what con\nstitutes adelta-neutral spread in the first place). \nLet'suse afamiliar strategy, the straddle purchase, as an example. Simplistically, \nwhen one buys astraddle, he merely buys aput and acall with the same terms and \ndoesn'tget any fancier than that. However, it may be the case that, due to the deltas \nof the options involved, that approach is biased to the upside, and aneutral straddle \nposition should be established instead. \nExample: Suppose that XYZ is trading at 100, that the options have an implied \nvolatility of 40%, and that one is considering buying asix-month straddle with astrik\ning price of 100. The following data summarize the situation, including the option \nprices and the deltas: \nXYZ Common: l 00; Implied Volatility: 40% \nOption \nXYZ October l 00 call \nXYZ October l 00 put \nFIGURE 37-2. \nPrice \n12.00 \n10.00 \nDelta \n0.60 \n-0.40 \nValue of delta of a 6-month option at differing implied volatilities. \n90 \n80 \n70 \n.!!lai 60 \nCl \nC: 50 ,g \n8° 40 \n30 \n20 \n10 \n60 80 100 \nStock Price \n120 140", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:807", "doc_id": "2b5bde58ef50c86c2a16e7894b15a528bdff44de8b4cb68a40884b62eecaa090", "chunk_index": 0}
{"text": "756 Part VI: Measuring and Trading Volatility \nNotice that the stock price is equal to the strike price (100). However, the deltas \nare not at all equal. In fact, the delta of the call is 1.5 times that of the put (in absolute \nvalue). One must buy three puts and two calls in order to have adelta-neutral posi\ntion. \nMost experienced option traders know that the delta of an at-the-money call is \nsomewhat higher than that of an at-the-money put. Consequently, they often esti\nmate, without checking, that buying three puts and two calls produces adelta-neu\ntral \"straddle buy.\" However, consider asimilar situation, but with amuch higher \nimplied volatility- 110%, say. \nAAA Common: 100; Implied Volatility: 110% \nOption \nAAA October 100 call \nAAA October 1 00 put \nPrice \n31.00 \n28.00 \nDelta \n0.67 \n-0.33 \nThe delta-neutral ratio here is two-to-one (67 divided by 33), not three-to-two \nas in the earlier case - even though both stock prices are 100 and both sets of options \nhave six months remaining. This is abig difference in the delta-neutral ratio, espe\ncially if one is trading alarge quantity of options. This shows how different levels of \nimplied volatility can alter one'sperception of what is aneutral position. It also points \nout that one can'tnecessarily rely on his intuition; it is always best to check with amodel. \nCarrying this thought astep further, one must be mindful of achange in implied \nvolatility if he wants to keep his position delta-neutral. If the implied volatility of AAA \noptions should drop significantly, the 2-to-lratio will no longer be neutral, even if the \nstock is still trading at 100. Hence, atrader wishing to remain delta-neutral must \nmonitor not only changes in stock price, but changes in implied volatility as well. For\nmore complex strategies, one will also find the delta-neutral ratio changing due to achange in implied volatility. \nThe preceding examples summarize the major variables that might affect the \nvega and also show how vega affects things other than itself, such as delta and, there\nfore, delta neutrality. By the way, the vega of the underlying is zero; an increase in \nimplied volatility does not affect the price of the underlying instrument at all, in the\nory. In reality, if options get very expensive (i.e., implied volatility spikes up), that \nusually brings traders into astock and so the stock price will change. But that'snot amathematical relationship, just amarket cause-and-effect relationship.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:808", "doc_id": "52c66a0c0633bb343ce4e46ee48c4172ec204cc5ebeebf3b2b782e1b3a9c0281", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies \nPOSITION VEGA \n757 \nAs can be done with delta or with any other of the partial derivatives of the model, \none can compute aposition vega - the vega of an entire position. The position vega \nis determined by multiplying the individual option vegas by the quantity of options \nbought or sold. The \"position vega\" is merely the quantity of options held, times the \nvega, times the shares per options ( which is normally 100). \nExample: Using asimple call spread as an example, assume the following prices \nexist: \nSecurity Position Vega Position Vego \nXYZ Stock No position \nXYZ July 50 call Long 3 calls 0.098 +0.294 \nXYZ July 70 call Short 5 calls 0.076 -0.380 \nNet Position Vega: -0.086 \nThis concept is very important to avolatility trader, for it tells him if he has con\nstructed aposition that is going to behave in the manner he expects. For example, \nsuppose that one identifies expensive options, and he figures that implied volatility \nwill decrease, eventually becoming more in line with its historical norms. Then he \nwould want to construct aposition with anegative position vega. Anegative position \nvega indicates that the position will profit if implied volatility decreases. Conversely, \nabuyer of volatility - one who identifies some underpriced situation - would want to \nconstruct aposition with apositive position vega, for such aposition will profit if \nimplied volatility rises. In either case, other factors such as delta, time to expiration, \nand so forth will have an effect on the position'sactual dollar profit, but the concept \nof position vega is still important to avolatility trader. It does no good to identify \ncheap options, for example, and then establish some strange spread with anegative \nposition vega. Such aconstruct would be at odds with one'sintended purpose - in \nthis case, buying cheap options. \nOUTRIGHT OPTION PURCHASES AND SALES \nLet us now begin to investigate the affects of implied volatility on various strategies, \nbeginning with the simplest strategy of all - the outright option purchase. It was \nalready shown that implied volatility affects the price of an individual call or put in a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:809", "doc_id": "685d8057f339b6b4c00dfcc7b2d160a8636380552b3bb06c1377dea88cd834c8", "chunk_index": 0}
{"text": "758 Part VI: Measuring and Trading Volatility \ndirect manner. That is, an increase in implied volatility will cause the option price to \nrise, while adecrease in volatility will cause adecline in the option price. That piece \nof information is the most important one of all, for it imparts what an option trader \nneeds to know: An explosion in implied volatility is aboon to an option owner, but \ncan be adevastating detriment to an option seller, especially anaked option seller. \nAcouple of examples might demonstrate more clearly just how powerful the \neffect of implied volatility is, even when there isn'tmuch time remaining in the life \nof an option. One should understand the notion that an increase in implied volatility \ncan overcome days, even weeks, of time decay. This first example attempts to quan\ntify that statement somewhat. \nExample: Suppose that XYZ is trading at 100 and one is interested in analyzing a 3-\nmonth call with striking price of 100. Furthermore, suppose that implied volatility is \ncurrently at 20%. Given these assumptions, the Black-Scholes model tells us that the \ncall would be trading at aprice of 4.64. \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n3 months \n20% \n4.64 \nNow, suppose that amonth passes. If implied volatility remained the same \n(20% ), the call would lose nearly apoint of value due to time decay. However, how \nmuch would implied volatility have had to increase to completely counteract the \neffect of that time decay? That is, after amonth has passed, what implied volatility \nwill yield acall price of 4.64? lt turns out to be just under 26%. \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n2 months \n25.9% \n4.64 \nWhat would happen after another month passes? There is, of course, some \nimplied volatility at which the call would still be worth 4.64, but is it so high as to be \nunreasonable? Actually, it turns out that if implied volatility increases to about 38%, \nthe call will still be worth 4.64, even with only one month of life remaining:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:810", "doc_id": "5973c7f6dfb34183d52bb5190ec14ddba2c1125c9cffa7dba9dc3c28620f84c4", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n1 month \n38.1% \n4.64 \n759 \nSo, if implied volatility increases from 20% to 26% over the first month, then \nthis call option would still be trading at the same price - 4.64. That'snot an unusual \nincrease in implied volatility; increases of that magnitude, 20% to 26%, happen all \nthe time. For it to then increase from 26% to 38% over the next month is probably \nless likely, but it is certainly not out of the question. There have been many times in \nthe past when just such an increase has been possible - during any of the August, \nSeptember, or October bear markets or mini-crashes, for example. Also, such an \nincrease in implied volatility might occur if there were takeover rumors in this stock, \nor if the entire market became more volatile, as was the case in the latter half of the \n1990s. \nPerhaps this example was distorted by the fact that an implied volatility of 20% \nis afairly low number to begin with. What would asimilar example look like if one \nstarted out with amuch higher implied volatility - say, 80%? \nExample: Making the same assumptions as in the previous example, but now setting \nthe implied volatility to amuch higher level of 80%, the Black-Scholes model now \nsays that the call would be worth aprice of 16.45: \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n3 months \n80% \n16.45 \nAgain, one must ask the question: \"If amonth passes, what implied volatility \nwould be necessary for the Black-Scholes model to yield aprice of 16.45?\" In this \ncase, it turns out to be an implied volatility of just over 99%. \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n2 months \n99.4% \n16.45", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:811", "doc_id": "543bdf7b9f191aa0d60c230df4b8cd00d6dcd6ab501e37bfa47c305d5aa04904", "chunk_index": 0}
{"text": "758 Part VI: Measuring and Trading Volatility \ndirect manner. That is, an increase in implied volatility will cause the option price to \nrise, while adecrease in volatility will cause adecline in the option price. That piece \nof information is the most important one of all, for it imparts what an option trader \nneeds to know: An explosion in implied volatility is aboon to an option owner, but \ncan be adevastating detriment to an option seller, especially anaked option seller. \nAcouple of examples might demonstrate more clearly just how powerful the \neffect of implied volatility is, even when there isn'tmuch time remaining in the life \nof an option. One should understand the notion that an increase in implied volatility \ncan overcome days, even weeks, of time decay. This first example attempts to quan\ntify that statement somewhat. \nExample: Suppose that XYZ is trading at 100 and one is interested in analyzing a 3-\nmonth call with striking price of 100. Furthermore, suppose that implied volatility is \ncurrently at 20%. Given these assumptions, the Black-Scholes model tells us that the \ncall would be trading at aprice of 4.64. \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n3 months \n20% \n4.64 \nNow, suppose that amonth passes. If implied volatility remained the same \n(20% ), the call would lose nearly apoint of value due to time decay. However, how \nmuch would implied volatility have had to increase to completely counteract the \neffect of that time decay? That is, after amonth has passed, what implied volatility \nwill yield acall price of 4.64? It turns out to be just under 26%. \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n2 months \n25.9% \n4.64 \nWhat would happen after another month passes? There is, of course, some \nimplied volatility at which the call would still be worth 4.64, but is it so high as to be \nunreasonable? Actually, it turns out that if implied volatility increases to about 38%, \nthe call will still be worth 4.64, even with only one month of life remaining:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:812", "doc_id": "eda4da5c63df5fd837939872f66e19891d54f7375a85a1faeb29c4e9ab3966ac", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n1 month \n38.1% \n4.64 \n759 \nSo, if implied volatility increases from 20% to 26% over the first month, then \nthis call option would still be trading at the same price 4.64. That'snot an unusual \nincrease in implied volatility; increases of that magnitude, 20% to 26%, happen all \nthe time. For it to then increase from 26% to 38% over the next month is probably \nless likely, but it is certainly not out of the question. There have been many times in \nthe past when just such an increase has been possible - during any of the August, \nSeptember, or October bear markets or mini-crashes, for example. Also, such an \nincrease in implied volatility might occur if there were takeover rumors in this stock, \nor if the entire market became more volatile, as was the case in the latter half of the \n1990s. \nPerhaps this example was distorted by the fact that an implied volatility of 20% \nis afairly low number to begin with. What would asimilar example look like if one \nstarted out with amuch higher implied volatility say, 80%? \nExample: Making the same assumptions as in the previous example, but now setting \nthe implied volatility to amuch higher level of 80%, the Black-Scholes model now \nsays that the call would be worth aprice of 16.45: \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n3 months \n80% \n16.45 \nAgain, one must ask the question: \"If amonth passes, what implied volatility \nwould be necessary for the Black-Scholes model to yield aprice of 16.45?\" In this \ncase, it turns out to be an implied volatility of just over 99%. \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n2 months \n99.4% \n16.45", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:813", "doc_id": "408b73492fe0c6930232709d55e6ad942ab2ab8b72075886b2ea9d8cdf7aea25", "chunk_index": 0}
{"text": "760 Part VI: Measuring and Trading Volatility \nFinally, to be able to completely compare this example with the previous one, it \nis necessary to see what implied volatility would have to rise to in order to offset the \neffect of yet another month'stime decay. It turns out to be over 140%: \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n1 month \n140.9% \n16.45 \nTable 37-4 summarizes the results of these examples, showing the levels to \nwhich implied volatility would have to rise to maintain the call'svalue as time passes. \nAre the volatility increases in the latter example less likely to occur than the \nones in the former example? Probably yes - certainly the last one, in which implied \nvolatility would have to increase from 80% to nearly 141 % in order to maintain the \ncall'svalue. However, in another sense, it may seem more reasonable: Note that the \nincrease in volatility from 20% to 26% is a 30% increase. That is, 20% times 1.30 \nequals 26%. That'swhat'srequired to maintain the call'svalue for the lower volatility \nover the first month - an increase in the magnitude of implied volatility of 30%. At \nthe higher volatility, though, an increase in magnitude of only about 25% is required \n(from 80% to 99%). Thus, in those terms, the two appear on more equal footing. \nWhat makes the top line of Table 37-4 appear more likely than the bottom line \nis merely the fact that an experienced option trader knows that many stocks have \nimplied volatilities that can fluctuate in the 20% to 40% range quite easily. However, \nthere are far fewer stocks that have implied volatilities in the higher range. In fact, \nuntil the Internet stocks got hot in the latter portion of the 1990s, the only ones with \nvolatilities like those were very low-priced, extremely volatile stocks. Hence one'sexperience factor is lower with such high implied volatility stocks, but it doesn'tmean \nthat the volatility fluctuations appearing in Table 37-4 are impossible. \nIf the reader has access to asoftware program containing the Black-Scholes \nmodel, he can experiment with other situations to see how powerful the effect of \nimplied volatility is. For example, without going into as much detail, if one takes the \ncase of a 12-month option whose initial implied volatility is 20%, all it takes to main-\nTABLE 37-4 \nInitial Implied \nVolatility \n20% \n80% \nVolatility Leveled Required to Maintain Call Value ... \n... After One Month ... After Two Months \n26% \n99% \n38% \n141%", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:814", "doc_id": "7c9773f538d3a4d5907ae8e4f768c70f492856defe2f5d05ee0a47e61644a54a", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies 761 \ntain the call'svalue over a 6-month time period is an increase in implied volatility to \n27%. Taken from the viewpoint of the option seller, this is perhaps most enlighten\ning: If you sell aone-year (LEAPS) option and six months pass, during which time \nimplied volatility increases from 20% to 27% - certainly quite possible -you will have \nmade nothing! The call will still be selling for the same price, assuming the stock is \nstill selling for the same price. \nFinally, it was mentioned earlier that implied volatility often explodes during amarket crash. In fact, one could determine just how much of an increase in implied \nvolatility would be necessary in amarket crash in order to maintain the call'svalue. \nThis is similar to the first example in this section, but now the stock price will be \nallowed to decrease as well. Table 37-5, then, shows what implied volatility would be \nrequired to maintain the call'sinitial value (aprice of 4.64), when the stock price falls. \nThe other factors remain the same: time remaining (3 months), striking price (100), \nand interest rate (5% ). Again, this table shows instantaneous price changes. In real \nlife, aslightly higher implied volatility would be necessary, because each market crash \ncould take aday or two. \nThus, from Table 37-5, one could say that even if the underlying stock dropped \n20 points (which is 20% in this case) in one day, yet implied volatility exploded from \n20% to 67% at the same time, the call'svalue would be unchanged! Could such an \noutrageous thing happen? It has: In the Crash of '87, the market plummeted 22% in \none day, while the Volatility Index ($VIX) theoretically rose from 36% to 150% in one \nday. In fact, call buyers of some $OEX options actually broke even or made alittle \nmoney due to the explosion in implied volatility, despite the fact that the worst mar\nket crash in history had occurred. \nIf nothing else, these examples should impart to the reader how important it is \nto be aware of implied volatility at the time an option position is established. If you \nare buying options, and you buy them when implied volatility is \"low,\" you stand to \nTABLE 37-5 \nStock Price \n100 \n95 \n90 \n85 \n80 \n75 \n70 \nImplied Volatility Necessary for Call to Maintain Value \n20% (the initial parameters) \n33% \n44% \n55% \n67% \n78% \n89%", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:815", "doc_id": "830c9ad5a77cc88e8fc7b71c38e0957d43dbafe8f10603cfd6910753d99128cf", "chunk_index": 0}
{"text": "762 Part VI: Measuring and Trading Volatility \nbenefit if implied volatility merely returns to \"normal\" levels while you hold the posi\ntion. Of course, having the underlying increase in price is also important. \nConversely, an option seller should be keenly aware of implied volatility when \nthe option is initially sold - perhaps even more so than the buyer of an option. This \npertains equally well to naked option writers and to covered option writers. If implied \nvolatility is \"too low\" when the option writing position is established, then an increase \n(or worse, an explosion) in implied volatility will be very detrimental to the position, \ncompletely overcoming the effects of time decay. Hence, an option writer should not \njust sell options because he thinks he is collecting time decay each day that passes. \nThat may be true, but an increase in implied volatility can completely domin.ate what \nlittle time decay might exist, especially for alonger-term option. \nIn asimilar manner, adecrease in implied volatility can be just as important. \nThus, if the call buyer purchases options that are \"too costly,\" ones in which implied \nvolatility is \"too high,\" then he could lose money even if the underlying makes amod\nest move in his favor. \nIn the next chapters, the topic of just how an option buyer or seller should \nmeasure implied volatility to determine what is \"too low\" or \"too high\" will be dis\ncussed. For now, suffice it to grasp the general concept that achange in implied \nvolatility can have substantial effects on an option'sprice far greater effects than the \npassage of time can have. \nIn fact, all of this calls into question just exactly what time value premium is. \nThat part of an option'svalue that is not intrinsic value is really affected much more \nby volatility than it is by time decay, yet it carries the term \"time value premium.\" \nTIME VALUE PREMIUM IS A MISNOMER \nMany (perhaps novice) option traders seem to think of time as the main antagonist to \nan option buyer. However, when one really thinks about it, he should realize that the \nportion of an option that is not intrinsic value is really much more related to stock \nprice movement and/or volatility than anything else, at least in the short term. For \nthis reason, it might be beneficial to more closely analyze just what the \"excess value\" \nportion of an option represents and why abuyer should not primarily think of it as \ntime value premium. \nAn option'sprice is composed of two parts: (1) intrinsic value, which is the \"real\" \npart of the option'svalue - the distance by which the option is in-the-money, and (2) \n\"excess value\" - often called time value premium. There are actually five factors that \naffect the \"excess value\" portion of an option. Eventually, time will dominate them", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:816", "doc_id": "343eec91aa6228684e36712f70846c36cb65ce39023d22232b6a964412af427f", "chunk_index": 0}
{"text": "Chapter 37: How Volah'lity Affects Popular Strategies 763 \nall, but the longer the life of the option, the more the other factors influence the \n\"excess value.\" \nThe five factors influencing excess value are: \n1. stock price movements, \n2. changes in implied volatility, \n3. the passage of time, \n4. changes in the dividend (if any exist), and \n5. changes in interest rates. \nEach is stated in terms of amovement or change; that is, these are not static \nthings. In fact, to measure them one uses the \"greeks\": delta, vega, theta, (there is no \n\"greek\" for dividend change), and rho. Typically, the effect of achange in dividend or \nachange in interest rate is small (although alarge dividend change or an interest rate \nchange on avery long-term option can produce visible changes in the prices of \noptions). \nIf everything remains static, then time decay will eventually wipe out all of the \nexcess value of an option. That'swhy it'scalled time value premium. But things don'tever remain static, and on adaily basis, time decay is small, so it is the remaining two \nfactors that are most important. \nExample: XYZ is trading at 82 in late November. The January 80 call is trading at 8. \nThus, the intrinsic value is 2 (82 minus 80) and the excess value is 6 (8 minus 2). If \nthe stock is still at 82 at January expiration, the option will of course only be worth 2, \nand one will say that the 6 points of excess value that was lost was due to time decay. \nBut on that day in late November, the other factors are much more dominant. \nOn this particular day, the implied volatility of this option is just over 50%. One \ncan determine that the call'sgreeks are: \nDelta: 0.60 \nVega: 0.13 \nTheta: -0.06 \nThis means, for example, that time decay is only 6 cents per day. It would \nincrease as time went by, but even with aday or so to go, theta would not increase \nabove about 20 cents unless volatility increased or the stock moved closer to the \nstrike price. \nFrom the above figures, one can see - and this should be intuitively appealing that \nthe biggest factor influencing the price of the option is stock price movement (delta).", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:817", "doc_id": "bcc74722fa2599a927d9e0d955ed7ed707dccadcf1221431fe9200219870c755", "chunk_index": 0}
{"text": "764 Part VI: Measuring and Trading VolatiRty \nIt'salittle unfair to say that, because it'sconceivable (although unlikely) that volatil\nity could jump by alarge enough margin to become agreater factor than delta for \none day'smove in the option. Furthermore, since this option is composed mostly of \nexcess value, these more dominant forces influence the excess value more than time \ndecay does. \nThere is adirect relationship between vega and excess value. That is, if implied \nvolatility increases, the excess value portion of the option will increase and, if implied \nvolatility decreases, so will excess value. \nThe relationship between delta and excess value is not so straightforward. The \nfarther the stock moves away from the strike, the more this will have the effect of \nshrinking the excess value. If the call is in-the-money (as in the above example), then \nan increase in stock price will result in adecrease of excess value. That is, adeeply in\nthe-money option is composed primarily of intrinsic value, while excess value is quite \nsmall. However, when the call is out-of-the-money, the effect is just the opposite: \nThen, an increase in call price will result in an increase in excess value, because the \nstock price increase is bringing the stock closer to the option'sstriking price. \nFor some readers, the following may help to conceptualize this concept. The \npart of the delta that addresses excess value is this: \nOut-of-the-money call: 100% of the delta affects the excess value. \nIn-the-money call: \"1.00 minus delta\" affects the excess value. (So, if acall is very \ndeeply in-the-money and has adelta of 0.95, then the delta only has 1.00 - 0.95, \nor 0.05, room to increase. Hence it has little effect on what small amount of \nexcess value remains in this deeply in-the-money call.) \nThese relationships are not static, of course. Suppose, for example, that in the \nsame situation of the stock trading at 82 and the January 80 call trading at 8, there is \nonly week remaining until expiration! Then the implied volatility would be 155% \n(high, but not unheard of in volatile times). The greeks would bear asignificantly dif\nferent relationship to each other in this case, though: \nDelta: 0.59 \nVega: 0.044 \nTheta: -0 .5 1 \nThis very short-term option has about the same delta as its counterpart in the previ\nous example (the delta of an at-the-money option is generally slightly above 0.50). \nMeanwhile, vega has shrunk. The effect of achange in volatility on such ashort-term \noption is actually about athird of what it was in the previous example. However, time \ndecay in this example is huge, amounting to half apoint per day in this option.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:818", "doc_id": "5f98919793ba6460ae681626e9322adc453a947f203c9cde688f87925e833309", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies 765 \nSo now one has the idea of how the excess value is affected by the \"big three\" \nof stock price movement, change in implied volatility, and passage of time. How can \none use this to his advantage? First of all, one can see that an option'sexcess value \nmay be due much more to the potential volatility of the underlying stock, and there\nfore to the option'simplied volatility, than to time. \nAs aresult of the above information regarding excess value, one shouldn'tthink \nthat he can easily go around selling what appear to be options with alot of excess \nvalue and then expect time to bring in the profits for him. In fact, there may be alot \nof volatility both actual and implied - keeping that excess value nearly intact for afairly long period of time. In fact, in the coming chapters on volatility estimation, it \nwill be shown that option buyers have amuch better chance of success than conven\ntional wisdom has maintained. \nVOLATILITY AND THE PUT OPTION \nWhile it is obvious that an increase in implied volatility ½ill increase the price of aput \noption, much as was shown for acall option in. the preceding discussion, there are \ncertain differences between aput and acall, so alittle review of the put option itself \nmay be useful. Aput option tends to lose its premium fairly quickly as it becomes an \nin-the-money option. This is due to the realities of conversion arbitrage. In acon\nversion arbitrage, an arbitrageur or market-maker buys stock and buys the put, while \nselling the call. If he carries the position to expiration, he will have to pay carrying \ncosts on the debit incurred to establish the position. Furthermore, he would earn any \ndividends that might be paid while he holds the position. This information was pre\nsented in aslightly different form in the chapter on arbitrage, but it is recounted \nhere: \nIn aperfect world, all option prices would be so accurate that there would be \nno profit available from aconversion. That is, the following equation (1) would apply: \n(1) Call price+ Strike price - Stock price - Put price+ Dividend- Carrying cost= 0 \nwhere carrying cost = strike price/ (1 + r)tt = time to expiration \nr = interest rate \nNow, it is also known that the time value premium of aput is the amount by which \nits value exceeds intrinsic value. The intrinsic value of an in-the-money put option is \nmerely the difference between the strike price and the stock price. Hence, one can \nwrite the following equation (2) for the time value premium (TVP) of an in-the\nmoney put option:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:819", "doc_id": "b905e4dea1732b2ec32bbc69fe94f698b9c7428ed71cb42590aecd053566a7e7", "chunk_index": 0}
{"text": "766 Part VI: Measuring and Trading Volatility \n(2) Put TVP = Put price - Strike price + Stock price \nThe arbitrage equation, (1), can be rewritten as: \n(3) Put price - Strike price+ Stock price= Call price+ Dividends - Carrying cost \nand substituting equation (2) for the terms in equation (3), one arrives at: \n( 4) Put TVP = Call price + Dividends - Carrying cost \nIn other words, the time value premium of an in-the-money put is the same as the \n(out-of-the-money) call price, plus any dividends to be ea med until expiration, less \nany carrying costs over that same time period. \nAssuming that the dividend is small or zero (as it is for most stocks), one can see \nthat an in-the-money put would lose its time value premium whenever carrying costs \nexceed the value of the out-of-the-money call. Since these carrying costs can be rel\natively large ( the carrying cost is the interest being paid on the entire debit of the \nposition - and that debit is approximately equal to the strike price), they can quickly \ndominate the price of an out-of-the-money call. Hence, the time value premium of \nan in-the-money put disappears rather quickly. \nThis is important information for put option buyers, because they must under\nstand that aput won'tappreciate in value as much as one might expect, even when \nthe stock drops, since the put loses its time value premium quickly. It'seven more \nimportant information for put sellers: Ashort put is at risk of assignment as soon as \nthere is no time value premium left in the put. Thus, aput can be assigned well in \nadvance of expiration even a LEAPS put! \nNow, returning to the main topic of how implied volatility affects aposition, one \ncan ask himself how an increase or decrease in implied volatility would affect equa\ntion ( 4) above. If implied volatility increases, the call price would increase, and if the \nincrease were great enough, might impart some time value premium to the put. \nHence, an increase in implied volatility also may increase the price of aput, but if the \nput is too far in-the-nwney, amodest increase in implied volatility still won'tbudge \nthe put. That is, an increase in implied volatility would increase the value of the call, \nbut until it increases enough to be greater than the carrying costs, an in-the-money \nput will remain at parity, and thus ashort put would still remain at risk of assignment. \nSTRADDLE OR STRANGLE BUYING AND SELLING \nSince owning astraddle involves owning both aput and acall with the same terms, \nit is fairly evident that an increase in implied volatility will be very beneficial for astraddle buyer. Asort of double benefit occurs if implied volatility rises, for it will", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:820", "doc_id": "60b0103b8b8af9e1b6d9cef290354f7b89383fdabc4408a2ec9e7f369d2a0631", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies 767 \npositively affect both the put and the call in along straddle. Thus, if astraddle buyer \nis careful to buy straddles in situations in which implied volatility is \"low,\" he can \nmake money in one of two ways. Either (1) the underlying price makes amove great \nenough in magnitude to exceed the initial cost of the straddle, or (2) implied volatil\nity increases quickly enough to overcome the deleterious effects of time decay. \nConversely, astraddle seller risks just the opposite - potentially devastating loss\nes if implied volatility should increase dramatically. However, the straddle seller can \nregister gains faster than just the rate of time decay would indicate if implied volatil\nity decreases. Thus, it is very important when selling options - and this applies to cov\nered options as well as to naked ones - to sell only when implied volatility is \"high.\" \nAstrangle is the same as astraddle, except that the call and put have different \nstriking prices. Typically, the call strike price is higher than the put strike price. \nNaked option sellers often prefer selling strangles in which the options are well out\nof-the-money, so that there is less chance of them having any intrinsic value when \nthey expire. Strangles behave much like straddles do with respect to changes in \nimplied volatility. \nThe concepts of straddle ownership will be discussed in much more detail in the \nfollowing chapters. Moreover, the general concept of option buying versus option \nselling will receive agreat deal of attention. \nCALL BULL SPREADS \nIn this section, the bull spread strategy will be examined to see how it is affected by \nchanges in implied volatility. Let'slook at acall bull spread and see how implied \nvolatility changes might affect the price of the spread if all else remains equal. Make \nthe following assumptions: \nAssumption Set 1 : \nStock Price: 1 00 \nTime to Expiration: 4 months \nPosition: long Call Struck at 90 \nShort Call Struck at 110 \nAsk yourself this simple question: If the stock remains unchanged at 100, and implied \nvolatility increases dramatically, will the price of the 90-110 call bull spread grow or \nshrink? Answer before reading on. \nThe truth is that, if implied volatility increases, the price of the spread will \nshrink. Iwould suspect that this comes as something of asurprise to agood number \nof readers. Table 37-6 contains some examples, generated from a Black-Scholes", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:821", "doc_id": "7a586f2c7fe9fed4c763f47b91e0f51ec33ad000d50072693c1723ef39369fc9", "chunk_index": 0}
{"text": "768 \nTABLE 37-6 \nImplied \nVolatility \n20% \n30% \n40% \n50% \n60% \n70% \n80% \nStock Price = I 00 \nPart VI: Measuring and Trading VolatHity \n90-110 Call \nBull Spread \n(Theoretical Value) \n10.54 \n9.97 \n9.54 \n9.18 \n8.87 \n8.58 \n8.30 \nmodel, using the assumptions stated above, the most important of which is that the \nstock is at 100 in all cases in this table. \nOne should be aware that it would probably be difficult to actually trade the \nspread at the theoretical value, due to the bid-asked spread in the options. \nNevertheless, the impact of implied volatility is clear. \nOne can quantify the amount by which an option position will change for each \npercentage point of increase in implied volatility. Recall that this measure is called \nthe vega of the option or option position. In acall bull spread, one would subtract the \nvega of the call that is sold from that of the call that is bought in order to arrive at the \nposition vega of the call bull spread. Table 37-7 is areprint of Table 37-6, but now \nincluding the vega. \nSince these vegas are all negative, they indicate that the spread will shrink in \nvalue if implied volatility rises and that the spread will expand in value if implied \nTABLE 37-7 \n90-110 Call \nImplied Bull Spread Position \nVolatility (Theoretical Value) Vega \n20% 10.54 -0.67 \n30% 9.97 -0.48 \n40% 9.54 -0.38 \n50% 9.18 -0.33 \n60% 8.87 -0.30 \n70% 8.58 -0.28 \n80% 8.30 -0.26", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:822", "doc_id": "746285cd9b560f69a4c7ac6e17d1889d63033f973d651641b4d1db2b742c591f", "chunk_index": 0}
{"text": "Chapter 37: How VolatHity Afleds Popular Strategies 769 \nvolatility decreases. Again, these statements may seem contrary to what one would \nexpect from abullish call position. \nOf course, it'shighly unlikely that implied volatility would change much in the \ncourse of just one day while the stock price remained unchanged. So, to get abet\nter handle on what to expect, one really to needs to look at what might happen at \nsome future time (say acouple of weeks hence) at various stock prices. The graph \nin Figure 37-3 begins the investigation of these more complex scenarios. \nThe profit curve shown in Figure 37-3 makes certain assumptions: (1) The bull \nspread assumes the details in Assumption Set 1, above; (2) the spread was bought \nwith an implied volatility of 20% and remained at that level when the profit picture \nabove was drawn; and (3) 30 days have passed since the spread was bought. Under \nthese assumptions, the profit graph shows that the bull spread conforms quite well to \nwhat one would expect; that is, the shape of this curve is pretty much like that of abull spread at expiration, although if you look closely you'll see that it doesn'twiden \nout to nearly its maximum gain or loss potential until the stock is well above llO or \nbelow 90 the strike prices used in the spread. \nNow observe what happens if one keeps all the other assumptions the same, \nexcept one. In this case, assume implied volatility was 80% at purchase and remains \nat 80% one month later. The comparison is shown in Figure 37-4. The 80% curve is \noverlaid on top of the 20% curve shown earlier. The contrast is quite startling. \nInstead of looking like abull spread, the profit curve that uses 80% implied volatili-\nFIGURE 37-3. \nBull spread profit picture in 30 days, at 20% IV. \n1000 \n500 \n<J) \n<J) \n0 0 ...J \n?i:: 70 80 90 100 110 120 130 140 \nea. \n\"' -500 \nStock Price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:823", "doc_id": "57de8448fe59b5d2d2db5fa650838cda9784ec0aaafc339fc5893ca6c52268d4", "chunk_index": 0}
{"text": "770 Part VI: Measuring and Trading Volatility \nFIGURE 37-4. \nBull spread profit picture in 30 days. \n1000 \n500 \niv=80% \n(/) \n(/) \n0 \n0 -' :;:, \n70 801 90 e \n~ \na. \nfl'> \n-500 \n130 140 \niv= 20% \n-1000 Stock \nty is arather flat thing, sloping only slightly upward - and exhibiting far less risk and \nreward potential than its lower implied volatility counterpart. This points out anoth\ner important fact: For volatile stocks, one cannot expect a 4-rrwnth bull spread to \nexpand or contract much during the first rrwnth of life, even if the stock makes asub\nstantial rrwve. Longer-term spreads have even less movement. \nAs acorollary, note that if implied volatility shrinks while the stock rises, the \nprofit outlook will improve. Graphically, using Figure 37-4, if one'sprofit picture \nmoves from the 80% curve to the 20% curve on the right-hand side of the chart, that \nis apositive development. Of course, if the stock drops and the implied volatility \ndrops too, then one'slosses would be worse - witness the left-hand side of the graph \nin Figure 37-4. \nAgraph could be drawn that would incorporate other implied volatilities, but \nthat would be overkill. The profit graphs of the other spreads from Tables 37-6 or \n37-7 would lie between the two curves shown in Figure 37-4. \nIf this discussion had looked at bull spreads as put credit spreads instead of call \ndebit spreads, perhaps these conclusions would not have seemed so unusual. \nExperienced option traders already understand much of what has been shown here, \nbut less experienced traders may find this information to be different from what they \nexpected. \nSome general facts can be drawn about the bull spread strategy. Perhaps the \nmost important one is that, if used on avolatile stock, you won'tget much expansion \nin the spread even if the stock makes anice move upward in your favor. In fact, for", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:824", "doc_id": "4ffdc7d659750e71e0791500b0a342604f8c25864a84322426a0a26c6a3bb57b", "chunk_index": 0}
{"text": "Cbapter 37: How Volatility Affects Popular Strategies 771 \nhigh implied volatility situations, the bull spread won'texpand out to its maximum \nprice until expiration draws nigh. That can be frustrating and disappointing. \nOften, the bull spread is established because the option trader feels the options \nare \"too expensive\" and thus the spread strategy is away to cut down on the total \ndebit invested. However, the ultimate penalty paid is great. Consider the fact that, \nif the stock rose from 100 to 130 in 30 days, any reasonable four-month call pur\nchase (i.e., with astrike initially near the current stock price) would make anice \nprofit, while the bull spread barely ekes out a 5-point gain. To wit, the graph in \nFigure 37-5 compares the purchase of the at-the-money call with astriking price of \n100 and the 90-110 call bull spread, both having implied volatility of 80%. Quite \nclearly, the call purchase dominates to agreat extent on an upward move. Of course, \nthe call purchase does worse on the downside, but since these are bullish strategies, \none would have to assume that the trader had apositive outlook for the stock when \nthe position was established. Hence, what happens on the downside is not primary \nin his thinking. \nThe bull spread and the call purchase have opposite position vegas, too. That is, \narise in implied volatility will help the call purchase but will harm the bull spread \n( and vice versa). Thus, the call purchase and the bull spread are not very similar posi\ntions at all. \nIf one wants to use the bull spread to effectively reduce the cost of buying an \nexpensive at-the-money option, then at least make sure the striking prices are quite \nFIGURE 37-5. \nCall buy versus bull spread in 30 days; IV = 80%. \nCl) \n~ \n2500 \n2000 \n1500 \n1000 \ne 500 \nCl. \n-500 \n-1000 \nOutright Call Buy \nBull Spread \n---\n140 \nStock", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:825", "doc_id": "32c0a95572e7e3a9fc083e9b225bc1ef0c6dfd3c2a2041287f8e61158e65005e", "chunk_index": 0}
{"text": "772 Part VI: Measuring and Trading Volatility \nwide apart. That will allow for areasonable amount of price appreciation in the bull \nspread if the underlying rises in price. Also, one might want to consider establishing \nthe bull spread with striking prices that are both out-of-the-money. Then, if the stock \nrallies strongly, agreater percentage gain can be had by the spreader. Still, though, \nthe facts described above cannot be overcome; they can only possibly be mitigated \nby such actions. \nA FAMILIAR SCENARIO? \nOften, one may be deluded into thinking that the two positions are more similar than \nthey are. For example, one does some sort of analysis - it does not matter if it'sfun\ndamental or technical - and comes to aconclusion that the stock ( or futures contract \nor index) is ready for abullish move. Furthermore, he wants to use options to imple\nment his strategy. But, upon inspecting the actual market prices, he finds that the \noptions seem rather expensive. So, he thinks, \"Why not use abull spread instead? It \ncosts less and it'sbullish, too.\" \nFairly quickly, the underlying moves higher - agood prediction by the trader, \nand atimely one as well. If the move is aviolent one, especially in the futures mar\nket, implied volatility might increase as well. If you had bought calls, you'dbe ahappy \ncamper. But if you bought the bull spread, you are not only highly disappointed, but \nyou are now facing the prospect of having to hold the spread for several more weeks \n(perhaps months) before your spread widens out to anything even approaching the \nmaximum profit potential. \nSound familiar? Every option trader has probably done himself in with this line \nof thinking at one time or another. At least, now you know the reason why: High or \nincreasing implied volatility is not afriend of the bull spread, while it is afriendly ally \nof the outright call purchase. Somewhat surprisingly, many option traders don'treal\nize the difference between these two strategies, which they probably consider to be \nsomewhat similar in nature. \nSo, be careful when using bull spreads. If you really think acall option is too \nexpensive and want to reduce its cost, ti:ythis strategy: Buy the call and simultane\nously sell acredit put spread (bull spread) using slightly out-of-the-money puts. This \nstrategy reduces the call'snet cost and maintains upside potential (although it \nincreases downside risk, but at least it is still afixed risk). \nExample: With XYZ at 100, atrader is bullish and wants to buy the July 100 calls, \nwhich expire in two months. However, upon inspection, he finds that they are trad\ning at 10 - an implied volatility of 59%. He knows that, historically, the implied \nvolatility of this stock'soptions range from approximately 40% to 60%, so these are", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:826", "doc_id": "103a4ef7f7a83165c74af84b6daab97af4851b200a4664fddf337fe41eed08fd", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies 773 \nvery expensive options. If he buys them now and implied volatility returns to its \nmedian range near 50%, he will suffer from the decrease in implied volatility. \nAs apossible remedy, he considers selling an out-of-the-money put credit \nspread at the same time that he buys the calls. The credit from this spread will act as \nameans of reducing the net cost of the calls. If he'sright and the stock goes up, all \nwill be well. However, the introduction of the put spread into the mix has introduced \nsome additional downside risk. \nSuppose the following prices exist: \nXYZ: 100 \nJuly 100 call: 10 (as stated above) \nJuly 90 put: 5 \nJuly 80 put: 2 \nThe entire bullish position would now consist of the following: \nBuy 1 July 100 call at 1 0 \nBuy 1 July 80 put at 2 \nSell 1 July 90 put at 5 \nNet expenditure: 7 point debit (plus commission) \nFigure 37-6 shows the profitability, at expiration, of both the outright call pur\nchase and the bullish position constructed above. \nFIGURE 37-6. \nProfitability at expiration. \n2000 \nBullish Spread // \n/ \n1000 \n\"' \"' 0 ...J \n87 :!:: \nOutright Call Purchase \ne 0 \nC. 70 80 90 \n<Ft 100 /100 ,,....... ___ \n120 \n-1000 \nStock \n-2000", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:827", "doc_id": "26d1ec9a02acd043f39aaff4251d7dc5cd8b069124b7bdb3bd81b34fb4474e34", "chunk_index": 0}
{"text": "774 Part VI: Measuring and Trading Volatility \nFirst, one can see that the bullish spread position has atotal risk of 17 points, if \nX'YZ is below 80 (the lower striking price of the put spread) at expiration. That, of \ncourse, is more than the 10-point cost of the July 100 call by itself, but if one is using \natrading stop of any sort, he probably would not be at risk for the entire 17 points, \nsince he wouldn'thold on while the stock fell all the way to 80 and below. Note also \nthat the bullish spread position would have aloss of 10 points (the same as the call) \nat aprice of 87 for the common at expiration. Hence, the combined position actual\nly has less risk than the outright call purchase as long as XYZ is 87 or higher at expi\nration. Since one is supposedly bullish initially when establishing this strategy, it \nseems likely that he would figure the stock would be 87 or higher at expiration. · \nFigure 37-7 offers another comparison, that of the two positions after 30 days \nhave passed. Note that the spread position once again does better on the upside and \nworse on the downside. The crossover point between the two curves is at about aprice of95. That is, ifXYZ is above 95 in 30 days, the bullish spread position will out\nperform the call buy. \nOne final point should be made regarding the investment required. The out\nright call purchase requires an investment of $1,000 - the cost of the long call. The \nbullish spread position requires that $1,000, plus $700 for the spread (IO-point dif\nference in the strikes, less the 3-point credit received for selling the spread). That'satotal of $1,700, the risk of the bullish spread position. Hence, the rate of return might \nfavor the outright call purchase, depending on how far the stock rallies. \nFIGURE 37-7. \nResults of the two positions in 30 days. \nCl) \n_g \n:;::, \ne \nCl.. \n~ \n1000 \n-1000 \n-2000-\nSpread \n95 \n110 \nStock \n/ \nOutright Call Purchase \n120", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:828", "doc_id": "f32235085d68cf3ff9dbfcadc718fa1a4f944dd05e72f8f6e7980985d11d681c", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies 775 \nOverall, the bullish spread position is an attractive alternative to an outright call \npurchase, especially when the call is overpriced. The spread does risk agreater \namount of money if the underlying stock should collapse heavily. Still, if one is truly \nbullish, and if one employs areasonably tight downside stop on his entire position, \nthis spread can perform better than the outright purchase of an overpriced call. \nVERTICAL PUT SPREADS \nAlso of interest is the effect that implied volatility has on put spreads. One of the \nmore popular strategies involving puts is the sale of acredit spread - abull spread \nwith puts. Assume that astock is selling at 100, and one is going to sell aput with a \n110 strike and buy aput with a 90 strike. That is aput credit (bull) spread. Also \nassume that the options have four months of life remaining. (See Table 37-8.) \nOne would not rationally sell this credit spread if implied volatility were as low \nas 20%, because at that low level of volatility, the in-the-money December llO put is \ntrading for 10 dollars - parity - and thus would immediately be at risk of early \nassignment. But one can see that an increase in implied volatility increases the value \nof the spread. Now, if one had sold this spread to begin with, he would thus be los\ning money when implied volatility increased. This was proven with call bull spreads, \ntoo: They lose money when implied volatility increases. Conversely, of course, the \nput credit spread makes money when implied volatility decreases. \nWhat happens after thirty days have passed? Figure 37-8 shows just two cases \n- implied volatility at 30% and implied volatility at 80%. One can surmise that other \nlevels of implied volatility between 30% and 80% would have profit graphs that lie \nbetween the two shown in Figure 37-8. \nTABLE 37·8 \nImplied \nVolatility \n20% \n30% \n40% \n50% \n60% \n70% \n80% \n*Short option trading at parity \n90-110 \nPut Bull Spread \n(Theoretical Value) \n9.15 er* \n9.70 er \n10.12 er \n10.46 er \n10.78 er \n11.05 er \n11.33 er", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:829", "doc_id": "8bb5455014b3901faacca5306a9becf80d3e71b81a9d6a2711e9987958713940", "chunk_index": 0}
{"text": "174 Part VI: Measuring and Trading Volatility \nFirst, one can see that the bullish spread position has atotal risk of 17 points, if \nXYZ is below 80 (the lower striking price of the put spread) at expiration. That, of \ncourse, is more than the 10-point cost of the July 100 call by itself, but if one is using \natrading stop of any sort, he probably would not be at risk for the entire 17 points, \nsince he wouldn'thold on while the stock fell all the way to 80 and below. Note also \nthat the bullish spread position would have aloss of 10 points (the same as the call) \nat aprice of 87 for the common at expiration. Hence, the combined position actual\nly has less risk than the outright call purchase as long as XYZ is 87 or higher at expi\nration. Since one is supposedly bullish initially when establishing this strategy, it \nseems likely that he would figure the stock would be 87 or higher at expiration. \nFigure 37-7 offers another comparison, that of the two positions after 30 days \nhave passed. Note that the spread position once again does better on the upside and \nworse on the downside. The crossover point between the two curves is at about aprice of 95. That is, ifXYZ is above 95 in 30 days, the bullish spread position will out\nperform the call buy. \nOne final point should be made regarding the investment required. The out\nright call purchase requires an investment of $1,000 - the cost of the long call. The \nbullish spread position requires that $1,000, plus $700 for the spread (IO-point dif\nference in the strikes, less the 3-point credit received for selling the spread). That'satotal of $1,700, the risk of the bullish spread position. Hence, the rate of return might \nfavor the outright call purchase, depending on how far the stock rallies. \nFIGURE 37-7. \nResults of the two positions in 30 days. \n1000 \nen \nIll \n0 \n...J \nO 70 :;::, \n~ ... a. \nw \n-1000 \n-2000-\n80 \n95 \nBullish Spread \nStock \nSpread \n110 \n/ \n1/ \nOutright Call Purchase \n120", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:830", "doc_id": "a9a25efe8bfb22b86e5a0a0407e190f4f162f61f39bfd9b0f666fca4dcbe73a6", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies 775 \nOverall, the bullish spread position is an attractive alternative to an outright call \npurchase, especially when the call is overpriced. The spread does risk agreater \namount of money if the underlying stock should collapse heavily. Still, if one is truly \nbullish, and if one employs areasonably tight downside stop on his entire position, \nthis spread can perform better than the outright purchase of an overpriced call. \nVERTICAL PUT SPREADS \nAlso of interest is the effect that implied volatility has on put spreads. One of the \nmore popular strategies involving puts is the sale of acredit spread - abull spread \nwith puts. Assume that astock is selling at 100, and one is going to sell aput with a \n110 strike and buy aput with a 90 strike. That is aput credit (bull) spread. Also \nassume that the options have four months of life remaining. (See Table 37-8.) \nOne would not rationally sell this credit spread if implied volatility were as low \nas 20%, because at that low level of volatility, the in-the-money December llO put is \ntrading for 10 dollars - parity - and thus would immediately be at risk of early \nassignment. But one can see that an increase in implied volatility increases the value \nof the spread. Now, if one had sold this spread to begin with, he would thus be los\ning money when implied volatility increased. This was proven with call bull spreads, \ntoo: They lose money when implied volatility increases. Conversely, of course, the \nput credit spread makes money when implied volatility decreases. \nWhat happens after thirty days have passed? Figure 37-8 shows just two cases \n- implied volatility at 30% and implied volatility at 80%. One can surmise that other \nlevels of implied volatility between 30% and 80% would have profit graphs that lie \nbetween the two shown in Figure 37-8. \nTABLE 37-8 \nImplied \nVolatility \n20% \n30% \n40% \n50% \n60% \n70% \n80% \n*Short option trading at parity \n90-110 \nPut Bull Spread \n(Theoretical Value) \n9.15 er* \n9.70 er \n10. 12 er \n10.46 er \n10.78 er \n11.05 er \n11.33 er", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:831", "doc_id": "48fb66b0f5bfa99e7013cfaab7cd6e3227cf834e663cf4786c56b4c20c8fe078", "chunk_index": 0}
{"text": "776 \nFIGURE 37-8. \nPut credit (bull) spread profit in 30 days. \n1000 \n500 \n- 1000 _ _,±8± \nAssignment Risk Area \nIV=30% \nStock \nPart VI: Measuring and Trading Volatility \n-~ \nIV= 30% \n130 140 \nFirst, one can observe that abull put spread does not widen out to anywhere \nnear its maximum potential if implied volatility increases. The same thing was seen \nwith the call bull spread in the previous section. But aput bull spreader is caught in \nanother trap: If implied volatility falls and the stock falls too, the risk of early assign\nment materializes quicky. Note the shaded area at the lower left of the graph, extend\ning from aprice of about 94 on down. After thirty days (so there would be three \nmonths life remaining at that point in time), if implied volatility is 30%, the 110 put \n(the short put) would be trading at parity for stock prices of 94 and below. Thus, it \nwould be at risk of early assignment. If implied volatility were even lower, the puts \nwould be at parity for much higher stock prices. \nNow, in and of itself, early assignment on an equity or futures put spread is not \nnecessarily aterrible thing. There will be arequest for additional margin (because \nthe stock has to be paid for or the futures contract margined), but the risk is still the \nsame in dollar terms. Of course, the request for extra margin could be backbreaking \nfor astock trader if he can'tafford to fully pay for the stock, and the early assignment \nwould probably incur additional commission costs, too. However, with cash-based \nindex options there is amore serious increase in risk after an early assignment, \nbecause one is left with only the long side of the spread. If that option happens to \nhave substantial value, then there is considerable risk if the underlying should quick\nly move higher. In fact, by the time one unwinds the spread, he might actually end \nup losing more than his original limited risk amount - all due to the early assignment. \n(This could happen if the underlying first plunges in price, placing both options", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:832", "doc_id": "eccac672faf7c486ef652227afe2c8afb82369b3f7909704907c3d814d78b4fa", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies 777 \ndeeply in-the-money, after which one gets assigned on the short put option, followed \nby the underlying then dramatically rising in price.) \nThe lesson to be learned is this: If one is considering using bull spreads in which \nat least one of the options is at- or in-the-rrwney, then acall bull spread is asuperior \nchoice over aput bull spread. Early assignment is not really aconsideration for most \ncall spreads. \nIn both cases, however, amore serious problem exists, and that is that the \nspread does not widen out much even when the stock makes anice bullish move. \nThus, once again it is actually better to buy acall option in most cases than to use the \nbull spread, because profits are larger and an increase in implied volatility is afavor\nable thing for an outright call buyer. \nNote that these effects are similar, but much less pronounced, for out-of-the\nmoney put credit spreads. Still, it should be noted that an increase in implied volatil\nity will harm an out-of-the-money put credit spread, too. Hence, if the underlying \ngoes into arapid fall (crash, plunge), then implied volatility usually increases quickly \nand dramatically. So an out-of-the-money credit spreader is hit with the double \nwhammy of expanding implied volatility and the fact that the underlying is fast \napproaching the strike price of his options, . thereby expanding the price of the \nspread. \nPUT BEAR SPREADS \nWhat about the put spread in abearish situation? In avertical put spread one buys \nthe put with the higher strike and sells the put with the lower strike to construct asimple put bear spread. Actually, asudden increase in implied volatility is of help to \nthe bear put spread. That is, the spread will widen out slightly. To verify this, look at \nTable 37-8 again, only now imagine that one is buying the spread for adebit. Note \nthat the smallest debit is at the lower implied volatility- 9.15 debit with IV at 30%. \nIf implied volatility were to instantaneously jump to 80%, the spread would widen \nout to 11.33 debit. Avery quick profit could be had. So there'sadifference right away \nbetween adebit call bull spread (which loses money when implied volatility sudden\nly increases) and adebit put bear spread. \nUnfortunately, the other major drawback - that the spread doesn'twiden out \nmuch if the underlying makes afavorable move - is still true. Figure 37-9 shows abear put spread, 30 days hence, for two different implied volatilities. Once again, the \nlower-volatility spread widens out more quickly, because both options tend to go to \nparity in that case. In fact, one can see on the graph that there is early assignment \nrisk in the low-volatility case, below aprice of about 77 on the stock. That is not a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:833", "doc_id": "780815d5075a6e283e652c32b3890c9303f17fcc2f4119a532baca3500672104", "chunk_index": 0}
{"text": "778 Part VI: Measuring and Trading Volatility \nFIGURE 37-9. \nBear put spread profit in 30 days. \n1000 IV= 30% \nAssignment \nRisk \nArea \n(/) \n(/) \n0 \n...J \n~ 0 \ne 70 80 110 120 130 140 \na. \nff7 \nIV= 80% \n-1000 \n'~ \nStock \nproblem, though, since the spread would have widened to its maximum potential in \nthat case and could just be removed when the risk of early assignment materialized. \nWhen implied volatility remains high, though, the spread doesn'twiden out \nmuch, even when the stock drops alot after 30 days. Since it is common for implied \nvolatility to rise (even skyrocket) when the underlying drops quickly, the put bear \nspread probably won'twiden out much. That may not be apsychologically pleasing \nstrategy, because one won'tmake the level of profits that he had hoped to when the \nunderlying fell quickly. \nOnce again, it seems that the outright purchase of an option is probably superi\nor to aspread. In these cases, it is true with respect to puts, much as it was with call \noptions. Spreading often unnecessarily complicates atrader'soutlook. \nCALENDAR SPREADS \nIn the earlier chapter on calendar spreads, it was mentioned that an increase in \nimplied volatility will cause acalendar spread to widen out. Both options will become \nmore expensive, of course, since the increase in implied volatility affects both of \nthem, but the absolute price change will be greatest in the long-term option. \nTherefore, the calendar spread will widen. This may seem somewhat counterintu\nitive, especially where highly volatile stocks are concerned, so some examples may \nprove useful.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:834", "doc_id": "f71eba82334e7d6e1c63aa5479624420386c00bf63e62420b79a2ed99fa48ee3", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies 779 \nExample: Suppose that XYZ is trading at 100, and one is interested in acalendar \nspread in which an August (5-month) call is bought and a May (2-month) call is sold. \nFor the purpose of this example, it will be assumed that these are both at-the-money \noptions. First, the vegas of the two options will be examined, assuming that implied \nvolatility is 40%: \nStock: 100 \nImplied Volatility: \n40% Option \nSell May 100 call \nBuy August 1 00 call \nTheoretical Price \n6.91 \n11.22 \nVega \n0.162 \n0.251 \nIn theory, this spread should be worth 4.31 - the difference in the theoretical \nvalues. Perhaps more important, it has volatility exposure of 0.089 - the difference \nbetween the vega of the long call and that of the short call. Since vega is positive, this \nmeans that an increase in implied volatility will be beneficial to the spread. In other \nwords, one can expect the spread to widen if implied volatility rises, and can expect \nthe spread to shrink if implied volatility declines. \nThe following table can also be constructed, showing the theoretical value of \nthe spread at various levels of implied volatility. This table makes the assumption that \nvery little time has passed ( only one week) before the implied volatility changes take \nplace. It also assumes that the stock is still at 100. \nStock Price: 100 \nOne week ofter the spread hos been established: \nImplied Volatility Theoretical Spread Value \n20% 2.58 \n30% 3.52 \n40% 4.46 \n50% 5.40 \n60% 6.33 \n80% 8.16 \n100% 12.92 \nFrom the above data, it is quite obvious that implied volatility levels have ahuge \neffect on the value of acalendar spread. The actual initial contribution of time decay \nis rather small in comparison. For example, note that if volatility remains unchanged \nat 40%, then the spread will have widened only slightly - to 4.46 from 4.31 - after \nthe passage of one week'stime. That is small in comparison to the changes dictated \nby volatility expansion or contraction.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:835", "doc_id": "bf27a9225f084a25d27ccc0ddd1378cf32ece539c3365a8dce21b4af8b46f167", "chunk_index": 0}
{"text": "780 Part VI: Measuring and Trading Volatility \nAcommon mistake that calendar spreaders make is to think that such aspread \nlooks overly attractive on avery volatile stock. Consider the same stock as above, still \ntrading at 100, but for some reason implied volatility has skyrocketed to 80% (per\nhaps atakeover rumor is present). \nStock: JOO \nImplied Volatility: 80% \nColl \nMay 100 call \nJune 100 call \nTheoretical Value \n12.55 \n16.81 \nOn the surface, this seems like avery attractive spread. There are two months \nof life remaining in the May options (and three months in the Junes) and the spread \nis trading at 4.36. However, both options are completely composed of time value \npremium, and most certainly the June 100 call would be worth far more than 4.36 \nwhen the May expires, if the stock is still near 100. The fact that many traders miss \nwhen they think of the calendar spread this way is that the June call will only be \nworth \"far more than 4.36\" if implied volatility holds up. If implied volatility for this \nstock is normally something on the order of 40%, say, then it is probably not reason\nable to expect that the 80% level will hold up. Just for comparison, note that if the \nstock is at 100 at May expiration - the maximum profit potential for such acalendar \nspread - the June 100 call, with implied volatility now at 40%, and with one month \nof life remaining, would be worth only 4. 77. Thus the spread would only have made \naprofit of afew cents (4.36 to 4.77), and if the underlying stock were farther from \nthe strike price at expiration, there would probably be aloss rather than aprofit. \nThe point to be remembered is that acalendar spread is a \"long volatility\" play \n(and areverse calendar spread is just the opposite). Evaluate the position'srisk with \nan eye to what might happen to implied volatility, and not just to where the stock \nprice might go or how much time decay there might be in the position. \nRATIO SPREADS AND BACKSPREADS \nThe previous descriptions in this chapter describe fairly fully and accurately what \nthe effect of volatility changes are. More complicated strategies are usually nothing \nmore than combinations of the strategies presented earlier, so it is easy to discern \nthe effect that changes in implied volatility would have; just combine the effects on \nthe simpler strategies. For example, aratio call write is really just the equivalent of \nastraddle sale - astrategy whose volatility ramifications are fairly simple to under\nstand. \nRatio spreads, on the other hand, might not be as intuitive to interpret, but they \nare fairly simple nonetheless. Acall ratio spread is really just the combination of some", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:836", "doc_id": "9773b3eed4b69e749eb666f573910ddb0f508f6c691e425a0ac43428b73fb82d", "chunk_index": 0}
{"text": "Chapter 37: How Volatility Affects Popular Strategies 781 \ncall bull spreads and some naked call options. For example, acall ratio spread might \nconsist of buying an XYZ July 100 call and selling two XYZ July 120 calls. If one were \nto break it down into its components, this spread is really long one XYZ July 100-120 \ncall bull spread, plus an additional naked July 120 call. \nWe already know that an increase in implied volatility is very detrimental to anaked call option. In addition, it was shown earlier than an increase in implied volatil\nity actually harms the value of an at-the-money call bull spread. So, for aratio call \nspread, both components are harmed by an increase in implied volatility. Conversely, \nadecrease in implied volatility would be beneficial to aratio spread, but where naked \noptions are concerned, one should be more mindful of his risk than of this reward. \nIt was also shown previously that acall bull spread does not widen out much if \nthe underlying stock makes aquick upward move. The spread won'twiden out to its \nmaximum profit potential until expiration draws nigh or the stock is well above the \nupper strike in the spread. This scenario also does not bode well for the ratio call \nspread. Suppose that the underlying stock suddenly jumps upward and implied \nvolatility increases at the same time. That combination is seen quite frequently, espe\ncially if the stock were previously \"dull\" or if there is some sort of active corporate \n(takeover) rumor. The call ratio spread will fare miserably under these conditions, \nbecause the increase in stock price certainly harms the naked call position and the \nbull spread is not widening out much to compensate for it. In addition, the increase \nin implied volatility is working against both components. \nThe same sort of thing happens with put ratio spreads. They are really the com\nbination of aput bear spread plus some additional naked put options. If the under\nlying falls in price, while implied volatility increases - avery common occurrence in \nall markets then the put ratio spread will fare poorly. In fact, implied volatility \nsometimes explodes if the underlying falls very rapidly (crashes), so the ratio put \nspreader should clearly assess his risk in this light. \nIn summary, atrader utilizing ratio spread strategies should clearly understand \nand attempt to analyze the risks of an increase in implied volatility. This includes not \nonly assessing the vega risk of the spread, but also using aprobability calculator with \nsome inflated volatility estimates to see just what the chances are of the spread get\nting into real trouble. \nBACKSPREADS \nAcall backspread is merely the opposite of acall ratio spread. Thus, any of the earli\ner commentary about how an increase in implied volatility is detrimental to aratio \nspread can be reversed when discussing the backspread. An increase in implied \nvolatility will be beneficial to abackspread strategy, while adecrease in implied", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:837", "doc_id": "90acf10804d5466b3d967f6a934f0fda3b306149567b4f3705a9d8b620d27363", "chunk_index": 0}
{"text": "782 Part VI: Measuring and Trading Volatility \nvolatility will be slightly harmful to the spread. However, since risk is limited in abackspread, such adecrease in implied volatility would not have catastrophic conse\nquences unless one had overcommitted his funds to one position. \nSUMMARY \nIn general, one can always determine the exposure of his position to volatility by com\nputing the vega of this position. However, it is also useful for astrategist to have some \ngeneral feeling for how implied volatility will affect his positions and strategies. Thus, \nthis chapter was designed to point out the most common effects that changes .in \nimplied volatility will have on the basic types of option strategies. Once one has afeeling for his exposure to volatility, he can then assess whether an adverse volatility \nmovement is likely. For example, if an increase in implied volatility would be harm\nful, and the strategist sees that current levels of implied volatility are quite low in \ncomparison to historical norms, then perhaps he should remove or adjust the posi\ntion. \nVolatility and the price of the underlying are the two major components \naffecting profitability for most option positions. Time decay is only most pertinent \nas expiration approaches. Yet, many traders concentrate greatly on potential price \nmovements of the underlying, often while ignoring what changes in implied volatil\nity could do. That is amistake, for the most knowledgeable option traders plan for \nvolatility risk at all times. Understanding and handling that risk can have apositive \neffect on an option trader'sprofits.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:838", "doc_id": "a0d4688ede9f8495ab20a2d338f02cd1db3e93215a6d9bf8cf68e0d6d430be47", "chunk_index": 0}
{"text": "The Distribution of \nStock Prices \nMuch of the work that has been done in statistics and related areas regarding the \nstock market has made the assumption that stock prices are distributed normally, or \nmore specifically, lognonnally. In actual practice, this is usually an incorrect assump\ntion. For the option strategist, this means that some of the things one might believe \nabout certain option strategies having an advantage over certain other option strate\ngies might be incorrect. In this chapter, anumber of facts concerning stock price dis\ntribution will be brought to light, including how it might affect the option strategist. \nMISCONCEPTIONS ABOUT VOLATILITY \nStatistics are used to estimate stock price movement (and futures and indices as well) \nin many areas of financial analysis. Many authors have written extensively about the \nuse of probabilities to aid in choosing viable option strategies. Stock mutual fund \nmanagers often use volatility estimates to help them determine how risky their port\nfolios are. The uses are myriad. Unfortunately, almost all of these applications are \nwrong! Perhaps wrong is too strong aword, but almost all estimates of stock price \nmovement are overly conservative. This can be very dangerous if one is using such \nestimates for the purposes of, say, writing naked options or engaging in some other \nsuch strategy in which volatile stock price movement is undesirable. \nAs areview for those not familiar with mathematical distributions, the lognor\nmal distribution is what'scommonly used to describe stock prices because its shape \nis intuitively similar to the way stocks behave - they can'tgo below zero, they can rise \nto infinity, and most of the time they don'tgo much of anywhere. On top of that, the \ndistribution'sshape is based on the historical volatility of the underlying instrument. \nIn alognormal distribution (and normal distribution, too), stocks remain within 3 \nstandard deviations of their current price 99. 7 4% of the time. Astandard deviation \n783", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:839", "doc_id": "2507c3058a6a48ef0b7abc34e215b7eccb1a8bcfb3314354669f0d285cda2d74", "chunk_index": 0}
{"text": "788 Part VI: Measuring and Trading VolatiDty \nally including gap moves. There are not always gap moves, though, over astudy of \nthis length. Sometimes, there will be amore gradual transition. Consider the fact that \none of the stocks in the study moved 5.8 sigma in the 30 days. There weren'tany huge \ngaps during that time, but anyone who was short calls while the stock made its run \nsurely didn'tthink it was agradual advance. \nSo, what does this information mean to the average option trader? For one, \nyou should certainly think twice about selling stock options in apotentially volatile \nmarket ( or any market, for that matter, since these large moves are not by any means \nlimited to the volatile market periods). This statement encompasses naked option \nselling, but also includes many forms of option selling, because of the possibilities of \nlarge moves by the underlying stocks. \nFor example, covered call writing is considered to be \"conservative.\" However, \nwhen the stock has the potential to make these big moves, it will either cause one to \ngive up large upside profits or to suffer large downside losses. ( Covered call writing \nhas limited profit potential and relatively large downside risk, as does its equivalent \nstrategy, naked put selling.) When these large stock moves occur on the upside, acov\nered writer is often disappointed that he gave up too much of the upside profit poten\ntial. Conversely, if the stock drops quickly, and one is assigned on his naked put, he \noften no longer has much appetite for acquiring the stock ( even though he said he \n\"wouldn'tmind\" doing so when he sold the puts to begin with). \nEven spreading has problems along these lines. For example, avertical spread \nlimits profits so that one can'tparticipate in these relatively frequent large stock \nmoves when they occur. \nWhat can an option seller do? First, he must carefully analyze his position and \nallow for much larger stock movements than one would expect under the lognormal \ndistribution. Also, he must be careful to sell options only when they are expensive in \nterms of implied volatility, so that any decrease in implied will work in his favor. \nProbably most judicious, though, is that an option seller should really concentrate on \nindices (or perhaps certain futures contracts), because they are statistically much less \nvolatile than stocks. Hard as it is to believe, futures are less volatile than stocks \n(although the leverage available in futures can make them ariskier investment overall). \nTwo 30-day studies, similar to those conducted on stocks, were run on option\nable indices, covering the same time periods: 10/22/99 to 12/7/99 for one study and \n7/1/93 to 8/17/93 for the other. The results are shown in Tables 38-5 and 38-6. This \nmay be asomewhat distorted picture, though, because many of these indices overlap \n(there are four Internet indices, for example). The largest mover was the Morgan \nStanley High-Tech Index (5 standard deviations), but it should also be noted that \nsomething that is considered fairly tame, such as the Russell 2000 ($RUT), also had \na 3-standard deviation move in one study. The first study showed that 37% of the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:844", "doc_id": "aef6cc52bbd055fc721162222066664d31ec746411e92d5aba202290ba19c6f3", "chunk_index": 0}
{"text": "Chapter 38: The Distribution of Stock Prices 795 \nFigure 38-3 perhaps shows even more starkly how the bull market has affected \nthings over the last six-plus years. There are over 1,600 data points for IBM (i.e., daily \nreadings) in Figure 38-3, yet the whole distribution is skewed to the right. It appar\nently was able to move up quite easily throughout this time period. In fact, the worst \nmove that occurred was one move of -2.5 standard deviations, while there were \nabout ten moves of +4.0 standard deviations or more. \nFor alonger-term look at how IBM behaves, consider the longer-term distribu\ntion of IBM prices, going back to March 1987, as shown in Figure 38-4. \nFrom Figure 38-4, it'sclear that this longer-term distribution conforms more \nclosely to the normal distribution in that it has asort of symmetrical look, as opposed \nto Figure 38-3, which is clearly biased to the right (upside). \nThese two graphs have implications for the big picture study shown in Figure \n38-1. The database used for this study had data for most stocks only going back to \n1993 (IBM is one of the exceptions); but if the broad study of all stocks were run \nusing data all the way back to 1987, it is certain that the \"actual\" price distribution \nwould be more evenly centered, as opposed to its justification to the right (upside). \nThat'sbecause there would be more bearish periods in the longer study (1987, 1989, \nand 1990 all had some rather nasty periods). Still, this doesn'tdetract from the basic \npremise that stocks can move farther than the normal distribution would indicate. \nWHAT THIS MEANS FOR OPTION TRADERS \nThe most obvious thing that an option trader can learn from these distributions and \nstudies is that buying options is probably alot more feasible than conventional wisdom \nwould have you believe. The old thinking that selling an option is \"best\" because it \nwastes away every day is false. In reality, when you have sold an option, you are exposed \nto adverse price movements and adverse movements in implied volatility all during the \nlife of the option. The likelihood of those occurring is great, and they generally have \nmore influence on the price of the aption in the short run than does time decay. \nYou might ask, \"But doesn'tall the volatility in 1999 and 2000 just distort the \nfigures, making the big moves more likely than they ever were, and possibly ever will \nbe again?\" The answer to that is aresounding, \"Nol\" The reason is that the current \n20-day historical volatility was used on each day of the study in order to determine \nhow many standard deviations each stock moved. So, in 1999 and 2000, that histori\ncal volatility was ahigh number and it therefore means that the stock would have had \nto move avery long way to move four standard deviations. In 1993, however, when \nthe market was in the doldrums, historical volatility was low, and so amuch smaller", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:851", "doc_id": "09253c9b40b68f9f1dd90295df66b4bfdece6cbe6561e7414d5ce1e6e9ff8354", "chunk_index": 0}
{"text": "Chapter 38: The Distribution of Stock Prices 195 \nFigure 38-3 perhaps shows even more starkly how the bull market has affected \nthings over the last six-plus years. There are over 1,600 data points for IBM (i.e., daily \nreadings) in Figure 38-3, yet the whole distribution is skewed to the right. It appar\nently was able to move up quite easily throughout this time period. In fact, the worst \nmove that occurred was one move of -2.5 standard deviations, while there were \nabout ten moves of +4.0 standard deviations or more. \nFor alonger-term look at how IBM behaves, consider the longer-term distribu\ntion of IBM prices, going back to March 1987, as shown in Figure 38-4. \nFrom Figure 38-4, it'sclear that this longer-term distribution conforms more \nclosely to the normal distribution in that it has asort of symmetrical look, as opposed \nto Figure 38-3, which is clearly biased to the right (upside). \nThese two graphs have implications for the big picture study shown in Figure \n38-1. The database used for this study had data for most stocks only going back to \n1993 (IBM is one of the exceptions); but if the broad study of all stocks were run \nusing data all the way back to 1987, it is certain that the \"actual\" price distribution \nwould be more evenly centered, as opposed to its justification to the right (upside). \nThat'sbecause there would be more bearish periods in the longer study (1987, 1989, \nand 1990 all had some rather nasty periods). Still, this doesn'tdetract from the basic \npremise that stocks can move farther than the normal distribution would indicate. \nWHAT THIS MEANS FOR OPTION TRADERS \nThe most obvious thing that an option trader can learn from these distributions and \nstudies is that buying options is probably alot more feasible than conventional wisdom \nwould have you believe. The old thinking that selling an option is \"best\" because it \nwastes away every day is false. In reality, when you have sold an option, you are exposed \nto adverse price movements and adverse movements in implied volatility all during the \nlife of the option. The likelihood of those occurring is great, and they generally have \nmore influence on the price of the option in the short run than does time decay. \nYou might ask, \"But doesn'tall the volatility in 1999 and 2000 just distort the \nfigures, making the big moves more likely than they ever were, and possibly ever will \nbe again?\" The answer to that is aresounding, \"Nol\" The reason is that the current \n20-day historical volatility was used on each day of the study in order to determine \nhow many standard deviations each stock moved. So, in 1999 and 2000, that histori\ncal volatility was ahigh number and it therefore means that the stock would have had \nto move avery long way to move four standard deviations. In 1993, however, when \nthe market was in the doldrums, historical volatility was low, and so amuch smaller", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:853", "doc_id": "83d3642a0f8e6e67c567942995d0a00dbffe4b693e1982d303e74000064bd244", "chunk_index": 0}
{"text": "796 Part VI: Measuring and Trading Volatility \nmove was needed to register a 4-standard deviation move. To see aspecific example \nof how this works in actual practice, look carefully at the chart of IBM in Figure 38-\n4, the one that encompasses the crash of '87. Don'tyou think it'salittle strange that \nthe chart doesn'tshow any moves of greater than minus 4.0 standard deviations? The \nreason is that IBM'shistorical volatility had already increased so much in the days \npreceding the crash day itself, that when IBM fell on the day of the crash, its move \nwas less than minus 4.0 standard deviations. (Actually, its one-day move was greater \nthan -4 standard deviations, but the 30-day move - which is what the graphs in Figure \n38-3 and 38-4 depict - was not.) \nSTOCK PRICE DISTRIBUTION SUMMARY \nOne can say with agreat deal of certainty that stocks do not conform to the normal \ndistribution. Actually, the normal distribution is adecent approximation of stock \nprice movement rrwst of the time, but it'sthese \"outlying\" results that can hurt any\none using it as abasis for anonvolatility strategy. \nScientists working on chaos theo:ry have been trying to get abetter handle on \nthis. An article in Scientific American magazine (\"A Fractal Walk Down Wall Street,\" \nFebrua:ry 1999 issue) met some criticism from followers of Elliot Wave theo:ry, in that \nthey claim the article'sauthor is purporting to have \"invented\" things that R. N. \nElliott discovered years ago. Idon'tknow about that, but Ido know that the article \naddresses these same points in more detail. In the article, the author points out that \nchaos theo:ry was applied to the prediction of earthquakes. Essentially, it concluded \nthat earthquakes can'tbe predicted. Is this therefore auseless analysis? No, says the \nauthor. It means that humans should concentrate on building stronger buildings that \ncan withstand the earthquakes, for no one can predict when they may occur. Relating \nthis to the option market, this means that one should concentrate on building strate\ngies that can withstand the chaotic movements that occasionally occur, since chaotic \nstock price behavior can'tbe predicted either. \nIt is important that option traders, above all people, understand the risks of \nmaking too conservative an estimate of stock price movement. These risks are espe\ncially great for the writer of an option (and that includes covered writers and spread\ners, who may be giving away too much upside by writing acall against long stock or \nlong calls). By quantifying past stock price movements, as has been done in this chap\nter, my aim is to convince you that \"conventional\" assumptions are not good enough \nfor your analyses. This doesn'tmean that it'sokay to buy overpriced options just \nbecause stocks can make large moves with agreater frequency than most option", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:854", "doc_id": "0c5e7e93e80478e25b57300c44ca511ce28ccb07f7d506820955831f83531d4d", "chunk_index": 0}
{"text": "Chapter 38: The Distribution of Stock Prices 797 \nmodels predict; but it certainly means that the buyer of underpriced options stands \nto benefit in acouple of ways. Conversely, an option seller must certainly concentrate \nhis efforts where options are expensive, and even then should be acutely aware that \nhe may experience larger-than-expected stock price movements while the option \nposition is in place. \nSo what does this mean for option strategies? On the surface, it means that if \none uses the normal (or lognormal) distribution for estimating the probability of astrategy'ssuccess, he may get abig move in the stock that he didn'toriginally view as \npossible. If one were long straddles, that'sgreat. However, if he is short naked \noptions, then there could be anasty surprise in store. That'sone reason why extreme \ncaution should be used regarding selling naked options on stocks; they can make \nmoves of this sort too often. At least with indices, such moves are far less frequent, \nalthough the Dow drop of over 550 points in October 1997 was amove of seven stan\ndard deviations, and the crash of '87 was about a 16-standard deviation move - which \nProfessor Mark Rubenstein of the University of California at Berkeley says was some\nthing that should occur about once in ten times the life of our current universe! That'saccording to lognormal distribution, of course, which we know understates things \nsomewhat, but it'sstill abig number under any distribution. \nThere are two approaches that one can take, then, regarding option strategies. \nOne is to invent another method for estimating stock price distributions. Suffice it to \nsay that that is not an easy task, or someone would have made it well-known already. \nThere have been many attempts, including some in which alarge history of stock \nprice movements is observed and then adistribution is fitted to them. The problem \nwith accounting for these occasional large price moves is that it is perhaps an even \nmore grievous error to overestimate the probabilities of such moves than to underes\ntimate them. \nThe second approach is to continue to use the normal distribution, because it'sfast and accessible in alot of places. Then, either rely on option buying strategies \n( straddles, for example) where implied volatility appears to be low - knowing that you \nhave achance at better results than the statistics might indicate - or adjust your cal\nculations mentally for these large potential movements if you are using option selling \nstrategies. \nTHE PRICING OF OPTIONS \nThe extreme movements of the fat tail distribution should be figured into the pricing \nof an option, but they really are not, at least not by most models. The Black-Scholes", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:855", "doc_id": "ec3af725928ea9b07b33106d6a1d5a4cda6c1670c3f9db2552622493138a5465", "chunk_index": 0}
{"text": "798 Part VI: Measuring and Trading Volatility \nmodel, for example, uses alognormal distribution. Personally, this author believes \nthat the Black-Scholes model is an excellent tool for analyzing options and option \nstrategies, but one must understand that it may not be affording enough probability \nto large moves by the underlying. \nDoes this mean that most options are underpriced, since traders and market\nmakers are using the Black-Scholes model (or similar models) to price them? \nWithout getting too technical, the answer is that yes, some options - particularly out\nof-the-money options - are probably underpriced. However, one must understand \nthat it is still arelatively rare occurrence to experience one of these big moves - ifs \njust not as rare as the lognormal distribution would indicate. So, an out-of-the-money \noption might be slightly underpriced, but often not enough to make any real differ\nence. \nIn fact, futures options in grains, gold, oil, and other markets that often experi\nence large and sudden rallies display adistinct volatility skew. That is, out-of-the-money \ncall options trade at significantly higher implied volatilities than do at-the-money \noptions. Ironically, there is far less chance of one of these hyper-standard-deviation \nmoves occurring in commodities than there is in stocks, at least if history is aguide. So, \nthe fact that some out-of-the-money futures options are expensive is probably an incor\nrect overadjustment for the possibility of large moves. \nTHE PROBABILITY OF STOCK PRICE MOVEMENT \nThe distribution information introduced in this chapter can be incorporated into \nsomewhat rigorous methods of determining probabilities. That is, one can attempt to \nassess the chances of astock, futures contract, or index moving by agiven distance, \nand those chances can incorporate the fat tails or other non-lognormal behavior of \nprices. \nThe software that calculates such probabilities is typically named a \"probability \ncalculator.\" There are many such software programs available in the marketplace. \nThey range from free calculators to completely overpriced ones selling for more than \n$1,000. In reality, high-level probability calculation software can be created by some\none with agood understanding of statistics, or aprogram can be purchased for arather nominal fee - perhaps $100 or so. \nBefore getting into these various methods of probability estimation, it should be \nnoted that all of them require the trader to input avolatility estimate. There are only \nafew other inputs, usually the stock price, target price(s), and length of time of the \nstudy. The volatility one inputs is, of course, an estimate of future volatility - some-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:856", "doc_id": "45ce4c210a56f7693046d9e591d213a50ace7c33481e3175c345b2886f5219bc", "chunk_index": 0}
{"text": "Chapter 38: The Distribution of Stock Prices 799 \nthing that cannot be predicted with certainty. Nevertheless, any probability calcula\ntor requires this input. So, one must understand that the results one obtains from any \nof these probability calculators is an estimate of what might happen. It should not be \nrelied on as \"gospel.\" \nAdditionally, probability calculators make asecond assumption: that the volatil\nity one inputs will remain constant over the entire length of the study. We know this \nis incorrect, for volatility can change daily. However, there really isn'tagood way of \nestimating how volatility might change in the course of the study, so we are pretty \nmuch forced to live with this incorrect assumption as well. \nThere is no certain way to mitigate these volatility \"problems\" as far as the prob\nability calculator is concerned, but one helpful technique is to bias the volatility pro\njection against your objectives. That is, be overly conservative in your volatility pro\njections. If things tum out to be better than you estimated, fine. However, at least \nyou won'tbe overstating things initially. An example may help to demonstrate this \ntechnique. \nExample: Suppose that atrader is considering buying astraddle on XYZ. The five\nmonth straddle is selling for aprice of 8, with the stock currently trading near 40. Aprobability calculator will help him to determine the chances that XYZ can rise to 48 \nor fall to 32 (the break-even points) prior to the options' expiration. However, the \nprobability calculator'sanswer will depend heavily on the volatility estimate that the \ntrader plugs into the probability calculator. Suppose that the following information is \nknow about the historical volatility of XYZ: \nl 0-day historical volatility: \n20-day historical volatility: \n50-day historical volatility: \nl 00-day historical volatility \n22% \n20% \n28% \n33% \nWhich volatility should the trader use? Should he choose the 100-day historical \nvolatility since this is afive-month straddle, which encompasses just about 100 trad\ning days until expiration? Should he use the 20-day historical volatility, since that is \nthe \"generally accepted\" measure that most traders refer to? Should he calculate ahistorical volatility based exactly on the number of days until expiration and use that? \nTo be most conservative, none of those answers is right, at least not for the right \nreasons. Since one is buying options in this strategy, he should use the lowest of the \nabove historical volatility measures as his volatility estimate. By doing so, he is taking \naconservative approach. If the straddle buy looks good under this conservative \nassumption, then he can feel fairly certain that he has not overstated the possibilities", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:857", "doc_id": "c1c09dc1a1c30fecf60a85c3a42ffb14671721fcba28023a9c24f7e43b02f2a0", "chunk_index": 0}
{"text": "800 Part VI: Measuring and Trading Volatility \nof success. If it turns out that volatility is higher during the life of the position, that \nwill be an added benefit to this position consisting of long options. So, in this exam\nple, he should use the 20-day historical volatility because it is the lowest of the four \nchoices that he has. \nSimilarly, if one is considering the sale of options or is taking aposition with anegative vega ( one that will be harmed if volatility increases), then he should use the \nhighest historical volatility when making his probability projections. By so doing, he \nis again being conservative. If the strategy in question still looks good, even under an \nassumption of high volatility, then he can figure that he won'tbe unpleasantly sur\nprised by ahigher volatility during the life of the position. \nThere have been times when a 100-day lookback period was not sufficient for \ndetermining historical volatility. That is, the underlying has been performing in an \nerratic or unusual manner for over 100 days. In reality, its true nature is not described \nby its movements over the past 100 days. Some might say that 100 days is not enough \ntime to determine the historical volatility in any case, although most of the time the \nfour volatility measures shown above will be asufficient guide for volatility. \nWhen alonger lookback period is required, there is another method that can be \nused: Go back in ahistorical database of prices for the underlying and compute the \n20-day, 50-day, and l 00-day historic volatilities for all the time periods in the data\nbase, or at least during afairly large segment of the past prices. Then use the medi\nan of those calculations for your volatility estimates. \nExample: XYZ has been behaving erratically for several months, due to overall mar\nket volatility being high as well as to aseries of chaotic news events that have been \naffecting XYZ. Atrader wants to trade XYZ'soptions, but needs agood estimate of \nthe \"true\" volatility potential of XYZ, for he thinks that the news events are out of the \nway now. At the current time, the historical volatility readings are: \n20-day historical: 130% \n50-day historical l 00% \n100-day historical 80% \nHowever, when the trader looks farther back in XYZ'strading history, he sees \nthat it is not normally this volatile. Since he suspects that XYZ'srecent trading histo\nry is not typical of its true long-term performance, what volatility should he use in \neither an option model or aprobability calculator? \nRather than just using the maximum or minimum of the above three numbers \n(depending on whether one is buying or selling options), the trader decides to look", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:858", "doc_id": "54b4209c8896404280247e24ec5ae4955e505dfae634f98f7a7749c326913409", "chunk_index": 0}
{"text": "802 Part VI: Measuring and Trading Volatility \nUsing 1,000 days of data: \nMedian 100-day historical volatility: 48% \nMedian 50-day historical volatility: 49% \nMedian 20-day historical volatility: 52% \nMedian 10-day historical volatility: 49% \nIf these were all the data that one had, then he would probably use avolatility esti\nmate of 48% or so in his option models or probability calculators. Of course, this is \nstarkly different from the current levels of historical volatility (shown at the begin\nning of this example). So, one must be careful in assessing whether he expects the \nstock to perform more in line with its longer-term (1,000 trading days) characteristics \nor if there is some reason to think that the stock'sbehavior patterns have changed and \nthe higher, more recent volatilities should be used. \nThe pertinent volatilities to consider, then, in astrategy analysis are the medi\nans as well as the current figures. If the trader were going to be buying options in his \nstrategy, should he use the minimum of the volatilities shown, 48%? Probably. \nHowever, if he'saseller of options, should he use the maximum, 130%? That might \nbe alittle too much of apenalty, but at least he would feel safe that if his volatility \nselling position had apositive expected return with that high avolatility projection, \nthen it must truly be an attractive position. \nIn an analysis like that shown in this example, there is nothing magical about \nusing 1,000 trading days. Perhaps something like 600 trading days would be better. \nThe idea is to use enough trading days to bring in some historic data to counterbal\nance the recent, erratic behavior of the stock. \nAmong other things, this example also shows that volatilities are unstable, no \nmatter how much work and mathematics one puts into calculating them. Therefore, \nthey are at best afragile estimate of what might happen in the future. Still, it'sthe \nbest guess that one can make. The trader should realize, though, that when volatili\nties are this disparate when comparing recent and more distant activity, the results of \nany mathematical projections using those volatilities should not be relied upon too \nheavily. Those results will be just as tenuous as the volatility projections themselves. \nOf course, in any case, the actual volatility that occurs while the position is in place \nmay be even more unfavorable than the one the trader used in his initial analysis. There \nis nothing that one can do about that. But if you choose what appears to be asomewhat \nunfavorable volatility, and the position still looks good under those assumptions, then it \nis likely that the trader will be pleasantly surprised more often than not - that actual \nvolatility during the life of the position will tend to be more in his favor than not.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:860", "doc_id": "7901ea09bc4602338e29ce64cb8a1e11735fa1f44721b29de071e409e01565af", "chunk_index": 0}
{"text": "804 Part VI: Measuring and Trading Volatility \nIf one is interested in computing the probability of the stock being above the \ngiven price, the formula is \nP (above) = 1 - P (below) \nIn the above formula, Vt = v✓twhere tis time to expiration in years and vis \nannual volatility, as usual. \nThis formula is quite elementary for predictive purposes, and it is used by \nmany traders. This calculator can be found for free at the Web site www.option\nstrategist.com. Its main problem is that it gives the probability of the stock being \nabove or below the target price at the end of the time period, t. That'snot atotally \nrealistic way of approaching probability analysis. Most option traders are very con\ncerned with what happens to their positions during the life of the option, not just at \nexpiration. \nExample: suppose atrader is aseller of naked put options. He sells $OEX October \n550 puts naked, with $OEX currently trading at 600. He would not normally just walk \naway from this position until October expiration, because of the large risk involved \nwith the sale of anaked option. There are essentially three scenarios that can occur: \n1. $OEX might never fall to 550 by expiration. In this case, he would have avery comfortable trade that was never in jeopardy, and the options would \nexpire worthless. \n2. $OEX might fall below 550 and remain there until expiration. In this case, \nhe would surely have aloss unless $OEX were just atiny bit below 550. \n3. $OEX might fall below 550 at some time between when the trade was estab\nlished and when expiration occurred, but then subsequently rally back above \n550 by the time expiration arrived. \nAn experienced option trader would almost certainly adjust if scenario 3 arose, \nin order to prevent large losses from occurring. He might roll his naked puts down \nand out to another strike, or he might just close them out altogether. However, it is \nunlikely that he would do nothing. \nThe simple probability calculator formula shown above does not take into \naccount the trader'sthird scenario. Since it is only concerned with where the stock is \nat expiration of the options, only scenarios 1 and 2 apply to it. Hence the usage of this \nsimple calculator is not really descriptive of what might happen to atrade during its \nlifetime. \nLet'sassign some numbers to the above trade, so that you might see the differ\nence. Suppose that the volatility estimate is 25%, there are 30 days until expiration, \nand the prices are as stated in the previous example: $OEX is at 600, and the strik-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:862", "doc_id": "a0da87687bb9ffb7bd3ff1d220739e21543904e45a03c089e82391441dcaff99", "chunk_index": 0}
{"text": "Chapter 38: The Distribution of Stock Prices 805 \ning price of the naked put being sold is 550. The resulting probabilities might be \nsomething like this: \nScenario Actual Probability of Occurrence \n1 . $OEX never falls below 550 \n2. $OEX falls below 550 and remains there \n3. $OEX falls below 550 but rallies later \n67% \n19% \n14% \nThe probabilities stated above are the \"real\" probabilities of the three various \nscenarios occurring. However, if one were using the simple probability calculator \npresented above, he would only have the following information: \nProbability of $OEX being above 550 at expiration: 81 % \nProbability of $OEX being below 550 at expiration: 19% \nSo, with the simple calculator, it looks like there'san 81 % chance of aworry-free \ntrade. Just sit back and relax and let the option expire worthless. However, in real \nlife - as shown by the previous set of probabilities, there'sonly a 67% chance of aworry-free trade. The difference - the other 14% - is the probability of the third \nscenario occurring ($OEX falls below 550, but rallies back above it by expiration). \nThe simple probability calculator doesn'taccount for that scenario at all. \nHence, most serious traders don'tuse the simple model. Does that mean it'snot \nuseful at all? No, it is certainly viable as acomparative tool; for example, to compare \nthe chances of the $OEX put expiring worthless versus those of another put sale \nbeing considered, perhaps something in astock option. However, better analyses can \nbe undertaken. \nBefore leaving the scenario of the simple probability calculator, one more point \nshould be made. It has been mentioned earlier in this book that the delta of an option \nis actually afairly good estimate of the probability of the option being in-the-money \nat its expiration date. Thus, the delta and the simple endpoint probability calculator \nshown above attempt to convey the same information to atrader. In reality, because \nof the fact that implied volatility might be different for various strikes (avolatility \nskew), especially in index options, the delta of the option might not agree exactly with \nthe probability calculator. Even so, the delta is aquick and dirty way of estimating the \nprobability of the stock being above the strike price (in the case of call options) or \nbelow the strike price (in the case of put options) at expiration. \nTHE nEVER\" CALCULATOR \nHaving seen the frailties of the endpoint calculator, the next step is to try to design acalculator that can estimate the probability of the stock ever hitting the target price(s)", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:863", "doc_id": "3c242b3e98a25fc307403f02ff5e85dceaad4b0c918bea66d1dc16d3ebff1811", "chunk_index": 0}
{"text": "806 Part VI: Measuring and 1iading Vo/atillty \nat any time during the life of the probability study, usually the life of an option. It \nturns out that there are acouple of ways to approach this problem. One is with a \nMonte Carlo analysis, whereby one lets acomputer run alarge number of random\nly-generated scenarios (say, 100,000 or so) and counts the number of times the tar\nget price is hit. A Monte Carlo analysis is acompletely valid way of estimating the \nprobability of an event, but it is asomewhat complicated approach. \nIn reality, there is away to create asingle formula that can estimate the \"ever\" \nprobability, although it is not any easy task either. In the following discussion, Iam \nborrowing liberally from correspondence with Dr. Stewart Mayhew, Professor of \nMathematics at the University of Georgia. For proprietary reasons, the exact formu\nla is not given here, but the following description should be sufficient for amathe\nmatics or statistics major to encode it. If one is not interested in implementing the \nactual formula, the calculation can be obtained through programs sold by McMillan \nAnalysis Corp. at www.optionstrategist.com. \nThis discussion is quite technical, so readers not interested in the description of \nthe mathematics can skip the next paragraph and instead move ahead to the next sec\ntion on Monte Carlo studies. \nThese are the steps necessary in determining the formula for the \"ever\" proba\nbility of astock hitting an upside target at any time during its life. First, make the \nassumption that stock prices behave randomly, and perform at the risk-free rate, r. \nMathematicians call random behavior \"Brownian motion.\" There are anumber of \nformulae available in statistics books regarding Brownian motion. If one is to esti\nmate the probability of reaching amaximum (upside target) point, what is needed is \nthe known formula for the cumulative density function (CDP) for arunning maxi\nmum of a Brownian motion. In that formula, it is necessary to use the lognormal \nfunction to describe the upside target. Thus, instead of using the actual target price \nin the CDF formula, one substitutes ln( qlp ), where qis the target price and pis the \ncurrent stock price. \nThe \"ever\" probability calculator provides much more useful information to atrader of options. Not only does anaked option seller have amuch more realistic esti\nmate of the probability that he'sgoing to have to make an adjustment during the life \nof an option, but the option buyer can find the information useful as well. For exam\nple, if one is buying an option at aprice of 10, say, then he could use the \"ever\" prob\nability calculator to estimate the chances of the stock trading 10 points above the \nstriking price at any time during the life of the option. That is, what are the chances \nthat the option is going to at least break even? The option buyer can, cf course, deter\nmine other things too, such as the probability that the option doubles in price ( or \nreaches some other return on investment, such as he might deem appropriate for his \nanalysis).", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:864", "doc_id": "93329ebff566794d61c6d57b2a6d501d91a66735010a571c82c331551130e264", "chunk_index": 0}
{"text": "808 Part VI: Measuring and Trading Volatility \nof them resulted in the stock being unchanged. Also, only about 2,500 or them, or \n1110th of one percent, resulted in amove of-4.0 standard deviations or more. Those \npercentages, along with all of the others, would be built into the computer, so that \nthe total distribution accounts for 100% of all possible stock movements. \nThen, we tell the computer to allow astock to move randomly in accordance \nwith whatever volatility the user has input. So, there would be afairly large proba\nbility that it wouldn'tmove very far on agiven day, and avery small probability that \nit would move three or more standard deviations. Of course, with the fat tail distri\nbution, there would be alarger probability of amovement of three or more standard \ndeviations than there would be with the regular lognormal distribution. The Monte \nCarlo simulation progresses through the given number of trading days, moving the \nstock cumulatively as time passes. If the stock hits the break-even price, that partic\nular simulation can be terminated and the next one begun. At the end of all the tri\nals (100,000 perhaps), the number in which the upside target was touched is divided \nby the total number of trials to give the probability estimate. \nIs it really worth all this extra trouble to evaluate these more complicated prob\nability distributions? It seems so. Consider the following example: \nExample: Suppose that atrader is considering selling naked puts on XYZ stock, \nwhich is currently trading at aprice of 80. He wants to sell the November 60 puts, \nwhich expire in two months. Although XYZ is afairly volatile stock, he feels that he \nwouldn'tmind owning it if it were put to him. However, he would like to see the puts \nexpire worthless. Suppose the following information is available to him via the vari\nous probability calculators: \nSimple \"end point\" probability of XYZ < 60 at expiration: 10% \nProbability that XYZ ever trades < 60 (using the lognormal distribution) 20% \nProbability that XYZ ever trades < 60 (using the fat tail distribution): 22% \nIf the chances of the put never needing attention were truly only 10%, this trader \nwould probably sell the puts naked and feel quite comfortable that he had atrade \nthat he wouldn'thave to worry too much about later on. However, if the true proba\nbility that the put will need attention is 22%, then he might not take the trade. Many \nnaked option sellers try to sell options that have only probabilities of 15% or less of \npotentially becoming troublesome. \nHence, the choice of which probability calculation he uses can make adiffer\nence in whether or not atrade is established. \nOther strategies lend themselves quite well to probability analysis as well. \nCredit spreaders - sellers of out-of-the-money put spreads - usually attempt to quan\ntify the probability of having to take defensive action. Any action to adjust or remove", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:866", "doc_id": "40344aaf160391b165b7a0c3f7fc75d99403efdb880cd92f88b7c240b986134b", "chunk_index": 0}
{"text": "Chapter 38: The Distribution of Stock Prices 809 \nadeeply out-of-the-money put credit spread usually destroys most or all of its prof\nitability, so an accurate initial assessment of the probabilities of having to make such \nan adjustment is important. \nOption buyers, too, would benefit from the use of amore accurate probability \nestimate. This is especially true for neutral strategies, such as straddle or strangle \nbuying, when the trader is interested in the chances of the stock being able to move \nfar enough to hit one or the other of the straddle'sbreak-even points at some time \nduring the life of the straddle. \nThe Monte Carlo probability calculation can be expanded to include other sorts \nof distributions. In the world of statistics, there are many distributions that define ran\ndom patterns. The lognormal distribution is but one of them (although it is the one \nthat most closely follows stock prices movements in general). Also, there is aschool of \nthought that says that each stock'sindividual price distribution patterns should be ana\nlyzed when looking at strategies on that stock, as opposed to using ageneral stock \nprice distribution accumulated over the entire market. There is much debate about \nthat, because an individual stock'strading pattern can change abruptly just consider \nany of the Internet stocks in the late 1990s and early 2000s. Thus, aprobability esti\nmate based on asingle stock'sbehavior, even if that behavior extends back several \nyears, might be too unreliable astatistic upon which to base aprobability estimate. \nIn summary, then, one should use aprobability calculator before taking an \noption position, even an outright option buy. Perhaps straight stock traders should \nuse aprobability calcutor as well. In doing so, though, one should be aware of the \nlimitations of the estimate: It is heavily biased by the volatility estimate that is input \nand by the assumption of what distribution the underlying instrument will adhere to \nduring the life of the position. While neither of those limitations can be overcome \ncompletely, one can mitigate the problems by using aconservative volatility estimate. \nAlso, he can look at the results of the probability calculation under several distribu\ntions (perhaps lognormal, fat tail, and the distribution using only the past price \nbehavior of the underlying instrument in question) and see how they differ. In that \ncase, he would at least have afeeling for what could happen during the life of the \noption position. \nEXPECTED RETURN \nThe concept of expected return was described in the chapter on mathematical appli\ncations. In short, expected return is aposition'sexpected profit divided by its invest\nment ( or expected investment if the investment varies with stock price, as in anaked \noption position or afutures position). The crucial component, though, is expected \nprofit.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:867", "doc_id": "5c26b5902a56e9937c721b4be6100ec235d9402330fe53b85e1d141cf4d27191", "chunk_index": 0}
{"text": "810 Part VI: Measuring and Trading Volatility \nExpected profit is computed by calculating the profitability of aposition at acertain stock price times the probability of the stock being at that price, and summing \nthat multiple over all possible stock prices. When the concept was first introduced, \nthe \"probability of the stock being at that price\" was given as what we now know is \nthe \"endpoint\" probability. In reality, amuch better measure of the expected profit \nof aposition can be obtained by using one of the more advanced probability estima\ntion models presented above. \nIn generalized expected return studies done using the fat tails Monte Carlo sim\nulation, certain general conclusions can be drawn about some strategies. \n• Abull spread is an inferior strategy when the options are fairly priced, no matter \nwhich distribution is assumed. This more or less agrees with observations that \nhave been made previously regarding the disappointments that traders often \nencounter when using vertical spreads. \n• While covered writing might seem superior to stock ownership under the log\nnormal distribution, the two are about equal under afat tail distribution. \n• Most startling, though, is the fact that option buying strategies fare much, much \nbetter under afat tail distribution than alognormal one. This most clearly \ndemonstrates the \"power\" of the fat tail distribution: Alimited-risk investment \nwith unlimited profit potential can be expected to perform very well if the fat tails \nare allowed for. \nUsing the lognormal distribution more or less represents the conventional wisdom \nregarding option strategies - the one that many brokers promote: \"Don'tbuy options, \ndon'tmess with spreads, either buy stocks or do covered call writes.\" The fat tail dis\ntribution column stands much of that advice on its head. In real life (as demonstrat\ned by the fat tail distribution), strategies with limited profit potential and unlimited \nor large risk potential are inferior strategies. \nOne should be aware that the phrase \"expected return\" is used in many quasi\nsophisticated option analyses (and even in analyses not using options). Many \ninvestors accept these \"returns\" on blind faith, figuring that if they're generated by acomputer, they must be correct. In reality, they may be not be representative, even \nfor comparisons. \nSUMMARY \nThis chapter has demonstrated that probability analysis is an inexact science, because \nmarkets behave in ways that are very difficult to describe mathematically. However, \nprobability analysis is also necessary for the option strategist; without it he would be", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:868", "doc_id": "b38bb833e0aed2a93ea35e85951270c399c21698bd786fb9818cb99f65ac6600", "chunk_index": 0}
{"text": "Chapter 38: The Distribution of Stock Prices 811 \nin the dark as to the likelihood of profitable outcomes for his strategy. Overall, in adiversified set of positions, the option strategist should use the fat tail distribution in \na Monte Carlo simulation to estimate probabilities. However, if that is not available, \nhe can use the normal or lognormal distribution with the proviso that he understands \nit is not \"gospel.\" He should require ve:ry stringent criteria on any strategies that are \nantivolatility strategies, such as naked option writing of stock options, for there is agreater than normal chance of alarge move by the underlying, especially if the \nunderlying is stock. \nThe sophisticated trader may want to view his probabilities in the light of more \nthan one proposed distribution of prices. Of course, this type of analysis ( using sev\neral distributions) puts the onus on the investor to choose the distribution that he \nwants to use in order to analyze his investment. However, such an approach should \nbe extremely illustrative in that he can compare returns from different strategies and \nhave areasonable expectation as to which ones might perform the best under differ\nent market conditions.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:869", "doc_id": "7f09e07436d95decfbbaa8daaebd166d0ca58b78c763d5fe14b77287d6a97b9f", "chunk_index": 0}
{"text": "CHAPTER 39 \nVolatility Trading Techniques \nThe previous three chapters laid the foundation for volatility trading. In this chapter, \nthe actual application of the technique will be described. It should be understood \nthat volatility trading is both an art and ascience. It'sascience to the extent that one \nmust be rigorous about determining historical volatility or implied volatility, calculat\ning probabilities, and so forth. However, given the vagaries of those measurements \nthat were described in some detail in the previous chapters, volatility trading is also \nsomething of an art. Just as two fundamental analysts with the same information \nregarding earnings, sales projection, and so on might have two different opinions \nabout astock'sfortunes, so also can two volatility traders disagree about the potential \nfor movement in astock. \nHowever, volatility traders do agree on the approach. It is based on comparing \ntoday'simplied volatility with what one expects volatility to do in the future. As noted \npreviously, one'sexpectations for volatility might be based on volatility charts, pat\nterns of historical volatility and implied volatility, or something as complicated as a \nGAR CH forecasting model. None of them guarantees success. However, we do know \nthat volatility tends to trade in arange in the long run. Therefore, the approach that \ntraders agree upon is this: If implied volatility is \"low,\" buy it. If it's \"high,\" sell it with \ncaution. So simple: Buy low, sell high (not necessarily in that order). The theory \nbehind volatility trading is that it'seasier to buy low and sell high (or at least to deter\nmine what's \"low\" and \"high\") when one is speaking about volatility, than it is to do \nthe same thing when one is talking about stock prices. \nMost of the time, implied volatility will not be significantly high or low on any \nparticular stock, futures contract, or index. Therefore, the volatility trader will have \nlittle interest in most stocks on any given day. This is especially true of the big-cap \nstocks, the ones whose options are most heavily traded. There are so many traders \n812", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:870", "doc_id": "60aabbb16b9cff9566bce8bfced01adbb228be6624110d7414f4315dcd8c76b1", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques 813 \nwatching the situation for those stocks that they will rarely let volatility get to the \nextremes that one would consider \"too high\" or \"too low.\" Yet, with the large num\nber of optionable stocks, futures, and indices that exist, there are always some that \nare out of line, and that'swhere the independent volatility trader will concentrate \nhis efforts. \nOnce avolatility extreme has been uncovered, there are different methods of \ntrading it. Some traders - market-makers and short-term traders - are just looking \nfor very fleeting trades, and expect volatility to fall back into line quickly after an \naberrant move. Others prefer more of aposition traders' approach: attempting to \ndetermine volatility extremes that are so far out of line with accepted norms that it \nwill probably take some time to move back into line. Obviously, the trader'sown sit\nuation will dictate, to acertain extent, which strategy he pursues. Things such as \ncommission rates, capital requirements, and risk tolerance will determine whether \none is more of ashort-term trader or aposition trader. The techniques to be \ndescribed in this chapter apply to both methods, although the emphasis will be on \nposition trading. \nTWO WAYS VOLATILITY PREDICTIONS CAN BE WRONG \nWhen traders determine the implied volatility of the options on any particular under\nlying instrument, they may generally be correct in their predictions; that is, implied \nvolatility will actually be afairly good estimate of forthcoming volatility. However, \nwhen they're wrong, they can actually be wrong in two ways: either in the outright \nprediction of volatility or in the path of their volatility predictions. Let'sdiscuss both. \nWhen they're wrong about the absolute level of volatility, that merely means that \nimplied volatility is either \"too low\" or \"too high.\" In retrospect, one could only make \nthat assessment, of course, after having seen what actual volatility turned out to be \nover the life of the option. The second way they could be wrong is by making the \nimplied volatility on some of the options on aparticular underlying instrument much \ncheaper or more expensive than other options on that same underlying instrument. \nThis is called avolatility skew and it is usually an incorrect prediction about the way \nthe underlying will perform during the life of the options. \nThe rest of this chapter will be divided into two main parts, then. The first part \nwill deal with volatility from the viewpoint of the absolute level of implied volatility \nbeing \"wrong\" (which we'll call \"trading the volatility prediction\"), and the second \npart will deal with trading the volatility skew.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:871", "doc_id": "37d3f03570fedb829aef985313034a11933e389198db076dd795956209c35a0f", "chunk_index": 0}
{"text": "814 Part VI: Measuring and Trading Volatility \nTRADING THE VOLATILITY PREDICTION \nThe volatility trader must have some way of determining when implied volatility is \nsufficiently out of line that it warrants atrade. Then he must decide what trade to \nestablish. Furthermore, as with any strategy- especially option strategies - follow-up \naction is important too. We will not be introducing any new strategies, per se, in this \nchapter. Those strategies have already been laid out in the previous chapters of this \nbook. However, we will briefly review important points about those strategies and \ntheir follow-up actions where it is appropriate. \nFirst, one must try to find situations in which implied volatility is out of line. \nThat is not the end of the analysis, though. After that, one needs to do some proba\nbility work and needs to see how the underlying has behaved in the past. Other fine\ntuning measures are often useful, too. These will all be described in this chapter. \nDETERMINING WHEN VOLATILITY IS OUT OF LINE \nThere is much disagreement among volatility traders regarding the best method to use \nfor determining if implied volatility is \"out ofline.\" Most favor comparing implied with \nhistorical volatility. However, it was shown two chapters ago that implied volatility is \nnot necessarily agood predictor of historical volatility. Yet this approach cannot be dis\ncarded; however it must be used judiciously. Another approach is to compare today'simplied volatility with where it has been in the past. This concept relies heavily on the \nconcept of the percentile of implied volatility. Finally, there is the approach of trying \nto \"read\" the charts of implied and historical volatility. This is actually something akin \nto what GARCH tries to do, but on ashort-term horizon. So the approaches are: \n1. Compare implied volatility to its own past levels (percentile approach). \n2. Compare implied volatility to historical volatility. \n3. Interpret the chart of volatility. \nIn addition, we will examine two lesser-used methods: comparing current levels of \nhistorical volatility to past measures of historical volatility, and finally, using only aprobability calculator and trading the situation that has the best probabilities of \nsuccess. \nTHE PERCENTILE APPROACH \nIn this author'sopinion, there is much merit in the percentile approach. When one says \nthat volatility tends to trade in arange, which is the basic premise behind volatility trad-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:872", "doc_id": "77ef633ce2a61a8d6c9e631f13b2ae1a0c3909a3e15626f80df00188cffb4fdf", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques 815 \ning, he is generally talking about implied volatility. Thus, it makes sense to know where \nimplied volatility is within the range of the past readings of implied volatility. If volatil\nity is low with respect to where it usually trades, then we can say the options are cheap. \nConversely, if it'shigh with respect to those past values, then we can say the options are \nexpensive. These conclusions do not draw on historical volatility. \nThe percentile of implied volatility is generally used to describe just where the \ncurrent implied volatility reading lies with respect to its past values. The \"implied \nvolatility\" reading that is being used in this case is the composite reading - the one \nthat takes into account all the options on an underlying instrument, weighting them \nby their distance in- or out-of-the-money (at-the-money gets more weight) and also \nweighting them by their trading volume. This technique has been referred to many \ntimes and was first described in Chapter 28 on mathematical applications. That com\nposite implied volatility reading can be stored in adatabase for each underlying \ninstrument every day. Such databases are available for purchase from firms that spe\ncialize in option data. Also, snapshots of such data are available to members of \nwww.optionstrategist.com. \nIn general, most underlying instruments would have acomposite implied \nvolatility reading somewhere near the 50th percentile on any given day. However, it \nis not uncommon to see some underlyings with percentile readings near zero or 100% \non agiven day. These are the ones that would interest avolatility trader. Those with \nreadings in the 10th percentile or less, say, would be considered \"cheap\"; those in the \n90th percentile or higher would be considered expensive. \nIn reality, the percentile of implied volatility is going to be affected by what the \nbroad market is doing. For example, during asevere market slide, implied volatilities \nwill increase across the board. Then, one may find alarge number of stocks whose \noptions are in the 90th percentile or higher. Conversely, there have been other times \nwhen overall implied volatility has declined substantially: 1993, for example, and the \nsummer of 2001, for another. At those times, we often find agreat number of stocks \nwhose options reside in the 10th percentile of implied volatility or lower. The point \nis that the distribution of percentile readings is adynamic thing, not something stat\nic like alognormal distribution. Yes, perhaps over along period of time and taking \ninto account agreat number of cases, we might find that the percentiles of implied \nvolatility are normally distributed, but not on any given day. \nThe trader has some discretion over this percentile calculation. Foremost, he \nmust decide how many days of past history he wants to use in determining the per\ncentiles. There are about 255 trading days in ayear. So, if he wanted atwo-year his\ntory, he would record the percentile of today'scomposite implied volatility with \nrespect to the 510 daily readings over the past two years. This author typically uses", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:873", "doc_id": "c5745609c9bdeb644726ccf2e8d94a678f9daf78868867156cf5849d468be7ad", "chunk_index": 0}
{"text": "816 Part VI: Measuring and Trading Volatility \n600 days of implied volatility history for the purpose of determining percentiles, but \nacase could be made for other lengths of time. The purpose is to use enough implied \nvolatility history to give one agood perspective. Then, areading of the 10th per\ncentile or the 90th percentile will truly be significant and would therefore be agood \nstarting point in determining whether the options are cheap or expensive. \nIn addition to the actual percentile, the trader should also be aware of the width \nof the implied volatility distribution. This was discussed in an earlier chapter, but \nessentially the concept is this: If the first percentile is an implied volatility of 40% and \nthe 100th percentile is an implied volatility of 45%, then that entire range is so nar\nrow as to be meaningless in terms of whether one could classify the options as cheap \nor expensive. \nThe advantage of buying options in alow percentile of implied volatility is to \ngive oneself two ways to make money: one, via movement in the underlying (if astraddle were owned, for example), and two, by an increase in implied volatility. That \nis, if the options were to return to the 50th percentile of implied volatility, the volatil\nity trader who has bought \"cheap\" options should expect to make money from that \nmovement as well. That can only happen if the 50th percentile and the 10th per\ncentile are sufficiently far apart to allow for an increase in the price of the option to \nbe meaningful. Perhaps agood rule of thumb is this: If the option rises from the cur\nrent (low) percentile reading to the 50th percentile in amonth, will the increase in \nimplied volatility be equal to or greater than the time decay over that period? \nAlternatively stated, with all other things being equal, will the option be trading at \nthe same or agreater price in amonth, if implied volatility rises to the 50th percentile \nat the end of that time? If so, then the width of the range of implied volatilities is \ngreat enough to produce the desired results. \nThe attractiveness to this method for determining if implied volatility is out of \nline is that the trader is \"forced\" to buy options that are cheap ( or to sell options that \nare expensive), on arelative basis. Even though historical volatility has not been taken \ninto consideration, it will be later on when the probability calculators are brought to \nbear. There is no guarantee, of course, that implied volatility will move toward the \n50th percentile while the position is in place, but if it does, that will certainly be an \naid to the position. \nIn effect this method is measuring what the option trading public is \"thinking\" \nabout volatility and comparing it with what they've thought in the past. Since the pub\nlic is wrong (about prices as well as volatility) at major turning points, it is valid to want \nto be long volatility when \"everyone else\" has pushed it down to depressed levels. The \nconverse may not necessarily be true: that we would want to be short volatility when \neveryone else has pushed it up to extremely high levels. The caveat in that case is that", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:874", "doc_id": "79a1482a0a5ec9dfbc86243d78f4f87ab0cdf7c74245177230fbf09bf39f4705", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques 817 \nsomeone may have inside information that justifies expensive options. This is another \nreason why selling volatility can be difficult: You may be dealing with far less infor\nmation than those who are actually making the implied volatility high. \nCOMPARING IMPLIED AND HISTORICAL VOLATILITY \nThe most common way that traders determine which options are cheap or expensive \nis by comparing the current composite implied volatility with various historical \nvolatility measures. However, just because this is the conventional wisdom does not \nnecessarily mean that this method is the preferred one for determining which options \nare best for volatility trades. In this author'sopinion, it is inferior to the percentile \nmethod (comparing implied to past measures of implied), but it does have its merits. \nThe theory behind using this method is that it is avirtual certainty that implied and \nhistorical volatility will eventually converge with each other. So, if one establishes \nvolatility trading positions when they are far apart, there is supposedly an advantage \nthere. \nHowever, this argument has plenty of holes in it. First of all, there is no guar\nantee that the two will converge in atimely manner, for example, before the options \nin the trader'sposition can become profitable. Historical and implied volatility often \nremain fairly far apart for weeks at atime. \nSecond, even if the convergence does occur, it doesn'tnecessarily mean one will \nmake money. As an example, consider the case in which implied volatility is 40% and \nhistorical volatility is 60%. That'squite adifference, so you'dwant to buy volatility. \nFurthermore, suppose the two do converge. Does that mean you'll make money? No, \nit does not. What if they converge and meet at 40%? Or, worse yet, at 30%? You'dmost certainly lose in those cases as the stock slowed down while your options lost \ntime value. \nAnother problem with this method is that implied volatility is not necessarily \nlow when it is bought, nor high when it is sold. Consider the example just cited. We \nmerely knew that implied volatility was 40% and that historical volatility was 60%. We \nhad no perspective on whether 40% was high, medium, or low. Thus, it is also nec\nessary to see what the percentile of implied volatility is. If it turns out that 40% is arelatively high reading for implied volatility, as determined by looking at where \nimplied volatility has been over the past couple of years, then we would probably not \nwant to buy volatility in this situation, even though implied and historical volatility \nhave alarge discrepancy between them. \nMany market-makers and floor traders use this approach. However, they are \noften looking for an option that is briefly mispriced, figuring that volatilities will", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:875", "doc_id": "a971373d435688c48b0faa79735d7dacc3358058f143d505a969833c61323db8", "chunk_index": 0}
{"text": "818 Part VI: Measuring and Trading Volatility \nquickly revert back to where they were. But for aposition trader, the problems cited \nabove can be troublesome. \nHaving said that, if one looks to implement this method of trying to determine \nwhen options are out of line, something along the following lines should be imple\nmented. One should ensure that implied volatility is significantly different from all of \nthe pertinent historical volatilities. For example, one might require that implied \nvolatility is less than 80% of each of the 10-, 20-, 50-, and 100-day historical volatili\nty calculations. In addition, the current percentile of implied volatility should be \nnoted so that one has some relative basis for determining if all of the volatilities, his\ntorical and implied, are very high or very low. One would not want to buy options if \nthey were all in avery high percentile, nor sell them if they were all in avery low per\ncentile. \nOften, avolatility chart showing both the implied and certain historical volatili\nties will be auseful aid in making these decisions. One can not only quickly tell if the \noptions are in ahigh or low percentile, but he may also be able to see what happened \nat similar times in the past when implied and historical volatility deviated substan\ntially. \nFinally, one needs some measure to ensure that, if convergence between \nimplied and historical volatility does occur, he will be able to make money. So, for \nexample, if one is buying astraddle, he might require that if implied rises to meet his\ntorical (say, the lowest of the historicals) in amonth, he will actually make money. \nOne could use adifferent time frame, but be careful not to make it something unrea\nsonable. For example, if implied volatility is currently 40% and historical is 60%, it is \nhighly unlikely that implied would rise to 60% in aday or two. Using this criterion \nalso ensures that the absolute difference between implied and historical volatility is \nwide enough to allow for profits to be made. That is, if implied is 10% and historical \nis 13%, that'sadifference of 30% in the two - ostensibly a \"wide\" divergence \nbetween implied and historical. However, if implied rises to meet historical, it will \nmean only an absolute increase of 3 percentage points in implied volatility - proba\nbly not enough to produce aprofit, after costs, if any length of time passes. \nIf all of these criteria are satisfied, then one has successfully found \"mispriced\" \noptions using the implied versus historical method, and he can proceed to the next \nstep in the volatility analysis: using the probability calculator. \nREADING THE VOLATILITY CHART \nAnother technique that traders use in order to determine if options are mispriced is \nto actually try to analyze the chart of volatility - typically implied volatility, but it \ncould be historical. This might seem to be asubjective approach, except that it is real-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:876", "doc_id": "55e01ea05f5d69700ef6595ce7ffe4a5602eda017e3a6a9e75e83f3353fdeeed", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques 819 \nly not much different from the GARCH approach, which is considered to be highly \nadvanced. When one views the volatility chart, he is not looking for chart patterns like \ntechnical analysts might do with stock charts: support, resistance, head-and-shoul\nders, flags, pennants, and so on. Rather, he is merely looking for the trend of volatil\nity to change. \nThis is avalid approach in the use of many indicators, particularly sentiment \nindicators, that can go to extreme levels. By waiting for the trend to change, the user \nis not subjecting himself to buying into the midst of adowntrend in volatility, nor sell\ning into the midst of asteep uptrend in volatility. \nExample: Suppose avolatility trader has determined that the current level of implied \nvolatility for XYZ stock is in the 1st percentile of all past readings. Thus, the options \nare as cheap as they've ever been. Perhaps, though, the overall market is experienc\ning avery dull period, or XYZ itself has been in aprolonged, tight trading range -\neither of which might cause implied volatility to decline steadily and substantially. \nHaving found these cheap options, he wants to buy volatility. However, he has no \nguarantee that implied volatility won'tcontinue to decline, even though it is already \nas cheap as it'sever been. \nIf he follows the technique of waiting for areversal in the trend of implied \nvolatility, then he would keep an eye on XYZ'simplied volatility daily until it had at \nleast amodest increase, something to indicate that option buyers have become more \ninterested in XYZ'soptions. The chart in Figure 39-1 shows how this situation might \nlook. \nThere are anumber of items marked on the chart, so it will be described in \ndetail. There are two graphs in Figure 39-1: The top line is the implied volatility \ngraph, while on the bottom is the stock price chart. The implied volatility chart shows \nthat, near the first ofJune, it made new all-time lows near 28% (i.e., it was in the 0th \npercentile of implied volatility). Hence, one might have bought volatility at that \npoint. However, it is obvious that implied volatility was in asteep downtrend at that \ntime, so the volatility trader who reads the charts might have decided to wait for apop in volatility before buying. This turned out to be ajudicious decision, because \nthe stock went nowhere for nearly another month and ahalf, all the while volatility \nwas dropping. At the right of the chart, implied volatility has dropped to nearly 20%. \nThe solid lines on the two graphs indicate the data that is known about the \nimplied volatility and price history of XYZ. The dotted lines indicate ascenario that \nmight unfold. If implied volatility were to jump ( and the stock price might jump, too), \nthen one might think that the trend of implied volatility was no longer down, and he \nwould then buy volatility.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:879", "doc_id": "9d1fcd31600caa43ab22ae14b54a1ee44603786d3b86ef950f28745c9233110f", "chunk_index": 0}
{"text": "820 Part VI: Measuring and Trading VolatHity \nThe reason that this approach has merit is that one never knows how low volatil\nity can go, and more important, how high it can get. It was mentioned that the same \nsort of approach works well for other sentiment indicators, the put-call ratio, in par\nticular. During the bull market of the 1990s, the equity-only put-call ratio generally \nranged between about 30 and 55. Thus, some traders became accustomed to buying \nthe market when the put-call ratio reached numbers exceeding 50 (high put-call \nratio numbers are bullish predictors for the market in general). However, when the \nbull market ended, or at least faltered, the put-call ratios zoomed to heights near 70 \nor 75. Thus, those using astatic approach (that is, \"Buy at 50 or higher\") were buried \nas they bought too early and had to suffer while the put-call ratios went to new all\ntime highs. Atrend reversal approach would have saved them. It is amore dynamic \nprocedure, and thus one would have let the put-call ratio continue to rise until it \npeaked. Then the market could have been bought. \nThis is exactly what reading the volatility chart is about. Rather than relying on \npast data to indicate where the absolute maxima and minima of movements might \noccur, one rather notes that the volatility data is at extreme levels ( 1st percentile or \n100th percentile) and then watches it until it reverses direction. This is especially \nuseful for options sellers, because it avoids stepping into the vortex of massive option \nFIGURE 39-1. \nChart of the trend of implied volatility. \nXYZ \n,J' \n········································ · ························ ....................... ··················· 50. 0 \n... · ····················· 40. 0 \nImplied Volatility I/vi Ar \n···-····························· .. •·•······•·········-·············································-··vw•···················)·•······ 30. 0 \nAll-Time Volatility Low -\n, .... , ..... , .. ··················,·······~················ \nt :t·•····•····· ...•. ':·LJJSL5~?. \n--;---··········•·: \no, b ::r Ff1 hj ::r \n34.000 \n32.000 \n30. 000 \n28. 000 \n26.000 \n24.000 \n22.000 \n20. 000", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:880", "doc_id": "43728244f1529b575a1b736cbb0309f50d7c8d5f9f92ad64621021c28d0fb67b", "chunk_index": 0}
{"text": "Chapter 39: VolatiDty Trading Techniques 821 \nbuying, where the buyers perhaps have inside information about some forthcominf \ncorporate event such as atakeover. True, the options might be very expensive ( 10ot \npercentile), but there is areason they are, and those with the inside information know \nthe reason, whereas the typical volatility trader might not. However, if the volatility \ntrader merely waits for adownturn in implied volatility readings before selling these \noptions, he will most likely avoid the majority of trouble because the options will \nprobably not lose implied volatility until news comes out or until the buyers give up \n(perhaps figuring that the takeover rumor has died). \nVolatility buyers don'tface the same problems with early entry that volatility \nsellers do, but still it makes sense to wait for the trend of volatility to increase (as in \nFigure 39-1) before trying to guess the bottom in volatility. Just as it is usually fool\nhardy to buy astock that is in asevere downtrend, so it may be, too, with buying \nvolatility. \nAless useful approach would be to apply the same techniques to historical \nvolatility charts, for such charts say nothing about option prices. See the next section \nfor expansion on these thoughts. \nCOMPARING HISTORICAL VERSUS HISTORICAL \nThe above paragraphs summarize the three major ways that traders attempt to find \noptions that are out of line. Sometimes, another method is mentioned: comparing \ncurrent levels of historical volatility with past levels of the same measure, historical \nvolatility. This method will be described, but it is generally an inferior method \nbecause such acomparison doesn'ttell us anything about the option prices. It would \ndo little good, for example, to find that current historical volatility is in avery low per\ncentile of historical volatilities, only to learn later that the options are expensive and \nthat perhaps implied volatility is even higher than historical volatility. One would nor\nmally not want to buy options in that case, so the initial analysis of comparing histor\nical to historical is awasted effort. \nComparing current levels of historical volatility with past measures of historical \nvolatility is sort of abackward-looking approach, since historical volatility involves \nstrictly the use of past stock prices. There is no consideration of implied volatility in \nthis approach. Moreover, this method makes the tacit assumption that astock'svolatility characteristics do not change, that it will revert to some sort of \"normal\" past \nprice behavior in terms of volatility. In reality, this is not true at all. Nearly every stock \ncan be shown to have considerable changes in its historical volatility patterns over \ntime.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:881", "doc_id": "7709b4238784924b92d94f3b160fe96791d5bdbd7e466fea852e6dd23450f77b", "chunk_index": 0}
{"text": "822 Part VI: Measuring and Trading Volatility \nConsider the historical volatilities of one of the wilder stocks of the tech stock \nboom, Rambus (RMBS). Historical volatilities had ranged between 50% and ll0%, \nfrom the listing of RMBS stock, through February 2000. At that time, the stock aver\naged aprice of about $20 per share. \nThings changed mightily when RMBS stock began to rise at atremendous rate \nin February 2000. At that time, the stock blasted to ll5, pulled back to 35, made anew high near 135, and then collapsed to aprice near 20. Hence, the stock itself had \ncompleted awild round-trip over the two-year period. See Figures 39-2 and 39-3 for \nthe stock chart and the historical volatility chart of RMBS over the time period in \nquestion. \nAs this happened, historical volatility skyrocketed. After February 2000, and \nwell into 2001, historical volatility was well above 120%. Thus it is clear that the \nbehavior patterns of Rambus changed greatly after February 2000. However, if one \nhad been comparing historical volatilities at any time after that, he would have erro\nneously concluded that RMBS was about to slow down, that the historic volatilities \nwere too high in comparison with where they'dbeen in the past. If this had led one \nto sell volatility on RMBS, it could have been avery expensive mistake. \nWhile RMBS may be an extreme example, it is certainly not alone. Many other \nstocks experienced similar changes in behavior. In this author'sopinion, such behav\nior debunks the usefulness of comparing historical volatility with past measures of \nhistorical volatility as avalid way of selecting volatility trades. \nFIGURE 39-2. \nHistorical volatilities of RMBS. \nRMBS 19.000 17.250 18.875 20010410 \n............ ······· 60.0 \n· ·················· 50.0 \n...... ······· 40. 0 \n39 Mi·h··-:; s ·~ sa ~--f:i--·5--r;;····~··hs·s- Asa N □ s--r·;; r", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:882", "doc_id": "583df130bea55b61de038d6fe9717810abe9cbdc710baa5853f8709567074b51", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques 823 \nFIGURE 39-3. \nStock chart of RMBS. \n19. 000 17. 250 18. 875 20010410 \n30.000 \n22. 000 \n14. 000 \n' ' : : \n! : : : ; 1 : : 1 r : ! : : : : ; : : : : : il : l : 6. ooo \n99 Mil M :i Jii sb Nb J F Mil M :i Jil sb Nb J Fh 1 \nWhat this method may be best used for is to complement the other methods \ndescribed previously, in order to give the volatility trader some perspective on how \nvolatile he can expect the underlying instrument to be; but it obviously has to be \ntaken only as ageneral guideline. \nCHECK THE FUNDAMENTALS \nOnce these mispriced options have been found, it is always imperative to check the \nnews to see if there is some fundamental reason behind it. For example, if the options \nare extremely cheap and one then checks the news stories and finds that the under\nlying stock has been the beneficiary of an all-cash tender offer, he would not buy \nthose options. The stock is not going to go anywhere, and in fact will disappear if the \ndeal goes through as planned. \nSimilarly, if the options appear to be very expensive, and one checks the news \nand finds that the underlying has aproduct up for review before agovernmental \nagency (FDA, for example), then the options should not be sold because the stock \nmay be about to undergo alarge gap move based on the outcome of FDA hearings. \nThere could be any number of similar corporate events that would make the options \nvery expensive. The seller of volatility should not try to intercede when such events \nor rumors are occurring.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:883", "doc_id": "2ac89f51bfa0d0aff15f6e535cb16a3d84ebdfe3cbdb1b49328a9e2859e87d85", "chunk_index": 0}
{"text": "824 Part VI: Measuring and Trading Volatllity \nHowever, if there is no news that would seem to explain why the options are so \ncheap or so expensive, then the volatility trader can continue on to the rest of his \nanalyses. \nSELECTING THE STRATEGY TO USE \nIn general, when one wants to trade volatility, asimple approach is best, especially if \none is buying volatility. If there is avolatility skew involved, then there may be other \nstrategies that are superior, and they are discussed in the latter part of this chapter. \nHowever, when one is interested in the straight trading of volatility because he thinks \nimplied volatility is out of line, then only afew strategies apply. \nIf volatility is too low, then either astraddle or astrangle should be purchased. \nOne would normally choose astraddle if the underlying instrument is currently trad\ning near an available striking price. However, if the underlying is currently trading \nbetween two ~riking prices, then astrangle might be the better choice. In either case, \naposition trader would want to buy astraddle with several months of life remaining, \nin order to improve his chances of making aprofit. There is no \"best\" time length to \nuse, so one should use aprobability calculator to aid in that decision. The use of prob\nability calculators will be discussed shortly. \nExample: XYZ is trading at 39.60 and avolatility trader has determined that he wants \nto buy volatility. With this information, he should attempt to buy astraddle with astriking of 40 for both the put and the call. \nSuppose that the current date is in December, and the available expiration \nmonths for XYZ are January, February, April, July, and October, plus LEAPS for \nJanuary of the next year. Then he would analyze each straddle (January 40, February \n40, April 40, etc.) to see which is the best one to buy. It generally seems to work out \nthat the midrange straddles have the best probabilities of success, given the way that \noption prices are usually structured. Of course, the actual prices of each straddle \nwould be considered when using the probability calculator. In this case, then, the July \n40 or October 40 straddle would probably be the best choices from astatistical view\npoint for aposition trader. \nIf XYZ had been trading at aprice of 37.50, say, then the trader would proba\nbly want to consider buying astrangle: buying acall with astriking price of 40 and aput with astriking price of 35. From the viewpoint of buying strangles, it does not \nmake sense to separate the strikes by more than one striking price unit - 5 points for \nstock options, for example. This just makes the position more neutral to begin with.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:884", "doc_id": "f6f3943695e1a643c208aadfdf1f6feaf2466fdb537e0e7ee4500502061bc4a3", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques 825 \nSpeaking of neutrality, one can also use the deltas of the options in question to \nalter the ratio of puts to calls, making the position initially as neutral as possible. This \nis the suggested approach, since the volatility buyer does not care whether the stock \ngoes up or down. He is merely interested in stock movement and/or an increase in \nimplied volatility. \nExample: XYZ is again trading at 39.60, and the trader wants aneutral position. He \nshould use the deltas of the options to construct aneutral position. Consider the \nOctober 40 straddle, for example. Assume the volatility used for the probability cal\nculations is 40%. Under those conditions (and the ones assumed in the previous \nexample), the October 40 call has adelta of 0.60 and the October 40 put has adelta \nof -0.40. Thus aratio of buying 2 calls and 3 puts is aneutral ratio. If the call is sell\ning for 6 and the put is selling for 5, then the break-even points for a 2-by-3 position \nwould be 53.5 on the upside and 31 on the downside. This information is summarized \nas follows: \nDelta of October 40 call: \nDelta of October 40 put: \n+0.60 \n-0.40 \nDelta-neutral ratio: buy 2 calls and 3 puts \nPrice of October 40 coll: \nPrice of October 40 put: \nNet cost of 2-by-3 position: 27 points \nBreak-even points: \n6.00 \n5.00 \nUpside = 40 + 27 /2 = 53.50 \nDownside = 40 - 27 /3 = 31 .00 \nSo, the probability calculations would endeavor to determine what the chances are of \nthe stock ever trading at either 53.50 or 31.00 at any time prior to expiration. In fact, \nsince there are straddles available in several expiration months, the strategist would \nwant to analyze each of them in asimilar fashion. Table 39-1 shows how his choices \nmight look. If one were considering buying astrangle, similar calculations could be \nmade using the deltas of the put and the call, where the call strike is higher than the \nput strike. \nAnother simple strategy that can be used when volatility is low is the calendar \nspread, because it has apositive vega. That is, it can be expected to expand if implied \nvolatility increases. For most traders, though, the limited profit nature of the calen-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:885", "doc_id": "737857da8a947e349270a26a6dabf93a3648fd7b62dea282b28cfbced7cb0830", "chunk_index": 0}
{"text": "826 Part VI: Measuring and Trading Volatility \nTABLE 39-1 \nJanuary February April July October January LEAP \nCall price 1.25 2.25 3.50 5.00 6.00 7.15 \nPut price 1.50 2.35 3.35 4.35 5.00 5.55 \nCall delta 0.48 0.52 0.55 0.58 0.60 0.62 \nPut delta -0.52 -0.48 -0.45 -0.42 -0.40 -0.38 \nNeutral ~ 1-to-1 ~l-to-1 ~ 1-to-1 ~2-to-3 2-to-3 ~2-to-3 \nDebit 2.75 4.60 6.85 23.05 27.00 30.95 \nUpside break-even 42.75 44.60 46.85 51.57 53.50 55.47 \nDownside break-even 37.25 35.40 33.15 32.30 31.00 29.68 \ndar spread is too much of aburden\"° either psychologically or in terms of commis\nsions, and so this strategy is only modestly used by volatility traders. Some traders will \nuse the calendar spread if they don'tsee immediate prospects for an increase in \nimplied volatility. They perhaps buy acall calendar slightly out-of-the-money and also \nbuy aput calendar with slightly out-of-the-money puts. Then, if not much happens \nover the short term, the options that were sold expire worthless, and the remaining \nlong straddle or strangle is even more attractive than ever. Of course, this strategy has \nits drawback in that aquick move by the underlying may result in aloss, something \nthat would not have happened had asimple straddle or strangle been purchased. \nSELLING VOLATILITY \nIf one were selling volatility (i.e., volatility is too high), his choices are more complex. \nVirtually anyone who has ever sold volatility has had abad experience or two with \neither exploding stock prices or exploding volatility. Some of the concerns regarding \nthe sale of volatility will be discussed at length later in this chapter. For now, the sim\npler strategies will be considered, in keeping with the discussion involving the cre\nation of avolatility trading position. \nSimplistically, avolatility seller would generally have achoice between one of \ntwo strategies (although there is amore complicated strategy that can be introduced \nas well). The simplest strategy is just to sell both an out-of-the-money put and an out\nof-the-money call. The striking prices chosen should be far enough away from the \ncurrent underlying price so that the probabilities of the position getting in trouble \n(i.e., the probabilities that the underlying actually trades at the striking prices of the \nnaked options during the life of the position) are quite small. Just as the option buyer", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:886", "doc_id": "1e4759c6026fb983fc211948db04d36d4ad22a28c85ff4c16bd746b9cafc1e24", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques 827 \nabove outlined several expiration months, then computed the break-even prices, so \nshould avolatility seller. Generally he will probably want to sell short-term options, \nbut all expiration months should be considered, at least initially. Also, he may want to \ntry different strike prices in order to get abalance between alow probability of the \nstock reaching the striking price of the naked options and taking in enough premium \nto make the trade worthwhile. To this author, the sale of naked options at small frac\ntional prices does not appear attractive. \nOf course, merely selling such aput and acall means the options are naked, and \nthat strategy is not suitable for all traders. The next best choice then, Isuppose, is acredit spread. The problem with acredit spread is that one is both selling expensive \noptions and also buying expensive options as protection. The ramifications of volatil\nity changes on the credit spread strategy were detailed two chapters previously, so \nthey won'tbe recounted here, except to say that if volatility decreases, the profits to \nbe realized by acredit spreader are quite small (perhaps not even enough to over\ncome the commission expense of removing the position), whereas anaked option \nseller would benefit to agreater and more obvious extent. \nThe choice between naked writing and credit spreading should be made based \nlargely on the philosophy and psychological makeup of the trader himself. If one feels \nuncomfortable with naked options, or if he doesn'thave the ability to watch the mar\nket pretty much all the time (or have someone watch it for him), or ifhe doesn'thave \nthe financial wherewithal to margin the positions and carry them until the stock hits \nthe break-even point, then naked writing is not for that trader. \nAnother factor that might affect the choice of strategy for the option seller is \nwhat type of underlying instrument is being considered. Index options are by far the \nbest choices for naked option selling. Futures are next, and stocks are last. This is \nbecause of the ways those various instruments behave; stocks have by far the great\nest capability of making huge gap moves that are the bane of naked option selling. So, \nif one has found expensive stock or futures options, that might lend more credence \nto the credit spread strategy. \nThere is one other strategy that can be employed, upon occasion, when options \nare expensive. It is called the volatility backspread, but its discussion will be deferred \nuntil later in the chapter. \nUSING A PROBABILITY CALCULATOR \nNo matter which method is used to find options that are out of line, and no matter \nwhich strategy is preferred by the trader, it is still necessary to use aprobability cal\nculator to get ameaningful idea of whether or not the underlying has the ability to", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:887", "doc_id": "7a991e0e3ee3adbfdac2fb1044a5e86036034ff401129ca021aa3e6f15ba2b14", "chunk_index": 0}
{"text": "828 Part VI: Measuring and Trading Volatility \nmake the move to profitability (or not make the move into loss territory, if you're sell\ning options). This is where historical volatility plays abig part, for it is the input into \nthe probability calculator. In fact, no probability calculator will give reasonable pre\ndictions without agood estimate of volatility. Please refer to the previous chapter for \namore in-depth discussion of probability calculators and stock price distributions. \nThe use of probability analysis also mitigates some of the problems inherent in \nthe method of selection that compares implied and historical volatilities. If the prob\nabilities are good for success, then we might not care so much whether the options \nare currently in alow percentile of implied volatility or not (although we still would \nnot want to buy volatility when the options were in ahigh percentile of implied \nvolatility and we would not want to sell options that are in alow percentile). \nIn using the probability calculator, one first selects astrategy (straddle buying, \nfor example, if options are cheap) and then calculates the break-even points as \ndemonstrated in the previous section. Then the probability calculator is used to \ndetermine what the chances are of the underlying instrument ever trading at one or \nthe other of those break-even prices at any time during the life of the option position. \nIt was shown in the previous chapter that a Monte Carlo simulation using the fat tail \ndistribution is best used for this process. \nAn attractive volatility buying situation should have probabilities in excess of \n80% of the underlying ever exceeding the break-even point, while an attractive \nvolatility selling situation should have probabilities of less than 25% of ever trading \nat prices that would cause losses. The volatility seller can, of course, heavily influence \nthose probabilities by choosing options that are well out-of-the-money. As noted \nabove, the volatility seller should, in fact, calculate the probabilities on several dif\nferent striking prices, striving to find abalance between high probability of success \nand the ability to take in enough premium to make the risk worthwhile. \nExample: The OEX Index is trading at 650. Suppose that one has determined that \nvolatilities are too high and wants to analyze the sale of some naked options. \nFurthermore, suppose that the choices have been narrowed down to selling the \nSeptember options, which expire in about five weeks. The main choices under con\nsideration are those in Table 39-2. The option prices in this example, being index \noptions, reflect avolatility skew (to be discussed later) to make the example realistic. \nThe two right-hand columns should be rejected because the probabilities of \nthe stock hitting one or the other of the striking prices prior to expiration are too \nhigh well in excess of the 25% guideline mentioned earlier. That leaves the \nSeptember 500-800 strangle or the September 550-750 strangle to consider. The \nprobabilities are best for the farthest out-of-the-money options (September 500-\n800 strangle), but the options are selling at such small prices that they will not pro-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:888", "doc_id": "6bd6bde286bffd8768d06d2f54c10bb788948cdd853d5c502fb23bf98f64bb34", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques 829 \nTABLE 39-2 \nSeptember September September September \n800 call 750 call 730 call 700 call \nSeptember September September September \nNaked sale: 500 put 550 put 570 put 600 put \nCall price 0.20 1.50 3.50 8.80 \nPut price 0.40 2.00 3.70 8.50 \nProbability of call strike 4% 17% 30% 44% \nProbability of put strike 1% 11% 20% 40% \nvide much of areturn even if they expire worthless. Remember that one is \nrequired to establish the position with margin of at least 10% of the index price \nfor naked index options, which would be $6,500 in this case. In fact, it has been \nrecommended that one margin the position at the striking price itself (15% of 800, \nor $12,000 in this case). So, taking in only $60, less commissions, for the sale of \nthe September 500-800 strangle doesn'tseem to provide enough of areward. \nThus, the best choice seems to be the September 550-750 strangle. One would be \nmaking about $320 after commissions if the options expired worthless, and the \nrecommended margin would be 15% of 750 (the higher strike), or $11,250 - areturn of about 2.8% for one month. One cannot annualize these returns, for he \nhas no idea if the same option pricing structure will exist in five weeks, when these \noptions expire. \nOther probabilities can be calculated as well. For example, suppose one has \ndecided to buy astraddle. He might want to know what the odds are not only of \nbreaking even, but also of making at least acertain percentage return- say 20%. One \ncould also calculate the probability of the stock moving 20% past the break-even \npoints. That distance - 20% - is areasonable figure to use because one would most \nlikely be taking some partial profits or adjusting his position if the stock did indeed \nmove that far. \nUSING STOCK PRICE HISTORY \nAll of the work done so far - determining which options are expensive, selecting astrategy, and calculating the probabilities of success - has been somewhat theoretical \nin that we haven'tdone any \"back testing\" with regard to the volatility of the under\nlying instruments. At this point, one should look at past prices to see if the stock has \nbeen able to make large moves (whether or not such amove is desired).", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:889", "doc_id": "69d10007121c0fc09b1efd467cf466bb8609d6242a731c841699900740d219c8", "chunk_index": 0}
{"text": "830 Part VI: Measuring and Trading Volatility \nExample: Atrader is considering the purchase of the XYZ October 40 straddle for \n11 points, with the stock at 39.60. The options are cheap and the probabilities of suc\ncess appear to be good, according to the probability calculator. The question that now \nneeds to be asked and answered is this: \"In the past, has this stock been able to move \n11 points in 10 months (the time remaining in the straddle'slife)?\" Or, more impor\ntantly, since 11 divided by 39.60 is about 28%, \"Has this stock been able to make \nmoves of 28% over 10 months, in the past?\" The answers to these questions can be \nreadily obtained if stock price history data is available. One could even look at achart \nof the stock and attempt to answer the questions himself without the aid of acom\nputer, but computer analysis of the price history is more rigorous and is therefore \nencouraged. \nThe answers can be expressed in the form of probabilities, much as the results \nof the probability calculator are. \nSuppose one determines that the stock has been able to move 11 points in 10 \nmonths 77% of the time in the past. That'sokay, but not great. However, when one \nlooks at the price chart ofXYZ, he sees that it traded at much lower prices - near $10 \nashare - for along time before rising to its current levels. It would be very hard to \nexpect a $10 stock to move 11 points in 10 months. That'swhy the second figure, the \none involving the 28% move, is the more significant one. In this case, one might find \nthat XYZ has been able to move 28% in 10 months over 90% of the time in the past. \nNow one has what appears to be adecent-looking straddle buy. \nThis analysis of past prices can be done in amore sophisticated manner. Rather than \njust asking whether or not the stock has moved the required distance in the past, one \nmight want to see just how the stock'smovements \"look.\" That is, there are acouple \nof scenarios under which the past movements might look attractive, but upon closer \nexamination, one would not be so sanguine. \nFor example, what ifXYZ had repeatedly moved 28%, but never much more in \nmost of the IO-month periods that comprise its stock history? Then, one would be \nless inclined to want to own this straddle. \nAnother scenario of past movements might be that XYZ had made moves that \none could not reasonably expect to be repeated. Perhaps there was ahuge gap down \non an earnings shortfall, or if it was an Internet stock around the tum of the millen\nnium, it had ahuge move upward, followed by ahuge move downward. That would \nbe another nonrepeating type of move, because absent the Internet mania, the stock \nmight have been arather range-bound item both prior to and after the one huge, \nround-trip move.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:890", "doc_id": "f27ce378ac754e201ffa43b5c8864081bc84f93bca45a5cdd46f3d32a8d37782", "chunk_index": 0}
{"text": "832 Part VI: Measuring and Trading Volatility \nmoved two or three times that far with great frequency. Finally, there is acontinu\nity to the points on the histogram: There are some y-axis data points at almost all \npoints on the x-axis (between the minimum and maximum x-axis points). That is \ngood, because it shows that there has not been aclustering of movements by XYZ \nthat might have dominated past activity. \nAs for what is not a \"good\" histogram, we would not be so enamored of ahis\ntogram that showed ahuge cluster of points near and between the \"-1\" and 'T' points \non the X-axis. We want the stock to have shown an ability to move farther than just the \nbreak-even distance, if possible. As an example, see Figure 39-5, which shows astock \nwhose movements rarely exceed the \"-1\" or \"+l\" points, and even when they do, they \ndon'texceed it by much. Most of these would be losing trades because, even though \nthe stock might have moved the required percentage, that was its maximum move \nduring the 10-month period, and there is no way that atrader would know to take \nprofits exactly at that time. The straddles described by the histogram in Figure 39-5 \nshould not be bought, regardless of what the previous analyses might have shown. \nNor would it be desirable for the histogram to show alarge number of move\nments above the \"+3\" level on the histogram, with virtually nothing below that. Such \nahistogram would most likely be reflective of the spiky, Internet-type stock activity \nthat was referred to earlier as being unreasonable to expect that it might repeat itself. \nIn ageneral sense, one doesn'twant to see too many open spaces on the histogram's \nX-axis; continuity is desired. \nIf the histogram is afavorable one, then the volatility analysis is complete. One \nwould have found mispriced options, with agood theoretical probability of profit, \nwhose past stock movements verify that such movements are feasible in the future. \nANOTHER APPROACH? \nAfter having considered the descriptions of all of these analyses, one other approach \ncomes to mind: Use the past movements exclusively and ignore the other analyses \naltogether. This sounds somewhat radical, but it is certainly avalid approach. It'smore like giving some rigor to the person who \"knows\" IBM can move 18 points and \nwho therefore wants to buy the straddle. If the histogram (study of past movements) \ntells us that IBM does, indeed, have agood chance of moving 18 points, what do we \nreally care about the relationship of implied and historical volatility, or about the cur\nrent percentiles of either type of volatility, or what atheoretical probability calcula\ntor might say? In some sense, this is like comparing implied volatility (the price of the \nstraddle) with historical volatility (the history of stock price movements) in astrictly \npractical sense, not using statistics.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:892", "doc_id": "bc2bb2bbe3a55521695c01a7da02f066491cc25ee7053ac7f24ffb6e4bacbb18", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques 833 \nIn reality, one would have to be mindful of not buying overly expensive options ( or \nselling overly cheap ones), because implied volatility cannot be ignored. However, the \nprice of the straddle itself, which is what determines the x-axis on the histogram, does \nreflect option prices, and therefore implied volatility, in anontechnical sense. This author \nsuspects that alist of volatility trading candidates generated only by using past movements \nwould be arather long list. Therefore, as apractical matter, it may not be useful. \nMORE THOUGHTS ON SELLING VOLATILITY \nEarlier, it was promised that another, more complex volatility selling strategy would \nbe discussed. An option strategist is often faced with adifficult choice when it comes \nto selling (overpriced) options in aneutral manner - in other words, \"selling volatili\nty.\" Many traders don'tlike to sell naked options, especially naked equity options, yet \nmany forms of spreads designed to limit risk seem to force the strategist into adirec\ntional (bullish or bearish) strategy that he doesn'treally want. This section addresses \nthe more daunting prospect of trying to sell volatility with protection in the equity \nand futures option markets. \nThe quandary in trying to sell volatility is in trying to find aneutral strategy that \nallows one to benefit from the sale of expensive options without paying too much for \nahedge - the offsetting purchase of equally expensive options. The simple strategy \nthat most traders first attempt is the credit spread. Theoretically, if implied volatility \nwere to fall during the time the credit spread position is in place, aprofit might be \nrealized. However, after commissions on four different options in and possibly out \n(assuming one sold both out-of-the-money put and call spreads), there probably \nwouldn'tbe any real profit left if the position were closed out early. In sum, there is \nnothing really wrong with the credit spread strategy, but it just doesn'tseem like any\nthing to get too excited about. What other strategy can be used that has limited risk \nand would benefit from adecline in implied volatility? The highest-priced options are \nthe longer-term ones. If implied volatility is high, then if one can sell options such as \nthese and hedge them, that might be agood strategy. \nThe simplest strategy that has the desired traits is selling acalendar spread \nthat is, sell alonger-term option and hedge it by buying ashort-term option at the \nsame strike. True, both are expensive (and the near-term option might even have aslightly higher implied volatility than the longer-term one). But the longer-term one \ntrades with afar greater absolute price, so if both become cheaper, the longer-term \none can decline quite abit farther in points than the near-term one. That is, the vega \nof the longer-term option is greater than the vega of the shorter-term one. When one \nsells acalendar spread, it is called areverse calendar spread. The strategy was", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:893", "doc_id": "47e456fe7f4100aa77d7f13e31cb31fb911dd5543f1233e05bf762c7d02ed516", "chunk_index": 0}
{"text": "834 Part VI: Measuring and Trading Volatility \ndescribed in the chapter on reverse spreads. The reader might want to review that \nchapter, not only for the description of the strategy, but also for the description of the \nmargin problems inherent in reverse spreads on stocks and indices. \nOne of the problems that most traders have with the reverse calendar spread is \nthat it doesn'tproduce very large profits. The spread can theoretically shrink to zero \nafter it is sold, but in reality it will not do so, for the longer-term option will retain \nsome amount of time value premium even if it is very deeply in- or out-of-the-money. \nHence the spread ·will never really shrink to zero. \nYet, there is another approach that can often provide larger profit potential and \nstill retain the potential to make money if implied volatility decreases. In some sense \nit is amodification of the reverse calendar spread strategy that can create apoten\ntially even more desirable position. The strategy, known as avolatility backspread, \ninvolves selling along-term at-the-money option (just as in the reverse calendar \nspread) and then buying agreater number of near-er term out-of-the-money options. \nThe position is generally constructed to be delta-neutral and it has anegative vega, \nmeaning that it will profit if implied volatility decreases. \nExample: XYZ is trading at 115 in early June. Its options are very expensive. Atrad\ner would like to construct avolatility backspread using the following two options: \nCall Option \nJuly 130 call: \nOctober 120 call: \nPrice \n2.50 \n13 \nDelta \n0.26 \n0.53 \nVega \n0.10 \n0.27 \nAdelta-neutral position would be to buy 2 of the July 130 calls and sell one of \nthe October 120 calls. This would bring in acredit of 8 points. Also, it would have asmall negative position vega, since tvvo times the vega of the July calls minus one \ntimes the vega of the October call is -0.07. That is, for each one percentage point \ndrop in implied volatility of XYZ options in general, this position would make $7 -\nnot alarge amount, but it is asmall position. \nThe profitability of the position is shown in Figure 39-6. This strategy has lim\nited risk because it does not involve naked options. In fact, if XYZ were to rally by agood distance, one could make large profits because of the extra long call. \nMeanwhile, on the downside, if XYZ falls heavily, all the options would lose most of \ntheir value and one would have aprofit approaching the amount of the initial credit \nreceived. Furthermore, adecrease in implied volatility produces asmall profit as \nwell, although time decay may not be in the trader'sfavor, depending on exactly \nwhich short-term options were bought. The biggest risk is that XYZ is exactly at 130 \nat July expiration, so any strategist employing this strategy should plan to close it out", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:894", "doc_id": "db1520e558c92e0d235fc997cdc974535864af117d8e9fafd20dfb41da082a20", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques \nFIGURE 39-6. \nVolatility backspread neutral position. \nUnderlying Price \n835 \nin advance of the near-term expiration. It should not be allowed to deteriorate to the \npoint of maximum loss. \nModifications to the strategy can be considered. One is to sell even longer-term \noptions and of course hedge them with the purchase of the near-term options. The \nlonger-term the option is, the bigger its vega will be, so adecrease in implied volatil\nity will cause the heftier-priced long-term option to decline more in price. This mod\nification is somewhat tempered, though, by the fact that when options get really \nexpensive, there is often atendency for the near-term options to be skewed. That is, \nthe near-term options will be trading with amuch higher implied volatility than will \nthe longer-term options. This is especially true for LEAPS options. For that reason, \none should make sure that he is not entering into asituation in which the shorter\nterm options could lose volatility while the longer-term ones more or less retain the \nsame implied volatility, as LEAPS options often do. This concept of differing volatil\nity between near- and long-term options was discussed in more detail in Chapter 36 \non the basics of volatility trading. As asort of general rule, if one finds that the longer\nterm option has amuch lower implied volatility than the one you were going to buy, \nthis strategy is not recommended. As acorollary, then, it is unlikely that this strate\ngy will work well with LEAPS options. \nOne other thing that you should analyze when looking for this type of trade is \nwhether it might be better to use the puts than the calls. For one thing, you can estab\nlish aposition in which the heavy profitability is on the downside (as opposed to the \nupside, as in the XYZ example above). Then, of course, having considered that, it \nmight actually behoove one to establish both the call spread and the put spread. If", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:895", "doc_id": "86f90b3eb75049dc007c6f3d8235605cb351e686b4999ec875957e2c6b8d053b", "chunk_index": 0}
{"text": "836 Part VI: Measuring and Trading Volatility \nyou do both, though, you create a \"good news, bad news\" situation. The good news \nis that the maximum risk is reduced; for example, if XYZ goes exactly to 130 (the \nworst point for the call spread), the companion put spread'scredit would reduce that \nrisk alittle. However, the bad news is that there is amuch wider range over which \nthere is not profit, since there are two spots where losses are more or less maximized \n(at the strike price of the long calls and again at the strike price of the long puts). \nMargin will be discussed only briefly, since it was addressed in the chapter on \nreverse spreads. For both index and stock options, this strategy is considered to have \nnaked options - apreposterous assumption, since one can see from the profit graph \nthat the position is fully hedged until the near-term options expire. This raises the \ncapital requirement for nonmember traders. The margin anomaly is not aproblem \nwith futures options, however. For those options, one need only margin the differ\nence in the strikes, less any credit received, because that is the true risk of the posi\ntion. In summary, the volatility trader who wants to sell volatility in equity and futures \noptions markets needs to be hedged, because gaps are prevalent and potentially very \ncostly. This strategy creates amore neutral, less price-dependent way to benefit if \nimplied volatility decreases, especially when compared with simple credit spreads. \nSUMMARY: TRADING THE \nVOLATILITY PREDICTION \nAttempting to establish trades when implied volatility is out of line is atheoretically \nattractive strategy. The process outlined above consisted of afew steps, employing \nboth statistical and theoretical analysis. In any case, though, probability calculators \nmust \"say\" that avolatility trade has good probabilities of success. It'smerely amat\nter of what criteria we apply to limit our choices before we run the probability analy\nsis. So, it might be more useful to view volatility trading analysis in this light: \nStep I: Use aselection criterion to limit the myriad of volatility trading choices. Any \nof these could be used as the first criterion, but not all of them at once: \na. Require implied volatility to be at an extreme percentile. \nb. Require historical and implied volatility to have alarge discrepancy \nbetween them. \nc. Interpret the chart of implied volatility to see if it has reversed trend. \nStep 2: Use aprobability calculator to project whether the strategy can be expected \nto be asuccess. \nStep 3: Using past price histories, determine whether the underlying has been able \nto create profitable trades in the past. (For example, if one is considering", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:896", "doc_id": "1f6ab18bc5020d0e73b3e0163108c879480f9c2fd6f842276bfe3d18ba98203a", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques 837 \nbuying astraddle, ask the question, \"Has this stock been able to move far \nenough, with great enough frequency, to make this straddle purchase prof\nitable?\") Use histograms to ensure that the past distribution of stock prices \nis smooth, so that an aberrant, nonrepeatable move is not overly influenc\ning the results. \nEach criterion from Step 1 would produce adifferent list of viable volatility \ntrading candidates on any given day. If aparticular candidate were to appear on more \nthan one of the lists, it might be the best situation of all. \nTRADING THE VOLATILITY SKEW \nIn the early part of this chapter, it was mentioned that there are two ways in which \nvolatility predictions could be \"wrong.\" The first was that implied volatility was out of \nline. The second is that individual options on the same underlying instrument have \nsignificantly different implied volatilities. This is called avolatility skew, and presents \ntrading opportunities in its own right. \nDIFFERING IMPLIED VOLATILITIES ON THE SAME UNDERLYING SECURITY \nThe implied volatility of an option is the volatility that one would have to use as input \nto the Black-Scholes model in order for the result of the model to be equal to the \ncurrent market price of the option. Each option will thus have its own implied volatil\nity. Generally, they will be fairly close to each other in value, although not exactly the \nsame. However, in some cases, there will be large enough discrepancies between the \nindividual implied volatilities to warrant the strategist'sattention. It is this latter con\ndition of large discrepancies that will be addressed in this section. \nExample: XYZ is trading at 45. The following option prices exist, along with their \nimplied volatilities: \nActual Implied \nOption Price Volatility \nJanuary 45 call 2.75 41% \nJanuary 50 call 1.25 47% \nJanuary 55 call 0.63 53% \nFebruary 45 call 3.50 38% \nFebruary 50 call 4.00 45%", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:897", "doc_id": "0dd43ab1b9474e8928560a9fd66d6e72a8490dde3d199cfd3910cc80ef375f8d", "chunk_index": 0}
{"text": "838 Part VI: Measuring and Trading Volatility \nNote that the implied volatilities of the individual options range from alow of \n38% to ahigh of 53%. This is arather large discrepancy for options on the same \nunderlying security, but it is useful for exemplary purposes. \nAneutral strategy could be established by buying options with lower implied \nvolatilities and simultaneously selling ones with higher volatilities, such as buy 10 \nFebruary 45 calls and sell 20 January 50 calls. Examples of neutral spreads will be \nexpanded upon in the next chapter, when more exact measures for determining how \nmany calls to buy and sell are discussed. \nBefore jumping into such aposition, the strategist should ask himself if there is \navalid reason why the different options have such different implied volatilities. As ageneralization, it might be fair to say that out-of-the-money options have slightly \nhigher implieds than at-the-money ones, and that longer-term options have lower \nimplieds than short-term ones. But there are many instances in which such is not the \ncase, so one must be careful not to overgeneralize. \nSpeculators often desire the lowest dollar-cost option available. Thus, in atakeover rumor situation, they would buy the out-of-the-moneys as opposed to the \nhigher-priced at- or in-the-moneys. If the out-of-the-moneys are extremely expen\nsive because of atakeover rumor, then the strategist must be careful, because the \nneutral strategy concept may lead him into selling naked calls. This is not to say \nhe should avoid the situation altogether; he may be able to structure aposition \nwith enough upside room to protect himself, or he may believe the rumors are \nfalse. \nReturning to the general topic of differing implied volatilities on the same \nunderlying stock, the strategist might ask how he is to determine if the discrepancies \nbetween the individual options are significantly large to warrant attention. Amathe\nmatical approach is presented at the end of the next chapter in asection on advanced \nmathematical concepts. Suffice it to say that there is away that the differences in the \nvarious implieds can be reduced to asingle number - asort of \"standard deviation of \nthe implieds\" that is easy for the strategist to use. Alist of these numbers can be con\nstructed, comparing which stocks or futures might be candidates for this type of neu\ntral spreading. On agiven day, the list is usually quite short - perhaps 20 stocks and \n10 futures contracts will qualify. \nThe concept of the implied volatilities of various options on the same underly\ning stock remaining out of line with each other is one that needs more discussion. In \nthe following section, the idea of semipermanent distortion between the volatilities \nof different striking prices is discussed.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:898", "doc_id": "ae02edcad74a253846c41f1cc9a9107cf44fb57cc24548c69329bff284ae81d6", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques \nVOLATILITY SKEWING \n839 \nAfter the stock market crashed in 1987, index options experienced what has since \nproven to be apermanent distortion: Out-of-the-money puts have remained more \nexpensive than out-of-the-money calls. Furthermore, out-of-the-money puts are \nmore expensive than at-the-money puts; out-of-the-money calls are cheaper than at\nthe-money calls. This distorted effect is due to several factors, but it is so deep-seat\ned that it has remained through all kinds of up and down markets since then. Other \nmarkets, particularly futures markets, have also experienced along-lasting distortion \nbetween the implied volatilities at various strikes. \nThe proper name given to this phenomenon is volatility skewing: the long-last\ning effect whereby options at different striking prices trade with differing implied \nvolatilities. It should be noted that the calls and puts at the same strike must trade \nfor the same implied volatility; otherwise, conversion or reversal arbitrage would \neliminate the difference. However, there is no true arbitrage between different strik\ning prices. Hence, arbitrage cannot eliminate volatility skewing. \nExample: Volatility skewing exists in OEX index options. Assume the average volatil\nity of OEX and its options is 16%. With volatility skewing present, the implied volatil\nities at the various striking prices might look like this: \nOEX: 580 \nImplied Volatility \nStrike of Both Puts and Calls \n550 22% \n560 19% \n570 17% \n580 16% \n590 15% \n600 14% \n610 13% \nIn this form of volatility skewing, the out-of-the-money puts are the most \nexpensive options; the out-of-the-money calls are the cheapest. This pattern of \nimplied volatilities is called areverse volatility skew or, alternatively, anegative \nvolatility skew.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:899", "doc_id": "a6b4eec710c4eafa9c2058908682f14bcb10328a39f97f657a802850c6842fde", "chunk_index": 0}
{"text": "840 Part VI: Measuring and Trading Volatility \nThe causes of this effect stem from the stock market'spenchant to crash occa\nsionally. Investors who want protection buy index puts; they don'tsell index futures \nas much as they used to because of the failure of the portfolio insurance strategy dur\ning the 1987 crash. In addition, margin requirements for selling naked index puts \nhave increased, especially for market-makers, who are the main suppliers of naked \nputs. Consequently, demand for index puts is high and supply is low. Therefore, out\nof-the-money index puts are overly expensive. \nThis does not entirely explain why index calls are so cheap. Part of the reason \nfor that is that institutional traders can help finance the cost of those expensive index \nputs by selling some out-of-the-money index calls. Such sales would essentially be \ncovered calls if the institution owned stocks, which it most certainly would. This strat\negy is called acollar. \nThis distortion in volatilities is not in accordance with the probability distribu\ntion of stock prices. These distorted implied volatilities define adifferent probability \ncurve for stock movement. They seem to say that there is more chance of the market \ndropping than there is of it rising. This is not true; in fact, just the opposite is true. \nRefer to the reasons for using lognormal distribution to define stock price move\nments. Consequently, there are opportunities to profit from volatility skewing, if one \nis able to hold the position until expiration. \nIt was shown in previous examples that one would attempt to sell the options \nwith higher implied volatilities and buy ones with lower implieds as ahedge. Hence, \nfor OEX traders, three strategies seem relevant: \n1. Buy abear put spread in OEX. \nExample: Buy 10 OEX June 560 puts \nSell IO OEX June 540 puts \n2. Buy OEX puts and sell alarger number of out-of-the-money puts - aratio write \nof put options. \nExample: Buy 10 OEX June 560 puts \nSell 20 OEX June 550 puts \n3. Sell OEX calls and buy alarger number of out-of-the-money calls - abackspread \nof call options. \nExample: Buy 20 OEX June 590 calls \nSell IO OEX June 580 calls \nIn all three cases, one is selling the higher implied volatility and buying options \nwith lower implied volatilities. The first strategy is asimple bear spread. While it will", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:900", "doc_id": "e898bc400bc406cc84ca7a0910c2beb046c38db3c716ee149acc3ce291d317d4", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques 841 \nbenefit from the fact that the options are skewed in terms of implied volatility, it is not \naneutral strategy. It requires that the underlying drop in price in order to become \nprofitable. There is nothing wrong with using adirectional strategy like this, but the \nstrategist must be aware that the skew is unlikely to disappear ( until expiration) and \ntherefore the index price movement is going to be necessary for profitability. \nThe second strategy would be best suited for moderately bearish investors, \nalthough asevere market decline might drive the index so low that the additional \nshort puts could cause severe losses. However, statistically this is an attractive strat\negy. At expiration, the volatility skewing must disappear; the markets will have moved \nin line with their real probability distribution, not the false one being implied by the \nskewed options. This makes for apotentially profitable situation for the strategist. \nThe backspread strategy would work best for bullish investors, although some \nbackspreads can be created for credits, so alittle money could also be made if the \nindex fell. In theory, astrategist could implement both strategies simultaneously, \nwhich would give him an edge over awide range of index prices. Again, this does not \nmean that he cannot lose money; it merely means that his strategy is statistically \nsuperior because of the way the options are priced. That is, the odds are in his favor. \nIn reality, though, aneutral trader would choose either the ratio spread or the \nbackspread - not both. As ageneral rule of thumb, one would use the ratio spread \nstrategy if the current level of implied volatility were in ahigh percentile. The back\nspread strategy would be used if implied volatility were in alow percentile current\nly. In that way, amovement of implied volatility back toward the 50th percentile \nwould also benefit the trade that is in place. \nAnother interesting thing happens in these strategies that may be to their ben\nefit: The volatility skewing that is present propagates itself throughout the striking \nprices as OEX moves around. It was shown in the previous section'sexample that one \nshould probably continue to project his profits using the distorted volatilities that \nwere present when he establishes aposition. This is aconservative approach, but acorrect one. In the case of these OEX spreads, it may be abenefit. \nAssuming that the skewing is present wherever OEX is trading means that the \nat-the-money strike will have 16% as its implied volatility regardless of the absolute \nprice level; the skewing will then extend out from that strike. So, if OEX rises to 600, \nthen the 600 strike would have avolatility of 16%; or if it fell to 560, then the 560 \nputs and calls would have avolatility of 16%. Of course, 16% is just arepresentative \nfigure; the \"average\" volatility of OEX can change as well. For illustrative purposes, \nit is convenient to assume that the at-the-money strike keeps aconstant volatility. \nExample: Initially, atrader establishes acall backspread in OEX options in order to \ntake advantage of the volatility skewing:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:901", "doc_id": "42dab561af2c6992e89b9958372997cd459aa80d97c9e6ba24432446be4f5330", "chunk_index": 0}
{"text": "842 \nInitial situation: OEX: 580 \nOption \nJune 590 call \nJune 600 call \nAneutral spread would be: \nBuy 2 June 600 calls \nSell I June 590 call \nImplied Volatility \n15% \n14% \nsince the deltas are in the ratio of 2-to-l. \nPart VI: Measuring and Trading Volatility \nDelta \n0.40 \n0.20 \nNow, suppose that OEX rises to 600 at alater date, but well before expiration. \nThis is not aparticularly attractive price for this position. Recall that, at expiration, abackspread has its worst result at the striking price of the purchased options. Even \nprior to expiration, one would not expect to have aprofit with the index right at 600. \nHowever, the statistical advantage that the strategist had to begin with might be \nable to help him out. The present situation would probably look like this: \nOption \nJune 590 call \nJune 600 call \nImplied Volatility \n17% \n16% \nThe June 600 call is now the at-the-money call, since OEX has risen to 600. As \nsuch, its implied volatility will be 16% ( or whatever the \"average\" volatility is for OEX \nat that time - the assumption is made that it is still 16% ). The June 590 call has aslightly higher volatility (17%) because volatility skewing is still present. \nThus, the options that are long in this spread have had their implied volatility \nincrease; that is abenefit. Of course, the options that are short had theirs increase as \nwell, but the overall spread should benefit for two reasons: \n1. Twice as many options are owned as were sold. \n2. The effect of increased volatility is greatest on the at-the-money option; the in\nthe-money will be affected to alesser degree. \nAll index options exhibit this volatility skewing. Volatility skewing exists in other \nmarkets as well. The other markets where volatility skewing is prevalent are usually", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:902", "doc_id": "ca28ad6ae15b338583a7b89ec8a0dae92de942695378d3e0e53aa013ea11efff", "chunk_index": 0}
{"text": "Chapter 39: Volatility Trading Techniques 843 \nfutures option markets. In particular, gold, silver, sugar, soybeans, and coffee options \nwill from time to time display aform of volatility skewing that is the opposite of that \ndisplayed by index options. In these futures markets, the cheapest options are out-of\nthe-money puts, while the most expensive options are out-of-the-money calls. \nExample: January soybeans are trading at 580 ($5.80 per bushel). The following \ntable of implied volatilities shows how volatility skewing that is present in the soybean \nmarket is the opposite of that shown by the OEX market in the previous examples: \nJanuary beans: 580 \nStrike Implied Volatility \n525 12% \n550 13% \n575 15% \n600 17% \n625 19% \n650 21% \n675 23% \nNotice that the out-of-the-money calls are now the more expensive items, while \nout-of-the-money puts are the cheapest. This pattern of implied volatilities is called \nforward volatility skew or, alternatively, positive volatility skew. \nThe distribution of soybean prices implied by these volatilities is just as incor\nrect as the OEX one was for the stock market. This soybean implied distribution is \ntoo bullish. It implies that there is amuch larger probability of the soybean market \nrising 100 points than there is of it falling 50 points. That is incorrect, considering the \nhistorical price movement of soybeans. \nAstrategist attempting to benefit from the forward ( or positive) volatility skew \nin this market has essentially three strategies available. They are the opposite of the \nthree recommended for the $OEX, which had areverse (or negative) volatility skew. \nFirst would be acall bull spread, second would be aput backspread, and third would \nbe acall ratio spread. In all three cases, one would be buying options at the lower \nstriking price and selling options at the higher striking price. This would give him the \ntheoretical advantage. \nThe same sorts of comments that were made about the OEX strategies can be \napplied here. The bull spread is adirectional strategy and can probably only be \nexpected to make money if the underlying rises in price, despite the statistical advan-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:903", "doc_id": "8c36d301b9758273389fc224caf5dd0a8a542cbfaecaa7e0773d7d0f3835eaa8", "chunk_index": 0}
{"text": "844 Part VI: Measuring and Trading VolatiRty \ntage of the volatility skew. The put backspread is best established when the overall \nlevel of implied volatility is in alow percentile. Finally, the call ratio spread has agreat deal of risk to the upside ( and futures prices can fly to the upside quickly, espe\ncially if bad fundamental conditions develop, such as weather in the grain markets). \nThe call ratio spread would best be used when implied volatilities are already in ahigh percentile. \nAs ageneral comment, it should be noted that if the volatility skew disappears \nwhile the trader has the position in place, aprofit will generally result. It would nor\nmally behoove the strategist to take the profit at that time. Otherwise, follow-up \naction should adhere to the general kinds of action recommended for the strategies \nin question: protective action to prevent large losses in the case of the ratio spreads, \nor the taking of partial profits and possibly rolling the long options to amore at-the\nmoney strike in the case of the backspread strategies. \nSUMMARY OF VOLATILITY SKEWING \nWhenever volatility skewing exists - no matter what market - opportunities arise for \nthe neutral strategist to establish aposition that has advantages. These advantages \narise out of the fact that normal market movements are different from what the \noptions are implying. Moreover, the options are wrong when there is skewing at all \nstrikes, from the lowest to the highest. The strategist should be careful to project his \nprofits prior to expiration using the same skewing, for it may persist for some time to \ncome. However, at expiration, it must of course disappear. Therefore, the strategist \nwho is planning to hold the position to expiration will find that volatility skewing has \npresented him with an opportunity for apositive expected return. \nSUMMARY OF VOLATILITY TRADING \nThe theoretical trading of options, mostly in aneutral manner, has evolved into one \nlarge branch - volatility trading. This part of the book has attempted to lay out the \nfoundations, structures, and practices prevalent in this branch of trading. As the read\ner can see, there are some sophisticated techniques being applied - not so much in \nterms of strategy, but in terms of the ways that one looks at volatility and in the ways \nthat stocks can move. \nStatistical methods are used liberally in trying to determine the ways that either \nvolatility can move or stocks can move. The probability calculators, stock price dis\ntributions, and related topics are all statistical in nature. The volatility trader is intent \non finding situations in which current market implied volatility is incorrect, either in \nits absolute value or in the skew that is prevalent in the options on aparticular under-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:904", "doc_id": "3a62f2c4a1f573ed1978d144ea407fa7cf1e0551e83721b319f18bdd9164798e", "chunk_index": 0}
{"text": "Chapter 39: VolatiDty Trading Techniques 845 \nlying instrument. Upon finding such discrepancies, the trader attempts to take \nadvantage by constructing amore or less neutral position, preferring not to predict \nprice so much, but rather attempting to predict volatility. \nMost volatility traders attempt to buy volatility rather than sell it, for the rea\nsons that the strategies inherent in doing so have limited risk and large potential \nrewards, and don'trequire one to monitor them continuously. If one owns astraddle, \nany major market movements resulting in gaps in prices are abenefit. Hence, mon\nitoring of positions as little as just once aday is sufficient, afact that means that the \nvolatility buyer can have alife apart from watching atrading screen all day long. In \naddition, volatility buyers of stock options can avail themselves of the chaotic move\nments that stocks can make, taking advantage of the occasional fat tail movements. \nHowever, since volatility and prices are so unstable, one cannot predict their \nmovements with any certainty. The vagaries of historical volatility as compared to \nimplied volatility, the differences between the implied volatility of short- and long\nterm options, and the difficulty in predicting stock price distributions all compli\ncate the process of predicting volatility. Hence, volatility trading is not a \"lock,\" but \nits practitioners normally believe that it is by far the best approach to theoretical \noption trading available today. Moreover, most option professionals primarily trade \nvolatility rather than directional positions.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:905", "doc_id": "d7051616c459711ef2b478201efc28131ee52eeaf276aeb113427333b4de7f0b", "chunk_index": 0}
{"text": ", CHAPTER 40 \nAdvanced Concepts \nAs the option markets have matured, strategists have been forced to rely more on \nmathematics in order to select new positions as well as to discern how their positions \nwill behave in fluctuating markets. These techniques can be used on simple strategies, \nsuch as bull spreads or ratio spreads, or on far more complex portfolios of options. \nFirst, the concept of implied volatility will be examined in more detail, prima\nrily as an aid in choosing new positions that have apositive expected return. Then, \nthe concept of risk management will be explored. In effect, one can reduce his option \nposition into several components of risk measurement that can be readily under\nstood. This chapter describes the techniques used to evaluate one'sposition, and \nshows how to use this information to reduce the risk in the position. The actual math\nematical calculations required to perform these analyses are included at the end of \nthe chapter. \nNEUTRALITY \nIn many of the examples in previous chapters, it was generally assumed that one \nwould take a \"neutral\" position in order to capture the pricing or volatility differen\ntial. Why this concentration on neutrality? Neutrality, as it applies to option positions, \nmeans that one is noncommittal with respect to at least one of the factors that influ\nence an option'sprice. Simply put, this means that one can design an option position \nin which he can profit, no matter which way the underlying security moves. \n846", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:906", "doc_id": "6c2fa55c4e6c719db83227e449539a712dde1188454a971582896ab99b5032c8", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 847 \nMost option strategies fall into one of two categories: as ahedge to astock or \nfutures strategy (for example, buying puts to protect aportfolio of stocks), or as aprofit venture unto itself. The latter category is where most traders find themselves, \nand they often approach it in afairly speculative manner - either by buying options \nor by being apremium seller (covered or uncovered). In such strategies, the trader \nis taking aview of the market; he needs certain price action from the underlying \nsecurity in order to profit. Even covered call writing, which is considered to be acon\nservative strategy, is subject to large losses if the underlying stock drops drastically. \nIt doesn'thave to be that way. Strategies can be devised that will have achance \nto profit regardless of price changes in the underlying stock, as well as because of \nthem. Such strategies are neutral strategies and they always require at least two \noptions in the position - aspread, straddle, or some other combination. Often, when \none constructs aneutral strategy, he is neutral with respect to price changes in the \nunderlying security. It is also possible, and often wise, to be neutral with respect to \nthe rate of price change of the underlying security, with respect to the volatility of \nthe security, or with respect to time decay. This is not to imply that any option spread \nthat is neutral will automatically be amoney-maker; rather, one looks for an \nopportunity - perhaps an overpriced series of options - and attempts to capture that \noverpricing by constructing aneutral strategy around it. Then, regardless of the \nmovement of the underlying stock, the strategist has achance of making money if the \noverpricing disappears. \nNote that the neutral approach is distinctly different from the speculator's, who, \nupon determining that he has discovered an underpriced call, would merely buy the \ncall, hoping for the stock to increase in price. He would not make money if XYZ fell \nin price unless there was ahuge expansion in implied volatility - not something to \ncount on. The next section of this chapter deals with how one determines his neu\ntrality. In effect, if he is not neutral, then he has risk of some sort. The following sec\ntions outline various measures of risk that the strategist can use to establish anew \nposition or manage an existing one. \nThe most important of these risk measurements is how much market exposure \nthe position currently has. This has previously been described as the \"delta.\" Of near\nly equal importance to the strategist is how much the option strategy will change with \nrespect to the rate of change in the price of the underlying security. Also of interest \nare how changes in volatility, in time remaining until expiration, or even in the risk\nfree interest rate will affect the position. Once the components of the option position \nare defined, the strategist can then take action to reduce the risk associated with any \nof the factors, should he so desire.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:907", "doc_id": "be82c112c3a860ebff3ccfdfa8c97aa55a28f14ea4068813199733854831d8b0", "chunk_index": 0}
{"text": "848 Part VI: Measuring and Trading Volatmty \nTHE \"GREEKS\" \nRisk measurements have generally been given the names of actual or contrived \nGreek letters. For example, \"delta\" was discussed in previous chapters. It has become \ncommon practice to refer to the exposure of an option position merely by describing \nit in terms of this \"Greek\" nomenclature. For example, \"delta long 200 shares\" means \nthat the entire option position behaves as if the strategist were merely long 200 shares \nof the underlying stock. In all, there are six components, but only four are heavily \nused. \nDELTA \nThe first risk measurement that concerns the option strategist is how much current \nexposure his option position has as the underlying security moves. This is called the \n\"delta.\" In fact, the term delta is commonly used in at least two different contexts: to \nexpress the amount by which an option changes for a I-point move in the underlying \nsecurity, or to describe the equivalent stock position of an entire option portfolio. \nReviewing the definition of the delta of an individual option (first described in \nChapter 3), recall that the delta is anumber that ranges between 0.0 and 1.0 for calls, \nand between -1.0 and 0.0 for puts. It is the amount by which the option will move if \nthe underlying stock moves 1 point; stated another way, it is the percentage of any \nstock price change that will be reflected in the change of price of the option. \nExample: Assume an XYZ January 50 call has adelta of 0.50 with XYZ at aprice of \n49. This means that the call will move 50% as fast as the stock will move. So, if XYZ \njumps to 51, again of 2 points, then the January 50 call can be expected to increase \nin price by 1 point (50% of the stock increase). \nIn another context, the delta of acall is often thought of as the probability of the \ncall being in-the-money at expiration. That is, ifXYZ is 50 and the January 55 call has \nadelta of 0.40, then there is a 40% probability that XYZ will be over 55 at January \nexpiration. \nPut deltas are expressed as negative numbers to indicate that put prices move \nin the opposite direction from the underlying security. Recall that deltas of out-of\nthe-money options are smaller numbers, tending toward 0 as the option becomes \nvery far out-of-the-money. Conversely, deeply in-the-money calls have deltas \napproaching 1.0, while deeply in-the-money puts have deltas approaching -1.0. \nNote: Mathematically, the delta of an option is the partial derivative of the \nBlack-Scholes equation ( or whatever formula one is using) with respect to stock \nprice. Graphically, it is the slope of aline that is tangent to the option pricing curve.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:908", "doc_id": "7d1ffff72af9f5e4663cbf43229b8339fb12e6c09ee3ac5256ca9b8538a9b386", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 849 \nLet us now take alook at how both volatility and time affect the delta of acall \noption. Much of the data to be presented in this chapter will be in both tabular and \ngraphical form, since some readers prefer one style or the other. \nThe volatility of the underlying stock has an effect on delta. If the stock is not \nvolatile, then in-the-money options have ahigher delta, and out-of-the-money \noptions have alower delta. Figure 40-1 and Table 40-1 depict the deltas of various \ncalls on two stocks with differing volatilities. The deltas are shown for various strike \nprices, with the time remaining to expiration equal to 3 months and the underlying \nstock at aprice of 50 in all cases. Note that the graph confirms the fact that alow\nvolatility stock'sin-the-money options have the higher delta. The opposite holds true \nfor out-of-the-money options: The high-volatility stock'soptions have the higher delta \nin that case. Another way to view this data is that ahigher-volatility stock'soptions will \nalways have more time value premium than the low-volatility stock's. In-the-money, \nthese options with more time value will not track the underlying stock price move\nment as closely as ones with little or no time value. Thus, in-the-money, the low\nvolatility stock'soptions have the higher delta, since they track the underlying stock \nprice movements more closely. Out-of-the-money, the entire price of the option is \ncomposed of time value premium. The ones with higher time value (the ones on the \nhigh-volatility stock) will move more since they have ahigher price. Thus, out-of-the\nmoney, the higher-volatility stock'soptions have the greater delta. \nTime also affects delta. Figures 40-2 (see Table 40-2) and 40-4 show the rela\ntionships between time and delta. Figure 40-2'sscales are similar to those in Figure \n40-2, delta vs. volatility: The deltas are shown for various striking prices, with XYZ \nassumed to be equal to 50 in all cases. Notice that in-the-money, the shorter-term \noptions have the higher delta. Again, this is because they have the least time value \npremium. Out-of-the-money, the opposite is true: The longer-term options have the \nhigher deltas, since these options have the most time value premium. \nFigure 40-3 (see Table 40-3) depicts the delta for an XYZ January 50 call with \nXYZ equal to 50. The horizontal axis in this graph is \"weeks until expiration.\" Note \nthat the delta of alonger-term at-the-money option is larger than that of ashorter\nterm option. In fact, the delta shrinks more rapidly as expiration draws nearer. Thus, \neven if astock remains unchanged and its volatility is constant, the delta of its options \nwill be altered as time passes. This is an important point to note for the strategist, \nsince he is constantly monitoring the risk characteristics of his position. He cannot \nassume that his position is the same just because the stock has remained at the same \nprice for aperiod of time. \nPosition Delta. Another usage of the term delta is what has previously been \nreferred to as the equivalent stock position (ESP); for futures options, it would be", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:909", "doc_id": "fed8e711c1e967424a74a8436e1797c11e3ec51927238a85b1134933f4a81c97", "chunk_index": 0}
{"text": "850 \nFIGURE 40-1. \nDelta comparison, with XYZ = 50. \n100 \n75 \n$ \n<ii 50 \n0 ',, .. .......... \nLow-Volatility Stock , \nPart VI: Measuring and Trading Volatility \n25 ', ', High-Volatility Stock \n', ',, .............. \n---.............. \n0 L..L _______ .....L _______ __:::::i~~ ..... -..:L-_ \n40 45 50 \nTABLE 40-1. \n55 \nStrike Price \n60 65 \nDelta comparison for different volatilities with XYZ = 50 and \ntime = 3 months. \nDelta \nStrike Price Low-Volatility Stock High-Volatility Stock \n40 100 94 \n45 93 78 \n50 51 53 \n55 11 29 \n60 1 13 \n65 0 5 \nreferred to as EFP (equivalent futures position). To differentiate between the two \nterms, the delta of the option is generally referred to as \"option delta,\" while the ESP \nor EFP is called \"position delta.\" Recall that the position delta is computed accord\ning to the following simple equation: \nPosition delta = Option'sdelta x Shares per option x Option quantity", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:910", "doc_id": "29df8e2123c564a1d4aeaad20f4753a546143263f6fc896def8d1f85cdae749a", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 853 \nif the stock moves far enough by expiration. Many market-makers and professional \ntraders attempt to structure these types of positions, if possible, in order to take \nadvantage of the sudden volatility that is inherent in today'smarkets. \nPosition \nPosition Delta Delta \nShort 4,500 XYZ 1.00 - 4,500 \nShort 1 00 XYZ April 25 calls 0.89 - 8,900 \nLong 50 XYZ April 30 calls 0.76 + 3,800 \nLong 139 XYZ July 30 calls 0.74 + 10,286 \nTotal ESP: + 686 \nThis position, though complicated to the naked eye, reduces to being long only \napproximately 700 shares of XYZ. This is commonly referred to as being \"delta long \n700 shares.\" Thus, the terms \"delta,\" when referring to the sum of the deltas of awhole position, and \"equivalent stock position\" are synonymous. \nThis position has some exposure to the market since it is delta long. If the posi\ntion delta were zero, it would be referred to as being delta neutral and would, theo\nretically, have no exposure to the market at that time. \nNote that one can derive some general characteristics of his delta by just exam\nining his portfolio by eye: Short calls or long puts will introduce negative delta into \nthe position; long calls or short puts will introduce positive delta. Furthermore, it is \nobvious that being long the underlying security adds to the long delta of the position, \nwhile being short the underlying security places more negative delta in the position. \nThe use of this information to adjust the delta of one'sposition will be discussed in alater section of this chapter. \nObviously, the delta of this entire position will change as the stock price moves \nup or down as time passes. The figure given is merely an instantaneous look at how \nthe position is structured. It is the need to know how the position will change when \nother factors change that has led strategists to employ the following concepts. \nGAMMA \nSimply stated, the gamma is how fast the delta changes with respect to changes in the \nunderlying stock price. It is known that the delta of acall increases as the call moves \nfrom out-of-the-money to in-the-money. The gamma is merely aprecise measure\nment of how fast the delta is increasing.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:913", "doc_id": "b96226a96475f927ae635a23532ecccf6645d68c3c99ec8fc9df59a6161eac14", "chunk_index": 0}
{"text": "854 Part VI: Measuring and Trading Volatility \nExample: With XYZ at 49, assume the January 50 call has adelta of 0.50 and agamma of 0.05. If XYZ moves up one point to 50, the delta of the call will increase \nby the amount of the gamma: It will increase from 0.50 to 0.55. \nAs with the delta, the gamma can also be expressed as apercentage. But in this \ncase, the increase or decrease applies to the delta. \nExample: Again, with XYZ at 49, assume the January 50 call has adelta of 0.50 and agamma of 0.05. If XYZ moves up 2 points to 51, the delta of the call will increase by \n5% of the stock rrwve, because the gamma is 0.05, or 5 percent. Five percent of the \nstock move is 0.05 x 2, or 0.10. Thus, the delta will increase by 0.10, from 0.50 to 0.60. \nObviously, the delta cannot keep increasing by 0.05 each time XYZ gains anoth\ner point in price, for it will eventually exceed 1.00 by that calculation, and it is known \nthat the delta has amaximum of 1.00. Thus, it is obvious that the gamma changes. In \ngeneral, the gamma is at its maximum point when the stock is near the strike of the \noption. As the stock moves away from the strike in either direction, the gamma \ndecreases, approaching its minimum value of zero. \nConceptually, this means that adeeply in-the-money or deeply out-of-the\nmoney option has agamma of nearly zero. This makes sense - it implies that the delta \nof adeep in- or deep out-of-the-money option does not change very much at all, even \nif the stock moves by one point. \nExample: Assume XYZ is 25, and the January 50 call has adelta of virtually zero. If \nXYZ moves up one point to 26, the call is still so far out-of-the-money that the delta \nwill still be zero. Thus, the gamma of this call is zero, since the delta does not change \nwhen the stock increases in price by apoint. \nIn asimilar manner, the January 45 put on XYZ would have adelta of -1.0 with \nXYZ at 25. If XYZ moved up one point to 26, the put' sdelta would not change; it is \nstill so far in-the-money that it would still be - 1.0. Thus, the gamma of this deeply \nin-the-money option is also zero, since the delta remains unchanged in the face of a \nI-point rise in the underlying security. \nNote that the gamma of any option is expressed as apositive number, whether \nthe option is aput or acall. \nOther properties of gamma are useful to know as well. As expiration nears, the \ngamma of at-the-money options increases dramatically. Consider an option with aday \nor two of life remaining. If it is at-the-money, the delta is approximately 0.50. \nHowever, if the stock were to move 2 points higher, the delta of the option would jump", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:914", "doc_id": "11449293f466cbcc3fe8fe73471098e8fbb6687437cffad98e1b5c0134c40a89", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 855 \nto nearly 1.00 because of the short time remaining until expiration. Thus, the gamma \nwould be roughly 0.25 (the delta increased by 0.50 when the stock moved 2 points), \nas compared to much smaller values of gamma for at-the-money options with several \nweeks or months of life remaining. The same 2-point rise in the underlying stock \nwould not result in much of an increase in the delta of longer-term options at all. \nOut-of-the-money options display adifferent relationship between gamma and \ntime remaining. An out-of-the-money option that is about to expire has avery small \ndelta, and hence avery small gamma. However, if the out-of-the-money option has asignificant amount of time remaining, then it will have alarger gamma than the \noption that is close to expiration. \nFigure 40-4 (see Table 40-4) depicts the gammas of three options with varying \namounts of time remaining until expiration. The properties regarding the relation\nship of gamma and time can be observed here. Notice that the short-term options \nhave very low gammas deeply in- or out-of the-money, but have the highest gamma \nat-the-money (at 50). Conversely, the longest-term, one-year option has the highest \ngamma of the three time periods for deeply in- or out-of-the-money options. The \ndata is presented in Table 40-4. This table contains aslight amount of additional data: \nthe gamma for the at-the-money option at even shorter periods of time remaining \nuntil expiration. Notice how the gamma explodes as time decreases, for the at-the\nmoney option. With only one week remaining, the gamma is over 0.28, meaning that \nthe delta of such acall would, for example, jump from 0.50 to 0.78 if the stock mere\nly moved up from 50 to 51. \nGamma is dependent on the volatility of the underlying security as well. At-the\nmoney options on less volatile securities will have higher gammas than similar options \non more volatile securities. The following example demonstrates this fact. \nExample: Assume XYZ is at 49, as is ABC. Moreover, XYZ is amore volatile stock \n(30% implied) as compared to ABC (20% ). Then, similar options on the two stocks \nwould have significantly different gammas. \nXYZ Gammas ABC Gammas \nOption (Volatility = 30%) (Volatility= 20%) \nJanuary 50 .066 .097 \nJanuary 55 .045 .039 \nJanuary 60 .019 .0053 \nFebruary 50 .055 .081 \nFebruary 60 .024 .011", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:915", "doc_id": "e36d9c067bba5c477ec628bff5e40c52f23fadd7cfd8ff795f9dcb14fd65c6cc", "chunk_index": 0}
{"text": "856 Part VI: Measuring and Trading VolatHity \nFIGURE 40-4. \nGamma comparison, with XYZ = 50. \n8 \n7 \n0 6 0 ..-\nX 5 \nCl! \nE 4 E \nCl! 3 (!) \n2 t= 1 year \nt= 6 months \nt= 3 months 0 '-'----~---__._ ___ _._ ___ _._ ___ ....___ \n40 45 50 55 60 65 \nStrike Price \nTABLE 40-4. \nGamma comparison - various amounts of time remaining \n(with XYZ = 50). \nTime Remaining Strike Price \n40 45 50 55 60 \n1 year .015 .029 .039 .04 .033 \n6 months .011 .037 .058 .051 .030 \n3 months .003 .039 .086 .057 .015 \n2 months .108 \n1 month .166 \n1 week .288 \n65 \n.023 \n.013 \n.002 \nNote that the at-the-money options (January 50'sand February 50's) on ABC, \nthe less volatile stock, have larger gammas than do their XYZ counterparts. However, \nlook one strike higher (January 55's), and notice that the more volatile options have aslightly higher gamma. Look two strikes higher and the more volatile options have avastly higher gamma, both for the January 60'sand the February 60's. \nThis concept makes sense if one thinks about the relationship between volatili\nty and delta. On nonvolatile stocks, one finds that the delta of even aslightly in\nthe-money option increases rapidly. This is because, since the stock is not volatile, \nbuyers are not willing to pay much time premium for the option. As aresult, the \ngamma is high as well, because as the stock moves into-the-money, the increase in", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:916", "doc_id": "edd3478171228547f44262a209feb086498bed10962b403db01259c87bb2ec09", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 857 \ndelta will be more dramatic than it would be for avolatile stock. Out-of-the-money \noptions are an entirely different story. Since the nonvolatile stock will have difficulty \nmoving fast enough to reach an out-of-the-money striking price, the delta of the out\nof-the-money option is small and it will not change quickly (that is, the gamma is \nsmall also). \nThese concepts are summarized in Figure 40-5 (see Table 40-5), which depicts \nthe gammas for similar options on stocks with differing volatilities. For the purposes \nof these graphs, XYZ is equal to 50 and there are three months remaining until expi\nration. \nNotice that for avery volatile stock, the gamma is quite stable over nearly all \nstriking prices when there are 3 months remaining until expiration. This means that \nthe deltas of all options on such avolatile stock will be changing quite abit for even \na 1-point move in the underlying stock. This is an important point for neutral strate\ngists to note, because aposition that starts out as delta neutral may quickly change if \nthe underlying stock is very volatile. As this table implies, the deltas of the options in \nthat \"neutral\" spread may be altered quickly, thereby rendering the spread quite un\nneutral. This concept will be discussed in greater detail later in this chapter. \nAs delta was used to construct the equivalent stock position of an entire option \nposition or portfolio, gamma can be used in asimilar manner. An example of this fol\nlows, using the same securities from the preceding example on the delta of aposi\ntion. An important point to note is that the gamma of the underlying security itself is \nzero. This is true because the delta of the underlying security (which is always 1.0) \nnever changes - hence the gamma is zero. The gamma is measuring the amount of \nchange of the delta; if the delta of the underlying security never changes, the gamma \nof the underlying security must be zero. \nExample: The following position exists when XYZ is at 31.75. Recall that it resem\nbles along straddle ( or backspread) in that there is increased profit potential in either \ndirection if the stock moves far enough by expiration. In addition to the delta previ\nously listed, the gamma is now shown as well. Note that since gamma is asmall \nabsolute number, it is sometimes calculated out to three or four decimal places. \nOption Position Option Position \nPosition Delta Delta Gamma Gamma \nShort 4,500 XYZ 1.00 - 4,500 0.0000 0 \nShort l 00 XYZ April 25 calls 0.89 - 8,900 0.0100 -100 \nLong 50 XYZ April 30 calls 0.76 + 3,800 0.0300 +150 \nLong 139 XYZ July 30 calls 0.74 +10,286 0.0200 +278 \nTotals: + 686 +328", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:917", "doc_id": "767be33cf78e345abdba455851e0af2ca014fa392e578b3f0564dc4115fd8ab8", "chunk_index": 0}
{"text": "858 Part VI: Measuring and Trading Volatility \nFIGURE 40-5. \nGamma comparison, with XYZ = 50, t = three months. \n8 \n7 \n0 6 \n0 \n~ 5 \n<ti \nE 4 E \n~ 3 \n2 \nTABLE 40-5. \n40 45 \nLow Volatility \nVery High Volatility \n50 55 60 \nStrike Price \n65 \nGamma comparison for varying volatilities (XYZ = 50, t = 3 \nmonths). \nGamma Very \nStrike Low Volatility High Volatility High Volatility \n40 .003 .013 .017 \n45 .039 .039 .022 \n50 .086 .057 .024 \n55 .057 .049 .025 \n60 .015 .028 .023 \n65 .002 .012 .020 \nAs before, the position still has adelta long of almost 700 shares. In addition, \none can now see that it has apositive gamma of over 300 shares. This means that the \ndelta can be expected to change by 328 shares for each point that XYZ moves: If it \nmoves up 1 point, the delta will increase to +1,014 (the current delta, 686, plus the \ngamma of 328). However, ifXYZ moves down by 1 point, then the delta will decrease \nto +358 (the current delta, 686, less the gamma of 328). \nNote that, in the above example, if XYZ continues higher, the gamma will \nremain positive (although it will eventually shrink some), and the delta will continue \nto increase. This means the position is getting longer and longer - afact that makes", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:918", "doc_id": "015ea557b6a44d6315c95ef20eda7d3a03e1faf59a3427e302e37f1a312b64ed", "chunk_index": 0}
{"text": "Chapter 40: Atlvanced Concepts 859 \nsense when one notes that there are extra long calls and they would be getting deep\ner in-the-money as the stock moves up. Conversely, if XYZ continues to move lower, \nthe delta will continue to decrease and will quickly become negative, meaning that \nthe position would become short overall. Hence, the position does indeed resemble \nalong straddle: It gets longer as the market moves up and it gets shorter as the mar\nket moves down. \nLong options, whether puts or calls, have positive gamma, while short options \nhave negative gamma. Thus, astrategist with aposition that has positive gamma has \nanet long option position and is generally hoping for large market movements. \nConversely, if one has aposition with negative gamma, it means he has shorted \noptions and wants the market to remain fairly stable. \nNote that it is possible to be delta neutral, but to have asignificant gamma. (For \nexample, if one owns puts and calls with offsetting deltas, he would be delta neutral, \nbut would have positive gamma since both options are long.) If one is delta neutral, \nhe knows he has no market exposure at this time, but his gamma will show him what \nexposure his position will acquire as the market moves. These concepts will be dis\ncussed in greater detail later in this chapter. \nVEGA OR TAU \nThere is no letter in the Greek alphabet called \"vega.\" Thus, some strategists, being \npurists, prefer to use areal Greek letter, \"tau,\" to refer to this risk measurement. The \nterm \"vega\" will be used in this book, but the reader should note that \"tau\" means \nthe same thing. Vega is the arrwunt by which the option price changes when the \nvolatility changes. Vega is always expressed as apositive number, whether it refers to \naput or acall. \nIt is known that more volatile stocks have more expensive options. Thus, as \nvolatility increases, the price of an option will rise. If volatility falls, the price of the \noption will fall as well. The vega is merely an attempt to quantify how much the \noption price will increase or decrease as the volatility moves, all other factors being \nequal. \nBefore considering an example, areview of the term volatility is in order. \nVolatility is ameasure of how quickly the underlying security moves around. \nStatistically, it is usually calculated as the standard deviation of stock prices over some \nperiod of time, generally annualized. This statistical measure is expressed as aper\ncent, although relating that percent to actual stock movements can be complicated. \nSuffice it to say that astock that has a 50% volatility is more volatile than astock with \n30% volatility. The stock market generally has avolatility of about 15% overall, \nalthough that may change from time to time (crashes, for example).", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:919", "doc_id": "59552a83350dae042416df93e84acb1596cd0c2b00fb2e7c20c3d97791cc90a6", "chunk_index": 0}
{"text": "860 Part VI: Measuring and Trading Vo/atiHty \nExample: Again, assume XYZ is at 49, and the January 50 call is selling for 3.50. The \nvega of the option is 0.25, and the current volatility of XYZ is 30%. \nIf the volatility increases by one percentage point or 1 % to 31 %, then the vega \nindicates that the option will increase in value by 0.25, to 3. 75. \nIf the volatility had instead decreased by 1 percent to 29%, then the January 50 \ncall would have decreased to 3.25 (aloss of 0.25, the amount of the vega). \nIf the implied volatility of an option increases, the option price will increase as \nwell. Consequently, even though XYZ stock may be exhibiting the same historic \nmovement that it always has, and therefore its (historical) volatility would be \nunchanged, if option buyers appear in sufficient quantity, they may drive the implied \nvolatility ofXYZ'soptions higher. Likewise, an excess of option sellers could drive the \nimplied volatility lower, even though the historical volatility does not change. So, it \nmust be concluded that vega measures how much the option price changes as implied \nvolatility changes. \nVega is related to time. Figure 40-6 (see Table 40-6) shows the vegas for options \nwith differing times remaining until expiration. The underlying stock is assumed to \nbe 50 in all cases. Notice that the more time that remains, the higher the vega is. It \nis interesting to note that, for very long-term options, the vega of the slightly out-of\nthe-money calls (strike = 55) is actually higher than that of the at-the-money. \nHowever, this discrepancy disappears as time passes. Not shown, but equally true, is \nthat the vega of aslightly out-of-the-money option on avery volatile stock may be \nhigher than that of the at-the-money. \nAs with the measurements of risk discussed already, vega can refer to the option \nitself (\"option vega\") or to the position as awhole (\"position vega\"). Since vega is \nexpressed as apositive number, if one is long options, then his position vega will be \npositive. This means he has exposure if volatilities decrease, or can make money if \nvolatilities increase. \nExample: Again, assume that we have the same backspread position as before, with \nXYZ at 31.75. \nOption Position \nPosition Vega Vega \nShort 4,500 XYZ 0.00 0 \nShort 100 XYZ April 25 calls 0.02 - 200 \nLong 50 XYZ April 30 calls 0.05 + 250 \nLong 139 XYZ July 30 calls 0.07 + 973 \nTotal Vega: + 1,023", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:920", "doc_id": "f4749572e948697462725ac86610970f8f4d400bda8aef661ce2547fe42f2b80", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts \nFIGURE 40-6. \nVega comparison, XYZ = 50. \n20 \n18 \n16 \n14 \n0 \n0 12 ,--\n.2S 10 C1l \nCl \n~ 8 \n6 t= 3 months \n4 \n2 \n0 \n40 45 50 \nStrike Price \nTABLE 40-6. \n861 \n55 60 65 \nVega comparison for different time periods (with XYZ = 50). \nVega \nStrike Price t = 1 Year t = 6 Months t = 3 Months \n40 0.12 0.06 0.02 \n45 0.16 0.11 0.06 \n50 0.19 0.13 0.09 \n55 0.20 0.13 0.08 \n60 0.18 0.11 0.05 \n65 0.16 0.07 0.02 \nThe vega is apositive 10.23 points ($1,023 since each point for these equity \noptions is worth $100). The fact that the position has apositive vega means that it is \nexposed to variations in volatility. If volatility decreases, the position will lose money: \n$1,023 for each one percentage point decrease in volatility. However, if volatility \nincreases, the position will benefit. \nVega is greatest for at-the-money options and approaches zero as the option is \ndeeply in- or out-of-the-money. Again, this is common sense, since adeep in- or out-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:921", "doc_id": "b95c78c942e9494b2903569327f64b95a9f2ac165adf7eb4a6e161590ba4c31d", "chunk_index": 0}
{"text": "860 Part VI: Measuring and Trading Volatility \nExample: Again, assume XYZ is at 49, and the January 50 call is selling for 3.50. The \nvega of the option is 0.25, and the current volatility of XYZ is 30%. \nIf the volatility increases by one percentage point or 1 % to 31 %, then the vega \nindicates that the option will increase in value by 0.25, to 3. 75. \nIf the volatility had instead decreased by 1 percent to 29%, then the January 50 \ncall would have decreased to 3.25 (aloss of 0.25, the amount of the vega). \nIf the implied volatility of an option increases, the option price will increase as \nwell. Consequently, even though XYZ stock may be exhibiting the same historic \nmovement that it always has, and therefore its (historical) volatility would be \nunchanged, if option buyers appear in sufficient quantity, they may drive the implied \nvolatility of XYZ'soptions higher. Likewise, an excess of option sellers could drive the \nimplied volatility lower, even though the historical volatility does not change. So, it \nmust be concluded that vega measures how much the option price changes as implied \nvolatility changes. \nVega is related to time. Figure 40-6 (see Table 40-6) shows the vegas for options \nwith differing times remaining until expiration. The underlying stock is assumed to \nbe 50 in all cases. Notice that the more time that remains, the higher the vega is. It \nis interesting to note that, for very long-term options, the vega of the slightly out-of\nthe-money calls (strike = 55) is actually higher than that of the at-the-money. \nHowever, this discrepancy disappears as time passes. Not shown, but equally true, is \nthat the vega of aslightly out-of-the-money option on avery volatile stock may be \nhigher than that of the at-the-money. \nAs with the measurements of risk discussed already, vega can refer to the option \nitself (\"option vega\") or to the position as awhole (\"position vega\"). Since vega is \nexpressed as apositive number, if one is long options, then his position vega will be \npositive. This means he has exposure if volatilities decrease, or can make money if \nvolatilities increase. \nExample: Again, assume that we have the same backspread position as before, with \nXYZ at 31.75. \nOption Position \nPosition Vega Vego \nShort 4,500 XYZ 0.00 0 \nShort 100 XYZ April 25 calls 0.02 - 200 \nLong 50 XYZ April 30 calls 0.05 + 250 \nLong 139 XYZ July 30 calls 0.07 + 973 \nTotal Vega: + 1,023", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:922", "doc_id": "4b7aac09763ba11da07b76f0b39ad5ec610ccb9af19205868a4b95ef02995ecb", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts \nFIGURE 40-6. \nVega comparison, XYZ = 50. \n20 \n18 \n16 \n14 \n0 \n0 12 ... \n6 10 (13 \n0) \n;g? 8 \n6 \n4 \n2 \n0 \n40 45 \nTABLE 40-6. \n861 \n50 55 60 65 \nStrike Price \nVega comparison for different time periods (with XYZ = 50). \nVega \nStrike Price t = 1 Year t = 6 Months t = 3 Months \n40 0.12 0.06 0.02 \n45 0.16 0.11 0.06 \n50 0.19 0.13 0.09 \n55 0.20 0.13 0.08 \n60 0.18 0.11 0.05 \n65 0.16 0.07 0.02 \nThe vega is apositive 10.23 points ($1,023 since each point for these equity \noptions is worth $100). The fact that the position has apositive vega means that it is \nexposed to variations in volatility. If volatility decreases, the position will lose money: \n$1,023 for each one percentage point decrease in volatility. However, if volatility \nincreases, the position will benefit. \nVega is greatest for at-the-money options and approaches zero as the option is \ndeeply in- or out-of-the-money. Again, this is common sense, since adeep in- or out-", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:923", "doc_id": "6c8a081ff1a1d2863c195856699a1fa9abc5e1a51673a5076cf2c4cf21e85b58", "chunk_index": 0}
{"text": "862 Part VI: Measuring and Trading Volatility \nof-the-money option will not be affected much by achange in volatility. In addition, \nfor at-the-money options, longer-term options have ahigher vega than short-term \noptions. To verify this, think of it in the extreme: An at-the-money option with one \nday to expiration will not be overly affected by any change in volatility, due to its \npending expiration. However, athree-month at-the-money option will certainly be \nsensitive to changes in volatility. \nVega does not directly correlate with either delta or gamma. One could have aposition with no delta and no gamma (delta neutral and gamma neutral) and still have \nexposure to volatility. This does not mean that such aposition would be undesirable; \nit merely means that if one had such aposition, he would have removed most of the \nmarket risk from his position and would be concerned only with volatility risk. \nIn later sections, the use of volatility to establish positions and the use of vega \nto monitor them will be discussed. \nTHETA \nTheta measures the time decay of aposition. All option traders know that time is the \nenemy of the option holder, and it is the friend of the option writer. Theta is the name \ngiven to the risk measurement of time in one'sposition. Theta is generally expressed \nas anegative number, and it is expressed as the amount by which the option value \nwill change. Thus, if an option has atheta of -0.12, that means the option will lose \n12 cents, or about an eighth of apoint, per day. This is true for both puts and calls, \nalthough the theta of aput and acall with the same strike and expiration date are not \nequal to each other. \nVery long-term options are not subject to much time decay in one day'stime. \nThus, the theta of along-term option is nearly zero. On the other hand, short-term \noptions, especially at-the-money ones, have the largest absolute theta, since they are \nsubject to the ravages of time on adaily basis. The theta of options on ahighly volatile \nstock will be higher than the theta of options on alow-volatility stock. Obviously, the \nformer options are more expensive (have more time value) and therefore have more \ntime value to lose on adaily basis, thereby implying that they have ahigher theta. \nFinally, the decay is not linear - an option will lose agreater percent of its daily value \nnear the end of its life. \nFigure 40-7 (see Table 40-7) depicts the relationships of thetas for various strik\ning prices and for differing volatilities on options with three months of life remain\ning. Again, notice that for very volatile stocks, the out-of-the-money options have \nthetas as large as the at-the-moneys. This is saying that as each day passes, the prob\nability of the stock reaching that out-of-the-money strike drops and causes the option", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:924", "doc_id": "51a78fdedd1288d577584aff1ba65549ea73a275bb7c713b912895ad595fd0f2", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts \nFIGURE 40-7. \nTheta comparison, with XYZ = 50, t = three months. \n-16 \nVery High Volatility \n-14 \n-12 \n0 0 \nT\"\" \nX \n~ \n-10 \n.i::: \nI-\n-8 Low Volatility \n-6 \n0 \n40 45 50 55 60 \nStrike Price \nTABLE 40-7. \n863 \n65 \nTheta comparison for differing volatilities (XYZ = 50, t = 3 months). \nStrike low Volatility Medium Volatility High Volatility \n40 -0.005 -0.008 -0.013 \n45 -0.007 -0.010 -0.014 \n50 -0.008 -0.010 -0.015 \n55 -0.007 -0.010 -0.016 \n60 -0.006 -0.009 -0.016 \n65 -0.004 -0.008 -0.015 \nto lose value. This does not change the fact that, for very short-term options, the theta \nis largest at-the-money. \nNormally, the theta of an individual option is of little interest to the strategist. \nHe generally would be more concerned with delta or gamma. However, as with the \nother risk measures, theta can be computed for an entire portfolio of options. This \nmeasure, the \"position theta,\" can be quite important because it gives the strategist \nagood idea of how much gain or loss he can expect on adaily basis, due to time ero\nsion. The following example demonstrates this point. Note that the underlying secu\nrity itself has atheta of zero, since it cannot lose any value due to time decay.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:925", "doc_id": "f4addaa5fd11e6d0f00823169a31ce73c7c2dd2a9e58db360de4ebcdf6388353", "chunk_index": 0}
{"text": "864 Part VI: Measuring and Trading Volatility \nExample: With XYZ at 49, the strategist has the following position in February, so \nthat the April calls are nearer to expiration than the July calls. This position is similar \nto alarge calendar spread position. \nOption Position \nPosition Theta Theta \nShort 4,000 XYZ 0.00 0 \nShort 150 XYZ April 50 calls -0.04 +600 \nLong 150 XYZ April 30 calls -0.02 -300 \nShort 78 XYZ July 30 puts -0.02 +156 \nTotal Theta: +456 \nThis position is expected to make $456 per day due to time decay. Note that \nshort options, whether puts or calls, have apositive position theta, while long options \nhave anegative position theta. Anegative position theta means the position has risk \ndue to time, while apositive position theta means time is working for the position. \nRHO \nRho is the name given to the price change of an option'svalue due to achange in \ninterest rates. Recall that one of the components that contributes to an option'sprice \nis interest rates. As interest rates rise, call prices will rise, but put prices will fall. The \nopposite is true as well: As interest rates fall, call prices decline and put prices rise. \nRho measures the amount by which these prices rise or fall. \nThis behavior of puts and calls with respect to interest rates may not be imme\ndiately obvious, but recall that the arbitrage that can be established with in-the\nmoney calls (the \"interest play,\" discussed in Chapter 27 on arbitrage) demonstrates \nthat arbitrageurs are willing to pay more for an in-the-money call as interest rates rise \nbecause they will be earning more interest on the stock that they sell short against \nthat in-the-money call. Thus, rising interest rates cause call prices to increase. \nThe opposite is true for puts: Rising interest rates cause put prices to decline. \nAgain, an arbitrage can be used to demonstrate the point. Recall that in areversal \narbitrage, the arbitrageur is selling the stock and the put while buying the call. We \nhave just demonstrated that, as interest rates rise, he is willing to pay more for the \ncall since he can earn extra interest on the short sale of his stock. This automatically \nmeans that he will be willing to sell the put for less. \nRho is expressed as apositive number for calls and anegative one for puts. Rho \nis smallest for deeply out-of-the-money options and is large for deeply-in-the-money \noptions. It is larger for longer-tenn options and is nearly zero for very short-tenn", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:926", "doc_id": "3d19fe865ba8aa391efc52ef110e7aa7a87b76ef931942e6d36bd52664bc81df", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 865 \noptions. The following table of option prices may help to demonstrate these rela\ntionships: \nExample: With XYZ at 49, the following options have the rho indicated (January is \nthe near-term expiration): \nMonth/Strike Call Rho Put Rho \nJanuary 35 0.05 -0.01 \nJanuary 50 0.03 -0.03 \nJanuary 60 0.00 -0.05 \nJuly 35 0.18 -0.02 \nJuly 50 0.14 -0.15 \nJuly 60 0.07 -0.18 \nNote that the in-the-money calls (35 strike) have larger rho than the out-of-the\nmoney 60's, in both January and July. Similarly, the in-the-money puts (the 60's) have \nlarger rho on an absolute basis than the out-of-the-money 35's. Again, this is true for \nboth January and July. \nFurthermore, note that the longer-term July rhos are all larger (again as \nabsolute numbers) than their shorter-term January counterparts. \nRho can also be calculated for an entire portfolio to obtain a \"position rho,\" sim\nilar to previous examples. Generally, one would not be overly concerned with his \nposition rho unless his portfolio contained quite afew long-term options and/or \ndeeply in-the-money ones. Thus, rho is more important as aconsideration when one \nis trading LEAPS or warrants, both of which may be extremely long-term vehicles. \nOf the risk measures discussed so far, rho is the least used, since many traders tend \nto have relatively short-term options in their positions. \nTHE GA,\\1MA OF THE GAMMA \nOccasionally, one may hear reference to the \"six measures of risk.\" This is the sixth \none and it is the most arcane. At any point, one knows the delta and gamma of an \noption. As the stock moves, the delta changes (by the amount of the gamma), but so \ndoes the gamma. Some traders are interested in knowing how much the gamma will \nchange when the stock moves. Hence, they will compute the gamma of the gamma, \nwhich is the arrwunt by which the gamma will change when the stock price changes. \nThis concept will be discussed at the end of this chapter. It is most important for \nstrategists involved in positions on highly volatile stocks, for if the stock moves far", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:927", "doc_id": "d866186c95aa92035e2e8c4af5861375d73da76fdcb5c72e72df7a7cc1012599", "chunk_index": 0}
{"text": "866 Part VI: Measuring and Trading VolatOity \nenough, the gamma (and therefore the delta) may change dramatically. Thus, one \nmight want to know how this risk measure affects his profitability. \nSUMMARY \nDelta: Positive delta indicates that aposition is currently bullish; if the underly\ning security goes up in price, the position should make money. Anegative \ndelta indicates abearish slant. \nGamma: Positive gamma means that the delta will increase if the underlying secu\nrity rises in price. Positive gamma generally implies that there is apre\nponderance of long options in the position, either puts or calls; negative \ngamma indicates written or naked options in the position. \nTheta: Negative theta means that the position will lose money as time passes \n(typical of positions with long options); positive theta implies that time is \nworking for the position (positions with written options). \nVega: Positive vega means that an increase of (perceived) volatility will benefit \nthe position - usually true of positions with long options in them; nega\ntive vega means that adecrease of volatility would be beneficial. \nSTRATEGY CONSIDERATIONS: USING THE \n11\nGREEKS\" \nBefore looking at how one operates aparticular strategy using delta, gamma, etc., it \nmight be beneficial to see how these factors relate to the individual strategies that \nhave been described throughout this book. Table 40-8 is ageneral guide to how the \nvarious strategies are exposed to various market factors. It is not an all-purpose or \nspecific table, because as the stock moves higher or lower, some of the risk measure\nment factors will certainly be affected. \nAfew assumptions were made in constructing the table. First, it was assumed \nthat the strategies where delta is noted as being zero are established in aneutral \nstance. The bull spread and bear spread strategies assumed that the stock was mid\nway between the striking prices. Two other spread strategies - ratio call and ratio put \n- assumed the stock was at the striking price of the option that was sold. In all other \ncases, there is only one striking price involved, and it was assumed that the stock was \nat the strike. \nThe table may help to clarify some of the concepts concerning the risk meas\nurement factors. First, notice that stock or futures - or any underlying security- have \nonly delta. None of the other factors pertains to the underlying security itself.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:928", "doc_id": "ccd4c319011d5e5ccc19a6a0ad3c85d1f6259738011b005da4428c1735034485", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 867 \nTABLE 40·8. \nGeneral risk exposure of common strategies. \nStrategy Delta Gamma Theta Vega RHo \nBuy stock + 0 0 0 0 \nSell stock short 0 0 0 0 \nCall buy + + + + \nPut buy + + \nStraddle buy 0 + + + \nCovered write + + \nNaked call sale + \nNaked put sale + + + \nRatio write \n(straddle sale) 0 + \nCalendar spread 0 + + \nBull spread + + \nBear spread + \nRatio call spread 0 + \nRatio put spread 0 + + \nAs might be expected, spread strategies involving both long and short options are \nless easily quantified than outright buys or sells. The calendar spread strategy is one \nin which the spreader does not want alot of stock movement - he would prefer the \nunderlying security to remain near the striking price, for that is the area of maximum \nprofit potential. This is reflected by the fact that gamma is negative. Also, for calendar \nspreads, the passage of time is good, afact that is reflected by the fact that theta is pos\nitive. Finally, since an increase in implied volatilities or interest rates would boost \nprices and widen the spread (creating aprofit), vega is positive and rho is negative. \nAbull spread has positive delta, reflecting the bullish nature of the spread, but \nit has negative gamma. The reason gamma is negative is that the position becomes \nless bullish as the underlying security rises, since the profit potential, and hence the \nbullishness of the position, is limited. For similar reasons, abear spread has negative \ndelta (reflecting bearishness) and negative gamma (reflecting limited bearishness). \nBoth the bull spread and the bear spread are the same with respect to the other risk \nmeasurements: Theta is negative, reflecting the fact that time decay can hurt the \nspread. Less obvious is the fact that these spreads are hurt by an increase in per\nceived volatility; anegative vega tells us this is true, however. \nThese risk measurement tools are important in that they can quite graphically \ndepict the risk and reward characteristics of an option position or option portfolio.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:929", "doc_id": "4039f40ec04fd15e688986d9676a28f610b9ad021aae6ee585948768720a260e", "chunk_index": 0}
{"text": "868 Part VI: Measuring and Trading Volatility \nThey are useful in establishing anew position, because one can see how much expo\nsure he is taking on. In addition, they are extremely useful for follow-up action, since \none can see how his position'scharacteristics have developed in the current market\nplace at the present time. In the following sections, the use of the risk measurement \ntools as aids in establishing aposition or in following up on aposition will be dis\ncussed in detail. \nDELTA NEUTRAL \nOne popular type of neutral position is to be delta neutral - that is, to have the equiv\nalent stock position (ESP) or equivalent futures position (EFP) be zero. Adelta neu\ntral position is one in which the sum of the projected price changes of the long options \nin the spread is essentially offset by the projected price changes of the short options \nin the same spread. \nExample: XYZ is trading at 50. The following three options are trading with the \nprices and deltas indicated. Furthermore, the \"theoretical value\" of each option is \nshown: \nXYZ:50 \n\"Theoretical \nOption Price Delta Value\" \nJanuary 50 call 3.00 0.55 3.50 \nJanuary 55 call 1.50 0.35 1.48 \nFebruary 50 put 3.50 -0.40 3.44 \nAssuming that one can rely upon these \"theoretical values\" (abig assumption, \nby the way), it is obvious that the January 50 call is cheap with respect to the other \noptions: They are close to their values, while the January 50 is 50 cents under. The \nneutral strategist would want to buy the January 50 call and hedge his purchase with \none of the other two options presented. One choice would be to establish aspread \nwherein the January 50 calls are bought and anumber of January 55'sare sold. To \ndetermine how many are to be bought and sold, one merely has to divide the deltas \nof the two options: \nDelta neutral spread ratio = 0.55/0.35 = 11-to-7 \nThus, adelta neutral ratio spread would consist of buying 7 January 50'sand sell\ning 11 January 55's. To verify that this spread is neutral with respect to the change in \nprice ofXYZ, notice that ifXYZ moves up in price 1 point, the January 50 will increase", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:930", "doc_id": "619b8a0795ecae92a4b1311d488a05df2b7dd82a5ed38fc3d2ae312bf6c3ff27", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 869 \nin price by 0.55; so seven of them will increase by 7 x 0.55, or 3.85 points total. \nSimilarly, the January 55 will increase in price by 0.35, so eleven of them would \nincrease in price by 11 x 0.35, or 3.85 points total. Hence, the long side of the spread \nwould profit by 3.85 points, while the short side loses 3.85 points - aneutral situation. \nThe resulting position is aratio spread. The profitability of the spread occurs \nbetween about 51 and 62 at expiration as shown in Figure 40-8, but that is not the \nmajor point. The real attractiveness of the spread to the neutral trader is that if the \nunderpriced nature of the January 50 call (vis-a-vis the January 55 call) should dis\nappear, the spread should produce aprofit, regardless of the short-term market \nmovement of XYZ. The spread could then be closed if this should occur. \nTo illustrate this fact, suppose that XYZ actually falls to 49, but the January 50 \ncall returns to \"fair value\": \nXYZ: 49 \n\"Theoretical \nOption Price Delta Value\" \nJanuary 50 call 3.00 0.52 3.00 \nJanuary 55 call 1.10 0.34 1.13 \nFebruary 50 put 3.90 -0.42 3.84 \nNotice that the theoretical values in this table are equal to the theoretical val\nues from the previous table, less the amount of the delta. Since the XYZ January 50 \ncall is no longer underpriced, the position would be removed, and the strategist \nwould make nothing on his January 50's, but would make .40 on each of the eleven \nshort January 55's, for aprofit of $440 less commissions. \nThis example leans heavily on the assumption that one is able to accurately esti\nmate the theoretical value and delta of the options. In real life, this chore can be \nquite difficult, since the estimate requires one to define the future volatility of the \ncommon stock. This is not easy. However, for the purposes of aspread, the ratio of \nthe two deltas is used. Moreover, the example didn'trequire that one know the exact \ntheoretical value of each option; rather, the only knowledge that was required was \nthat one of the options was cheap with respect to the other options. \nAs an alternative to aratio spread, another type of delta neutral position could \nbe established from the previous data: Buy the January 50 call (this is the basis of the \nposition since it is supposedly the cheap option) and buy the February 50 put - the \nonly other choice from the data given. This position is along straddle of sorts. Recall \nthat the delta of aput is negative; so again, the delta neutral ratio can be calculated \nby dividing the absolute value of two deltas: \nDelta neutral straddle ratio= 0.55/1-0.401 = 11-to-8", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:931", "doc_id": "f96761fcad3859c11dbe37e64dcfb63da487582a106d83954c85e7a0310078a0", "chunk_index": 0}
{"text": "870 \nFIGURE 40-8. \nXYZ ratio spread. \nf/) \nf/) \n3000 \n2000 \n.3 1000 \n~ \nea.. \n(r.> \n40 \nPart VI: Measuring and Trading Volatility \n45 55 60 \nAt Expiration \nStock Price \nThus, adelta neutral straddle position would consist of buying 8 Janua:ry 50 calls \nand buying 11 Februa:ry 50 puts. The straddle has no market exposure, at least over \nthe short term. Note that the delta neutral straddle has asignificantly different prof\nit picture from the delta neutral ratio spread, but they are both neutral and are both \nbased on the fact that the Janua:ry 50 call is cheap. The straddle makes money if the \nstock moves alot, while the other makes money if the stock moves only alittle. (See \nFigure 40-9.) \nCan these two vastly different profit pictures be depicting strategies in which \nthe same thing is to be accomplished ( that is, to capture the underpriced nature of \nthe XYZ Janua:ry 50 call)? Yes, but in order to decide which strategy is \"best,\" the \nstrategist would have to take other factors into consideration: the historical volatility \nof the underlying security, for example, or how much actual time remains until \nJanua:ry expiration, as well as his own psychological attitude toward selling uncovered \ncalls. Amore precise definition of the other risks of these two positions can be \nobtained by looking at their position gammas. \nDelta Neutral Is Not Entirely Neutral. In fact, delta neutral means that \none is neutral only with respect to small price changes in the underlying securi\nty. Adelta neutral position may have seriously unneutral characteristics when", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:932", "doc_id": "ff9350e5045a90f42b5fa2bc22d2d734252f40361eab237a93a92321ab2db286", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts \nFIGURE 40-9. \nXYZ straddle buy. \nCl) \n8000 \n7000 \n6000 \n5000 \n4000 \n~ 3000 \n~ 2000 \n! 1000 \n01------------------------\n-1000 \n-2000 \n-3000 At January Expiration \nStock Price \n871 \nsome of the other risk measurements are considered. Consequently, one cannot \nblithely go around establishing delta neutral positions and ignoring them, for \nthey may have significant market risk as certain factors change. \nFor example, it is obvious to the naked eye that the two positions described in \nthe previous section - the ratio spread and the long straddle - are not alike at all, \nbut both are delta neutral. If one incorporates the usage of some of the other risk \nmeasurements into his position, he will be able to quantify the differences between \n\"neutral\" strategies. The sale of astraddle will be used to examine how these vari\nous factors work. \nPositions with naked options in them have negative position gamma. This \nmeans that as the underlying security moves, the position will acquire traits opposite \nto that movement: If the security rises, the position becomes short; if it falls, the posi\ntion becomes long. This description generally fits any position with naked options, \nsuch as aratio spread, anaked straddle, or aratio write. \nExample: XYZ is at 88. There are three months remaining until July expiration, and \nthe volatility of XYZ is 30%. Suppose 100 July 90 straddles are sold for 10 points -\nthe put and the call each selling for 5. Initially, this position is nearly delta neutral, as", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:933", "doc_id": "916d62e246e36cd55e4d45e8e222875072f8ac8701330e97804fe973d0c9928d", "chunk_index": 0}
{"text": "872 Part VI: Measuring and Trading Volatility \nshown in Table 40-9. However, since both options are sold, each sale places negative \ngamma in the position. \nThe usefulness of calculating gamma is shown by this example. The initial posi\ntion is NET short only 100 shares of XYZ, avery small delta. In fact, aperson who is \natrader of small amounts of stock might actually be induced into believing that he \ncould sell these 100 straddles, because that is equivalent to being short merely 100 \nshares of the stock. \nTABLE 40-9. \nPosition delta and gamma of straddle sale. XYZ = 88. \nOption Position Option Position \nPosition Delto Delta Gamma Gamma \nSell l 00 July 90 calls 0.505 -5,050 0.03 -300 \nSell 1 00 July 90 puts 0.495 +4,950 0.03 -300 \nTotal shares - 100 -600 \nCalculating the gamma quickly dispels those notions. The gamma is large: 600 \nshares of negative gamma. Hence, if the stock moves only 2 points lower, this trad\ner'sstraddle position can be expected to behave as if it were now long 1,100 shares \n(the original 100 shares short plus 1,200 that the gamma tells us we can expect to get \nlong)! The position might look like this after the stock drops 2 points: \nXYZ: 86 \nPosition \nSold 1 00 July 90 calls \nSold 100 July 90 puts \nOption \nDelta \n0.44 \n0.55 \nPosition \nDelta \n-4,400 \n+5,500 \n+ 1 , 100 shares \nHence, a 2-point drop in the stock means that the position is already acquiring \na \"long\" look. Further drops will cause the position to become even \"longer.\" This is \ncertainly not aposition - being short 100 straddles - for asmall trader to be in, even \nthough it might have erroneously appeared that way when one observed only the \ndelta of the position. Paying attention to gamma more fully discloses the real risks. \nIn asimilar manner, if the stock had risen 2 points to 90, the position would \nquickly have become delta short. In fact, one could expect it to be short 1,300 shares \nin that case: the original short 100 shares plus the 1,200 indicated by the negative \ngamma. Arise to 90, then, would make the position look like this:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:934", "doc_id": "dd780f91f25d99f7a04b3539e0c508166e202c4b6148a4c3feb941037efa9512", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts \nXYZ:90 \nPosition \nSold 100 July 90 calls \nSold 1 00 July 90 puts \nOption \nDelto \n0.56 \n0.43 \nPosition \nDelta \n-5,600 \n+4,300 \n873 \n1,300 shares \nThese examples demonstrate how quickly alarge position, such as being short \n100 straddles, can acquire alarge delta as the stock moves even asmall distance. \nExtrapolating the moves is not completely correct, because the gamma changes as \nthe stock price changes, but it can give the trader some feel for how much his delta \nwill change. \nIt is often useful to calculate this information in advance, to some point in the \nnear future. Figure 40-10 depicts what the delta of this large short straddle position \nwill be, two weeks after it was first sold. The points on the horizontal axis are stock \nprices. The quickness with which the neutrality of the position disappears is alarm\ning. Asmall move up to 93 - only one standard deviation - in two weeks makes the \noverall position short the equivalent of about 3,300 shares of XYZ. Figure 40-10 real\nly shows nothing more than the effect that gamma is having on the position, but it is \npresented in aform that may be preferable for some traders. \nWhat this means is that the position is \"fighting\" the market: As the market goes \nup, this position becomes shorter and shorter. That can be an unpleasant situation, \nboth from the point of view of creating unrealized losses as well as from apsycho\nlogical viewpoint. The position delta and gamma can be used to estimate the amount \nof unrealized loss that will occur: Just how much can this position be expected to lose \nif there is aquick move in the underlying stock? The answer is quickly obtained from \nthe delta and gamma: With the first point that XYZ moves, from 88 to 89, the posi\ntion acts as if it is short 100 shares (the position delta), so it would lose $100. With \nthe next point that XYZ rises, from 89 to 90, the position will act as if it is short the \noriginal 100 shares (the position delta), plus another 600 shares (the position \ngamma). Hence, during that second point of movement by XYZ, the entire position \nwill act as if it is short 700 shares, and therefore lose another $700. Therefore, an \nimmediate 2-point jump in XYZ will cause an unrealized loss of $800 in the position. \nSummarizing: \nLoss, first point of stock movement = position delta \nLoss, second point of stock movement = position delta + gamma \nTotal loss for 2 points of stock movement \n= 2 xposition delta + position gamma", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:935", "doc_id": "2736b4fab5cc16971abf93ae2d50b971c5ccb4dc4c4f5edefb2d2561ad6ed1b2", "chunk_index": 0}
{"text": "874 Part VI: Measuring and Trading Volatility \nFIGURE 40· 1 O. \nProiected delta, in 14 days. \n6000 \n4500 \n3000 \nCl) 1500 ~ ro .c \n(/) \n0 'E \n(1) \n80 85 ~ ·5 -1500 \n95 \nXYZ Stock Price \nC\" \nUJ \n-3000 \n-4500 \nUsing the example data: \nLoss, XYZ moves from 88 to 89: -$100 (the position delta) \nLoss, XYZ moves from 89 to 90: -$100 (delta) - $600 (gamma) \n: -$700 \nTotal loss, XYZ moves from 88 to 90: -$100 x 2 - $600 = -$800 \nThis can be verified by looking at the prices of the call and put after XYZ has jumped \nfrom 88 to 90. One could use amodel to calculate expected prices if that happened. \nHowever, there is another way. Consider the following statements: \nIf the stock goes up by 1 point, the call will then have aprice of: \np 1 = Po + delta \n5.505 = 5.00 + 0.505 (if XYZ goes to 89 in the example) \nIf the stock goes up 2 points, the call will have an increase of the above amount \nplus asimilar increase for the next point of stock movement. The delta for that sec\nond point of stock movement is the original delta plus the gamma, since gamma tells \none how much his delta is going to change.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:936", "doc_id": "4abb45927ba76017134ddbf562d2ae2ec092c94b97ab8ffb448043d7869af6a2", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts \np2 = p 1 +delta+ gamma, or substituting from above \np2 = (p0 + delta) + delta + gamma \n= Po + 2 xdelta + gamma \n6.04 = 5.00 + 2 x 0.505 + 0.03 (in the example if XYZ = 90) \n875 \nBy the same calculation, the put in the example will be priced at 4.04 if XYZ imme\ndiately jumps to 90: \n4.04 = 5.00 - 2 X 0.495 + 0.03 \nSo, overall, the call will have increased by 1.04, but the put will only have \ndecreased by 0.96. The unrealized loss would then be computed as -$10,400 for the \n100 calls, offset by again of $9,600 on the sale of 100 puts, for anet unrealized loss \nof $800. This verifies the result obtained above using position delta and position \ngamma. Again, this confirms the logical fact that aquick stock movement will cause \nunrealized losses in ashort straddle position. \nContinuing on, let us look at some of the other factors affecting the sale of this \nstraddle. The straddle seller has time working in his favor. After the position is estab\nlished, there will not be as much decay in the first two-week period as there will be \nwhen expiration draws near. The exact amount of time decay to expect can be calcu\nlated from the theta of the position: \nXYZ: 88 \nPosition \nSold l 00 July 90 calls \nSold l 00 July 90 puts \nOption \nTheta \n-0.03 \n-0.03 \nPosition \nTheta \n+$300 \n+$300 \n+$600 \nThis is how the position looked with respect to time decay when it was first \nestablished (XYZ at 88 and three months remaining until expiration). The theta of the \nput and the call are essentially the same, and indicate that each option is losing about \n3 cents of value each day. Note that the theta is expressed as anegative number, and \nsince these options are sold, the position theta is apositive number. Apositive posi\ntion theta means time decay is working in your favor. One could expect to make $300 \nper day from the sale of the 100 calls. He could expect to make another $300 per day \nfrom the sale of the 100 puts. Thus, his overall position is generating atheoretical \nprofit from time decay of $600 per day. \nThe fact that the sale of astraddle generates profits from time decay is not \nearth-shattering. That is awell-known fact. However, the amount of that time decay", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:937", "doc_id": "294649cd86d712d7de0ffa3239e91435ffc5ebd4650681c8d3ec0cc9eeadb697", "chunk_index": 0}
{"text": "876 Part VI: Measuring and Trading Volatility \nis quantified by using theta. Furthermore, it serves to show that this position, which \nis delta neutral, is not neutral with respect to the passage of time. \nFinally, let us examine the position with respect to changes in volatility. This is \ndone by calculating the position vega. \nXYZ:88 \nPosition \nSold 1 00 July 90 calls \nSold 100 July 90 puts \nOption \nVega \n0.18 \n0.18 \nPosition \nVega \n-$1,800 \n-$1,800 \n-$3,600 \nAgain, this information is displayed at the time the position was established, \nthree months to expiration, and with avolatility of 30% for XYZ. The vega is quite \nlarge. The fact that the call'svega is 0.18 means that the call price is expected to \nincrease by 18 cents if the implied volatility of the option increases by one percent\nage point, from 30% to 31 %. Since the position is short 100 calls, an increase of 18 \ncents in the price of the call would translate into aloss of $1,800. The put has asim\nilar vega, so the overall position would lose $3,600 if the options trade with an \nincrease in volatility of just one percentage point. Of course, the position would make \n$3,600 if the volatility decreased by one percentage point, to 29%. \nThis volatility risk, then, is the greatest risk in this short straddle position. As \nbefore, it is obvious that an increase in volatility is not good for aposition with naked \noptions in it. The use of vega quantifies this risk and shows how important it is to \nattempt to sell overpriced options when establishing such positions. One should not \nadhere to any one strategy all the time. For example, one should not always be sell\ning naked puts. If the implied volatilities of these puts are below historical norms, \nsuch astrategy is much more likely to encounter the risk represented by the posi\ntion vega. There have been several times in the recent past - mostly during market \ncrashes - when the implied volatilities of both index and equity options have leaped \ntremendously. Those times were not kind to sellers of options. However, in almost \nevery case, the implied volatility of index options was quite low before the crash \noccurred. Thus, any trader who was examining his vega risk would not have been \ninclined to sell naked options when they were historically \"cheap.\" \nIn summary then, this \"neutral\" position is, in reality, much more complex when \none considers all the other factors.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:938", "doc_id": "e655b0dbf5c8f60667d74854f493d75a0ca0bc89979f401ef6bd8c5d03204c82", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts \nPosition summary \nRisk Factor \nPosition delta = l 00 \nPosition gamma = -600 \nPosition theta = +$600 \nPosition vega = -$3,600 \n877 \nComment \nNeutral; no immediate exposure to small \nmarket movements; lose $100 for 1 \npoint move in underlying. \nFairly negative; position will react \ninversely to market movements, causing \nlosses of $700 for second point of \nmovement by underlying. \nFavorable; the passage of time works in the \nposition'sfavor. \nVery negative; position is extremely \nsubject to changes in implied volatility. \nThis straddle sale has only one thing guaranteed to work for it initially: time \ndecay. (The risk factors will change as price, time, and volatility change.) Stock price \nmovements will not be helpful, and there will always be stock price movements, so \none can expect to feel the negative effect of those price changes. Volatility is the big \nunknown. If it decreases, the straddle seller will profit handsomely. Realistically, \nhowever, it can only decrease by alimited amount. If it increases, very bad things will \nhappen to the profitability of the position. Even worse, if the implied volatility is \nincreasing, there is afairly likely chance that the underlying stock will be jumping \naround quite abit as well. That isn'tgood either. Thus, it is imperative that the strad\ndle seller engage in the strategy only when there is areasonable expectation that \nvolatilities are high and can be expected to decrease. If there is significant danger of \nthe opposite occurring, the strategy should be avoided. \nIf volatility remains relatively stable, one can anticipate what effects the passage \nof time will have on the position. The delta will not change much, since the options \nare nearly at-the-money. However, the gamma will increase, indicating that nearer to \nexpiration, short-term price movements will have more exaggerated effects on the \nunrealized profits of the position. The theta will grow even more, indicating that time \nwill be an even better friend for the straddle writer. Shorter-term options tend to \ndecay at afaster rate than do longer-term ones. Finally, the vega will decrease some \nas well, so that the effect of an increase in implied volatility alone will not be as dam\naging to the position when there is significantly less time remaining. So, the passage", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:939", "doc_id": "37f5f1163cc978e89a7f64b441aa546d5411f06551cdaf075f8b6e0766393f92", "chunk_index": 0}
{"text": "878 Part VI: Measuring and Trading Volatility \nof time generally will improve most aspects of this naked straddle sale. However, that \ndoes not mitigate the current situation, nor does it imply that there will be no risk if \nalittle time passes. \nThe type of analysis shown in the preceding examples gives amuch more in\ndepth look than merely envisioning the straddle sale as being delta short 100 shares \nor looking at how the position will do at expiration. In the previous example, it is \nknown that the straddle writer will profit if XYZ is between 80 and 100 in three \nmonths, at expiration. However, what might happen in the interim is another matter \nentirely. The delta, gamma, theta, and vega are useful for the purpose of defining \nhow the position will behave or misbehave at the current point in time. \nRefer back to the table of strategies at the beginning of this section. Notice that \nratio writing or straddle selling ( they are equivalent strategies) have the characteris\ntics that have been described in detail: Delta is 0, and several other factors are neg\native. It has been shown how those negative factors translate into potential profits or \nlosses. Observing other lines in the same table, note that covered writing and naked \nput selling ( they are also equivalent, don'tforget) have adescription very similar to \nstraddle selling: Delta is positive, and the other factors are negative. This is aworse \nsituation than selling naked straddles, for it entails all the same risks, but in addition \nwill suffer losses on immediate downward moves by the underlying stock. The point \nto be made here is that if one felt that straddle selling is not aparticularly attractive \nstrategy after he had observed these examples, he then should feel even less inclined \nto do covered writing, for it has all the same risk factors and isn'teven delta neutral. \nAn example that was given in the chapter on futures options trading will be \ne,,'Panded as promised at this time. To review, one may often find volatility skewing \nin futures options, but it was noted that one should not normally buy an at-the-money \ncall (the cheapest one) and sell alarge quantity of out-of-the-money calls just because \nthat looks like the biggest theoretical advantage. The following example was given. It \nwill now be expanded to include the concept of gamma. \nExample: Heavy volatility skewing exists in the prices of January soybean options: \nThe out-of-the-money calls are much more expensive than the at-the-money calls. \nThe following data is known: \nJanuary soybeans: 583 \nOption Price Implied Volatility Delta Gamma \n575 call 19.50 15% 0.55 .0100 \n675 call 2.25 23% 0.09 .0026", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:940", "doc_id": "60f48f3ce82ae84556c4191a60331e6730c8a80e2c099bf9138687b02af3ca05", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts \nUsing deltas, the following spread appears to be neutral: \nBuy l January bean 57 5 call at 19 .50 \nSell 6 January bean 675 calls at 2.25 \nNet position: \n19.50 DB \n13.50 CR \n6 Debit \n879 \nAt the time the original example was presented, it was demonstrated through \nthe use of the profit picture that the ratio was too steep and problems could result in \nalarge rally. \nNow that one has the concept of gamma at his disposal, he can quantify what \nthose problems are. \nThe position gamma of this spread is quite negative: \nPosition gamma = .01 - 6 x .0026 = -0.0056 \nThat is, for every 10 points that January soybeans rally, the position will become \nshort about 1/2 of one futures contract. The maximum profit point, 675, is 92 points \nabove the current price of 583. While beans would not normally rally 92 points in \nonly afew days, it does demonstrate that this position could become very short if \nbeans quickly rallied to the point of maximum profit potential. Rest assured there \nwould be no profit if that happened. \nEven asmall rally of 20 cents (points) in soybeans - less than the daily limit -\nwould begin to make this tiny spread noticeably short. If one had established the \nspread in some quantity, say buying 100 and selling 600, he could become seriously \nshort very fast. \nAneutral spreader would not use such alarge ratio in this spread. Rather, he \nwould neutralize the gamma and then attempt to deal with the resulting delta. The \nnext section deals with ways to accomplish that. \nCREATING MULTIFACETED NEUTRALITY \nSo what is the strategist to do? He can attempt to construct positions that are neutral \nwith respect to the other factors if he perceives them as arisk. There is no reason why \naposition cannot be constructed as veg aneutral rather than delta neutral, if he wants \nto eliminate the risk of volatility increases or decreases. Or, maybe he wants to elim\ninate the risk of stock price movements, in which case he would attempt to be gamma \nneutral as well as delta neutral. \nThis seems like asimple concept until one first attempts to establish aposition \nthat is neutral with respect to more than one risk variable. For example, if one is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:941", "doc_id": "454cedd2b7b6b4ffec87049ea7cbedc22485b9a4c219b723be09970ec8a7e505", "chunk_index": 0}
{"text": "880 Part VI: Measuring and Trading VolatiRty \nattempting to create aspread that is neutral with respect to both gamma and delta, \nhe could attempt it in the following way: \nExample: XYZ is 60. Aspreader wants to establish aspread that is neutral with \nrespect to both gamma and delta, using the following prices: \nOption \nOctober 60 call \nOctober 70 call \nDelta \n0.60 \n0.25 \nGamma \n0.050 \n0.025 \nThe secret to determining aspread that is neutral with respect to both risk meas\nures is to neutralize gamma first, for delta can always be neutralized by taking an off\nsetting position in the underlying security, whether it be stock or futures. First, deter\nmine agamma neutral spread by dividing the two gammas: \nGamma neutral ratio= 0.050/0.025 = 2-to-l \nSo, buying one October 60 and selling two October 70 calls would be agamma \nneutral spread. Now, the position delta of that spread is computed: \nPosition \nLong 1 October 60 call \nShort 2 October 70 calls \nNet position delta: \nDelta \n0.60 \n0.25 \nPosition Delta \n+60 shares \n-50 shares \n+ 10 shares \nHence, this gamma neutral ratio is making the position delta long by 10 shares \nof stock for each l-by-2 spread that is established. For example, if one bought 100 \nOctober 60 calls and sold 200 October 70 calls, his position delta would be long 1,000 \nshares. \nThis position delta is easily neutralized by selling short 1,000 shares of the stock. \nThe resulting position is both gamma neutral and delta neutral: \nOption Position Option Position \nPosition Delta Delta Gamma Gamma \nShort 1,000 XYZ 1.00 -1,000 0 0 \nLong 1 00 October 60 calls 0.60 +6,000 0.050 + 500 \nShort 200 October 70 calls 0.25 -5,000 0.025 - 500 \nNet Position: 0 0", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:942", "doc_id": "40af942f1b382f31e358b354dbcf1d98f3f0f4e8da2f35071de4b781f0164544", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 881 \nHence, it is always asimple matter to create aposition that is both gamma and delta \nneutral. In fact, it is just as simple to create aposition that is neutral with respect to \ndelta and any other risk measure, because all that is necessary is to create aneutral \nratio of the other risk measure (gamma, vega, theta, etc.) and then eliminate the \nresulting position delta by using the underlying. \nIn theory, one could construct aposition that was neutral with respect to all five \nrisk measures (or six, if you really want to go overboard and include \"gamma of the \ngamma\" as well). Of course, there wouldn'tbe much profit potential in such aposi\ntion, either. But such constructions are actually employed, or at least attempted, by \ntraders such as market-makers who try to make their profits from the difference \nbetween the bid and off er of an option quote, and not from assuming market risk \nStill, the concept of being neutral with respect to more than one risk factor is avalid one. In fact, if astrategist can determine what he is really attempting to accom\nplish, he can often negate other factors and construct aposition designed to accom\nplish exactly what he wants. Suppose that one thought the implied volatility of acer\ntain set of options was too high. He could just sell straddles and attempt to capture \nthat volatility. However, he is then exposed to movements by the underlying stock He \nwould be better served to construct aposition with negative vega to reflect his expec\ntation on volatility, but then also have the position be delta neutral and gamma \nneutral, so that there would be little risk to the position from market movements. This \ncan normally be done quite easily. An example will demonstrate how. \nExample: XYZ is 48. There are three months to expiration, and the volatility of XYZ \nand its options is 35%. The following information is also known: \nXYZ:48 \nOption Price Delta Gamma Vega \nApril 50 call 2.50 0.47 0.045 0.08 \nApril 60 call l.00 0.17 0.026 0.06 \nFor whatever reasons - perhaps the historical volatility is much lower - the \nstrategist decides that he wants to sell volatility. That is, he wants to have anegative \nposition vega so that when the volatility decreases, he will make money. This can \nprobably be accomplished by buying some April 50 calls and selling more April 60 \ncalls. However, he does not want any risk of price movement, so some analysis must \nbe done. \nFirst, he should determine agamma neutral spread. This is done in much the \nsame manner as determining adelta neutral spread, except that gamma is used.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:943", "doc_id": "ba57da46696dd248e7539ffc2b6a7148d9f0fdc6a7c3b0262ebac6a263d40c17", "chunk_index": 0}
{"text": "882 Part VI: Measuring and Trading Volatmty \nMerely divide the two gammas to determine the neutral ratio to be used. In this case, \nassume that the April 50 call and the April 60 call are to be used: \nGamma neutral ratio: 0.045/0.026 = 1.73-to-l \nThus, agamma neutral position would be created by buying 100 April 50'sand sell\ning 173 April 60's. Alternatively, buying 10 and selling 17 would be close to gamma \nneutral as well. The larger position will be used for the remainder of this example. \nNow that this ratio has been chosen, what is the effect on delta and vega? \nOption Position Option Position Option Position \nPosition Delta Delta Gamma Gamma Vega Vega \nLong 1 00 April 50 0.47 +4,700 0.045 +450 0.08 + $800 \nShort 173 April 60 0.17 -2,941 0.026 -450 0.06 -1,038 \nTotal: + 1,759 0 - $238 \nThe position delta is long 1,759 shares of XYZ. This can easily be \"cured\" by \nshorting 1,700 or 1,800 shares ofXYZ to neutralize the delta. Consequently, the com\nplete position, including the short 1,700 shares, would be neutral with respect to both \ndelta and gamma, and would have the desired negative vega. \nThe actual profit picture at expiration is shown in Figure 40-11. Bear in mind, \nhowever, that the strategist would normally not intend to hold aposition like this until \nexpiration. He would close it out if his expectations on volatility decline were fulfilled \n( or proved false). \nFIGURE 40-11. \nSpread with negative vega; gamma and delta neutral. \n40000...., .... \n10000 \n50 55 60 \nXVZ :Stock Price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:944", "doc_id": "9d7df90ef2330588feeb16fcfa6ec0ab55e82eb8ee8fe08f340ed5657c653365", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 883 \nOne other point should be made: The fact that gamma and delta are neutral to \nbegin with does not mean that they will remain neutral indefinitely as the stock \nmoves (or even as volatility changes). However, there will be little or no effect of \nstock price movements on the position in the short run. \nIn summary, then, one can always create aposition that is neutral with respect \nto both gamma and delta by first choosing aratio that makes the gamma zero, and \nthen using aposition in the underlying security to neutralize the delta that is created \nby the chosen ratio. This type of position would always involve two options and some \nstock. The resulting position will not necessarily be neutral with respect to the other \nrisk factors. \nTHE MATHEMATICAL APPROACH \nThe strategist should be aware that the process of determining neutrality in several \nof the risk variables can be handled quite easily by acomputer. All that is required is \nto solve aseries of simultaneous equations. \nIn the preceding example, the resulting vega was negative: -$238. For each \ndecline of 1 percentage point in volatility from .the current level of 35%, one could \nexpect to make $238. This result could have been reached by another method, as \nlong as one were willing to spell out in advance the amount of vega risk he wants to \naccept. Then, he can also assume the gamma is zero and solve for the quantity of \noptions to trade in the spread. The delta would be neutralized, as above, by using the \ncommon stock. \nExample: Prices are the same as in the preceding example. XYZ is 48. There are \nthree months to expiration, and the volatility of XYZ and its options is 35%. The fol\nlowing information is also the same: \nOption \nApril 50 call \nApril 60 call \nPrice \n2.50 \n1.01 \nDelta \n0.47 \n0.17 \nGamma \n0.045 \n0.026 \nVega \n0.08 \n0.06 \nAspreader expects volatility to decline and is willing to set up aposition where\nby he will profit by $250 for each one percentage decrease in volatility. Moreover, he \nwants to be gamma and delta neutral. He knows that he can eventually neutralize any \ndelta by using XYZ common stock, as in the previous example. How many options \nshould be spread to achieve the desired result?", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:945", "doc_id": "a174332f3b853a1080ad22f482a353c25b8e9cfa3bd1073828908651bed6d461", "chunk_index": 0}
{"text": "884 Part VI: Measuring and Trading VolatiHty \nTo answer the question, one must create two equations in two unknowns, xand \ny. The unknowns represent the quantities of options to be bought and sold, respec\ntively. The constants in the equations are taken from the table above. \nThe first equation represents gamma neutral: \n0.045 X + 0.026 y = 0, \nwhere \nxis the number of April 50'sin the spread and yis the number of April 60's. Note \nthat the constants in the equation are the gammas of the two calls involved. \nThe second equation represents the desired vega risk of making 2.5 points, or $250, \nif the volatility decreases: \n0.08 X + 0.06 y = - 2.5, \nwhere \nxand yare the same quantities as in the first equation, and the constants in this equa\ntion are the gammas of the options. Furthermore, note that the vega risk is negative, \nsince the spreader wants to profit if volatility decreases. \nSolving the two equations in two unknowns by algebraic methods yields the fol\nlowing results: \nEquations: \n0.045 X + 0.026 y = 0 \n0.08 X + 0.06 Y = - 2.5 \nSolutions: \nX = 104.80 \ny = -181.45 \nThis means that one would buy 105 April 50 calls, since xbeing positive means that \nthe options would be bought. He would also sell 181 April 60 calls (yis negative, \nwhich implies that the calls would be sold). This is nearly the same ratio determined \nin the previous example. The quantities are slightly higher, since the vega here is \n-$250 instead of the -$238 achieved in the previous example. \nFinally, one would again determine the amount of stock to buy or sell to neu\ntralize the delta by computing the position delta: \nPosition delta = 105 x 0.47 - 181 x 0.17 = 18.58 \nThus 1,858 shares of XYZ would be shorted to neutralize the position.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:946", "doc_id": "ae59dc06f5452c12139c97e869b5049860beaf8ac42ef1834c6c38fe7f2bbe57", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 885 \nNote: All the equations cannot be set equal to zero, or the solution will be all \nzeros. This is easily handled by setting at least one equation equal to asmall, nonzero \nquantity, such as 0.1. As long as at least one of the risk factors is nonzero, one can \ndetermine the neutral ratio for all other factors merely by solving these simultaneous \nequations. There are plenty of low-cost computer programs that can solve simultane\nous equations such as these. \nThis concept can be carried to greater lengths in order to determine the best \nspread to create in order to achieve the desired results. One might even try to use \nthree different options, using the third option to neutralize delta, so that he wouldn'thave to neutralize with stock. The third equation would use deltas as constants and \nwould be set to equal zero, representing delta neutral. Solving this would require \nsolving three equations in three unknowns, asimple matter for acomputer. \nAs long as at least one of the risk factors is nonzero, one can determine the neu\ntral ratio for all other factors merely by solving these simultaneous equations. Even \nmore importantly, the computer can scan many combinations of options that produce \naposition that is both gamma and delta neutral and has aspecific position vega \n(-$238, for example). One would then choose the \"best\" spread of the available pos\nsibilities by logical methods including, if possible, choosing one with positive theta, \nso time is working in his favor. \nTo summarize, one can neutralize all variables, or he can specify the risk that he \nwants to accept in any of them. Merely write the equations and solve them. It is best \nto use acomputer to do this, but the fact that it can be done adds an entirely new, \nbroad dimension to option spreading and risk-reducing strategies. \nEVALUATING A POSITION USING THE RISK MEASURES \nThe previous sections have dealt with establishing anew position and determining its \nneutrality or lack thereof. However, the most important use of these risk measures is \nto predict how aposition will perform into the future. At aminimum, aserious strate\ngist should use acomputer to print out aprojection of the profits and losses and posi\ntion risk at future expected prices. Moreover, this type of analysis should be done for \nseveral future times in order to give the strategist an idea of how the passage of time \nand the resultant larger movements by the underlying security would affect the posi\ntion. \nFirst, one would choose an appropriate time period - say, 7 days hence - for the \nfirst analysis. Then he should use the statistical projection of stock prices (see Chapter \n28 on mathematical applications) to determine probable prices for the underlying \nsecurity at that time. Obviously, this stock price projection needs to use volatility, and", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:947", "doc_id": "dfe4cfd155828d9eff9e12648c48363662c61a1b31850f493f0d142337cdc06d", "chunk_index": 0}
{"text": "886 Part VI: Measuring and Trading Volatility \nthat is somewhat variable. But, for the purposes of such aprojection, it is acceptable \nto use the current volatility. The results of as many as 9 stock prices might be dis\nplayed: every one-half standard deviation from -2 through + 2 (-2.0, -1.5, -1.0, \n-0.5, 0, 0.5, 1.0, 1.5, 2.0). \nExample: XYZ is at 60 and has avolatility of 35%. Adistribution of stock prices 7 \ndays into the future would be determined using the equation: \nFuture Price = Current Price xeav-ft \nwhere \nacorresponds to the constants in the following table: (-2.0 ... 2.0): \n# Standard Deviations \n-2.0 \n- 1.5 \n- 1.0 \n-0.5 \n0 \n0.5 \n1.0 \n1.5 \n2.0 \nProjected Stack Price \n54.46 \n55.79 \n57.16 \n58.56 \n60.00 \n61.47 \n62.98 \n64.52 \n66.11 \nAgain, refer to Chapter 28 on mathematical applications for amore in-depth \ndiscussion of this price determination equation. \nNote that the formula used to project prices has time as one of its components. \nThis means that as we look further out in time, the range of possible stock prices will \nexpand - anecessary and logical component of this analysis. For example, if the \nprices were being determined 14 days into the future, the range of prices would be \nfrom 52.31 to 68.82. That is, XYZ has the same probability of being at 54.46 in 7 days \nthat it has of being at 52.31 in 14 days. At expiration, some 90 days hence, the range \nwould be quite abit wider still. Do not make the mistake of trying to evaluate the \nposition at the same prices for each time period (7 days, 14 days, 1 rnonth, expiration, \netc.). Such an analysis would be wrong. \nOnce the appropriate stock prices have been determined, the following quanti\nties would be calculated for each stock price: profit or loss, position delta, position \ngamma, position theta, and position vega. (Position rho is generally aless important \nrisk measure for stock and futures short-term options.) Armed with this information, \nthe strategist can be prepared to face the future. An important item to note: Amodel", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:948", "doc_id": "64cfb859a89d96256604c09aca50088de9e694655098f273aaa1b0911548fe89", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 887 \nwill necessarily be used to make these projections. As was shown earlier, if there is adistortion in the current implied volatilities of the options involved in the position, \nthe strategist should use the current implieds as input to the model for future option \nprice projections. If he does not, the position may look overly attractive if expensive \noptions are being sold or cheap ones are being bought. Atruer profit picture is \nobtained by propagating the current implied volatility structure into the near future. \nUsing an example similar to the previous one aratio spread using short stock \nto make it delta neutral - the concepts will be described. \nInitial Position. XYZ is at 60. The January 70 calls, which have three months \nuntil expiration, are expensive with respect to the January 60 calls. Astrategist \nexpects this discrepancy to disappear when the implied volatility of XYZ options \ndecreases. He therefore established the following position, which is both gamma \nand delta neutral. \nPosition Delta Gamma \nLong 100 January 60 calls 0.57 0.0723 \nShort 240 January 70 calls 0.20 0.0298 \nShort 800 XYZ \nThe risk measures for the entire position are: \nPosition delta: -38 shares (virtually delta neutral) \nPosition gamma: + 7 shares (gamma neutral) \nPosition theta: + $263 \nPosition vega: -$827 \nTheta Vega \n-0.020 0.109 \n-0.019 0.080 \nThus, the position is both gamma and delta neutral. Moreover, it has the attrac\ntive feature of making $263 per day because of the positive theta. Finally, as was the \nintention of the spreader, it will make money if the volatility of XYZ declines: $827 \nfor each percentage point decrease in implied volatility. Two equations in two \nunknowns (gamma and vega) were solved to obtain the quantities to buy and sell. The \nresulting position delta was neutralized by selling 800 XYZ. \nThe following analyses will assume that the relative expensiveness of the April \n70 calls persists. These are the calls that were sold in the position. If that overpricing \nshould disappear, the spread would look more favorable, but there is no guarantee \nthat they will cheapen - especially over ashort time period such as one or two weeks. \nHow would the position look in 7 days at the stock prices determined above?", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:949", "doc_id": "5eff98ce33fd37f8e81a8fb64a1f99082c6686079c62df117bdc904028d5dc98", "chunk_index": 0}
{"text": "888 Part VI: Measuring and Trading Vo/atillty \nStock \nPrice P&L Delta Gamma Theta Vega \n54.46 1905 - 7.40 1.62 0.94 - 1.57 \n55.79 1077 - 4.90 2.07 1.18 - 1.96 \n57.16 606 1.97 2.13 1.53 - 2.90 \n58.56 528 0.74 1.65 2.00 -4.62 \n60.00 771 2.38 0.56 2.63 -7.22 \n61.47 1127 2.07 - 1.01 3.38 -10.63 \n62.98 1252 - 0.87 - 2.85 4.22 -14.56 \n64.52 702 - 6.73 - 4.67 5.07 -18.61 \n66.11 - 1019 -15.42 - 6.21 5.85 -22.31 \nIn asimilar manner, the position would have the following characteristics after \n14 days had passed: \nStock \nPrice P&L Delto Gamma Theta Vega \n52.31 4221 - 9.10 0.69 0.55 - 0.98 \n54.14 2731 - 6.93 1.69 0.75 - 0.89 \n56.02 1782 - 2.87 2.51 1.06 - 1.21 \n57.98 1717 2.17 2.44 1.61 - 2.69 \n60.00 2577 5.85 1.00 2.51 -6.00 \n62.09 3839 5.29 - 1.63 3.73 -11.05 \n64.26 4361 - 1.55 - 4.61 5.09 -16.90 \n66.50 2631 -14.80 - 7.02 6.31 -22.17 \n68.82 - 2799 -32.83 - 8.32 7.18 -25.72 \nThe same information will be presented graphically in Figure 40-13 so that \nthose who prefer pictures instead of columns of numbers can follow the discussions \neasily. \nFirst, the profitability of the spread can be examined. This profit picture \nassumes that the volatility of XYZ remains unchanged. Note that in 7 days, there is asmall profit if the stock remains unchanged. This is to be expected, since theta was \npositive, and therefore time is working in favor of this spread. Likewise, in 14 days, \nthere is an even bigger profit if XYZ remains relatively unchanged - again due to the \npositive theta. Overall, there is an expected profit of $800 in 7 days, or $2,600 in 14 \ndays, from this position. This indicates that it is an attractive situation statistically, but, \nof course, it does not mean that one cannot lose money.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:950", "doc_id": "917417492cf42a12fa6d9214f3fdd5160882906766af281eee02740ad9adc040", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 889 \nContinuing to look at the profit picture, the downside is favorable to the spread \nsince the short stock in the position would contribute to ever larger profits in the case \nthat XYZ tumbles dramatically (see Figure 40-12). The upside is where problems \ncould develop. In 7 days, the position breaks even at about 65 on the upside; in 14 \ndays, it breaks even at about 67.50. \nThe reader may be asking, \"Why is there such adramatic risk to the upside? Ithought the position was delta neutral and gamma neutral.\" True, the position was \noriginally neutral with respect to both those variables. That neutrality explains the \nflatness of the profit curves about the current stock price of 60. However, once the \nstock has moved 1.50 standard deviations to the upside, the neutrality begins to dis\nappear. To see this, let us look at Figures 40-13 and 40-14 that show both the posi\ntion delta and position gamma 7 days and 14 days after the spread was established. \nAgain, these are the same numbers listed in the previous tables. \nFirst, look at the position delta in 7 days (Figure 40-13). Note that the position \nremains relatively delta neutral with XYZ between 57 and 63. This is because the \ngamma was initially neutral. However, the position begins to get quite delta short if \nXYZ rises above 63 or falls below 57 in 7 days. What is happening to gamma while \nthis is going on? Since we just observed that the delta eventually changes, that has to \nmean that the position is acquiring some gamma. \nFIGURE 40-12. \nXYZ ratio spread, gamma and delta neutral. \n4300 \n3400 \n2500 \n1600 \n~ 700 a.. \n0 \n-200 53 55 57 59 61 63 \n.-1100 \n-2000 \nStock Price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:951", "doc_id": "ee616c1e79cced63d5b9949722b059724debcd4203f6a51fe63ac226d456ac49", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 891 \nFigure 40-14 depicts the fact that gamma is not very stable, considering that it \nstarted at nearly zero. If XYZ falls, gamma increases alittle, reflecting the fact that \nthe position will get somewhat shorter as XYZ falls. But since there are only calls cou\npled with short stock in this position, there is no risk to the downside. Positive \ngamma, even asmall positive gamma like this one, is beneficial to stock movement. \nThe upside is another matter entirely. The gamma begins to become seriously \nnegative above astock price of 63 in 7 days. Recall that negative gamma means that \none'sposition is about to react poorly to price changes in the market - the position \nwill soon be \"fighting the market.\" As the stock goes even higher, the gamma \nbecomes even more negative. These observations apply to stock price movements in \neither 7 days or 14 days; in fact, the effect on gamma does not seem to be particu\nlarly dependent on time in this example, since the two lines on Figure 40-15 are very \nclose to each other. \nThe above information depicts in detailed form the fact that this position will \nnot behave well if the stock rises too far in too short atime. However, stable stock \nprices will produce profits, as will falling prices. These are not earth-shattering con\nclusions since, by simple observation, one can see that there are extra short calls plus \nsome short stock in the position. However, the point of calculating this information \nin advance is to be able to anticipate where to make adjustments and how much to \nadjust. \nFollow-Up Action. How should the strategist use this information? Asim\nplistic approach is to adjust the delta as it becomes non-neutral. This won'tdo \nanything for gamma, however, and may therefore not necessarily be the best \napproach. If one were to adjust only the delta, he would do it in the following \nmanner: The chart of delta (Figure 40-13) shows that the position will be \napproximately delta short 800 shares if XYZ rises to 64.50 in aweek. One sim\nple plan would be to cover the 800 shares of XYZ that are short if the stock rises \nto 64.50. Covering the 800 shares would return the position to delta neutral at \nthat time. Note that if the stock rises at aslower pace, the point at which the \nstrategist would cover the 800 shares moves higher. For example, the delta in 14 \ndays (again in Figure 40-13) shows that XYZ would have to be at about 65.50 for \nthe position to be delta short 800 shares. Hence, if it took two weeks for XYZ to \nbegin rising, one could wait until 65.50 before covering the 800 shares and \nreturning the position to delta neutral. \nIn either case, the purchase of the 800 shares does not take care of the negative \ngamma that is creeping into the position as the stock rises. The only way to counter \nnegative gamma is to buy options, not stock. To return aposition to neutrality with", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:953", "doc_id": "19f86e21052c13d246e4309a376288f3a28c45de614898e07a90cc055a879221", "chunk_index": 0}
{"text": "892 Part VI: Measuring and Trading Volatility \nrespect to more than one risk variable requires one to approach the problem as he \ndid when the position was established: Neutralize the gamma first, and then use stock \nto adjust the delta. Note the difference between this approach and the one described \nin the previous paragraph. Here, we are trying to adjust gamma first, and will get to \ndelta later. \nIn order to add some positive gamma, one might want to buy back (cover) some \nof the January 70 calls that are currently short. Suppose that the decision is made to \ncover when XYZ reaches 65.50 in 14 days. From the graph above, one can see that \nthe position would be approximately gamma short 700 shares at the time. Suppose \nthat the gamma of the January 70 calls is 0.07. Then, one would have to cover 100 \nJanuary 70 calls to add 700 shares of positive gamma to the position, returning it to \ngamma neutral. This purchase would, of course, make the position delta long, so \nsome stock would have to be sold short as well in order to make the position delta \nneutral once again. \nThus, the procedure for follow-up action is somewhat similar to that for estab\nlishing the position: First, neutralize the gamma and then eliminate the resulting \ndelta by using the common stock. The resulting profit graph will not be shown for \nthis follow-up adjustment, since the process could go on and on. However, afew \nobservations are pertinent. First, the purchase of calls to reduce the negative gamma \nhurts the original thesis of the position - to have negative vega and positive theta, if \npossible. Buying calls will add vega to and subtract theta from the position, which is \nnot desirable. However, it is more desirable than letting losses build up in the posi\ntion as the stock continues to run to the upside. Second, one might choose to rerrwve \nthe position if it is profitable. This might happen if the volatility did decrease as \nexpected. Then, when the stock rallies, producing negative gamma, one might actu\nally have aprofit, because his assumption concerning volatility had been right. If he \ndoes not see much further potential gains from decreasing volatility, he might use the \npoint at which negative gamma starts to build up as the exit point from his position. \nThird, one might choose to accept the acquired gamma risk. Rather than jeopardize \nhis initial thesis, one may just want to adjust the delta and let the gamma build up. \nThis is no longer aneutral strategy, but one may have reasons for approaching the \nposition this way. At least he has calculated the risk and is aware of it. If he chooses \nto accept it rather than eliminate it, that is his decision. \nFinally, it is obvious that the process is dynamic. As factors change (stock price, \nvolatility, time), the position itself changes and the strategist is presented with new \nchoices. There is no absolutely correct adjustment. The process is more of an art than \nascience at times. Moreover, the strategist should continue to recalculate these prof\nit pictures and risk measures as the stock moves and time passes, or if there is a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:954", "doc_id": "8e9cbbefb74a794c08b4dba976848e2b03ea43bcd9850e7ad2334010784b8d5f", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 893 \nchange in the securities involved in the position. There is one absolute truism and \nthat is that the serious strategist should be aware of the risk his position has with \nrespect to at least the four basic measures of delta, gamma, theta, and vega. To be \nignorant of the risk is to be delinquent in the management of the position. \nTRADING GAMMA FROM THE LONG SIDE \nThe strategist who is selling overpriced options and hedging that purchase with other \noptions or stock will often have aposition similar to the one described earlier. Large \nstock movements - at least in one direction will typically be aproblem for such \npositions. The opposite of this strategy would be to have aposition that is long \ngamma. That is, the position does better if the stock moves quickly in one direction. \nWhile this seems pleasing to the psyche, these types of positions have their own \nbrand of risk. \nThe simplest position with long gamma is along straddle, or abackspread \n(reverse ratio spread). Another way to construct aposition with long gamma is to \ninvert acalendar spread - to buy the near-term option and to sell alonger-term one. \nSince anear-term option has ahigher gamma than alonger-term one with the same \nstrike, such aposition has long gamma. In fact, traders who expect violent action in \nastock often construct such aposition for the very reason that the public will come \nin behind them, bid up the short-term calls (increasing their implied volatility), and \nmake the spread more profitable for the trader. \nUnfortunately, all of these positions often involve being long just about every\nthing else, including theta and vega as well. This means that time is working against \nthe position, and that swings in implied volatility can be helpful or harmful as well. \nCan one construct aposition that is long gamma, but is not so subject to the other \nvariables? Of course he can, but what would it look like? The answer, as one might \nsuspect, is not an ironclad one. \nFor the following examples, assume these prices exist: \nXYZ: 60 \nOption \nMarch 60 call \nJune 60 call \nPrice \n3.25 \n5.50 \nDelta \n0.54 \n0.57 \nGamma \n0.0510 \n0.0306 \nTheta \n0.033 \n0.021 \nVega \n0.089 \n0.147 \nExample: Suppose that astrategist wants to create aposition that is gamma long, but \nis neutral with respect to both delta and vega. He thinks the stock will move, but is \nnot sure of the price direction, and does not want to have any risk with respect to", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:955", "doc_id": "da58fb0d3db32a6d14a87e044496622ece33444a33093478ba9e74cd5c841fd3", "chunk_index": 0}
{"text": "894 Part VI: Measuring and Trading Volatility \nquick changes in volatility. In order to quantify the statement that he \"wants to be \ngamma long,\" let us assume that he wants to be gamma long 1,000 shares or 10 con\ntracts. \nIt is known that delta can always be neutralized last, so let us concentrate on the \nother two variables first. The two equations below are used to determine the quanti\nties to buy in order to make gamma long and vega neutral: \n0.0510x + 0.0306y = 10 (gamma, expressed in# of contracts) \n0.089x + 0.147y = 0 (vega) \nThe solution to these equations is: \nX = 308, y = -186 \nThus, one would buy 308 March 60 calls and would sell 186 June 60 calls. This is the \nreverse calendar spread that was discussed: Near-term calls are bought and longer\nterm calls are sold. \nFinally, the delta must be neutralized. To do this, calculate the position delta \nusing the quantities just determined: \nPosition delta= 0.54 x 308 - 0.57 x 186 = 60.30 \nSo, the position is long 60 contracts, or 6,000 shares. It can be made delta neutral by \nselling short 6,000 shares of XYZ. \nThe overall position would look like this: \nPosition \nShort 6,000 XYZ \nLong 308 March 60 calls \nShort 186 June 60 calls \nIts risk measurements are: \nDelta \n1.00 \n0.54 \n0.57 \nPosition delta: long 30 shares (neutral) \nPosition vega: $7 (neutral) \nPosition gamma: long 1,001 shares \nGamma \n0 \n0.0510 \n0.0306 \nVega \n0 \n0.089 \n0.147 \nThis position then satisfies the initial objectives of wanting to be gamma long \n1,000 shares, but delta and vega neutral. \nFinally, note that theta = -$625. The position will lose $625 per day from time \ndecay. \nThe strategist must go further than this analysis, especially if one is dealing with \npositions that are not simple constructions. He should calculate aprofit picture as", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:956", "doc_id": "ecc1140c5f21c768b6fb977257eb0e876e51e926ae758b288dee8c0d472a74d2", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 895 \nwell as look at how the risk measures behave as time passes and the stock price \nchanges. \nFigure 40-15 (see Tables 40-10, 40-11, and 40-12) shows the profit potential in \n7 days, in 14 days, and at March expiration. Figure 40-16 shows the position vega at \nthe 7- and 14-day time intervals. Before discussing these items, the data will be pre\nsented in tabular form at three different times: in 7 days, in 14 days, and at March \nexpiration. \nThe data in Table 40-10 depict the position in 7 days. \nTable 40-11 represents the results in 14 days. \nFinally, the position as it looks at March expiration should be known as well (see \nTable 40-12). \nIn each case, note that the stock prices are calculated in accordance with the \nstatistical formula shown in the last section. The more time that passes, the further it \nis possible for the stock to roam from the current price. \nThe profit picture (Figure 40-15) shows that this position looks much like along \nstraddle would: It makes large, symmetric profits if the stock goes either way up or \nway down. Moreover, the losses if the stock remains relatively unchanged can be \nlarge. These losses tend to mount right away, becoming significant even in 14 days. \nHence, if one enters this type of position, he had better get the desired stock move\nment quickly, or be prepared to cut his losses and exit the position. \nThe most startling thing to note about the entire position is the devastating effect \nof time on the position. The profit picture shows that large losses will result if the stock \nmovement that is expected does not materialize. These losses are completely due to \ntime decay. Theta is negative in the initial position ($625 of losses per day), and \nremains negative and surprisingly constant - until March expiration ( when the long \ncalls expire). Time also affects vega. Notice how the vega begins to get negative right \naway and keeps getting much more negative as time passes. Simply, it can be seen that \nas time passes, the position becomes vulnerable to increases in implied volatility. \nThis relationship between time and volatility might not be readily apparent to \nthe strategist unless he takes the time to calculate these sorts of tables or figures. In \nfact, one may be somewhat confounded by this observation. What is happening is \nthat as time passes, the options that are owned are less explosive if volatility increas\nes, but the options that were sold have alot of time remaining, and are therefore apt \nto increase violently if volatility spurts upward. \nFigures 40-17 and 40-18 provide less enlightening information about delta and \ngamma. Since gamma was positive to start with, the delta increases dramatically as \nthe stock rises, and decreases just as fast if the stock falls (Figure 40-18). This is stan\ndard behavior for positions with long gamma; along straddle would look very similar.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:957", "doc_id": "796d2a5e5d3043312b41da4a897ead3e0a51268b72a8d34d17d998ede9cc81b6", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts \nFIGURE 40-16. \nTrading long gamma, position vega. \n55 60 \n0 \n-2 \n-4 \nal \n0) \n~ \n-6 \n-8 \n-10 \nStock Price \nTABLE 40-11. \n65 \nRisk measures of long gamma position in 14 days. \nStock \nPrice P&L Delta Gamma \n52.31 24945 - 79.34 4.75 \n54.14 11445 - 67.68 8.00 \n56.02 277 -49.79 10.79 \n57.98 - 7263 -26.87 12.42 \n60.00 - 10141 - 1.44 12.47 \n62.09 - 7784 23.32 10.99 \n64.26 347 44.47 8.45 \n66.50 11491 60.12 5.55 \n68.82 26672 69.81 2.92 \n891 \nTheta Vega \n2.10 - 9.91 \n3.91 - 7.87 \n5.76 - 5.56 \n7.21 - 3.73 \n7.88 - 3.04 \n7.60 - 3.78 \n6.47 - 5.71 \n4.82 - 8.20 \n3.09 -10.48 \nSo, is this agood position? That is adifficult question to answer unless one \nknows what is going to happen to the underlying stock. Statistically, this type of posi\ntion has anegative expected return and would generally produce losses over the long \nrun. However, in situations in which the near-term options are destined to get over\nheated - perhaps because of atakeover rumor or just aleak of material information", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:959", "doc_id": "65c24e0842c4bc990fadc99bea8b28caa98853ad820fcc1b0e0f39d6efdd6f60", "chunk_index": 0}
{"text": "898 Part VI: Measuring and Trading Volatility \nTABLE 40-12. \nRisk measures of long gamma position at March expiration. \nStock \nPrice P&L Delta \n46.19 81327 - 75.69 \n49.31 55628 - 89.84 \n52.64 22378 -110.50 \n56.20 - 21523 -136.65 \n60.00 78907 144.68 \n64.06 - 25946 117.44 \n68.39 19787 95.03 \n73.01 59732 79.05 \n77.95 96062 69.19 \nFIGURE 40-17. \nTrading long gamma, position gamma. \n(J) \n(I) \n1200 \n1000 \n800 \n~ 600 .c \n(/) \n400 \n200 \n55 60 \nStock Price \nGamma Theta Vega \n- 3.65 -1.32 - 6.88 \n- 5.39 -2.25 -11.43 \n- 6.89 -3.33 -16.50 \n- 7.62 -4.28 -20.67 \n- 7.29 -4.79 -22.49 \n- 6.03 -4.70 -21.26 \n- 4.31 -4.10 -17.44 \n- 2.67 -3.24 -12.43 \n- 1.43 -2.41 - 7.69 \n65 \nabout acompany - many sophisticated traders establish this type of position to take \nadvantage of the expected explosion in stock price. \nOther Variations. Without going into as much detail, it is possible to com\npare the above position with similar ones. The purpose in doing so is to illustrate \nhow achange in the strategist'sinitial requirements would alter the established", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:960", "doc_id": "d8f84368d07b731aee74778fecf4d55dad406891ea09166bd5f4da059c4a238f", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts \nFIGURE 40-1 8. \nTrading long gamma, position delta. \n6000 \n4000 \n2000 \n\"' ~ 01---------,-----~rr------,,-----\n.s::. \n(J) \n-2000 \n-4000 \n-8000 \n-8000 \n55 65 \nStock Price \n899 \nposition. In the preceding position, the strategist wanted to be gamma long, but \nneutral with respect to delta and volatility. Suppose he not only expects price \nmovement (meaning he wants positive gamma), but also expects an increase in \nvolatility. If that were the case, he would want positive vega as well. Suppose he \nquantifies that desire by deciding that he wants to make $1,000 for every one \npercentage increase in volatility. The simultaneous equations would then be: \n0.050lx + 0.0306y = 10 (gamma) \n0.089x + 0.147y = 10 (vega) \nThe solution to these equations is: \nX = 243, y = -80 \nFurthermore, 8,500 shares would have to be sold short in order to make the position \ndelta neutral. The resulting position would then be: \nShort 8,500 XYZ \nLong 243 March 60 calls \nShort 80 June 60 calls \nDelta: neutral \nGamma: long 1,000 shares \nVega: long $1,000 \nTheta: long $630", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:961", "doc_id": "5b4e7dcdba60837f43f325e5d0203a25b38ef9781634beb62118524b6eb87759", "chunk_index": 0}
{"text": "900 Part VI: Measuring and Trading VolatiHty \nRecall that the position discussed in the last section was vega neutral and was: \nShort 6,000 XYZ \nLong 308 March 60 calls \nShort 186 June 60 calls \nDelta: neutral \nGamma: long 1,000 shares \nVega: neutral \nTheta: long $625 \nNotice that in the new position, there are over three times as many long March \n60 calls as there are short June 60 calls. This is amuch larger ratio than in the vega \nneutral position, in which about 1.6 calls were bought for each one sold. This even \ngreater preponderance of near-term calls that are purchased means the newer posi\ntion has an even larger exposure to time decay than did the previous one. That is, in \norder to acquire the positive vega, one is forced to take on even more risk with \nrespect to time decay. For that reason, this is aless desirable position than the first \none; it seems overly risky to want to be both long gamma and long volatility. \nThis does not necessarily mean that one would never want to be long volatility. \nIn fact, if one expected volatility to increase, he might want to establish aposition that \nwas delta neutral and gamma neutral, but had positive vega. Again, using the same \nprices as in the previous examples, the following position would satisfy these criteria: \nShort 2,600 XYZ \nShort 64 March 60 calls \nLong 106 June 60 calls \nDelta: neutral \nGamma: neutral \nVega: long $1,000 \nTheta: long $11 \nThis position has amore conventional form. It is acalendar spread, except that \nmore long calls are purchased. Moreover, the theta of this position is only $11- it will \nonly lose $11 per day to time decay. At first glance it might seem like the best of the \nthree choices. Unfortunately, when one draws the profit graph (Figure 40-19), he \nfinds that this position has significant downside risk: The short stock cannot com\npensate for the large quantity of June 60 calls. Still, the position does make money on \nthe upside, and will also make money if volatility increases. If the near-term March \ncalls were overpriced with respect to the June calls at the time the position was estab\nlished, it would make it even more desirable. \nTo summarize, defining the risks one wants to take or avoid specifies the con\nstruction of the eventual position. The strategist should examine the potential risks \nand rewards, especially the profit picture. If the potential risks are not desirable, the \nstrategist should rethink his requirements and try again. Thus, in the example pre\nsented, the strategist felt that he initially wanted to be long gamma, but it involved too", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:962", "doc_id": "abb795e466dc8113c38b052a270ae6ecf6ce02bf83d4a7ed438f91dd2606c582", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts \nFIGURE 40-19. \nTrading long gamma, 11 conventional\" calendar. \n7500 \n5000 \n2500 \nfJ) \nfJ) \n.3 :;:, 0 '§ 45 50 Q. \n-2500 \n-5000 At March Expiration \n-7500 \nStock Price \n901 \n75 \nmuch risk of time decay. Asecond attempt was made, introducing positive volatility \ninto the situation, but that didn'tseem to help much. Finally, athird analysis was gen\nerated involving only long volatility and not long gamma. The resulting position has lit\ntle time risk, but has risk if the stock drops in price. It is probably the best of the three. \nThe strategist arrives at this conclusion through alogical process of analysis. \nADVANCED MATHEMATICAL CONCEPTS \nThe remainder of this chapter is ashort adjunct to Chapter 28 on mathematical \napplications. It is quite technical. Those who desire to understand the basic concepts \nbehind the risk measures and perhaps to utilize them in more advanced ways will be \ninterested in what follows. \nCALCULATING THE \"'GREEKS\" \nIt is known that the equation for delta is adirect byproduct of the Black-Scholes \nmodel calculation: \n~ = N(dl)", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:963", "doc_id": "fd6f9e66268519f378386c172b063f6a08eb6de45410a664c6a8e5e0c223698a", "chunk_index": 0}
{"text": "902 Part VI: Measuring and Trading Volatility \nEach of the risk measures can be derived mathematically by taking the partial \nderivative of the model. However, there is ashortcut approximation that works just \nas well. For example, the formula for gamma is as follows: \nx=ln[ P ]/v-ft+v-ft \ns X (1 + r)t 2 \nr - e(-x212) \n- pv ✓ 27tt \nThere is asimpler, yet correct, way to arrive at the gamma. The delta is the par\ntial derivative of the Black-Scholes model with respect to stock price - that is, it is \nthe amount by which the option'sprice changes for achange in stock price. The \ngamma is the change in delta for the same change in stock price. Thus, one can \napproximate the gamma by the following steps: \n1. Calculate the delta with p = Current stock price. \n2. Set p = p + 1 and recalculate the delta. \n3. Gamma = delta from step 1 - delta from step 2. \nThe same procedure can be used for the other \"greeks\": \nVega: 1. Calculate the option price with aparticular volatility. \n2. \n3. \nTheta: 1. \n2. \n3. \nRho: 1. \n2. \n3. \nCalculate another option price with volatility increased by 1 %. \nVega = difference of the prices in steps 1 and 2. \nCalculate the option price with the current time to expiration. \nCalculate the option price with 1 day less time remaining to expiration. \nTheta = difference of the prices in steps 1 and 2. \nCalculate the option price with the current risk-free interest rate. \nCalculate the option price with the rate increased by 1 % . \nRho = difference of the prices in steps 1 and 2. \nTHE GAMMA OF THE GAMMA \nThe discussion of this concept was deferred from earlier sections because it is some\nwhat difficult to grasp. It is included now for those who may wish to use it at some \ntime. Those readers who are not interested in such matters may skip to the next sec\ntion.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:964", "doc_id": "fb16622895ef368198cac78f699a9bc46f6c4f4156661b9050bb58a5df28dc79", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 903 \nRecall that this is the sixth risk measurement of an option position. The gamma \nof the gamma is the anwunt by which the gamma will change when the stock price \nchanges. \nRecall that in the earlier discussion of gamma, it was noted that gamma \nchanges. This example is based on the same example used earlier. \nExample: With XYZ at 49, assume the January 50 call has adelta of 0.50 and agamma of 0.05. If XYZ moves up 1 point to 50, the delta of the call will increase by \nthe amount of the gamma: It will increase from 0.50 to 0.55. Simplistically, if XYZ \nmoves up another point to 51, the delta will increase by another 0.05, to 0.60. \nObviously, the delta cannot keep increasing by 0.05 each time XYZ gains anoth\ner point in price, for it will eventually exceed 1.00 by that calculation, and it is known \nthat the delta has amaximum of 1.00. Thus, it is obvious that the gamma changes. \nIn reality, the gamma decreases as the stock moves away from the strike. Thus, \nwith XYZ at 51, the gamma might only be 0.04. Therefore, if XYZ moved up to 52, \nthe call'sdelta would only increase by 0.04, to 0.64. Hence, the gamma of the gamma \nis -0.01, since the gamma decreased from .05 to .04 when the stock rose by one \npoint. \nAs XYZ moves higher and higher, the gamma will get smaller and smaller. \nEventually, with XYZ in the low 60's, the delta will be nearly 1.00 and the gamma \nnearly 0.00. \nThis change in the gamma as the stock moves is called the gamma of the \ngamma. It is probably referred to by other names, but since its use is limited to only \nthe most sophisticated traders, there is no standard name. Generally, one would use \nthis measure on his entire portfolio to gauge how quickly the portfolio would be \nresponding to the position gamma. \nExample: With XYZ at 31. 75 as in some of the previous examples, the following risk \nmeasures exist: \nOption Option Option Position \nPosition Delta Gamma Gamma/Gamma Gamma/Gamma \nShort 4,500 XYZ 1.00 0.00 0.0000 0 \nShort 100 XYZ April 25 calls 0.89 0.01 -0.0015 -15 \nLong 50 XYZ April 30 calls 0.76 0.03 -0.0006 - 3 \nLong 139 XYZ July 30 calls 0.74 0.02 -0.0003 - 4 \nTotal Gamma of Gamma: -22", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:965", "doc_id": "ec825f0f494c679b5bfb97176af0b319099ac98ad40f27d694c214d25eb12f3e", "chunk_index": 0}
{"text": "904 Part VI: Measuring and Trading Volatility \nRecall that, in the same example used to describe gamma, the position was delta \nlong 686 shares and had apositive gamma of 328 shares. Furthermore, we now see \nthat the gamma itself is going to decrease as the stock moves up ( it is negative) or will \nincrease as the stock moves down. In fact, it is expected to increase or decrease by \n22 shares for each point XYZ moves. \nSo, if XYZ moves up by 1 point, the following should happen: \na. Delta increases from 686 to 1,014, increasing by the amount of the gamma. \nb. Gamma decreases from 328 to 306, indicating that afurther upward move by \nXYZ will result in asmaller increase in delta. \nOne can build ageneral picture of how the gamma of the gamma changes over \ndifferent situations - in- or out-of-the-money, or with more or less time remaining \nuntil expiration. The following table of two index calls, the January 350 with one \nmonth of life remaining and the December 350 with eleven months of life remain\ning, shows the delta, gamma, and gamma of the gamma for various stock prices. \nIndex January 350 call December 350 call \nPrice Delta Gamma Gamma/Gamma Delta Gamma Gamma/Gamma \n310 .0006 .0001 .0000 .3203 .0083 .0000 \n320 .0087 .0020 .0004 .3971 .0082 .0000 \n330 .0618 .0100 .0013 .4787 .0080 -.0000 \n340 .2333 .0744 .0013 .5626 .0078 -.0001 \n350 .5241 .0309 -.0003 .6360 .0073 -.0001 \n360 .7957 .0215 -.0014 .6984 .0067 -.0001 \n370 .9420 .0086 -.0010 .7653 .0060 -.0001 \n380 .9892 .0021 -.0003 .8213 .0052 -.0001 \nSeveral conclusions can be drawn, not all of which are obvious at first glance. \nFirst of all, the gamma of the gamma for long-term options is very small. This should \nbe expected, since the delta of along-term option changes very slowly. The next fact \ncan best be observed while looking at the shorter-term January 350 table. The \ngamma of the gamma is near zero for deeply out-of-the-money options. But, as the \noption comes closer to being in-the-money, the gamma of the gamma becomes apos\nitive number, reaching its maximum while the option is still out-of-the-money. By the \ntime the option is at-the-money, the gamma of the gamma has turned negative. It \nthen remains negative, reaching its most negative point when slightly in-the-money. \nFrom there on, as the option goes even deeper into-the-money, the gamma of the \ngamma remains negative but gets closer and closer to zero, eventually reaching \n(minus) zero when the option is very far in-the-money.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:966", "doc_id": "5e52bdec0a1d3098ef715f067a32455065bd85026974168d3e06c2b0838becff", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 905 \nCan one possibly reason this risk measurement out without making severe \nmathematical calculations? Well, possibly. Note that the delta of an option starts as asmall number when the option is out-of-the-money. It then increases, slowly at first, \nthen more quickly, until it is just below 0.60 for an at-the-money option. From there \non, it will continue to increase, but much more slowly as the option becomes in-the\nmoney. This movement of the delta can be observed by looking at gamma: It is the \nchange in the delta, so it starts slowly, increases as the stock nears the strike, and then \nbegins to decrease as the option is in-the-money, always remaining apositive num\nber, since delta can only change in the positive direction as the stock rises. Finally, \nthe gamma of the gamma is the change in the gamma, so it in tum starts as apositive \nnumber as gamma grows larger; but then when gamma starts tapering off, this is \nreflected as anegative gamma of the gamma. \nIn general, the gamma of the gamma is used by sophisticated traders on large \noption positions where it is not obvious what is going to happen to the gamma as the \nstock changes in price. Traders often have some feel for their delta. They may even \nhave some feel for how that delta is going to change as the stock moves (i.e., they \nhave afeel for gamma). However, sophisticated traders know that even positions that \nstart out with zero delta and zero gamma may eventually acquire some delta. The \ngamma of the gamma tells the trader how much and how soon that eventual delta will \nbe acquired. \nMEASURING THE DIFFERENCE OF IMPLIED VOLATILITIES \nRecall that when the topic of implied volatility was discussed, it was shown that if one \ncould identify situations in which the various options on the same underlying securi\nty had substantially different implied volatilities, then there might be an attractive \nneutral spread available. The strategist might ask how he is to determine if the dis\ncrepancies between the individual options are significantly large to warrant attention. \nFurthermore, is there aquick way (using acomputer, of course) to determine this? \nAlogical way to approach this is to look at each individual implied volatility and \ncompute the standard deviation of these numbers. This standard deviation can be \nconverted to apercentage by dividing it by the overall implied volatility of the stock. \nThis percentage, if it is large enough, alerts the strategist that there may be opportu\nnities to spread the options of this underlying security against each other. An exam\nple should clarify this procedure. \nExample: XYZ is trading at 50, and the following options exist with the indicated \nimplied volatilities. We can calculate astandard deviation of these implieds, called \nimplied deviation, via the formula:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:967", "doc_id": "32b574b000bff20b8c503127f7bef52c831f820a24141d964c9cd115de238e4b", "chunk_index": 0}
{"text": "906 Part VI: Measuring and Trading Volatility \nImplied deviation = sqrt (sum of differences from mean) 2/(# options - 1) \nXYZ:50 \nImplied \nOption Volatility \nOctober 45 call 21% \nNovember 45 call 21% \nJanuary 45 call 23% \nOctober 50 call 32% \nNovember 50 call 30% \nJanuary 50 call 28% \nOctober 55 call 40% \nNovember 55 call 37% \nJanuary 55 call 34% \nAverage: 30.44% \nSum of ( difference from avg)2 = 389.26 \nImplied deviation = sqrt (sum of diff)2/(# options - 1) \n= sqrt (389.26 I 8) \n= 6.98 \nDifference \nfrom Average \n-9.44 \n-9.44 \n-7.44 \n+ 1.56 \n-0.44 \n-2.44 \n+9.56 \n+6.56 \n+3.56 \nThis figure represents the raw standard deviation of the implied volatilities. To \nconvert it into auseful number for comparisons, one must divide it by the average \nimplied volatility. \nPd . . Implied deviation ercent eV1at10n = A . 1. dverage imp ie \n= 6.98/30.44 \n= 23% \nThis \"percent deviation\" number is usually significant if it is larger than 15%. \nThat is, if the various options have implied volatilities that are different enough from \neach other to produce aresult of 15% or greater in the above calculation, then the \nstrategist should take alook at establishing neutral spreads in that security or futures \ncontract. \nThe concept presented here can be refined further by using aweighted average \nof the implieds ( taking into consideration such factors as volume and distance from the \nstriking price) rather than just using the raw average. That task is left to the reader.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:968", "doc_id": "ec4bf2c5d0e84a1ec05c5f72fd661180e67ae3893ab8ab191e76e97ed240a95c", "chunk_index": 0}
{"text": "Chapter 40: Advanced Concepts 907 \nRecall that acomputer can perform alarge number of Black-Scholes calcula\ntions in ashort period of time. Thus, the computer can calculate each option'simplied volatility and then perform the \"percent deviation\" calculation even faster. \nThe strategist who is interested in establishing this type of neutral spread would only \nhave to scan down the list of percent deviations to find candidates for spreading. On \nagiven day, the list is usually quite short - perhaps 20 stocks and 10 futures contracts \nwill qualify. \nSUMMARY \nIn today'shighly competitive and volatile option markets, neutral traders must be \nextremely aware of their risks. That risk is not just risk at expiration, but also the cur\nrent risk in the market. Furthermore, they should have an idea of how the risk will \nincrease or decrease as the underlying stock or futures contract moves up and down \nin price. Moreover, the passage of time or the volatility that the options are being \nassigned in the marketplace - the implied volatility - are important considerations. \nEven changes in short-term interest rates can be of interest, especially iflonger-term \noptions (LEAPS) are involved. \nOnce the strategist understands these concepts, he can use them to select new \npositions, to adjust existing ones, and to formulate specific strategies to take advan\ntage of them. He can select aspecific criteria that he wants to exploit - selling high \nvolatility, for example and use the other measures to construct aposition that has \nlittle risk with respect to any of the other variables. Furthermore, the market-maker \nor specialist, who does not want to acquire any market risk if he can help it, will use \nthese techniques to attempt to neutralize all of the current risk, if possible.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:969", "doc_id": "b3f54e6f4cf2c93179d86c004d38ec7d40b18120fe64f7b481502caf8d69ea9d", "chunk_index": 0}
{"text": "Taxes \nIn this chapter, the basic tax treatment of listed options will be outlined and sev\neral tax strategies will be presented. The reader should be aware of the fact that tax \nlaws change, and therefore should consult tax counsel before actually implementing \nany tax-oriented strategy. The interpretation of certain tax strategies by the Internal \nRevenue Service is subject to reclarification or change, as well. \nAn option is acapital asset and any gains or losses are capital gains or losses. \nDiffering tax consequences apply, depending on whether the option trade is acomplete transaction by itself, or whether it becomes part of astock transaction via \nexercise or assignment. Listed option transactions that are closed out in the options \nmarket or are allowed to expire worthless are capital transactions. The holding period \nfor option transactions to qualify as long-term is always the same as for stocks ( cur\nrently, it'sone year). Gains from option purchases could possibly be long-term gains if \nthe holding period of the option exceeds the long-term capital gains holding period. \nGains from the sale of options are short-term capital gains. In addition, the tax \ntreatment of futures options and index options and other listed nonequity options \nmay differ from that of equity options. We will review these points individually. \nHISTORY \nIn the short life of listed option trading. there have been several major changes in the \ntax rules. When options were first listed in 1973, the tax laws treated the gains and \nlosses from writing options as ordinary income. That is, the thinking was that only \nprofessionals or those people in the business actually wrote over-the-counter options, \nand thus their gains and losses represented their ordinary income, or means of mak\ning aliving. This rule presented some interesting strategies involving spreads, \nbecause the long side of the spread could be treated as long-term gain (if held for \n908", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:970", "doc_id": "ffaae00b27c641bd5ca7bcfe9e6ef088b4bff52e95b44e8e6e075da78e7b14da", "chunk_index": 0}
{"text": "Chapter 41: Taxes 909 \nmore than 6 months, which was the required holding period for along-term gain at \nthat time), and the short side of the spread could be ordinary loss. Of course, the \nstock would have had to move in the desired direction in order to obtain this result. \nIn 1976, the tax laws changed. The major changes affecting option traders were \nthat the long-term holding period was extended to one year and also that gains or \nlosses from writing options were considered to be capital gains. The extension of the \nlong-term period essentially removed all possibilities of listed option holders ever \nobtaining along-term gain, because the listed option market'slongest-term options \nhad only 9 months of life. \nAll through this period there were awide array of tax strategies that were avail\nable, legally, to allow investors to defer capital gains from one year to the next, there\nby avoiding payment of taxes. Essentially, one would enter into aspread involving \ndeep in-the-money options that would expire in the next calendar year. Perhaps the \nspread would be established during October, using January options. Then one would \nwait for the underlying stock to move. Once amove had taken place, the spread \nwould have aprofit on one side and aloss on the other. The loss would be realized \nby rolling the losing option into another deep in-the-money option. The realized loss \ncould thus be claimed on that year'staxes. The remaining spread - now an unrealized \nprofit - would be left in place until expiration, in the next calendar year. At that time, \nthe spread would be removed and the gain would be realized. Thus, the gain was \nmoved from one year to the next. Then, later in that year, the gain would again be \nrolled to the next calendar year, and so on. \nThese practices were effectively stopped by the new tax ruling issued in 1984. \nTwo sweeping changes were made. First, the new rules stated that, in any spread \nposition involving offsetting options - as the two deep in-the-money options in the \nprevious example - the losses can be taken only to the extent that they exceed the \nunrealized gain on the other side of the spread. (The tax literature insists on calling \nthese positions \"straddles\" after the old commodity term, but for options purposes \nthey are really spreads or covered writes.) As aby-product of this rule, the holding \nperiod of stock can be terminated or eliminated by writing options that are too deeply \nin-the-money. Second, the new rules required that all positions in nonequity options \nand all futures be marked to market at the end of the tax year, and that taxes be paid \non realized and unrealized gains alike. The tax rate for nonequity options was low\nered from that of equity options. Then, in 1986, the long-term and short-term capi\ntal gains rates were made equal to the lowest ordinary rate. All of these points will be \ncovered in detail.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:971", "doc_id": "91e80999fd508da6d7e52c9ee27b2fb5b8952766b466ee8497a612fefe6e2361", "chunk_index": 0}
{"text": "910 Part VI: Measuring and Trading Volatility \nBASIC TAX TREATMENT \nListed options that are exercised or assigned fall into adifferent category for tax pur\nposes. The original premium of the option transaction is combined into the stock \ntransaction. There is no tax liability on this stock position until the stock position itself \nis closed out. There are four different combinations of exercising or assigning puts or \ncalls. Table 41-1 summarizes the method of applying the option premium to the stock \ncost or sale price. \nExamples of how to treat these various transactions are given in the following \nsections. In addition to examples explaining the basic tax treatment, some supple\nmentary strategies are included as well. \nCALL BUYER \nIf acall holder subsequently sells the call or allows it to expire worthless, he has acapital gain or loss. For equity options, the holding period of the option determines \nwhether the gain or loss is long-term or short-term. As mentioned previously, along\nterm gain would be possible if held for more than one year. For tax purposes, an \noption that expires worthless is considered to have been sold at zero dollars on the \nexpiration date. \nExample: An investor purchases an XYZ October 50 call for 5 points on July l. He \nsells the call for 9 points on September 1. That is, he realizes acapital gain via aclos\ning transaction. His taxable gain would be computed as shown in Table 41-1, assum\ning that a $25 commission was paid on both the purchase and the sale. \nTABLE 41-1. \nApplying the option premium to the stock cost or sale price. \nAction \nCall buyer exercises \nPut buyer exercises \nCall writer assigned \nPut writer assigned \nNet proceeds of sale ($900 - $25) \nNet cost ($500 + $25) \nShort-term gain: \nTax Treatment \nAdd call premium to stock cost \nSubtract put premium from stock sale price \nAdd call premium to stock sale price \nSubtract put premium from stock cost \n$875 \n-525 \n$350", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:972", "doc_id": "b5f9c9de905699628e7d98fa0f170382d8c934f916c8733174163438f609bda3", "chunk_index": 0}
{"text": "Chapter 41: Taxes 911 \nAlternatively, if the stock had fallen in price by October expiration and the October \n50 call had expired worthless, the call buyer would have lost $525 - his entire net \ncost. If he had held the call until it expired worthless, he would have ashort-term \ncapital loss of $525 to report among his taxable transactions. \nPUT BUYER \nThe holder of aput has much the same tax consequences as the holder of acall, pro\nvided that he is not also long the underlying stock. This initial discussion of tax con\nsequences to the put holder will assume that he does not simultaneously own the \nunderlying stock. If the put holder sells his put in the option market or allows it to \nexpire worthless, the gain or loss is treated as capital gain, long-term for equity puts \nheld more than one year. Historically, the purchase of aput was viewed as perhaps \nthe only way an investor could attain along-term gain in adeclining market. \nExample: An investor buys an XYZ April 40 put for 2 points with the stock at 43. \nLater, the stock drops in price and the put is sold for 5 points. The commissions were \n$25 on each option trade, so the tax consequences would be: \nNet sale proceeds ($500 - $25) \nNet cost ($200 + $25) \nShort-term capital gain: \n$475 \n-225 \n$250 \nAlternatively, if he had sold the put at aloss, perhaps in arising market, he would \nhave ashort-term capital loss. Furthermore, if he allowed the put to expire totally \nworthless, his short-term loss would be equal to the entire net cost of $225. \nCALL WRITER \nWritten calls that are bought back in the listed option market or are allowed to expire \nworthless are short-term capital gains. Awritten call cannot produce along-term \ngain, regardless of the holding period. This treatment of awritten call holds true even \nif the investor simultaneously owned the underlying stock (that is, he had acovered \nwrite). As long as the call is bought back or allowed to expire worthless, the gain or \nloss on the call is treated separately from the underlying stock for tax purposes. \nExample: Atrader sells naked an XYZ July 30 call for 3 points and buys it back three \nmonths later at aprice of 1. The commissions were $25 for each trade, so the tax gain \nwould be:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:973", "doc_id": "511e0a5c928504dcf4470a8758aac4b4cae1761dd43bd4964e55e7733bff76d7", "chunk_index": 0}
{"text": "912 \nNet sale proceeds ($300 - $25) \nNet cost ($100 + $25) \nShort-term gain: \nPart VI: Measuring and Trading Volatility \n$275 \n-125 \n$150 \nIf the investor had not bought the call back, but had been fortunate enough to be \nable to allow it to expire worthless, his gain for tax purposes would have been the \nentire $275, representing his net sale proceeds. The purchase cost is considered to \nbe zero for an option that expires worthless. \nPUT WRITER \nThe tax treatment of written puts is quite similar to that of written calls. If the put is \nbought back in the open market or is allowed to expire worthless, the transaction is \nashort-term capital item. \nExample: An investor writes an XYZ July 40 put for 4 points, and later buys it back \nfor 2 points after arally by the underlying stock. The commissions were $25 on each \noption trade, so the tax situation would be: \nNet put sale price ($400 - $25) \nNet put cost ($100 + $25) \nShort-term gain: \n$375 \n-125 \n$250 \nIf the put were allowed to expire worthless, the investor would have anet gain of \n$375, and this gain would be short-term. \nTHE 60/40 RULE \nAs mentioned earlier, nonequity option positions and future positions must be \nmarked to market at the end of the tax year and taxes paid on both the unrealized and \nrealized gains and losses. This same rule applies to futures positions. The tax rate on \nthese gains and losses is lower than the equity options rate. Regardless of the actual \nholding period of the positions, one treats 60% of his tax liability as long-term and \n40% as short-term. This ruling means that even gains made from extremely short\nterm activity such as day-trading can qualify partially as long-term gains. \nSince 1986, long-term and short-term capital gains rates have been equal. If \nlong-term rates should drop, then the rule would again be more meaningful. \nExample: Atrader in nonequity options has made three trades during the tax year. \nIt is now the end of the tax year and he must compute his taxes. First, he bought S&P", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:974", "doc_id": "6b1f7ae9528e47dde52c88796ff240d6ff2a9ad9ad3fb80afe9db62b82b67939", "chunk_index": 0}
{"text": "Chapter 41: Taxes 913 \n500 calls for $1,500 and sold them 6 weeks later for $3,500. Second, he bought an \nOEX January 160 call for 3.25 seven months ago and still holds it. It currently is trad\ning at 11.50. Finally, he sold 5 SPX February 250 puts for 1.50 three days ago. They \nare currently trading at 2. The net gain from these transactions should be computed \nwithout regard to holding period. \nNonequity Original Current Gain/ \nContract Price Price Cost Proceeds Loss \nS&Pcalls $1,500 $3,500 +$2,000 realized \nOEX January 160 3.25 11.50 $ 325 $1,150 + 825 unrealized \nSPX February 250 1.50 2.00 $1,000 $ 750 250 unrealized \nTotal caeital gains +$2,575 \nThe total taxable amount is $2,575, regardless of holding period and regardless of \nwhether the item is realized or unrealized. Of this total taxable amount, 60% ($1,545) \nis subject to long-term treatment and 40% ($1,030) is subject to short-term treat\nment. \nIn practice, one computes these figures on aseparate form (Section 1256) and \nmerely enters the two final figures - $1,545 and $1,030- on the tax schedule for cap\nital gains and losses. Note that if one loses money in nonequity options, he actually \nhas atax disadvantage in comparison to equity options, because he must take some \nof his loss as along-term loss, while the equity option trader can take all of his loss as \nshort-term. \nEXERCISE AND ASSIGNMENT \nExcept for aspecified situation that we will discuss later, exercise and assignment do \nnot have any tax effect for nonequity options because everything is marked to mar\nket at the end of the year. However, since equity options are subject to holding peri\nod considerations, the following discussion pertains to them. \nCALL EXERCISE \nAn equity call holder who has an in-the-money call might decide to exercise the call \nrather than sell it in the options market. If he does this, there are no tax consequences \non the option trade itself. Rather, the cost of the stock is increased by the net cost of \nthe original call option. Moreover, the holding period begins on the day the stock is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:975", "doc_id": "6fee31614450550bf7a49f9cbfdc3e7ca1aa4e4ba7c627e20b95aab89cb6eac9", "chunk_index": 0}
{"text": "914 Part VI: Measuring and Trading Volatility \npurchased (the day after the call was exercised). The option'sholding period has no \nbearing on the stock position that resulted from the exercise. \nExample: An XYZ October 50 call was bought for 5 points on July 1. The stock had \nrisen by October expiration, and the call holder decided to exercise the call on \nOctober 20th. The option commission was $25 and the stock commission was $85. \nThe cost basis for the stock would be computed as follows: \nBuy 1 00 XYZ at 50 via exercise \n($5,000 plus $85 commission) \nOriginal call cost ($500 plus $25) \nTotal tax basis of stock \nHolding period of stock begins on October 21. \n$5,085 \n525 \n$5,610 \nWhen this stock is eventually sold, it will be again or aloss, depending on the stock'ssale price as compared to the tax basis of $5,610 for the stock. Furthermore, it will \nbe ashort-term transaction unless the stock is held until October 21st of the follow\ning year. \nCALL ASSIGNMENT \nIf awritten call is not closed out, but is instead assigned, the call'snet sale proceeds \nare added to the sale proceeds of the underlying stock. The call'sholding period is \nlost, and the stock position is considered to have been sold on the date of the assign\nment. \nExample: Anaked writer sells an XYZ July 30 call for 3 points, and is later assigned \nrather than buying back the option when it was in-the-money near expiration. The \nstock commission is $75. His net sale proceeds for the stock would be computed as \nfollows: \nNet call sale proceeds ($300 - $25) \nNet stock proceeds from assignment \nof 100 shares at 30 ($3,000 - $75) \nNet stock sale proceeds \n$ 275 \n2,925 \n$3,200 \nIn the case in which the investor writes anaked, or uncovered, call, he sells \nstock short upon assignment. He may, of course, cover the short sale by purchasing \nstock in the open market for delivery. Such ashort sale of stock is governed by the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:976", "doc_id": "085adad76dcaf90bb7feb3eaf4f2d27a776cbe8c9fdeba30df53d02ed00f407e", "chunk_index": 0}
{"text": "Chapter 41: Taxes 915 \napplicable tax rules pertaining to short sales that any gains or losses from the short \nsale of stock are short-term gains or losses. \nTax Treatment for the Covered Writer. If, on the other hand, the \ninvestor was assigned on acovered call - that is, he was operating the covered \nwriting strategy and he elects to deliver the stock that he owns against the \nassignment notice, he has acomplete stock transaction. The net cost of the stock \nwas determined by its purchase price at an earlier date and the net sale proceeds \nare, of course, determined by the assignment in accordance with the preceding \nexample. \nDetermining the proceeds from the stock purchase and sale is easy, but deter\nmining the tax status of the transaction is not. In order to prevent stockholders from \nusing deeply in-the-money calls to protect their stock while letting it become along\nterm item, some complicated tax rules have been passed. They can be summarized \nas follows: \n1. If the equity option was out-of-the-money when first written, it has no effect on \nthe holding period of the stock. \n2. If the equity option was too deeply in-the-money when first written and the stock \nwas not yet held long-term, then the holding period of the stock is eliminated. \n3. If the equity option was in-the-money, but not too deeply, then the holding peri\nod of the stock is suspended while the call is in place. \nThese rules are complicated and merit further explanation. The first rule mere\nly says that one can write out-of-the-money calls without any problem. If the stock \nlater rises and is called away, the sale proceeds for the stock include the option pre\nmium, and the transaction is long-term or short-term depending on the holding peri\nod of the stock. \nExample: Assume that on September 1st of aparticular year, an investor buys 100 \nXYZ at 35. He holds the stock for awhile, and then on July 15th of the following year \n- after the stock has risen to 43 - he sells an October 45 call for 3 points. \nNet call sale proceeds ($300 - $25) \nNet stock proceeds from \nassignment ($4,500 - $75) \nNet stock sale proceeds \nNet stock cost ($3,500 + $75) \nNet long-term gain \n$ 275 \n$4,425 \n$4,700 $4,700 \n$3,575 \n+$1, 125", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:977", "doc_id": "4c8fe9b2902410facf2530482aded82ad419431fbdd17d8575025d87d356bfd8", "chunk_index": 0}
{"text": "916 Part VI: Measuring and Trading Volatllity \nThus, this covered writer has anet gain of $1,125 and it is along-term gain because \nthe stock was held for more than one year (from September 1st of the year in which \nhe bought it, to October expiration of the next year, when the stock was called away). \nNote that in asimilar situation in which the stock had been held for less than \none year before being called away, the gain would be short-term. \nLet us now look at the other two rules. They are related in that their differen\ntiation relies on the definition of \"too deeply in-the-money.\" They come into play \nonly if the stock was not already held long-term when the call was written. If the writ\nten call is too deeply in-the-money, it can eliminate the holding period of short-term \nstock. Otherwise, it can suspend it. If the call is in-the-money, but not too deeply in\nthe-money, it is referred to as aqualified covered call. There are several rules regard\ning the determination of whether an in-the-money call is qualified or not. Before \nactually getting to that definition, which is complicated, let us look at two examples \nto show the effect of the call being qualified or not qualified. \nExample: Qualified Covered Write: On March 1st, an investor buys 100 XYZ at 35. \nHe holds the stock for 3% months, and, on July 15th, the stock has risen to 43. This \ntime he sells an in-the-money call, the October 40 call for 6. By October expiration, \nthe stock has declined and the call expires worthless. \nHe would now have the following situation: a $575 short-term gain from the \nsale of the call, plus he is long 100 XYZ with aholding period of only 3% months. \nThus, the sale of the October call suspended his holding period, but did not elimi\nnate it. \nHe could now hold the stock for another 8½ months and then sell it as along\nterm item. \nIf the stock in this example had stayed above 40 and been called away, the net \nresult would have been that the option proceeds would have been added to the stock \nsale price as in previous examples, and the entire net gain would have been short\nterm due to the fact that the writing of the qualified covered call had suspended the \nholding period of the stock at 3½ months. \nThat example was one of writing acall which was not too deeply in-the-money. \nIf, however, one writes acall on stock that is not yet held long-term and the call is too \ndeeply in-the-money, then the holding period of the stock is eliminated. That is, if the \ncall is subsequently bought back or expires worthless, the stock must then be held for \nanother year in order to qualify as along-term investment. This rule can work to an \ninvestor'sadvantage. If one buys stock and it goes down and he is in jeopardy of hav\ning along-term loss, but he really does not want to sell the stock, he can sell acall", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:978", "doc_id": "ea988282e72891be717ff58b0be1ca28d423f160a3836ed93a4504908271f54e", "chunk_index": 0}
{"text": "Chapter 41: Taxes 917 \nthat is too deeply in-the-money (if one exists), and eliminate the holding period on \nthe stock \nQualified Covered Call. The preceding examples and discussion summa\nrize the covered writing rules. Let us now look at what is aqualified covered call. \nThe following rules are the literal interpretation. Most investors work from \ntables that are built from these rules. Such atable may be found in Appendix E. \n(Be aware that these rules may change, and consult atax advisor for the latest \nfigures.) Acovered call is qualified if: \n1. the option has more than 30 days of life remaining when it is written, and \n2. the strike of the written call is not lower than the following benchmarks: \na. First determine the applicable stock price (ASP). That is normally the closing \nprice of the stock on the previous day. However, if the stock opens more than \nll0% higher than its previous close, then the applicable stock price is that \nhigher opening. \nb. If the ASP is less than $25, then the benchmark strike is 85% of ASP. So any \ncall written with astrike lower than 85% of ASP would not be qualified. (For \nexample, if the stock was at 12 and one wrote acall with astriking price of 10, \nit would not be qualified- it is too deeply in-the-money.) \nc. If the ASP is between 25.13 and 60, then the benchmark is the next lowest \nstrike. Thus, if the stock were at 39 and one wrote acall with astrike of 35, it \nwould be qualified. \nd. If the ASP is greater than 60 and not higher than 150, and the call has more \nthan 90 days of life remaining, the benchmark is two strikes below the ASP. \nThere is afurther condition here that the benchmark cannot be more than 10 \npoints lower than the ASP. Thus, if astock is trading at 90, one could write acall with astrike of 80 as long as the call had more than 90 days remaining \nuntil expiration, and still be qualified. \ne. If the ASP is greater than 150 and the call has more than 90 days of life remain\ning, the benchmark is two strikes below the ASP. Thus, if there are 10-point \nstriking price intervals, then one could write acall that was 20 points in-the\nmoney and still be qualified. Of course, if there are 5-point intervals, then one \ncould not write acall deeper than 10 points in-the-money and still be qualified. \nThese rules are complicated. That is why they are summarized in Appendix E. \nIn addition, they are always subject to change, so if an investor is considering writing \nan in-the-money covered call against stock that is still short-term in nature, he should \ncheck with his tax advisor and/or broker to determine whether the in-the-money call \nis qualified or not.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:979", "doc_id": "0410697147ae49818afbeae1738448b9fb06f106db3ddfd79a6da9799c760caa", "chunk_index": 0}
{"text": "918 Part VI: Measuring and Trading Volatility \nThere is one further rule in connection with qualified calls. Recall that we stat\ned that the above rules apply only if the stock is not yet held long-term when the call \nis written. If the stock is already long-term when the call is written, then it is consid\nered long-term when called away, regardless of the position of the striking price when \nthe call was written. However, if one sells an in-the-money call on stock already held \nlong-term, and then subsequently buys that call back at aloss, the loss on the call \nmust be taken as along-term loss because the stock was long-term. \nOverall, arising market is the best, taxwise, for the covered call writer. If he \nwrites out-of-the-money calls and the stock rises, he could have ashort-term loss on \nthe calls plus along-term gain on the stock. \nExample: On January 2nd of aparticular year, an investor bought 100 shares of XYZ \nat 32, paying $75 in commissions, and simultaneously wrote a July 35 call for 2 points. \nThe July 35 expired worthless, and the investor then wrote an October 35 call for 3 \npoints. In October, with XYZ at 39, the investor bought back the October 35 call for \n6 points (it was in-the-money) and sold a January 40 call for 4 points. In January, on \nthe expiration day, the stock was called away at 40. The investor would have along\nterm capital gain on his stock, because he had held it for more than one year. He \nwould also have two short-term capital transactions from the July 35 and October 35 \ncalls. Tables 41-2 and 41-3 show his net tax treatment from operating this covered \nwriting strategy. The option commission on each trade was $25. \nThings have indeed worked out quite well, both profit-wise and tax-wise, for this \ncovered call writer. Not only has he made anet profit of $850 from his transactions on \nthe stock and options over the period of one year, but he has received very favorable \ntax treatment. He can take ashort-term loss of $175 from the combined July and \nOctober option transactions, and is able to take the $1,025 gain as along-term gain. \nTABLE 41-2. \nSummary of trades. \nJanuary 2 \nJuly \nOctober \nJanuary \nBought 100 XYZ at 32 \nSold 1 July 35 call at 2 \nJuly call expired worthless (XYZ at 32) \nSold 1 October 35 call at 3 \nBought back October 35 call for 6 points (XYZ at 39) \nSold 1 January 40 call for 4 points \n(of the following year) \n1 00 XYZ called away at 40", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:980", "doc_id": "1d2f769eba2a63b7ec5abd35e829e1f903eb03d0bea7750bec12c57c02fecb6a", "chunk_index": 0}
{"text": "Chapter 41: Taxes \nTABLE 41-3. \nTax treatment of trades. \nShort-term capital items: \nJuly 35 call: Net proceeds ($200 - $25) \nNet cost {expired worthless) \nShort-term capital gain \nOctober 35 call: Net proceeds ($300 - $25) \nNet cost ($600 + $25) \nShort-term capital loss \n919 \n$175 \n0 \n$175 \n$275 \n- 625 \n($350) \nLong-term capital item: \n100 shares XYZ: Purchased January 2 of one year and sold at January \nexpiration of the following year. Therefore, held for \nmore than one year, qualifying for long-term treatment. \nNet sale proceeds of stock {assigned call): \nJanuary 40 call sale proceeds \n($400 - $25) \nSold 1 00 XYZ at 40 strike \n{$4,000 $75) \nNet cost of stock (January 2 trade): \nBought 100 at 32 {$3,200 + $75) \nLong-term capital gain \n$375 \n+ 3,925 \n$4,300 \n- 3,275 \n$1,025 \nThis example demonstrates an important tax consequence for the covered call \nwriter: His optimum scenario tax-wise is arising market, for he may be able to \nachieve along-term gain on the underlying stock if he holds it for at least one year, \nwhile simultaneously subtracting short-term losses from written calls that were \nclosed out at higher prices. Unfortunately, in adeclining market, the opposite result \ncould occur: short-term option gains coupled with the possibility of along-term loss \non the underlying stock. There are ways to avoid long-term stock losses, such as buy\ning aput ( discussed later in the chapter) or going short against the box before the \nstock becomes long-term. However, these maneuvers would interrupt the covered \nwriting strategy, which may not be awise tactic. \nIn summary, then, the covered call writer who finds himself with an in-the\nmoney call written and expiration date drawing near may have several alternatives \nopen to him. If the stock is not yet held long-term, he might elect to buy back the \nwritten call and to write another call whose expiration date is beyond the date \nrequired for along-term holding period on the stock. This is apparently what the \nhypothetical investor in the preceding example did with his October 35 call. Since", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:981", "doc_id": "abde901ab4bcae4915998351b64c4f91a8879f21d02d9479e3a02ea0d0ed9937", "chunk_index": 0}
{"text": "920 Part VI: Measuring and Trading VolatiRty \nthat call was in-the-money, he could have elected to let the call be assigned and to \ntake his profit on the position at that time. However, this would have produced ashort-term gain, since the stock had not yet been held for one year, so he elected \ninstead to terminate the October 35 call through aclosing purchase transaction and \nto simultaneously write acall whose expiration date exceeded the one year period \nrequired to make the stock along-term item. He thus wrote the January 40 call, \nexpiring in the next year. Note that this investor not only decided to hold the stock \nfor along-term gain, but also decided to try for more potential profits: He rolled the \ncall up to ahigher striking price. This lets the holding period continue. An in-the\nmoney write would have suspended it. \nDELIVERING .,.,NEW\" STOCK TO AVOID A LARGE LONG· TERM GAIN \nSome covered call writers may not want to deliver the stock that they are using to \ncover the written call, if that call is assigned. For example, if acovered writer were \nwriting against stock that had an extremely low cost basis, he might not be willing to \ntake the tax consequences of selling that particular stock holding. Thus, the writer of \nacall that is assigned may sometimes wish to buy stock in the open market to deliv\ner against his assignment, rather than deliver the stock he already owns. Recall that \nit is completely in accordance with the Options Clearing Corporation rules for acall \nwriter to buy stock in the open market to deliver against an assignment. For tax pur\nposes, the confirmation that the investor receives from his broker for the sale of the \nstock via assignment should clearly specify which particular shares of stock are being \nsold. This is usually accomplished by having the confirmation read \"Versus Purchase\" \nand listing the purchase date of the stock being sold. This is done to clearly identify \nthat the \"new\" stock, and not the older long-term stock, is being delivered against the \nassignment. The investor must give these instructions to his broker, so that the \nbrokerage firm puts the proper notation on the confirmation itself. If the investor \nrealizes that his stock might be in danger of being called away and he wants to avail \nhimself of this procedure, he should discuss it with his broker beforehand, so that the \nproper procedures can be enacted when the stock is actually called away. \nExample: An investor owns 100 shares ofXYZ and his cost basis, after multiple stock \nsplits and stock dividends over the years, is $2 per share. With XYZ at 50, this investor \ndecides to sell an XYZ July 50 call for 5 points to bring in some income to his port\nfolio. Subsequently, the call is assigned, but the investor does not want to deliver his \nXYZ, which he owns at acost basis of $2 per share, because he would have to pay cap\nital gains on alarge profit. He may go into the open market and buy another 100 \nshares of XYZ at its current market price for delivery against the assignment notice.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:982", "doc_id": "896b125486d5cbfd8285ff93d25c2d6df9be4bceefe6c6a875ab3bc62c065c8d", "chunk_index": 0}
{"text": "Chapter 41: Taxes 921 \nSuppose he does this on July 20th, the day he receives the assignment notice on his \nXYZ July 50 call. The confirmation that he receives from his broker for the sale of \n100 XYZ at 50 - that is, the confirmation for the call assignment - should be marked \n\"Versus Purchase July 20th.\" The year of the sale date should be noted on the con\nfirmation as well. This long-term holder of XYZ stock must, of course, pay for the \nadditional XYZ bought in the open market for delivery against the assignment notice. \nThus, it is imperative that such an investor have areserve of funds that he can fall \nback on if he thinks that he must ever implement this sort of strategy to avoid the tax \nconsequences of selling his low-cost-basis stock. \nPUT EXERCISE \nIf the put holder does not choose to liquidate the option in the listed market, but \ninstead exercises the put - thereby selling stock at the striking price - the net cost of \nthe put is subtracted from the net sale proceeds of the underlying stock. \nExample: Assume an XYZ April 45 put was bought for 2 points. XYZ had declined in \nprice below 45 by April expiration, and the put holder decides to exercise his in-the\nmoney put rather than sell it in the option market. The commission on the stock sale \nis $85, so the net sale proceeds for the underlying stock would be: \nSale of 100 XYZ at 45 strike ($4,500 - $85) \nNet cost of put ($200 + 25) \nNet sale proceeds on stock for tax purposes: \n$4,415 \n- 225 \n$4,190 \nIf the stock sale represents anew position - that is, the investor has shorted the \nunderlying stock - it will eventually be ashort-term gain or loss, according to pres\nent tax rules governing short sales. If the put holder already owns the underlying \nstock and is using the put exercise as ameans of selling that stock, his gain or loss on \nthe stock transaction is computed, for tax purposes, by subtracting his original net \nstock cost from the sale proceeds as determined above. \nPUT ASSIGNMENT \nIf awritten put is assigned, stock is bought at the striking price. The net cost of this \npurchased stock is reduced by the amount of the original put premium received. \nExample: If one initially sold an XYZ July 40 put for 4 points, and it was assigned, \nthe net cost of the stock would be determined as follows, assuming a $75 commission \ncharge on the stock purchase:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:983", "doc_id": "febc98d11c7e55544598b0048b871741d6161cff17bc84714c6ca57b6cb5047c", "chunk_index": 0}
{"text": "922 \nCost of 100 XYZ assigned at 40 ($4,000 + $75) \nNet proceeds of put sale ($400 - $25) \nNet cost basis of stock \nPart VI: Measuring and Trading Volatility \n$4,075 \n- 375 \n$3,700 \nThe holding period for stock purchased via aput assignment begins on the day of the \nput assignment. The period during which the investor was short the put has no bear\ning on the holding period of the stock. Obviously, the put transaction itself does not \nbecome acapital item; it becomes part of the stock transaction. \nSPECIAL TAX PROBLEMS \nTHE WASH SALE RULE \nThe call buyer should be aware of the wash sale rule. In general, the wash sale rule \ndenies atax deduction for asecurity sold at aloss if asubstantially identical security, \nor an option to acquire that security, is purchased within 30 days before or 30 days \nafter the original sale. This means that one cannot sell XYZ to take atax loss and also \npurchase XYZ within the 61-day period that extends 30 days before and 30 days after \nthe sale. Of course, an investor can legally make such atrade, he just cannot take the \ntax loss on the sale of the stock. Acall option is certainly an option to acquire the \nsecurity. It would thus invoke the wash sale rule for an investor to sell XYZ stock to \ntake aloss and also purchase any XYZ call within 30 days before or after the stock \nsale. \nVarious series of call options are not generally considered to be substantially \nidentical securities, however. If one sells an XYZ January 50 call to take aloss, he may \nthen buy any other XYZ call option without jeopardizing his tax loss from the sale of \nthe January 50. It is not clear whether he could repurchase another January 50 call\nthat is, an identical call - without jeopardizing the taxable loss on the original sale of \nthe January 50. \nIt would also be acceptable for an investor to sell acall to take aloss and then \nimmediately buy the underlying security. This would not invoke the wash sale rule. \nAvoiding a Wash Sale. It is generally held that the sale of aput is not the \nacquisition of an option to buy stock, even though that is the effect of assign\nment of the written put. This fact may be useful in certain cases. If an investor \nholds astock at aloss, he may want to sell that stock in order to take the loss on \nhis taxes for the current year. The wash sale rule prevents him from repurchas\ning the same stock, or acall option on that stock, within 30 days after the sale. \nThus, the investor will be \"out of\" the stock for amonth; that is, he will not be", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:984", "doc_id": "30df4043ebb8be412cdfaaa2d8ae860c6263e92ac6afa03c4b53dc749c090260", "chunk_index": 0}
{"text": "Chapter 41: Taxes 923 \nable to participate in any rally in the stock in the next 30 days. If the underlying \nstock has listed put options, the investor may be able to partially offset this neg\native effect. By selling an in-the-money put at the same time that the stock is \nsold, the investor will be able to take his stock loss on the current year'staxes \nand also will be able to participate in price movements on the underlying stock. \nIf the stock should rally, the put will decrease in price. However, if the stock ral\nlies above the striking price of the put, the investor will not make as much from the \nput sale as he would have from the ownership of the stock. Still, he does realize some \nprofits if the stock rallies. \nConversely, if the stock falls in price, the investor will lose on the put sale. This \ncertainly represents arisk although no more of arisk than owning the stock did. An \nadditional disadvantage is that the investor who has sold aput will not receive the div\nidends, if any are paid by the underlying stock. \nOnce 30 days have passed, the investor can cover the put and repurchase the \nunderlying stock. The investor who utilizes this tactic should be careful to select aput \nsale in which early assignment is minimal. Therefore, he should sell along-term, in\nthe-money put when utilizing this strategy. (He needs the in-the-money put in order \nto participate heavily in the stock'smovements.) Note that if stock should be put to \nthe investor before 30 days had passed, he would thus be forced to buy stock, and the \nwash sale rule would be invoked, preventing him from taking the tax loss on the stock \nat that time. He would have to postpone taking the loss until he makes asale that \ndoes not invoke the wash sale rule. \nFinally, this strategy must be employed in amargin account, because the put \nsale will be uncovered. Obviously, the money from the sale of the stock itself can be \nused to collateralize the sale of the put. If the stock should drop in value, it is always \npossible that additional collateral will be required for the uncovered put. \nTHE SHORT-SALE RULE - PUT HOLDER'S PROBLEM \nAput purchase made by an investor who also owns the underlying stock may have an \neffect on the holding period of the stock. If astock holder buys aput, he would nor\nmally do so to eliminate some of the downside risk in case the stock falls in price. \nHowever, if aput option is purchased to protect stock that is not yet held long enough \nto qualify for long-term capital gains treatment, the entire holding period of the stock \nis wiped out. Furthermore, the holding period for the stock will not begin again until \nthe put is disposed of. For example, if an investor has held XYZ for 11 months - not \nquite long enough to qualify as along-term holding - and then buys aput on XYZ, \nhe will wipe out the entire accrued holding period on the stock. Furthermore, when \nhe finally disposes of the put, the holding period for the stock must begin all over", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:985", "doc_id": "4fcf61d5a4749ae79c21dcfb36207dead9bcbee47a01d2405604e6a75901c5ea", "chunk_index": 0}
{"text": "924 Part VI: Measuring and Trading VolatHity \nagain. The previous 11-month holding period is lost, as is the holding period during \nwhich the stock and put were held together. This tax consequence of aput purchase \nis derived from the general rules governing short sales, which state that the acquisi\ntion of an option to sell property at afixed price (that is, aput) is treated as ashort \nsale. This ruling has serious tax consequences for an investor who has bought aput \nto protect stock that is still in ashort-term tax status. \n✓,,Married\" Put and Stock. There are two cases in which the put purchase \ndoes not affect the holding period of the underlying stock. First, if the stock has \nalready been held long enough to qualify for long-term capital treatment, the \npurchase of aput has no bearing on the holding period of the underlying stock. \nSecond, if the put and the stock that it is intended to protect are bought at the \nsame time, and the investor indicates that he intends to exercise that particular \nput to sell those particular shares of stock, the put and the stock are considered \nto be \"married\" and the normal tax rulings for astock holding would apply. The \ninvestor must actually go through with the exercise of the put in order for the \n\"married\" status to remain valid. If he instead should allow the put to expire \nworthless, he could not take the tax loss on the put itself but would be forced to \nadd the put' scost to the net cost of the underlying stock. Finally, if the investor \nneither exercises the put nor allows it to expire worthless but sells both the put \nand the stock in their respective markets, it would appear that the short sale \nrules would come back into effect. \nThis definition of \"married\" put and stock, with its resultant ramifications, is \nquite detailed. What exactly are the consequences? The \"married\" rule was original\nly intended to allow an investor to buy stock, protect it, and still have achance of real\nizing along-term gain. This is possible with options with more than one year of life \nremaining. The reader must be aware of the fact that, if he initially \"marries\" stock \nand alisted 3-month put, for example, there is no way that he can replace that put at \nits expiration with another put and still retain the \"married\" status. Once the original \n\"married\" put is disposed of - through sale, exercise, or expiration - no other put may \nbe considered to be \"married\" to the stock. \nProtecting a Long· Term Gain or Avoiding a Long-Term Loss. The \ninvestor may be able, at times, to use the short-sale aspect of put purchases to \nhis advantage. The most obvious use is that he can protect along-term gain with \naput purchase. He might want to do this if he has decided to take the long-term \ngain, but would prefer to delay realizing it until the following tax year. Apur\nchase of aput with amaturity date in the following year would accomplish that \npurpose.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:986", "doc_id": "97a7dd25e90643e0eed8d5c752211bd99454375ba047d26f206df3758595493a", "chunk_index": 0}
{"text": "Chapter 41: Taxes 92S \nAnother usage of the put purchase, for tax purposes, might be to avoid along\nterm loss on astock position. If an investor owns astock that has declined in price \nand also is about to become along-term holding, he can buy aput on that stock to \neliminate the holding period. This avoids having to take along-term loss. Once the \nput is removed, either by its sale or by its expiring worthless, the stock holding peri\nod would begin all over again and it would be ashort-term position. In addition, if \nthe investor should decide to exercise the put that he purchased, the result would be \nashort-term loss. The sale basis of the stock upon exercise of the put would be equal \nto the striking price of the put less the amount of premium paid for the put, less all \ncommission costs. Furthermore, note that this strategy does not lock in the loss on \nthe underlying stock. If the stock rallies, the investor would be able to participate in \nthat rally, although he would probably lose all of the premium that he paid for the \nput. Note that both of these long-term strategies can be accomplished via the sale of \nadeeply in-the-money call as well. \nSUMMARY \nThis concludes the section of the tax chapter dealing with listed option trades and \ntheir direct consequences on option strategies. In addition to the basic tax treatment \nfor option traders of liquidation, expiring worthless, or assignment or exercise, sev\neral other useful tax situations have been described. The call buyer should be aware \nof the wash sale rule. The put buyer must be aware of the short sale rules involving \nboth put and stock ownership. The call writer should realize the beneficial effects of \nselling an in-the-money call to protect the underlying stock, while waiting for areal\nization of profit in the following tax year. The put writer may be able to avoid awash \nsale by utilizing an in-the-money put write, while still retaining profit potential from \narally by the underlying stock. \nTAX PLANNING STRATEGIES FOR EQUITY OPTIONS \nDEFERRING A SHORT· TERM CALL GAIN \nThe call holder may be interested in either deferring again until the following year \nor possibly converting ashort-term gain on the call into along-term gain on the stock. \nIt is much easier to do the former than the latter. Aholder of aprofitable call that is \ndue to expire in the following year can take any of three possible actions that might \nlet him retain his profit while deferring the gain until the following tax year. One way \nin which to do this would be to buy aput option. Obviously, he would want to buy an", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:987", "doc_id": "319f2352bbf8fafdf8b06ec9526ec3148293b51ab8cb16eb8574d51b308a4de5", "chunk_index": 0}
{"text": "926 Part VI: Measuring and Trading Volatillty \nin-the-money put for this purpose. By so doing, he would be spending as little as pos\nsible in the way of time value premium for the put option and he would also be lock\ning in his gain on the call. The gains and losses from the put and call combination \nwould nearly equal each other from that time forward as the stock moves up or down, \nunless the stock rallies strongly, thereby exceeding the striking price of the put. This \nwould be ahappy event, however, since even larger gains would accrue. The combi\nnation could be liquidated in the following tax year, thus achieving again. \nExample: On September 1st, an investor bought an XYZ January 40 call for 3 points. \nThe call is due to expire in the following year. XYZ has risen in price by December \n1st, and the call is selling for 6 points. The call holder might want to take his 3-point \ngain on the call, but would also like to defer that gain until the following year. He \nmight be able to do this by buying an XYZ January 50 put for 5 points, for example. \nHe would then hold this combination until after the first of the new year. At that \ntime, he could liquidate the entire combination for at least 10 points, since the strik\ning price of the put is 10 points greater than that of the call. In fact, if the stock should \nhave climbed to or above 50 by the first of the year, or should have fallen to or below \n40 by the first of the year, he would be able to liquidate the combination for more \nthan 10 points. The increase in time value premium at either strike would also be abenefit. In any case, he would have again - his original cost was 8 points (3 for the \ncall and 5 for the put). Thus, he has effectively deferred taking the gain on the orig\ninal call holding until the next tax year. The risk that the call holder incurs in this type \nof transaction is the increased commission charges of buying and selling the put as \nwell as the possible loss of any time value premium in the put itself. The investor \nmust decide for himself whether these risks, although they may be relatively small, \noutweigh the potential benefit from deferring his tax gain into the next year. \nAnother way in which the call holder might be able to defer his tax gain into the \nnext year would be to sell another XYZ call against the one that he currently holds. \nThat is, he would create aspread. To assure that he retains as much of his current \ngain as possible, he should sell an in-the-money call. In fact, he should sell an in-the\nmoney call with alower striking price than the call held long, if possible, to ensure \nthat his gain remains intact even if the underlying stock should collapse substantial\nly. Once the spread has been established, it could be held until the following tax year \nbefore being liquidated. The obvious risk in this means of deferring gain is that one \ncould receive an assignment notice on the short call. This is not aremote possibility, \nnecessarily, since an in-the-money call should be used as protection for the current \ngain. Such an assignment would result in large commission costs on the resultant pur\nchase and sale of the underlying stock, and could substantially reduce one'sgain.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:988", "doc_id": "406b47080d53ae1e90214ef28adbf51935e8eae2c84d047d6180a5a96faedfff", "chunk_index": 0}
{"text": "Chapter 41: Taxes 927 \nThus, the risk in this strategy is greater than that in the previous one (buying aput), \nbut it may be the only alternative available if puts are not traded on the underlying \nstock in question. \nExample: An investor bought an XYZ February 50 call for 3 points in August. In \nDecember, the stock is at 65 and the call is at 15. The holder would like to \"lock in\" \nhis 12-point call profit, but would prefer deferring the actual gain into the following \ntax year. He could sell an XYZ February 45 call for approximately 20 points to do this. \nIf no assignment notice is received, he will be able to liquidate the spread at acost \nof 5 points with the stock anywhere above 50 at February expiration. Thus, in the end \nhe would still have a 12-point gain - having received 20 points for the sale of the \nFebruary 45 and having paid out 3 points for the February 50 plus 5 points to liqui\ndate the spread to take his gain. If the stock should fall below 50 before February \nexpiration, his gain would be even larger, since he would not have to pay out the \nentire 5 points to liquidate the spread. \nThe third way in which acall holder could lock in his gain and still defer the gain \ninto the following tax year would be to sell the stock short while continuing to hold \nthe call. This would obviously lock in the gain, since the short sale and the call pur\nchase will offset each other in profit potential as the underlying stock moves up or \ndown. In fact, if the stock should plunge downward, large profits could accrue. \nHowever, there is risk in using this strategy as well. The commission costs of the short \nsale will reduce the call holder'sprofit. Furthermore, if the underlying stock should \ngo ex-dividend during the time that the stock is held short, the strategist will be liable \nfor the dividend as well. In addition, more margin will be required for the short stock. \nThe three tactics discussed above showed how to defer aprofitable call gain into \nthe following tax year. The gain would still be short-term when realized. The only way \nin which acall holder could hope to convert his gain into along-term gain would be \nto exercise the call and then hold the stock for more than one year. Recall that the \nholding period for stock acquired through exercise begins on the day of exercise - the \noption'sholding period is lost. If the investor chooses this alternative, he of course is \nspending some of his gains for the commissions on the stock purchase as well as sub\njecting himself to an entire year'sworth of market risk. There are ways to protect astock holding while letting the holding period accrue - for example, writing out-of\nthe-money calls - but the investor who chooses this alternative should carefully \nweigh the risks involved against the possible benefits of eventually achieving along\nterm gain. The investor should also note that he will have to advance considerably \nmore money to hold the stock.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:989", "doc_id": "30b905d4c8223596c22fc85c082fe295db5ce8845d40bbb198e11a765ad3bc97", "chunk_index": 0}
{"text": "928 Part VI: Measuring and Trading Volatility \nDEFERRING A PUT HOLDER'S SHORT· TERM GAIN \nWithout going into as much detail, there are similar ways in which aput holder who \nhas ashort-term gain on aput due to expire in the following tax year can attempt to \ndefer the realization of that gain into the following tax year. One simple way in which \nhe could protect his gain would be to buy acall option to protect his profitable put. \nHe would want to buy an in-the-money call for this purpose. This resulting combina\ntion is similar in nature to the one described for the call buyer in the previous section. \nAsecond way that he could attempt to protect his gain and still defer its real\nization into the following tax year would be to sell another XYZ put option against the \none that he holds long. This would create avertical spread. This put holder should \nattempt to sell an in-the-money put, if possible. Of course, he would not want to sell \naput that was so deeply in-the-money that there is risk of early assignment. The \nresults of such aspread are analogous to the call spread described in detail in the last \nsection. \nFinally, the put holder could buy the underlying stock if he had enough avail\nable cash or collateral to finance the stock purchase. This would lock in the profit, as \nthe stock and the put would offset each other in terms of gains or losses while the \nstock moved up or down. In fact, if the stock should experience alarge rally, rising \nabove the striking price of the put, even larger profits would become possible. \nIn each of the tactics described, the position would be removed in the follow\ning tax year, thereby realizing the gain that was deferred. \nDIFFICULTY OF DEFERRING GAINS FROM WRITING \nAs afinal point in this section on deferring gains from option transactions, it might \nbe appropriate to describe the risks associated with the strategy of attempting to \ndefer gains from uncovered option writing into the following tax year. Recall that in \nthe previous sections, it was shown that acall or put holder who has an unrealized \nprofit in an option that is due to expire in the following tax year could attempt to \"lock \nin\" the gain and defer it. The dollar risks to aholder attempting such atax deferral \nwere mainly commission costs and/or small amounts of time value premium paid for \noptions. However, the option writer who has an unrealized profit may have amore \ndifficult time finding away to both \"lock in\" the gain and also defer its realization into \nthe following tax year. It would seem, at first glance, that the call writer could mere\nly take actions opposite to those that the call buyer takes: buying the underlying \nstock, buying another call option, or selling aput. Unfortunately, none of these \nactions \"locks in\" the call writer'sprofit. In fact, he could lose substantial investment \ndollars in his attempt to defer the gain into the following year.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:990", "doc_id": "ad3bdba550164222a1b1ba8ceeaf1bf37e7a0006a8ef0589db46537e927684f8", "chunk_index": 0}
{"text": "Chapter 41: Taxes 929 \nExample: An investor has written an uncovered XYZ January 50 call for 5 points and \nthe call has dropped in value to 1 point in early December. He might want to take \nthe 4-point gain, but would prefer to defer realization of the gain until the following \ntax year. Since the call write is at aprofit, the stock must have dropped and is prob\nably selling around 45 in early December. Buying the underlying stock would not \naccomplish his purpose, because if the stock continued to decline through year-end, \nhe could lose asubstantial amount on the stock purchase and could make only 1 more \npoint on the call write. Similarly, acall purchase would not work well. Acall with alower striking price - for example, the XYZ January 45 or the January 40- could lose \nsubstantial value if the underlying stock continued to drop in price. An out-of-the\nmoney call - the XYZ January 60 - is also unacceptable, because if the underlying \nstock rallied to the high 50's, the writer would lose money both on his January 50 call \nwrite and on his January 60 call purchase at expiration. Writing aput option would \nnot \"lock in\" the profit either. If the underlying stock continued to decline, the loss\nes on the put write would certainly exceed the remaining profit potential of 1 point \nin the January 50 call. Alternatively, if the stock rose, the losses on the January 50 call \ncould offset the limited profit potential provided by aput write. Thus, there is no rel\natively safe way for an uncovered call writer to attempt to \"lock in\" an unrealized gain \nfor the purpose of deferring it to the following tax year. The put writer seeking to \ndefer his gains faces similar problems. \nUNEQUAL TAX TREATMENT ON SPREADS \nThere are two types of spreads in which the long side may receive different tax treat\nment than the short side. One is the normal equity option spread that is held for more \nthan one year. The other is any spread between futures, futures options, or cash\nbased options and equity options. \nWith equity options, if one has aspread in place for more than one year and if \nthe movement of the underlying stock is favorable, one could conceivably have along-term gain on the long side and ashort-term loss on the short side of the spread. \nExample: An investor establishes an XYZ bullish call spread in options that have 15 \nmonths of life remaining: In October of one year, he buys the January 70 LEAPS call \nexpiring just over ayear in the future. At the same time, he sells the January 80 \nLEAPS call, again expiring just over ayear hence. Suppose he pays 13 for the January \n70 call and receives 7 for the January 80 call. In December of the following year, he \ndecides to remove the spread, after he has held it for more than one year - specifi\ncally, for 14 months in this case. XYZ has advanced by that time, and the spread is \nworth 9. With XYZ at 90, the January 70 call is trading at 20 and the January 80 call \nis trading at 11. The capital gain and loss results for tax purposes are summarized in \nthe following table (commissions are omitted from this example):", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:991", "doc_id": "31de947159f9c8e689b3b55d8bc8aec9153925fab9f2ee5216e2703a6cf7e3cb", "chunk_index": 0}
{"text": "930 \nOption \nXYZ January 70 LEAPS call \nXYZ January 80 LEAPS call \nCost \n$1,300 \n$1,100 \nPart VI: Measuring and Trading Volatllity \nProceeds \n$2,000 \n$ 700 \nGoin/Loss \n$700 long-term gain \n$400 short-term loss \nNo taxes would be owed on this spread since one-half of the long-term gain is \nless than the short-term loss. The investor with this spread could be in afavorable \nposition since, even though he actually made money in the spread - buying it at a 6-\npoint debit and selling it at a 9-point credit - he can show aloss on his taxes due to \nthe disparate treatment of the two sides of the spread. \nThe above spread requires that the stock move in afavorable direction in order \nfor the tax advantage to materialize. If the stock were to move in the opposite direc\ntion, then one should liquidate the spread before the long side of the spread had \nreached aholding period of one year. This would prevent taking along-term loss. \nAnother type of spread may be even more attractive in this respect. That is aspread in which nonequity options are spread against equity options. In this case, the \ntrader would hope to make aprofit on the nonequity or futures side, because part of \nthat gain is automatically long-term gain. He would simultaneously want to take aloss \non the equity option side, because that would be entirely short-term loss. \nThere is no riskless way to do this, however. For example, one might buy apack\nage of puts on stocks and hedge them by selling an index put on an index that per\nforms more or less in line with the chosen stocks. If the index rises in price, then one \nwould have short-term losses on his stock options, and part of the gain on his index \nputs would be treated as long-term. However, if the index were to fall in price, the \nopposite would be true, and long-term losses would be generated - not something \nthat is normally desirable. Moreover, the spread itself has risk, especially the tracking \nrisk between the basket of stocks and the index itself. \nThis brings out an important point: One should be cautious about establishing \nspreads merely for tax purposes. He might wind up losing money, not to mention that \nthere could be unfavorable tax consequences. As always, atax advisor should be con\nsulted before any tax-oriented strategy is attempted. \nSUMMARY \nOptions can be used for many tax purposes. Short-term gains can be deferred into \nthe next tax year, or can be partially protected with out-of-the-money options until \nthey mature into long-term gains. Long-term losses can be avoided with the purchase \nof aput or sale of adeeply in-the-money call. Wash sales can be avoided without giv\ning up the entire ownership potential of the stock. There are risks as well as rewards", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:992", "doc_id": "38c16cec3d93b1705e040fa0d96f75281cf4cef4354f9757590b7ee0664f82f8", "chunk_index": 0}
{"text": "Chapter 41: Taxes 931 \nin any of the strategies. Commission costs and the dissipation of time value premium \nin purchased options will both work against the strategist. \nAtax advisor should be consulted before actually implementing any tax strate\ngy, whether that strategy employs options or not. Tax rules change from time to time. \nIt is even possible that acertain strategy is not covered by awritten rule, and only atax advisor is qualified to give consultation on how such astrategy might be inter\npreted by the IRS. \nFinally, the options strategist should be careful not to confuse tax strategies with \nhis profit-oriented strategies. It is generally agood idea to separate profit strategies \nfrom tax strategies. That is, if one finds himself in aposition that conveniently lends \nitself to tax applications, fine. However, one should not attempt to stay in aposition \ntoo long or to close it out at an illogical time just to take advantage of atax break. The \ntax consequences of options should never be considered to be more important than \nsound strategy management.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:993", "doc_id": "ee8e89db1acebbbd3d4282529876dacdcc6b069c95c80231128652a2690cc408", "chunk_index": 0}
{"text": "Chapter 42: The Best Strategy? 933 \nis generally called volatility trading. If the net change in the market is small over aperiod of time, these strategies should perform well: ratio writing, ratio spreading \n(especially \"delta neutral spreads\"), straddle and strangle writing, neutral calendar \nspreading, and butterfly spreads. On the other hand, if options are cheap and the \nmarket is expected to be volatile, then these would be best: straddle and strangle \nbuys, backspreads, and reverse hedges and spreads. \nCertain other strategies overlap into more than one of the three broad \ncategories. For example, the bullish or bearish calendar spread is initially aneutral \nposition. It only assumes abullish or bearish bias after the near-term option expires. \nIn fact, any of the diagonal or calendar strategies whose ultimate aim is to generate \nprofits on the sale of shorter-term options are similar in nature. If these near-term \nprofits are generated, they can offset, partially or completely, the cost oflong options. \nThus, one might potentially own options at areduced cost and could profit from adefinitive move in his favor at the right time. It was shown in Chapters 14, 23, and \n24 that diagonalizing aspread can often be very attractive. \nThis brief grouping into three broad categories, does not cover all the strategies \nthat have been discussed. For example, some strategies are generally to be avoided \nby most investors: high-risk naked option writing (selling options for fractional prices) \nand covered or ratio put writing. In essence, the investor will normally do best with \naposition that has limited risk and the potential of large profits. Even if the profit \npotential is alow-probability event, one or two successful cases may be able to over\ncome aseries of limited losses. Complex strategies that fit this description are the \ndiagonal put and call combinations described in Chapters 23 and 24. The simplest \nstrategy fitting this description is the T-bill/option purchase program described in \nChapter 26. \nFinally, many strategies may be implemented in more than one way. The \nmethod of implementation may not alter the profit potential, but the percentage risk \nlevels can be substantially different. Equivalent strategies fit into this category. \nExample: Buying stock and then protecting the stock purchase with aput purchase \nis an equivalent strategy in profit potential to buying acall. That is, both have limit\ned dollar risk and large potential dollar profit if the stock rallies. However, they are \nsubstantially different in their structure. The purchase of stock and aput requires \nsubstantially more initial investment dollars than does the purchase of acall, but the \nlimited dollar risk of the strategy would normally be arelatively small percentage of \nthe initial investment. The call purchase, on the other hand, involves amuch small\ner capital outlay; in addition, while it also has limited dollar risk, the l~ss may easily \nrepresent the entire initial investment. The stockholder will receive cash dividends \nwhile the call holder will not. Moreover, the stock will not expire as the call will. This", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:995", "doc_id": "6492a017c9190d581f54d0d9b6879394aee2265863ba7e868d31132e62eb9c7e", "chunk_index": 0}
{"text": "934 Part VI: Measuring and Trading Volatility \nprovides the stock/put holder with an additional alternative of choosing to extend his \nposition for alonger period of time by buying another put or possibly by just contin\nuing to hold the stock after the original put expires. \nMany equivalent positions have similar characteristics. The straddle purchase \nand the reverse hedge (short stock and buy calls) have similar profit and loss poten\ntial when measured in dollars. Their percentage risks are substantially different, how\never. In fact, as was shown in Chapter 20, another strategy is equivalent to both of \nthese-buying stock and buying several puts. That is, buying astraddle is equivalent \nto buying 100 shares of stock and simultaneously buying two puts. The \"buy stock and \nputs\" strategy has alarger initial dollar investment, but the percentage risk is small\ner and the stockholder will receive any dividends paid by the common stock. \nIn summary, the investor must know two things well: the strategy that he is con\ntemplating using, and his own attitude toward risk and reward. His own attitude \nrepresents suitability, atopic that is discussed more fully in the following section. \nEvery strategy has risk. It would not be proper for an investor to pursue the best \nstrategy in the universe (such astrategy does not exist, of course) if the risks of that \nstrategy violated the investor'sown level of financial objectives or accepted investment \nmethodology. On the other hand, it is also not sufficient for the investor to merely feel \nthat astrategy is suitable for his investment objectives. Suppose an investor felt that \nthe T-bill/option strategy was suitable for him because of the profit and risk levels. \nEven if he understands the philosophies of option purchasing, it would not be proper \nfor him to utilize the strategy unless he also understands the mechanics of buying \nTreasury bills and, more important, the concept of annualized risk. \nWHAT IS BEST FOR ME MIGHT NOT BE BEST FOR YOU \nIt is impossible to classify any one strategy as the best one. The conservative investor \nwould certainly not want to be an outright buyer of options. For him, covered call \nwriting might be the best strategy. Not only would it accomplish his financial aims\nmoderate profit potential with reduced risk-but it would be much more appealing \nto him psychologically. The conservative investor normally understands and accepts \nthe risks of stock ownership. It is only asmall step from that understanding to the \ncovered call writing strategy. The aggressive investor would most likely not consider \ncovered call writing to be the best strategy, because he would consider the profit \npotential too small. He is willing to take larger risks for the opportunity to make larg\ner profits. Outright option purchases might suit him best, and he would accept, by \nhis aggressive stature, that he could lose nearly all his money in arelatively short time", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:996", "doc_id": "c5ae2a88cfd8ab89df0ccdc18e1e74f2658398db5cd309d2bd954efb261949bc", "chunk_index": 0}
{"text": "Chapter 42: The Best Strategy? 935 \nperiod. ( Of course, one would hope that he uses only 15 to 20% of his assets for spec\nulative option buying.) \nMany investors fit somewhere in between the conservative description and the \naggressive description. They might want to have the opportunity to make large prof\nits, but certainly are not willing to risk alarge percentage of their available funds in \nashort period of time. Spreads might therefore appeal to this type of investor, espe\ncially the low-debit bullish or bearish calendar spreads. He might also consider occa\nsional ventures into other types of strategies-bullish or bearish spreads, straddle \nbuys or writes, and so on-but would generally not be into awide range of these \ntypes of positions. The T-bill/option strategy might work well for this investor also. \nThe wealthy aggressive investor may be attracted by strategies that offer the \nopportunity to make money from credit positions, such as straddle or combination \nwriting. Although ratio writing is not acredit strategy, it might also appeal to this type \nof investor because of the large amounts of time value premium that are gathered in. \nThese are generally strategies for the wealthier investor because he needs the \"stay\ning power\" to be able to ride out adverse cycles. If he can do this, he should be able \nto operate the strategy for asufficient period of time in order to profit from the con\nstant selling of time value premiums. \nIn essence, the answer to the question of \"which strategy is best\" again revolves \naround that familiar word, \"suitability.\" The financial needs and investment objectives \nof the individual investor are more important than the merits of the strategy itself. It \nsounds nice to say that he would like to participate in strategies with limited risk and \npotentially large profits. Unfortunately, if the actual mechanics of the strategy involve \nrisk that is not suitable for the investor, he should not use the strategy, no matter how \nattractive it sounds. \nExample: The T-bill/option strategy seems attractive: limited risk because only 10% \nof one'sassets are subjected to risk annually; the remaining 90% of one'sassets earn \ninterest; and if the option profits materialize, they could be large. What if the worst \nscenario unfolds? Suppose that poor option selections are continuously made and \nthere are three or four years of losses, coupled with adeclining rate of interest earned \nfrom the Treasury bills (not to mention the commission charges for trading the secu\nrities). The portfolio might have lost 15 or 20% of its assets over those years. Agood \ntest of suitability is for the investor to ask himself, in advance: \"How will Ireact if the \nworst case occurs?\" If there will be sleepless nights, pointing of fingers, threats, and \nso forth, the strategy is unsuitable. If, on the other hand, the investor believes that he \nwould be disappointed (because no one likes to lose money), but that he can with\nstand the risk, the strategy may indeed be suitable.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:997", "doc_id": "842a8de5281ce90997ed0bb94cd2fec65261d413b827dea93daa4be0f20ad186", "chunk_index": 0}
{"text": "936 Part VI: Measuring and Trading Volatility \nMATHEMATICAL RANKING \nThe discussion above demonstrates that it is not possible to ultimately define the best \nstrategy when one considers the background, both financial and psychological, of the \nindividual investor. However, the reader may be interested in knowing which strate\ngies have the best mathematical chances of success, regardless of the investor'sper\nsonal feelings. Not unexpectedly, strategies that take in large amounts of time value \npremium have high mathematical expectations. These include ratio writing, ratio \nspreading, straddle writing, and naked call writing (but only if the \"rolling for cred\nits\" follow-up strategy is adhered to). The ratio strategies would have to be operated \naccording to adelta-neutral ratio in order to be mathematically optimum. Unfor\ntunately, these strategies are not for everyone. All involve naked options, and also \nrequire that the investor have asubstantial amount of money ( or collateral) available \nto make the strategies work properly. Moreover, naked option writing in any form is \nnot suitable for some investors, regardless of their protests to the contrary. \nAnother group of strategies that rank high on an expected profit basis are those \nthat have limited risk with the potential of occasionally attaining large profits. The Thill/option strategy is aprime example of this type of strategy. The strategies in which \none attempts to reduce the cost of longer-term options through the sale of near-term \noptions fit in this broad category also, although one should limit his dollar commit\nment to 15 to 20% of his portfolio. Calendar spreads such as the combinations \ndescribed in Chapter 23 (calendar combination, calendar straddle, and diagonal but\nterfly spread) or bullish call calendar spreads or bearish put calendar spreads are all \nexamples of such strategies. These strategies may have arather frequent probability \nof losing asmall amount of money, coupled with alow probability of earning large \nprofits. Still, afew large profits may be able to more than overcome the frequent, but \nsmall, losses. Ranking behind these strategies are the ones that offer limited profits \nwith areasonable probability of attaining that profit. Covered call writing, large debit \nbull or bear spreads (purchased option well in-the-money and possible written option \nas well), neutral calendar spreads, and butterfuly spreads fit into this category. \nUnfortunately, all these strategies involve relatively large commission costs. \nEven though these are not strategies that normally require alarge investment, the \ninvestor who wants to reduce the percentage effect of commissions must take larger \npositions and will therefore be advancing asizable amount of money. \nSpeculative buying and spreading strategies rank the lowest on amathematical \nbasis. The T-bill/option strategy is not aspeculative buying strategy. In-the-money \npurchases, including the in-the-money combination, generally outrank out-of-the\nmoney purchases. This is because one has the possibility of making alarge percent\nage profit but has decreased the chance of losing all his investment, since he starts", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:998", "doc_id": "1e932895e6be7f094e868db2ce0d5604fd0c0fce212c7e4e033757e9ceab830c", "chunk_index": 0}
{"text": "Chapter 42: The Best Strategy? 937 \nout in-the-money. In general, however, the constant purchase of time value premi\nums, which must waste away by the time the options expire, will have aburdensome \nnegative effect. The chances of large profits and large losses are relatively equal on amathematical basis, and thus become subsidiary to the time premium effect in the \nlong run. This mathematical outlook, of course, precludes those investors who are \nable to predict stock movements with an above-average degree of accuracy. Although \nthe true mathematical approach holds that it is not possible to accurately predict the \nmarket, there are undoubtedly some who can and many who try. \nSUMMARY \nMathematical expectations for astrategy do not make it suitable even if the expect\ned returns are good, for the improbable may occur. Profit potentials also do not \ndetermine suitability; risk levels do. In the final analysis, one must determine the \nsuitability of astrategy by determining if he will be able to withstand the inherent \nrisks if the worst scenario should occur. For this reason, no one strategy can be des\nignated as the best one, because there are numerous attitudes regarding the degree \nof risk that is acceptable.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:999", "doc_id": "5803e436066913f6524eda75c84598dfd75db2d8b3a19f9895ac5580b3ab5903", "chunk_index": 0}
{"text": "Postscript \nOption strategies cannot be unilaterally classified as aggressive or conservative. \nThere are certainly many aggressive applications, the simplest being the outright pur\nchase of calls or puts. However, options can also have conservative applications, most \nnotably in reducing some of the risks of common stock ownership. In addition, there \nare less polarized applications, particularly spreading techniques, that allow the \ninvestor to take amiddle-of-the-road approach. \nConsequently, the investor himself-not options--becomes the dominant force \nin determining whether an option strategy is too risky. It is imperative that the \ninvestor understand what he is trying to accomplish in his portfolio before actually \nimplementing an option strategy. Not only should he be cognizant of the factors that \ngo into determining the initial selection of the position, but he must also have in mind \naplan of follow-up action. If he has thought out, in advance, what action he will take \nif the underlying entity rises or falls, he will be in aposition to make amore rational \ndecision when and if it does indeed make amove. The investor must also determine \nif the risk of the strategy is acceptable according to his financial means and objec\ntives. If the risk is too high, the strategy is not suitable. \nEvery serious investor owes it to himself to acquire an understanding of listed \noption strategies. Since various options strategies are available for amultitude of pur\nposes, alrrwst every money manager or dedicated investor will be able to use options \nin his strategies at one time or another. For astock-oriented investor to ignore the \npotential advantages of using options would be as serious amistake as it would be for \nalarge grain company to ignore the hedging properties available in the futures mar\nket, or as it would be for an income-oriented investor to concentrate only in utilities \nand Treasury bills while ignoring less well known, but equally compatible, alterna\ntives such as GNMAs. \n938", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1000", "doc_id": "4800c7c90c7d3102b629800a127710557de47a84a0ec52532bedcd0822016486", "chunk_index": 0}
{"text": "Strategy Sullllllary \nExcept for arbitrage strategies and tax strategies, the strategies we have described \ndeal with risk of market movement. It is therefore often convenient to summarize \noption strategies by their risk and reward characteristics and by their market out\nlook-bullish, bearish, or neutral. Table A-1 lists all the risk strategies that were dis\ncussed and gives ageneral classification of their risks and rewards. If astrategist has \nadefinite attitude about the market'soutlook or about his own willingness to accept \nrisks, he can scan Table A-1 and select the strategies that most closely resemble his \nthinking. The number in parentheses after the strategy name indicates the chapter in \nwhich the strategy was discussed. \nTable A-1 gives abroad classification of the various risk and reward potentials \nof the strategies. For example, abullish call calendar spread does not actually have \nunlimited profit potential unless its near-tenn call expires worthless. In fact, all cal\nendar spread or diagonal spread positions have limited profit potential at best until \nthe near-term options expire. \nAlso, the definition of limited risk can vary widely. Some strategies do have arisk that is truly limited to arelatively small percentage of the initial investment-the \nprotected stock purchase, for example. In other cases, the risk is limited but is also \nequal to the entire initial investment. That is, one could lose 100% of his investment \nin ashort time period. Option purchases and bull, bear, or calendar spreads are \nexamples. \nThus, although Table A-1 gives abroad perspective on the outlook for various \nstrategies, one must be aware of the differences in reward, risk, and market outlook \nwhen actually implementing one of the strategies. \n943", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1005", "doc_id": "9d6460fb88bf90188f2c6b156dea6d064a5e61982e1267a660ce005d1305f148", "chunk_index": 0}
{"text": "944 \nTABLE A-1. \nGeneral strategy summary. \nStrategy (Chapter) \nBullish strategies \nCall purchase (3) \nSynthetic long stock (short put/long call) (21) \nBull spread-puts or calls (7 and 22) \nProtected stock purchase (long stock/long put) ( 17) \nBullish call calendar spread (9) \nCovered call writing (2) \nUncovered put write ( 19) \nBearish Strategies \nPut purchase ( 16) \nProtected short sale (synthetic put) (4 and 16) \nSynthetic short sale (long put/short call) (21) \nBear spread-put or call (and 22) \nCovered put write ( 19) \nBearish put calendar spread (22) \nNaked call write (5) \nNeutral strategies \nStraddle purchase ( 1 8) \nReverse hedge (simulated straddle buy) (4) \nFixed income + option purchase (25) \nDiagonal spread (14, 23, and 24) \nNeutral calendar spread-puts or calls (9 and 22) \nButterfly spread ( 10 and 23) \nCalendar straddle or combination (23) \nReverse spread ( 13) \nRatio write-put or call (6 and 19) \nStraddle or combination write (20) \nRatio spread-put or call ( 11 and 24) \nRatio calendar spread-put or call (12 and 24) \nRisk \nLimited \nUnlimited 0 \nLimited \nLimited \nLimited \nUnlimited 0 \nUnlimited 0 \nLimited \nLimited \nUnlimited \nLimited \nUnlimited \nLimited \nUnlimited \nLimited \nLimited \nLimited \nLimited \nLimited \nLimited \nLimited \nLimited \nUnlimited \nUnlimited \nUnlimited \nUnlimited \nAppendix A \nReward \nUnlimited \nUnlimited \nLimited \nUnlimited \nUnlimited \nLimited \nLimited \nUnlimited 0 \nUnlimited 0 \nUnlimited 0 \nLimited \nLimited \nUnlimited 0 \nLimited \nUnlimited \nUnlimited \nUnlimited \nUnlimited \nLimited \nLimited \nUnlimited \nUnlimited \nLimited \nLimited \nLimited \nUnlimited \n0 Wherever the risk or reword is limited only by the fact that ostock cannot foll below zero in price, \nthe entry is marked. Obviously, although the potential may technically be limited, it could still be quite \nlarge if the underlying stock did foll alarge distance.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1006", "doc_id": "5ea53b9c21dc074d5a3e34a633c840a8f563e64a760a8b75c90624d9527fe64c", "chunk_index": 0}
{"text": "946 \nTABLE B-1. \nEquivalent strategies. \nThis Strategy is equivalent to \nCall purchase \nPut purchase \nLong stock \nShort stock \nNaked call write \nNaked put write \nBullish call spread \n(long call at lower strike/ \nshort call at higher strike) \nBearish call spread \n(long call at higher strike/ \nshort call at lower strike) \nRatio call write \n(long stock/short calls) \n... and is also equivalent to ... \nStraddle buy (long call/long put) \nAppendix B \nThis Strategy \nLong stock/long put \nShort stock/long call (synthetic put) \nLong call/ short put (synthetic stock) \nLong put/ short call (synthetic short sale) \nShort stock/short put \nCovered call write (long stock/ short call) \nBullish put spread \n(long put at lower strike/ \nshort put at higher strike) \nBearish put spread \n(long put at higher strike/ \nshort put at lower strike) \nStraddle write (short put/short call) \nRatio put write (short stock/ short puts) \nReverse hedge (short stock/long calls) \nor buy stock/buy puts \nButterfly call spread Butterfly put spread \n(long 1 call at each outside strike/ (long one put at each outer strike/ \nshort 2 calls at middle strike) short two calls at middle strike) \nAll four of these \"butterfly\" strategies are equivalent \nButterfly combination Protected straddle write \n(bullish call spread at two (short straddle at middle strike/ \nlower strikes/bearish put spread \nat two higher strikes) \nlong call at highest strike/ \nlong put at lowest strike", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1008", "doc_id": "6b58881da82e4e634c16e6c2c1bd5c604113edef121b2cfb8f907d7270c4ddbf", "chunk_index": 0}
{"text": "948 \nAnnualized Risk (Ch. 26) \nAnnualized risk = L INV 360 \ni \n1\nHi \nwhere INVi = percent of total assets invested in options \nwith holding periods, Hi \nlength of holding period in days \nBear Spread \n-Calls (Ch. 8) \n-Puts (Ch. 22) \np = Cl - C2 \nR = s2 - s1 - P \nB = s1 + P \nR = P2 - Pl \np = S2 - S1 - R \nB = s1 + P = s2 + Pl - P2 \nBlack Model (Ch. 34): \nXs \nCpr \nTheoretical futures call price= e-rt x BSM[r = 0%] \nwhere BSM[r = O) is the Black-Scholes Model \nusing r = 0% as the short-term interest rate \nPut price = Call price - e-rt x (f - s) \nwhere f = futures price \ncurrent stock price \nstriking price \ncall price \nput price \ninterest rate \ntime (in years) \nBu \nDp \nRbreak-even point \nupside break-even point \ndownside break-even point \nmaximum profit potential \nmaximum risk potential \nffutures price \nAppendix C \nSubscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in aformula. \nThe formulae are arranged alphabetically by title or by strategy.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1010", "doc_id": "6ce82e1eb6081c7e101f4eb375253eb98e8662f1ebc54b8fc3b036d9e4d2be2a", "chunk_index": 0}
{"text": "952 \nNtlt. Delta of long option eu ra ra 10 = -----=---=--Delta of short option \nEquivalent Futures Position (Ch. 34) \nEFP = Delta x Number of options \nEquivalent Stock Position (Ch. 28) \nESP = Unit of trading x Delta xnumber of options \nAppendix Cwhere unit of trading is the number of shares of the underlying stock that \ncan be bought or sold with the option (normally 100). \nFutures Contract Fair Value (Ch. 29) \n-Stock index futures \nIndex value x (1 + rt) + Present worth (dividends) \nAlso see Present worth. \nFuture Stock Price (Ch. 28) \nwhere \n-lognormal distribution, assuming amovement of afixed number of stan\ndard deviations \nq = future stock price \nVt = volatility for the time period \na = number of standard deviations of movement \n(normally-3.0::; a::; 3.0) \nGamma (Ch. 40) \nXs \nCprlet z = In [ x ] /v --ft + v --ft \nS X (1 + r)t 2 \nThen (-x212) \nr- __ e-===--\n- xv ✓ 2nt \ncurrent stock price Bstriking price \ncall price \nput price \ninterest rate \ntime (in years) \nu \nDp \nRbreak-even point \nupside break-even point \ndownside break-even point \nmaximum profit potential \nmaximum risk potential \nSubscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in aformula. \nThe formulae are arranged alphabetically by title or by strategy.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1016", "doc_id": "84d9270db566550434ea542c917de58f122c8eb2d27542d29db48add5d026367", "chunk_index": 0}
{"text": "954 Appendix C \nRatio Spread \n-Calls (Ch. 11): buy n1 calls at lower strike, s1, and sell n2 calls at higher \nstrike, s2 \nS1 < s2 \nn1 < n2 \nR = n1c1 - n2c2 \nP = (s2-s1)n1 -Rp \nU=s2+ --n2-n1 \nBreak-even cost of long calls for follow-up action (Ch. 11) \nBreak-even cost = n2(s2 - si) - Rn2 n1 \n-Puts (Ch. 24): buy n2 puts at higher strike, s2, and sell n1 puts at lower \nstrike, s1 \nS1 < S2 \nn2 < n1 \nR = n2p2 - n1p1 \nP = n2(s2 - s1) - Rp \nD =S1 ----n1 -n2 \nReversal-See Conversion and Reversal Profit \nReverse Hedge (Ch. 4)-simulated straddle purchase \nGeneral case: short mround lots of stock and long ncalls \nR = m(s -x) + nc \nU=s+-R-n-m \nR D=s--m \nXs \nCcurrent stock price \nstriking price \ncall price \npput price \nrinterest rate \nt = time (in years) \nBu \nDp \nRbreak-even point \nupside break-even point \ndownside break-even point \nmaximum profit potential \nmaximum risk potential \nSubscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in aformula. \nThe formulae are arranged alphabetically by title or by strategy.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1018", "doc_id": "86d74b04a0f54ac6a9ef2857a445260fd0574e8bb79e9f685773e9c65a96e5fc", "chunk_index": 0}
{"text": "954 Appendix C \nRatio Spread \n-Calls (Ch. 11): buy n1 calls at lower strike, s1, and sell n2 calls at higher \nstrike, s2 \ns1 < s2 \nn1 < n2 \nR = n1c1 - n2c2 \nP = (s2 - s1)n1 -Rp \nU=s 2 +--n2-n1 \nBreak-even cost oflong calls for follow-up action (Ch. 11) \nBreak-even cost = n2(s2 - si) - Rn2-n1 \n-Puts (Ch. 24): buy n2 puts at higher strike, s2, and sell n1 puts at lower \nstrike, s1 \nS1 < S2 \nn2 < n1 \nR = n2p2 - n1p1 \nP = n2(s2 - s1) - Rp D =S1----\nn1 -n2 \nReversed-See Conversion and Reversal Profit \nReverse Hedge (Ch. 4)-simulated straddle purchase \nGeneral case: short mround lots of stock and long ncalls \nR = m(s -x) + nc \nU=s+-R-n-m \nR D=s--m \nXs \nCcurrent stock price \nstriking price \ncall price \npput price \nrinterest rate \nt = time (in years) \nBu \nDp \nRbreak-even point \nupside break-even point \ndownside break-even point \nmaximum profit potential \nmaximum risk potential \nSubscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in aformula. \nThe formulae are arranged alphabetically by title or by strategy.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1020", "doc_id": "d58facac0e41280629b037297ac61705247b63cb152d764159bf5352136c22a8", "chunk_index": 0}
{"text": "TABLE E-1. ~ \nQualified covered call options. \n~ \nCall is not \"deep-in-the-money\" Call is not \nII \ndeep-in-the-money\" \nApplicable if Strike Price2 is at least: Applicable if Strike Price2 is at least: \nStock More than Stock More than \nPrice1 31-90-Day Call 90-Day Call Price1 31-90-Day Call 90-Day Call \n5.13-5.88 5 5 75.13-80 75 70 \n6-10 None None 80.13-85 80 75 \n10.13-11.75 10 10 85.13-90 85 80 \n11.88-15 None None 90.13-95 90 85 \n15.13-17.63 15 15 95.13-100 95 90 \n17.75-20 None None 100.13-105 100 95 \n20.13-23.50 20 20 105.13-110 100 100 \n23.63-25 None None 110.13-120 110 110 \n25.13-30 25 25 120.13-130 120 120 \n30.13-35 30 30 130.13-140 130 130 \n35.13-40 35 35 140.13-150 140 140 \n40.13-45 40 40 150.13-160 150 140 \n45.13-50 45 45 160.13-170 160 150 \n50.13-55 50 50 170.13-180 170 160 \n55.13-60 55 55 180.13-190 180 170 \n60.13-65 60 55 190.13-200 190 180 \n65.13-70 65 60 200.13-210 200 190 \n70.13-75 70 65 210.13-220 210 200 \n1 Applicable stock price is either the closing price of the stock on the day preceding the date the option was granted, or the opening price on \ntthe day the option is granted if such price is greater than 100% of the preceding day'sclosing price. \n2Assumption is that strike prices are only at $5 intervals up to $ 100 and $10 intervals over $100. Note: If the stock splits, option strike prices 5:c· \nwill have smaller intervals for aperiod of time. \"\"'", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1028", "doc_id": "088d6fa5291e046c10ba1f423f26436fe0bd7512d5f9eb9af9330a3343b7d4e5", "chunk_index": 0}
{"text": "Glossary \nAmerican Exercise: afeature of an option that indicates it may be exercised at any \ntime. Therefore, it is subject to early assignment. \nArbitrage: the process in which professional traders simultaneously buy and sell the \nsame or equivalent securities for ariskless profit. See also Risk Arbitrage. \nAssign: to designate an option writer for fulfillment of his obligation to sell stock (call \noption writer) or buy stock (put option writer). The writer receives an assignment \nnotice from the Options Clearing Corporation. See also Early Exercise. \nAssignment Notice: see Assign. \nAutomatic Exercise: aprotection procedure whereby the Options Clearing \nCorporation attempts to protect the holder of an expiring in-the-money option by \nautomatically exercising the option on behalf of the holder. \nAverage Down: to buy more of asecurity at alower price, thereby reducing the \nholder'saverage cost. (Average Up: to buy more at ahigher price.) \nBackspread: see Reverse Strategy. \nBear Spread: an option strategy that makes its maximum profit when the underly\ning stock declines and has its maximum risk if the stock rises in price. The strate\ngy can be implemented with either puts or calls. In either case, an option with ahigher striking price is purchased and one with alower striking price is sold, both \noptions generally having the same expiration date. See also Bull Spread. \nBearish: an adjective describing an opinion or outlook that expects adecline in \nprice, either by the general market or by an underlying stock, or both. See also \nBullish. \n963", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1029", "doc_id": "7fd60267643e7f3440ed928d836aef2a38421676bd3b1443950b3efe711f3d9a", "chunk_index": 0}
{"text": "964 Glossary \nBeta: ameasure of how astock'smovement correlates to the movement of the entire \nstock market. The beta is not the same as volatility. See also Standard Deviation, \nVolatility. \nBlack Model: amodel used to predict futures option prices; it is amodified version \nof the Black-Scholes model. See Model. \nBoard Broker: the exchange member in charge of keeping the book of public \norders on exchanges utilizing the \"market-maker\" system, as opposed to the \"spe\ncialist system,\" of executing orders. See also Market-Maker, Specialist. \nBox Spread: atype of option arbitrage in which both abull spread and abear spread \nare established for ariskless profit. One spread is established using put options and \nthe other is established using calls. The spreads may both be debit spreads ( call \nbull spread vs. put bear spread), or both credit spreads (call bear spread vs. put \nbull spread). \nBreak-Even Point: the stock price (or prices) at which aparticular strategy neither \nmakes nor loses money. It generally pertains to the result at the expiration date of \nthe options involved in the strategy. A \"dynamic\" break-even point is one that \nchanges as time passes. \nBroad-Based: generally referring to an index, it indicates that the index is composed \nof asufficient number of stocks or of stocks in avariety of industry groups. Broad\nbased indices are subject to more favorable treatment for naked option writers. \nSee also Narrow- Based. \nBull Spread: an option strategy that achieves its maximum potential if the underly\ning security rises far enough, and has its maximum risk if the security falls far \nenough. An option with alower striking price is bought and one with ahigher strik\ning price is sold, both generally having the same expiration date. Either puts or \ncalls may be used for the strategy. See also Bear Spread. \nBullish: describing an opinion or outlook in which one expects arise in price, either \nby the general market or by an individual security. See also Bearish. \nButterfly Spread: an option strategy that has both limited risk and limited profit \npotential, constructed by combining abull spread and abear spread. Three strik\ning prices are involved, with the lower two being utilized in the bull spread and the \nhigher two in the bear spread. The strategy can be established with either puts or \ncalls; there are four different ways of combining options to construct the same \nbasic position. \nCalendar Spread: an option strategy in which ashort-term option is sold and alonger-term option is bought, both having the same striking price. Either puts or", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1030", "doc_id": "283dc337992845bf734cbb23ff91af83f4c5e18079b8cac0527018e7a77f3397", "chunk_index": 0}
{"text": "Glossary 965 \ncalls may be used. Acalendar combination is astrategy that consists of acall cal\nendar spread and aput calendar spread at the same time. The striking prices of \nthe calls would be higher than the striking prices of the puts. Acalendar straddle \nconsists of selling anear-term straddle and buying alonger-term straddle, both \nwith the same striking price. \nCalendar Straddle or Combination: see Calendar spread. \nCall: an option that gives the holder the right to buy the underlying security at aspecified price for acertain, fixed period of time. See also Put. \nCall Price: the price at which abond or preferred stock may be called in by the issu\ning corporation; see Redemption Price. \nCapitalization-Weighted Index: astock index that is computed by adding the cap\nitalizations (float times price) of each individual stock in the index, and then divid\ning by the divisor. The stocks with the largest market values have the heaviest \nweighting in the index. See also Divisor, Float, Price-Weighted Index. \nCarrying Cost: the interest expense on adebit balance created by establishing aposition. \nCash- Based: Referring to an option or future that is settled in cash when exercised \nor assigned. No physical entity, either stock or commodity, is received or delivered. \nCBOE: the Chicago Board Options Exchange; the first national exchange to trade \nlisted stock options. \nCircuit Breaker: alimit applied to the trading of index futures contracts designed \nto keep the stock market from crashing. \nClass: aterm used to refer to all put and call contracts on the same underlying secu\nrity. \nClosing Transaction: atrade that reduces an investor'sposition. Closing buy trans\nactions reduce short positions and closing sell transactions reduce long positions. \nSee also Opening Transaction. \nCollateral: the loan value of marginable securities; generally used to finance the \nwriting of uncovered options. \nCombination: (1) any position involving both put and call options that is not astrad\ndle. See also Straddle. (2) the name given to the trade at expiration whereby an \narbitrageur rolls his options from one month to the next. For example, if he sells \nhis synthetic long stock position in June and reestablishes it by buying asynthetic \nlong stock position in September, the entire four-sided trade is called acombina\ntion by floor traders. See also Straddle, Strangle.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1031", "doc_id": "2232c5fcfdbc0be290d1ccc0acc7eb61c9fc4a072061bd2892af4331e1e87ce2", "chunk_index": 0}
{"text": "966 Glossary \nCommodities: see Futures Contract. \nContingent Order: an order whose execution or price is dependent on the align\nment or price of the underlying security and/or its options. Most commonly it is an \norder to buy stock and sell acovered call option that is given as one order to the \ntrading desk of abrokerage firm. Also called a \"net order.\" This is a \"not held\" \norder. See also Market Not Held Order. \nConversion Arbitrage: ariskless transaction in which the arbitrageur buys the \nunderlying security, buys aput, and sells acall. The options have the same terms. \nSee also Reversal Arbitrage. \nConversion Ratio: see Convertible Security. \nConverted Put: see Synthetic Put. \nConvertible Security: asecurity that is convertible into another security. Generally, \naconvertible bond or convertible preferred stock is convertible into the underly\ning stock of the same corporation. The rate at which the shares of the bond or pre\nferred stock are convertible into the common is called the conversion ratio. \nCover: to buy back as aclosing transaction an option that was initially written, or \nstock that was initially sold short. \nCovered: awritten option is considered to be covered if the writer also has an oppos\ning market position on ashare-for-share basis in the underlying security. That is, ashort call is covered if the underlying stock is owned, and ashort put is covered \n(for margin purposes) if the underlying stock is also short in the account. In addi\ntion, ashort call is covered if the account is also long another call on the same secu\nrity, with astriking price equal to or less than the striking price of the short call. Ashort put is covered if there is also along put in the account with astriking price \nequal to or greater than the striking price of the short put. \nCovered Call Write: astrategy in which one writes call options while simultane\nously owning an equal number of shares of the underlying stock. \nCovered Put Write: astrategy in which one sells put options and simultaneously is \nshort an equal number of shares of the underlying security. \nCovered Straddle Write: the term used to describe the strategy in which an \ninvestor owns the underlying security and also writes astraddle on that security. \nThis is not really acovered position. \nCredit: money received in an account. Acredit transaction is one in which the net \nsale proceeds are larger than the net buy proceeds ( cost), thereby bringing money \ninto the account. See also Debit.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1032", "doc_id": "da44301ef391d646b32270013b78fd5c6e78deb83147160dcdf983c061f56bf5", "chunk_index": 0}
{"text": "Glossary 967 \nCycle: the expiration dates applicable to various classes of options. There are three \ncycles: January/April/July/October, February/May/ August/November, and \nMarch/June/Septem ber/Decem ber. \nDebit: an expense, or money paid out from an account. Adebit transaction is one in \nwhich the net cost is greater than the net sale proceeds. See also Credit. \nDeliver: to take securities from an individual or firm and transfer them to another \nindividual or firm. Acall writer who is assigned must deliver stock to the call hold\ner who exercised. Aput holder who exercises must deliver stock to the put writer \nwho is assigned. \nDelivery: the process of satisfying an equity call assignment or an equity put exer\ncise. In either case, stock is delivered. For futures, the process of transferring the \nphysical commodity from the seller of the futures contract to the buyer. \nEquivalent delivery refers to asituation in which delivery may be made in any of \nvarious, similar entities that are equivalent to each other (for example, Treasury \nbonds with differing coupon rates). \nDelta: (1) the amount by which an option'sprice will change for acorresponding 1-\npoint change in price by the underlying entity. Call options have positive deltas, \nwhile put options have negative deltas. Technically, the delta is an instantaneous \nmeasure of the option'sprice change, so that the delta will be altered for even frac\ntional changes by the underlying entity. Consequently, the terms \"up delta\" and \n\"down delta\" may be applicable. They describe the option'schange after afull 1-\npoint change in price by the underlying security, either up or down. The \"up delta\" \nmay be larger than the \"down delta\" for acall option, while the reverse is true for \nput options. (2) the percent probability of acall being in-the-money at expiration. \nSee also Hedge Ratio. \nDelta Neutral Spread: aratio spread that is established as aneutral position by uti\nlizing the deltas of the options involved. The neutral ratio is determined by divid\ning the delta of the purchased option by the delta of the written option. See also \nDelta, Ratio Spread. \nDepository Trust Corporation (OTC): acorporation that will hold securities for \nmember institutions. Generally used by option writers, the DTC facilitates and \nguarantees delivery of underlying securities when assignment is made against \nsecurities held in DTC. \nDiagonal Spread: any spread in which the purchased options have alonger matu\nrity than do the written options, as well as having different striking prices. Typical", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1033", "doc_id": "552296e289c6de811d5d5e2397fd114e20e3b91832d6f026d42af8f91b6659ad", "chunk_index": 0}
{"text": "968 Glossary \ntypes of diagonal spreads are diagonal bull spreads, diagonal bear spreads, and \ndiagonal butterfly spreads. \nDiscount: an option is trading at adiscount if it is trading for less than its intrinsic \nvalue. Afuture is trading at adiscount if it is trading at aprice less than the cash \nprice of its underlying index or commodity. See also Intrinsic Value, Parity. \nDiscount Arbitrage: ariskless arbitrage in which adiscount option is purchased \nand an opposite position is taken in the underlying security. The arbitrageur may \neither buy acall at adiscount and simultaneously sell the underlying security \n(basic call arbitrage), or buy aput at adiscount and simultaneously buy the under\nlying security (basic put arbitrage). See also Discount. \nDiscretion: see Limit Order, Market Not Held Order. \nDividend Arbitrage: in the riskless sense, an arbitrage in which aput is purchased \nand so is the underlying stock. The put is purchased when it has time value pre\nmium less than the impending dividend payment by the underlying stock. The \ntransaction is closed after the stock goes ex-dividend. Also used to denote aform \nof risk arbitrage in which asimilar procedure is followed, except that the amount \nof the impending dividend is unknown and therefore risk is involved in the trans\naction. See also Ex-Dividend, Time Value Premium. \nDivisor: amathematical quantity used to compute an index. It is initially an arbitrary \nnumber that reduces the index value to asmall, workable number. Thereafter the \ndivisor is adjusted for stock splits (price-weighted index) or additional issues of \nstock (capitalization-weighted index). \nDownside Protection: generally used in connection with covered call writing, this \nis the cushion against loss, in case of aprice decline by the underlying security, that \nis afforded by the written call option. Alternatively, it may be expressed in terms \nof the distance the stock could fall before the total position becomes aloss (an \namount equal to the option premium), or it can be expressed as percentage of the \ncurrent stock price. See also Covered Call Write. \nDynamic: for option strategies, describing analyses made during the course of \nchanging security prices and during the passage of time. This is as opposed to an \nanalysis made at expiration of the options used in the strategy. Adynamic break\neven point is one that changes as time passes. Adynamic follow-up action is one \nthat will change as either the security price changes or the option price changes or \ntime passes. See also Break-Even Point, Follow-Up Action. \nEarly Exercise (assignment): the exercise or assignment of an option contract \nbefore its expiration date.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1034", "doc_id": "fe0a24075862177f87bc2c63248d4d9070ecb59621b140d461ef7ab727363844", "chunk_index": 0}
{"text": "Glossary 969 \nEquity Option: an option that has common stock as its underlying security. See also \nNon-Equity Option. \nEquity Requirement: arequirement that aminimum amount of equity must be \npresent in amargin account. Normally, this requirement is $2,000, but some bro\nkerage firms may impose higher equity requirements for uncovered option writing. \nEquivalent Positions: positiohs that have similar profit potential, when measured \nin dollars, but are constructed with differing securities. Equivalent positions have \nthe same profit graph. Acovered call write is equivalent to an uncovered put write, \nfor example. See also Profit Graph. \nEscrow Receipt: areceipt issued by abank in order to verify that acustomer ( who has \nwritten acall) in fact owns the stock and therefore the call is considered covered. \nEuropean Exercise: afeature of an option that stipulates that the option may be \nexercised only at its expiration. Therefore, there can be no early assignment with \nthis type of option. \nExchange-Traded Fund (ETF): an index fund that is listed on astock exchange. \nOptions are listed on some ETFs. See also Index Fund. \nEx-Dividend: the process whereby astock'sprice is reduced when adividend is \npaid. The ex-dividend date (ex-date) is the date on which the price reduction takes \nplace. Investors who own stock on the ex-date will receive the dividend, and those \nwho are short stock must pay out the dividend. \nExercise: to invoke the right granted under the terms of alisted options contract. \nThe holder is the one who exercises. Call holders exercise to buy the underlying \nsecurity, while put holders exercise to sell the underlying security. \nExercise Limit: the limit on the number of contracts aholder can exercise in afixed \nperiod of time. Set by the appropriate option exchange, it is designed to prevent \nan investor or group of investors from \"cornering\" the market in astock. \nExercise Price: the price at which the option holder may buy or sell the underlying \nsecurity, as defined in the terms of his option contract. It is the price at which the \ncall holder may exercise to buy the underlying security or the put holder may exer\ncise to sell the underlying security. For listed options, the exercise price is the \nsame as the striking price. See also Exercise. \nExpected Return: arather complex mathematical analysis involving statistical dis\ntribution of stock prices, it is the return an investor might expect to make on an \ninvestment if he were to make exactly the same investment many times through\nout history.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1037", "doc_id": "2de2a1cdde39b76971ce4fceebb48d6f2b3deb301def880d86fd49784fb04903", "chunk_index": 0}
{"text": "970 Glossary \nExpiration Date: the day on which an option contract becomes void. The expiration \ndate for listed stock options is the Saturday after the third Friday of the expiration \nmonth. All holders of options must indicate their desire to exercise, if they wish to \ndo so, by this date. See also Expiration Time. \nExpiration Time: the time of day by which all exercise notices must be received on \nthe expiration date. Technically, the expiration time is currently 5:00 P.M. on the \nexpiration date, but public holders of option contracts must indicate their desire \nto exercise no later than 5:30 P.M. on the business day preceding the expiration \ndate. The times are Eastern Time. See also Expiration Date. \nFacilitation: the process of providing amarket for asecurity. Normally, this refers \nto bids and offers made for large blocks of securities, such as those traded by insti\ntutions. Listed options may be used to offset part of the risk assumed by the trad\ner who is facilitating the large block order. See also Hedge Ratio. \nFair Value: normally, aterm used to describe the worth of an option or futures con\ntract as determined by amathematical model. Also sometimes used to indicate \nintrinsic value. See also Intrinsic Value, Model. \nFirst Notice Day: the first day upon which the buyer of afutures contract can be \ncalled upon to take delivery. See also Notice Period. \nFloat: the number of shares outstanding of aparticular common stock. \nFloor Broker: atrader on the exchange floor who executes the orders of public cus\ntomers or other investors who do not have physical access to the trading area. \nFollow-Up Action: any trading in an option position after the position is established. \nGenerally, to limit losses or to take profits. \nFundamental Analysis: amethod of analyzing the prospects of asecurity by observ\ning accepted accounting measures such as earnings, sales, assets, and so on. See \nalso Technical Analysis. \nFutures Contract: astandardized contract calling for the delivery of aspecified \nquantity of acommodity at aspecified date in the future. \nGamma: ameasure of risk of an option that measures the amount by which the delta \nchanges for a I-point change in the stock price; alternatively, when referring to an \nentire option position, the amount of change of the delta of the entire position \nwhen the stock changes in price by one point. \nGamma of the Gamma: amathematical measure of risk that measures by how \nmuch the gamma will change for a I-point move in the stock price. See Gamma.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1038", "doc_id": "73374bb2a2a8a9d2041a9e466f1df8cf28274e8cc464453ccd0fce0d1797fa5c", "chunk_index": 0}
{"text": "Glossary 971 \nGood Until Canceled (GTC): adesignation applied to some types of orders, mean\ning that the order remains in effect until it is either filled or canceled. See also \nLimit, Stop-Limit Order, Stop Order. \nHedge Ratio: the mathematical quantity that is equal to the delta of an option. It is \nuseful in facilitation in that atheoretically riskless hedge can be established by tak\ning offsetting positions in the underlying stock and its call options. See also Delta, \nFacilitation. \nHistoric Volatility: See Volatility. \nHolder: the owner of asecurity. \nHorizontal Spread: an option strategy in which the options have the same striking \nprice, but different expiration dates. \nImplied Volatility: aprediction of the volatility of the underlying stock, it is deter\nmined by using prices currently existing in the option market at the time, rather \nthan using historical data on the price changes of the underlying stock See also \nVolatility. \nIncremental Return Concept: astrategy of covered call writing in which the \ninvestor is striving to earn an additional return from option writing against astock \nposition that he is targeted to sell, possibly at substantially higher prices. \nIndex: acompilation of the prices of several common entities into asingle number. \nSee also Capitalization-Weighted Index, Price-Weighted Index. \nIndex Arbitrage: aform of arbitraging index futures against stock If futures are \ntrading at prices significantly higher than fair value, the arbitrager sells futures and \nbuys the exact stocks that make up the index being arbitraged; if futures are at adiscount to fair value, the arbitrage entails buying futures and selling stocks. \nIndex Fund: amutual fund whose components exactly match the stocks that make \nup awidely disseminated index, such as the S&P 500, Dow-Jones, Russell 2000, or \nNASDAQ-100. See also Exchange-Traded Fund. \nIndex Option: an option whose underlying entity is an index. Most index options are \ncash-based. \nInstitution: an organization, probably very large, engaged in investing in securities. \nNormally abank, insurance company, or mutual fund. \nIntermarket Spread: afutures spread in which futures contracts in one market are \nspread against futures contracts trading in another market. Examples: Currency \nspreads (yen vs. deutsche mark) or TED spread (T-Bills vs. Eurodollars).", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1039", "doc_id": "30a38450ed692fdab8744582c1c0355f82e6702cfc99e4e2e9a3a09ced714663", "chunk_index": 0}
{"text": "972 Glossary \nIn-the-Money: aterm describing any option that has intrinsic value. Acall option is \nin-the-money if the underlying security is higher than the striking price of the call. \nAput option is in-the-money if the security is below the striking price. See also \nIntrinsic Value, Out-of-the-Money. \nIntramarket Spread: afutures spread in which futures contracts are spread against \nother futures contracts in the same market; example, buy May soybeans, sell \nMarch soybeans. \nIntrinsic Value: the value of an option if it were to expire immediately with the \nunderlying stock at its current price; the amount by which an option is in-the\nmoney. For call options, this is the difference between the stock price and the \nstriking price, if that difference is apositive number, or zero otherwise. For put \noptions it is the difference between the striking price and the stock price, if that \ndifference is positive, and zero otherwise. See also In-the-Money, Parity, Time \nValue Premium. \nLast Trading Day: the third Friday of the expiration month. Options cease trading \nat 3:00 P.M. Eastern Time on the last trading day. \nLEAPS: Long-term Equity Anticipation Securities. These are long-term listed \noptions, currently having maturities as long as two and one-half years. \nLeg: arisk-oriented method of establishing atwo-sided position. Rather than enter\ning into asimultaneous transaction to establish the position (aspread, for exam\nple), the trader first executes one side of the position, hoping to execute the other \nside at alater time and abetter price. The risk materializes from the fact that abetter price may never be available, and aworse price must eventually be accept\ned. \nLetter of Guarantee: aletter from abank to abrokerage firm stating that acus\ntomer (who has written acall option) does indeed own the underlying stock and \nthe bank will guarantee delivery if the call is assigned. Thus, the call can be con\nsidered covered. Not all brokerage firms accept letters of guarantee. \nLeverage: in investments, the attainment of greater percentage profit and risk \npotential. Acall holder has leverage with respect to astockholder-the former will \nhave greater percentage profits and losses than the latter, for the same movement \nin the underlying stock. \nLimit: see Trading Limit. \nLimit Order: an order to buy or sell securities at aspecified price (the limit). Alimit \norder may also be placed \"with discretion\" -afixed; usually small, amount such as \n1/sor ¼ of apoint. In this case, the floor broker executing the order may use his", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1040", "doc_id": "776c39f405bb9f33000cb7ba9fa33cc16935772d4e687186b5e796f7623e01ba", "chunk_index": 0}
{"text": "Glossary 973 \ndiscretion to buy or sell at 1/sor ¼ of apoint beyond the limit if he feels it is nec\nessary to fill the order. \nListed Option: aput or call option that is traded on anational option exchange. \nListed options have fixed striking prices and expiration dates. See also Over-the\nCounter Option. \nLocal: atrader on afutures exchange who buys and sells for his own account and \nmay fill public orders. \nLognormal Distribution: astatistical distribution that is often applied to the move\nment of the stock prices. It is aconvenient and logical distribution because it \nimplies that stock prices can theoretically rise forever but cannot fall below zero-\nafact which is, of course, true. \nMargin: to buy asecurity by borrowing funds from abrokerage house. The margin \nrequirement-the maximum percentage of the investment that can be loaned by \nthe broker firm-is set by the Federal Reserve Board. \nMarket Basket: aportfolio of common stocks whose performance is intended to \nsimulate the performance of aspecific index. See Index. \nMarket-Maker: an exchange member whose function is to aid in the making of amarket, by making bids and offers for his account in the absence of public buy or \nsell orders. Several market-makers are normally assigned to aparticular security. \nThe market-maker system encompasses the market-makers and the board bro\nkers. See also Board Broker, Specialist. \nMarket Not Held Order: also amarket order, but the investor is allowing the floor \nbroker who is executing the order to use his own discretion as to the exact timing \nof the execution. If the floor broker expects adecline in price and he is holding a \n\"market not held\" buy order, he may wait to buy, figuring that abetter price will \nsoon be available. There is no guarantee that a \"market not held\" order will be \nfilled. \nMarket Order: an order to buy or sell securities at the current market. The order \nwill be filled as long as there is amarket for the security. \nMarried Put and Stock: aput and stock are considered to be married if they are \nbought on the same day, and the position is designated at that time as ahedge. \nModel: amathematical formula designed to price an option as afunction of certain \nvariables-generally stock price, striking price, volatility, time to expiration, divi\ndends to be paid, and the current risk-free interest rate. The Black\nScholes model is one of the more widely used models.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1041", "doc_id": "f47ca8e9c50b4b27852a7af8c453b6aba8493ac1f11b0fa90c89a7ad7a4bd2c4", "chunk_index": 0}
{"text": "974 Glossary \nMonte Carlo Simulation: amodel designed to simulate areal-world event that can\nnot be approximated merely with amathematical formula. The Monte Carlo sim\nulation approximates such an event (the movement of the stock market, for exam\nple) and then it is simulated agreat number of times. The net result of all the sim\nulations is then interpreted as the result, generally expressed as aprobability of \noccurrence. For example, a Monte Carlo simulation can be used to determine how \nstocks might behave under certain stock price distributions that are different from \nthe lognormal distribution. \nNaked Option: see Uncovered Option. \nNarrow-Based: Generally referring to an index, it indicates that the index is com\nposed of only afew stocks, generally in aspecific industry group. Narrow-based \nindices are not subject to favorable treatment for naked option writers. See also \nBroad-Based. \n\"Net\" Order: see Contingent Order. \nNeutral: describing an opinion that is neither bearish or bullish. Neutral option \nstrategies are generally designed to perform best if there is little nor no net change \nin the price of the underlying stock. See also Bearish, Bullish. \nNon-Equity Option: an option whose underlying entity is not common stock; typi\ncally refers to options on physical commodities, but may also be extended to \ninclude index options. \n\"Not Held\": see Market Not Held Order. \nNotice Period: the time during which the buyer of afutures contract can be called \nupon to accept delivery. Typically, the 3 to 6 weeks preceding the expiration of the \ncontract. \nOpen Interest: the net total of outstanding open contracts in aparticular option \nseries. An opening transaction increases the open interest, while any closing trans\naction reduces the open interest. \nOpening Transaction: atrade that adds to the net position of an investor. An open\ning buy transaction adds more long securities to the account. An opening sell \ntransaction adds more short securities. See also Closing Transaction. \nOption Pricing Curve: agraphical representation of the projected price of an \noption at afixed point in time. It reflects the amount of time value premium in the \noption for various stock prices, as well. The curve is generated by using amathe\nmatical model. The delta ( or hedge ratio) is the slope of atangent line to the curve \nat afixed stock price. See also Delta, Hedge Ratio, Model.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1042", "doc_id": "50610840ae652cf5ee320fd9c82a3cc953bfa5bf0bdb8c78ce171cb6da523baa", "chunk_index": 0}
{"text": "Glossary 975 \nOptions Clearing Corporation (OCC): the issuer of all listed option contracts that \nare trading on the national option exchanges. \nOriginal Issue Discount (O1D): the initial price of azero-coupon bond. The owner \nowes taxes on the theoretical interest, or phantom income, generated by the annu\nal appreciation of the bond toward maturity. In reality, no interest is paid by the \nzero-coupon bond, but the government is taxing the appreciation of the bond as if \nit were interest. \nOut-of-the-Money: describing an option that has no intrinsic value. Acall option is \nout-of-the-money if the stock is below the striking price of the call, while aput \noption is out-of-the-money if the stock is higher than the striking price of the put. \nSee also In-the-Money, Intrinsic Value. \nOver-the-Counter Option (OTC): an option traded over-the-counter, as opposed \nto alisted stock option. The OTC option has adirect link between buyer and sell\ner, has no secondary market, and has no standardization of striking prices and expi\nration dates. See a'lso Listed Option, Secondary Market. \nOvervalued: describing asecurity trading at ahigher price than it logically should. \nNormally associated with the results of option price predictions by mathematical \nmodels. If an option is trading in the market for ahigher price than the model indi\ncates, the option is said to be overvalued. See a'/so Fair Value, Undervalued. \nPairs Trading: ahedging technique in which one buys aparticular stock and sells \nshort another stock. The two stocks are theoretically linked in their price history, \nand the hedge is established when the historical relationship is out of line, in hopes \nthat it will return to its former correlation. \nParity: describing an in-the-money option trading for its intrinsic value: that is, an \noption trading at parity with the underlying stock. Also used as apoint of refer\nence-an option is sometimes said to be trading at ahalf-point over parity or at aquarter-point under parity, for example. An option trading under parity is adis\ncount option. See a'/so Discount, Intrinsic Value. \nPERCS: Preferred Equity Redemption Cumulative Stock. Issued by acorporation, \nthis preferred stock pays ahigher dividend than the common and has aprice at \nwhich it can be called in for redemption by the issuing corporation. As such, it is \nreally acovered call write, with the call premium being given to the holder in the \nform of increased dividends. See Call Price, Covered Call Write, Redemption Price. \nPhysical Option: an option whose underlying security is aphysical commodity that \nis not stock or futures. The physical commodity itself, typically acurrency or", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1043", "doc_id": "a8be4e66979190877b29ac67ba43ecf47149d9be696edd09c2b026642a147313", "chunk_index": 0}
{"text": "976 Glossary \nTreasury debt issue, underlies that option contract. See also Equity Option, Index \nOption. \nPortfolio Insurance: amethod of selling index futures or buying index put options \nto protect aportfolio of stocks. \nPosition: as anoun, specific securities in an account or strategy. Acovered call writ\ning position might be long 1,000 XYZ and short 10 XYZ January 30 calls. As averb, \nto facilitate; to buy or sell-generally ablock of securities-thereby establishing aposition. See also Facilitation, Strategy. \nPosition Limit: the maximum number of put or call contracts on the same side of \nthe market that can be held in any one account or group of related accounts. Short \nputs and long calls are on the same side of the market. Short calls and long puts \nare on the same side of the market. \nPremium: for options, the total price of an option contract. The sum of the intrinsic \nvalue and the time value premium. For futures, the difference between the \nfutures price and the cash price of the underlying index or commodity. \nPresent Worth: amathematical computation that determines how much money \nwould have to be invested today, at aspecified rate, in order to produce adesig\nnated amount at some time in the future. For example, at 10% for one year, the \npresent worth of $ll0 is $100. \nPrice-Weighted Index: astock index that is computed by adding the prices of each \nstock in the index, and then dividing by the divisor. See also Capitalization\nWeighted Index, Divisor. \nProfit Graph: agraphical representation of the potential outcomes of astrategy. \nDollars of profit or loss are graphed on the vertical axis, and various stock prices \nare graphed on the horizontal axis. Results may be depicted at any point in time, \nalthough the graph usually depicts the results at expiration of the options involved \nin the strategy. \nProfit Range: the range within which aparticular position makes aprofit. Generally \nused in reference to strategies that have two break-even points-an upside break\neven and adownside break-even. The price range between the two break-even \npoints would be the profit range. See also Break-Even Point. \nProfit Table: atable of results of aparticular strategy at some point in time. This is \nusually atabular compilation of the data drawn on aprofit graph. See also Profit \nGraph.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1044", "doc_id": "271200cd9197af4fca9332ff30bf641834911ad884553f297e825c97a6f8ef60", "chunk_index": 0}
{"text": "Glossary 917 \nProgram Trading: the act of buying or selling aparticular portfolio of stocks and \nhedging with an offsetting position in index futures. The portfolio of stocks may be \nsmall or large, but it is not the makeup of any stock index. See also Index Arbitrage. \nProtected Strategy: aposition that has limited risk. Aprotected short sale (short \nstock, long call) has limited risk, as does aprotected straddle write ( short straddle, \nlong out-of-the-money combination). See also Combination, Straddle. \nPublic Book (of orders): the orders to buy or sell, entered by the public, that are \naway from the current market. The board broker or specialist keeps the public \nbook. Market-makers on the CBOE can see the highest bid and lowest offer at any \ntime. The specialist'sbook is closed ( only he knows at what price and in what quan\ntity the nearest public orders are). See also Board Broker, Market-Maker, \nSpecialist. \nPut: an option granting the holder the right to sell the underlying security at acer\ntain price for aspecified period of time. See also Call. \nPut-Call Ratio: the ratio of put trading volume divided by call trading volume; \nsometime~ calculated with open interest or total dollars instead of trading volume. \nCan be calculated daily, weekly, monthly, etc. Moving averages are often used to \nsmooth out short-term, daily figures. \nRatio Calendar Combination: astrategy consisting of asimultaneous position of aratio calendar spread using calls and asimilar position using puts, where the strik\ning price of the calls is greater than the striking price of the puts. \nRatio Calendar Spread: selling more near-term options than longer-term ones \npurchased, all with the same strike, either puts or calls. \nRatio Spread: constructed with either puts or calls, the strategy consists of buying acertain amount of options and then selling alarger quantity of out-of-the-money \noptions. \nRatio Strategy: astrategy in which one has an unequal number of long securities \nand short securities. Normally, it implies apreponderance of short options over \neither long options or long stock. \nRatio Write: buying stock and selling apreponderance of calls against the stock that \nis owned. ( Occasionally constructed as shorting stock and selling puts.) \nRedemption Price: the price at which astructured product may be redeemed for \ncash. This is distinctly different from a \"call price,\" which is the price at which an \nissue may be called away by the issuer. See also Call Price, PERCS, Structured \nProduct.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1045", "doc_id": "dcb9d2b66af24e923cea3fe3ed6e6d6fdb9c196d695f0e05f1dc74fba1757833", "chunk_index": 0}
{"text": "978 Glossary \nResistance: aterm in technical analysis indicating aprice area higher than the cur\nrent stock price where an abundance of supply exists for the stock, and therefore \nthe stock may have trouble rising through the price. See also Support. \nReturn (on investment): the percentage profit that one makes, or might make, on \nhis investment. \nReturn if Exercised: the return that acovered call writer would make if the under\nlying stock were called away. \nReturn if Unchanged: the return that an investor would make on aparticular posi\ntion if the underlying stock were unchanged in price at the expiration of the \noptions in the position. \nReversal Arbitrage: ariskless arbitrage that involves selling the stock short, writing \naput, and buying acall. The options have the same terms. See also Conversion \nArbitrage. \nReverse Hedge: astrategy in which one sells the underlying stock short and buys \ncalls on more shares than he has sold short. This is also called asynthetic straddle \nand is an outmoded strategy for stocks that have listed puts trading. See also Ratio \nWrite, Straddle. \nReverse Strategy: ageneral name that is given to strategies that are the opposite of \nbetter-known strategies. For example, aratio spread consists of buying calls at alower strike and selling more calls at ahigher strike. Areverse ratio spread, also \nknown as abackspread, consists of selling the calls at the lower strike and buying \nmore calls at the higher strike. The results are obviously directly opposite to each \nother. See also Reverse Hedge Ratio Write, Reverse Hedge. \nRho: the measure of how much an option changes in price for an incremental mov<' \n(generally l % ) in short-term interest rates; more significant for longer-term or i11-\nthe-money options. \nRisk Arbitrage: aform of arbitrage that has some risk associated with it. Commonly \nrefers to potential takeover situations in which the arbitrageur buys the stock of \nthe company about to be taken over and sells the stock of the company that is \neffecting the takeover. See also Dividend Arbitrage. \nRoll: afollow-up action in which the strategist closes options currently in the posi\ntion and opens other options with different terms, on the same underlying stock. \nSee also Roll Down, Roll Forward, and Roll Up. \nRoll Down: close out options at one strike and simultaneously open other options al \nalower strike.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1046", "doc_id": "bf18f7f81bc7241aaf4122e0b9c40a9d5bf763ca287622aec6fef29a6941e67e", "chunk_index": 0}
{"text": "Glossary 979 \nRoll Forward: close out options at anear-term expiration date and open options at \nalonger-term expiration date. \nRoll Up: close out options at alower strike and open options at ahigher strike. \nRotation: atrading procedure on the open exchanges whereby bids and offers, but \nnot necessarily trades, are made sequentially for each series of options on an \nunderlying stock or index. \nSecondary M~ket: any market in which securities can be readily bought and sold \nafter their initial issuance. The national listed option exchanges provided, for the \nfirst time, asecondary market in stock options. \nSerial Option: afutures option for which there is no corresponding futures contract \nexpiring in the same month. The underlying futures contract is the next futures \ncontract out in time. Example: There is no March gold futures contract, but there \nis an April gold futures contract, so March gold options, which are serial options, \nare options on April gold futures. \nSeries: all op,tion contracts on the same underlying stock having the same striking \nprice, expiration date, and unit of trading. \nSkew: See Volatility Skew. \nSpecialist: an exchange member whose function it is both to make markets-buy \nand sell for his own account in the absence of public orders-and to keep the book \nof public orders. Most stock exchanges and some option exchanges utilize the spe\ncialist system of trading \nSpread Order: an order to simultaneously transact two or more option trades. \nTypically, one option would be bought while another would simultaneously be \nsold. Spread orders may be limit orders, not held orders, or orders with discretion. \nThey cannot be stop orders, however. The spread order may be either adebit or acredit. \nSpread Strategy: any option position having both long options and short options of \nthe same type on the same underlying security. \nStandard Deviation: ameasure of the volatility of astock. It is astatistical quanti\nty measuring the magnitude of the daily price changes of that stock. See also, \nVolatility. \nStop Order: an order, placed away from the current market, that becomes amarket \norder if the security trades at the price specified on the stop order. Buy stop orders \nare placed above the market, while sell stop orders are placed below.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1047", "doc_id": "b670922b08b008945a3f8c28f44cc7a2c1648a239d167cc49396fc8edefc05cf", "chunk_index": 0}
{"text": "980 Glossary \nStop-Limit Order: similar to astop order, the stop-limit order becomes alimit \norder, rather than amarket order, when the security trades at the price specified \non the stop. See also Stop Order. \nStraddle: the purchase or sale of an equal number of puts and calls having the same \nterms. \nStrangle: acombination involving aput and acall at different strikes with the same \nexpiration date. \nStrategy: with respect to option investments, apreconceived, logical plan of position \nselection and follow-up action. \nStriking Price: see Exercise Price. \nStriking Price Interval: the distance between striking prices on aparticular under\nlying security. For stocks, the interval is normally 2.5 points for lower-priced stocks \nand 5 points for higher-priced stocks. For indices, the interval is either 5 or 10 \npoints. For futures, the interval is often as low as one or two points. \nStructured Product: acombination of securities and possibly options into asingle \nsecurity that behaves like stock and trades on alisted stock exchange. Structured \nproducts are created by many of the largest financial institutions (banks and bro\nkerage firms). Many of the more popular ones are known by their acronyms, cre\nated by the institutions that issued them: MITTS, TARGETS, BRIDGES, LINKS, \nDINKS, ELKS, and PERCS. See also PERCS. \nSubindex: see Narrow-Based. \nSuitable: describing astrategy or trading philosophy in which the investor is operat\ning in accordance with his financial means and investment objectives. \nSupport: aterm in technical analysis indicating aprice area lower than the current \nprice of the stock, where demand is thought to exist. Thus, astock would stop \ndeclining when it reached asupport area. See also Resistance. \nSynthetic Put: astrategy constructed by shorting the underlying instrument and \nbuying acall. The resulting position has the same profit and loss characteristics as \nalong put option. \nSynthetic Stock: an option strategy that is equivalent to the underlying stock. Along \ncall and ashort put is synthetic long stock. Along put and ashort call is synthetic \nshort stock. \nTechnical Analysis: the method of predicting future stock price movements based \non observation of historical stock price movements.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1048", "doc_id": "8d3cf7d51920c56ce7421341532bd3d30f91ea3571635bd68de8716ea6d33ec5", "chunk_index": 0}
{"text": "Glossary 981 \nTerms: the collective name denoting the expiration date, striking price, and under\nlying stock of an option contract. \nTheoretical Value: the price of an option, or aspread, as computed by amathe\nmatical model. \nTheta: the measure of how much an option'sprice decays for each day of time that \npasses. \nTime Spread: see Calendar Spread. \nTime Value Premium: the amount by which an option'stotal premium exceeds its \nintrinsic value. \nTotal Return Concept: acovered call writing strategy in which one views the \npotential profit of the strategy as the sum of capital gains, dividends, and option \npremium.income, rather than viewing each one of the three separately. \nTracking Error: the amount of difference between the performance of aspecific \nportfolio of stocks and abroad-based index with which they are being compared. \nSee Market Basket. \nTrader: aspeculative investor or professional who makes frequent purchases and \nsales. \nTrading Limit: the exchange-imposed maximum daily price change that afutures \ncontract or futures option contract can undergo. \nTreasury BilVOption Strategy: amethod of investment in which one places \napproximately 90% of his funds in risk-free, interest-bearing assets such as \nTreasury bills, and buys options with the remainder of his assets. \nType: the designation to distinguish between aput or call option. \nUncovered Option: awritten option is considered to be uncovered if the investor \ndoes not have acorresponding position in the underlying security. See also \nCovered. \nUnderlying Security: the security that one has the right to buy or sell via the terms \nof alisted option contract. \nUndervalued: describing asecurity that is trading at alower price than it logically \nshould. Usually determined by the use of amathematical model. See also Fair \nValue, Overvalued. \nVariable Ratio Write: an option strategy in which the investor owns 100 shares of \nthe underlying security and writes two call options against it, each option having adifferent striking price.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1049", "doc_id": "77e970013b2b5e94c37a2fac4fed70af90f30b552a101e63a39071602b309db3", "chunk_index": 0}
{"text": "982 Glossary \nVega: the measure of how much an option'sprice changes for an incremental \nchange-usually one percentage point-in volatility. \nVertical Spread: any option spread strategy in which the options have different \nstriking prices but the same expiration dates. \nVolatility: ameasure of the amount by which an underlying security is expected to \nfluctuate in agiven period of time. Generally measured by the annual standard \ndeviation of the daily price changes in the security, volatility is not equal to the beta \nof the stock. Also called historical volatility, statistical volatility, or actual volatility. \nSee also Implied Volatility. \nVolatility Skew: the term used to describe aphenomenon in which individual \noptions on asingle underlying instrument have different implied volatilities. I 11 \ngeneral, not only are the individual options' implied volatilities different, but they \nform apattern. If the lower striking prices have the lowest implied volatilities, and \nthen implied volatility progresses higher as one moves up through the striking \nprices, that is called aforward or positive skew. Areverse or negative skew works \nin the opposite way: The higher strikes have the lowest implied volatilities. \nWarrant: along-term, nonstandardized security that is much like an option. \nWarrants on stocks allow one to buy (usually one share of) the common at a (\"(•rtain price until acertain date. Index warrants are generally warrants on the pri<·<· \nof foreign indices. Warrants have also been listed on other things such as cross-('mrency spreads and the future price of abarrel of oil. \nWrite: to sell an option. The investor who sells is called the writer.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1050", "doc_id": "09a14d5ea791834d349443ad9a9018e2e4c9b0bdc0b8244d87ff62c5a3ae1651", "chunk_index": 0}
{"text": "984 \nAssignment of options, 7, 16-22 \nanticipating, 18-22 \nautomatic, 18-19 \ncall options, 7 \nof cash-based options, 501 \ncommissions, 17-18 \nmargin requirements, 16-17 \nput options, 7 \nBackspreads, 232-235 (see also Reverse spreads) \ndiagonal, 240-241 \neffect on of implied volatility changes, 781-782 \nand LEAPS, 407-408 \nBear spreads using call options, 186-190 \ncall bear spread, 186-188 \nas credit spread, 186 \nfollow-up action, 190 \nassignment of short call, impending, 190 \nselecting, 189-190 \nan aggressive position usually, 189 \nsummary, 190 \nBear spread, put, 329-332 (see also Put spreads, basic) \nBeta, 533-539 \nBlack, Fisher, 459 \nBlack-Scholes model, 456-466, 538, 610, 611, 635, 640, \n644-645,646,647-648,651,677,678, 731,734, \n758, 767-768, 798,902 (see also Mathematical \napplications) \nBlack model, 647-648, 651, 677 \ncharacteristics, 459-461 \ndividends paid by common stock not included, 459 \nformula, 456-457 \nhedge ratio, 457 \nhistorical volatility, lognormal, computing, 461-466 \nlognormal distribution of stock prices, 460 \nvega, 750 \nvolatility, computation of, 460-466 \nweighting factor, 459-460, 463-465 \nBlock positioning, 455, 482-485 (see also Mathematical \napplications) \nBoard broker system, 22 \nBox spread, 338, 439-44,3, 643-644 \nrisks, 443 \n\"Box\" stock, 432 \nBroad-based indices, 500 \nBrownian motion, 806 \nBull spread, structured product as, 608-612 \nvaluing, 610-612 \nBull spreads, 110-111, 113-116, 117, 172-185 \naggressiveness, degrees of, 175-176 \ncall bull spread, 172-173 \neffect on of implied volatility changes, 767-775 \nfollow-up action, 178-180 \ncredit spread, 179 \n\"legging\" out of spread, 180 \nand outright purchase, comparison of, 179 \nand LEAPS, 403-404 \nranking, 176-178 \ndiagonal bull spread, 177 \nsummary, 185 \nuses, other, 180-184 \nIndex \nbreak-even price on common stock, lowering, 182, \n183 \nsimple form of spreading, 180, 185 \nas \"substitute\" for covered writing, 182-184 \nvertical, 172 \nwhen options are expensive, 177 \nBull spread, put, 332-333 (see also Put spreads, basic) \nBullish calendar spread, 196-198 (see also Calendar \nspread) \nButterfly spread, 200-209, 336-338 (see also Put \nspreads, basic) \ncombination of bull and bear spreads, 200, 209 \ncommissions costly, 200, 203 \nexample, 201 \nfollow-up action, 206-209 \nassignment, 206 \n\"legging out,\" 207 \nneutral position, 200 \nresults of at expiration, 201-203 \nselecting, 203-206 \nstriking prices, three, 200-203 \nsummary, 209 \nCalendar combination of calls and puts, 345-348 \nCalendar spread, 116-117, 191-199 \nas antivolatility strategy, 194 \nbullish, 196-198, 199 \nfollow-up action, 197-198 \ndefinition, 191 \nexpiration series, using all three, 198-199 \nhorizontal spread, 191 \nin volatility trading, 825-826 \nand LEAPS, 408-409 \nmathematical calculations of volatility, applying lo. \n478-480 \nneutral, 192-194, 199 \nfollow-up action, 194-196 \nvolatility, effect of, 194 \nsummary, 199 \ntime spread another name, 191 \nvolatility changes, effect of on, 778-780 \nwith futures options, 704-709 (see also Futtm'soptions and strategies)", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1052", "doc_id": "ff49a796812d1967990febd202b332a65e755f480e840cf4928ae0115e04b4bc", "chunk_index": 0}
{"text": "986 \nChicago Board Options Exchange (CBOE), 22 \nstructured products listed, 618 \nChicago Mercantile Exchange, 507, 509, 510, 672 \noption quotes, 515-516 \ntrading limits on futures options, 680 \nChicago Board of Trade: \ntrading limits on futures contracts, 658 \ntrading limits on futures options, 680 \nClasses of options, 5-6 \nClosing transactions, 6 \nCollar, 275, 840 \nno-cost, 278-280 \nCommissions, 17-18 \nConcepts, advanced, 846-907 (see also Advanced \nconcepts) \nConservative covered write, 46 \nContango, 697 \nConversion, 253-255, 428-430, 431-438 (see also Put \noptions basics and Arbitrage) \nreversal, 254, 428-430, 431-438 \nrisks in, four, 433-43 7 \nsummary, 437-438 \nConvertible security, covered writing against, 88-90, 94 \nCovered call writing, 39-94 \ndefinition, 39 \ndiversifying return and protection, 66-70 \n\"combined\" write, 67-69 \ntechniques, fundamental, 66-69 \ntechniques, other, 69-70 \nexecution of order, 56-58 \ncontingent order, 57 \nnet position, establishing, 57-58 \nfollow-up action, 70-87, 94 \naggressive action if stock rises, 71, 79-81 \nassignment, action to avoid if time premium \ndisappears, 71, 86-87 \nexpiration, at or near, 83-85 \ngetting out, 82-83 \nlocked-in loss, 73 \nprotective action if stock drops, 71-79 \nrolling action, 71-80 (see also Rolling action) \nrolling forward/down, 83-85 \nspread, 76 \nuncovered position, avoiding, 86 \nwhen to let stock be called away, 86-87 \nimportance, 39-42 \nfor downside protection, 39 \nincrease in stock price, benefits of, 40-41 \nprofit graph, 41-42 \nquantification, 41-42 \nand naked put writing, differences between, \n294-295 \nobjective, 42 \nIndex \nPERCS (Preferred Equity Redemption Cumulative \nStock), 91 \nphilosophy, 42-45 \nannual returns, 47 \nas conservative strategy, 46-4 7 \nDepository Trust Corp (DTC), role of, 43 \nin-the-money covered writes, 43-45, 93 \nletter of guarantee, 43 \nout-of-the-money covered writes, 43-45, 93 \nphysical location of stock, 43 \ntotal return concept, 45-47, 60-61, 93 \nreturn on investment, computing, 47-56 \ncompound interest, 53-54 \ndownside break-even point, 48, 49-50 \nin margin accounts, 50-53 \nprice,changesin,55-56 \nreturn if exercised, 47-48 \nreturn if unchanged, 48, 49 \nsize of position, 54-55 \nstatic return, 49 \nselecting position, 58-62 \ndownside protection, 59-60 \nreturns, projected, 59 \nstrategy, importance of, 60-62 \ntotal return concept, 60-61 \nspecial writing situations, 87-93 \nagainst convertible security, 88-90, 94 \nagainst LEAPS, 91, 94 \nagainst warrants, 90-91 \nincremental return concept, 87-88, 91-93 \nand stock ownership, 42 \nsummary, 93-94 \nand uncovered put writing strategy, similarity of, \n293-294 \nwriting against stock already owned, 62-66 \ncaution, 65-66 \nCovered pit sale, 300 \nCovered straddle write, 302-305 \nCrack spread, 702-704 \nCredit spread, 170, 179 \nCross-currency spreads, 701 \nCumulative density function (CDF), 806 \nCustomer margin method, 5 \nCustomer margin option requirements, 667 \nDay trading, call buying and, 101-102 \nDebit spread, 170 \nDefinitions, 3-35 (see also under particular definition or \nunder Options) \nDelta, 848-853, 866 \ncalculation of by Black-Scholes model, 457 \nexcess value, 764", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1054", "doc_id": "5beeeeb6ee25c88083a2939c77e0d557c85cc309313c1d8fda520d6d2640c8bf", "chunk_index": 0}
{"text": "988 \nFutures and futures options (continued) \nposition limits, 657 \npricing, 659-660 \nspeculating, 655-656 \nspot and spot price, 658 \nas stock with expiration date, 653 \ntenns, 656-657 \ntrading hours, 657 \ntrading limits, 657-658 \nunits of trading, 657 \nfutures options trading strategies, 67 4-683 \ndelta, 676-677 \nequivalent futures position (EFP), 676-677 \nfollow-up actions, 692-694 \nlimit bid, 679 \nlimit offered, 680 \nmathematical considerations, 677-679 \nmispricing strategies, common, 683-694 (see also \nFutures and futures option, mispricing strate\ngies) \nprice relationships, 67 4-676 \nsummary, 694 \nand trading limits, 679-683 \nmispricing strategies, common, for futures options, \n683-694 \nbackspreading puts, 686-688 \nfollow-up action, 692-694 \nimplied volatility, 685 \npoints, 687-688 \nratio spreading calls, 688-689 \nstrategies for profiting, two, 685-689 \nsummary, 694 \nvolatility skewing, 683, 685, 693-694 \nwhich strategy to use, 690-692 \noptions on futures, 660-673 \nassignment, 673 \nautomatic exercise, 662-663 \nbid-offer spread, 665 \ncash settlement future, 661 \ncommissions, 665 \ncustomer margin system, 667, 671 \ndefinition, 660 \ndescription, 660-662 \nexercise, 673 \nforeign currency options, 671-673 \nmargins, 666-671 \nmathematical considerations, 677-679 \nmonth symbols, 665 \nnotice day, 661-662 \nPhiladelphia Stock Exchange (PHUC), 671, 673, \n678-679 \nphysical currency options, 671-673 \non physical futures, 661, 678-679 \nposition limits, 666 \nquote symbols, 664 \n\"round-tum\" commission, 665-666 \nserial options, 663-666 \nIndex \nSPAN margin (Standard Portfolio Analysis of \nRisk), 667-671 (see also SPAN) \nstriking price intervals, 662 \nstandardization less than for equity or index options, \n652 \nsummary, 695 \nFutures Magazine, 661 \nFutures option strategies for futures spreads, 696-721 \nfutures options, using in futures spreads, 704-720 \ncalendar spread, 704-709 \nfollow-up considerations, 714-719 \nintramarket spread strategy, 719 \nlong combinations, 709-714 \nspreading futures against stock sector indices, \n719-720 \nfutures spreads, 696-704 \ncontango, 697 \ncrack spread, 702-704 \ncross-currency spreads, 701 \nintermarket, 700-704 \nintramarket, 697-700 \npricing differentials, 696-697 \nreverse carrying charge market, 697 \nTED spread, 701-702, 712-714 \nsummary, 720-721 \nFutures spread, futures option strategies for, 696-721 \n(see also Futures option strategies) \nGamma, 853-859, 867, 882 \nneutral spread, 882 \nGamma of the gamma, 865-866, 902-905 \nGARCH (Generalizes Autoregressive Conditional \nHeteroskedasticity), 731-732, 814, 819 \nGeneral Electric (GE), 567 \nGeneral Motors (GM), 567 \nGold and Silver Index (XAU), 588, 719 \nGood-until-canceled order, 34 \nGovernment National Mortgage Association \ncertificates, 420 \nGraphs, 957-960 \n\"Greeks,\" 848-866 (see also Advanced concepts) \ncalculating, 901-902 \nto measure excess value, 763-764 \nHedge ratio, 99-101, 457 \nadvantages of, 482-485 \ndelta spread, 484 \nneutral spread, 483-485 \nHedge wrapper, 275 \nHedging, futures contracts and, 653-655", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1056", "doc_id": "c370c7caa94beb420d3da82432a341bdf61fdac83817441e62cead4985288186", "chunk_index": 0}
{"text": "990 \nIndex spreading (continued) \nspreads using options, 583-584 \noptions, using in index spreads, 584-587 \nstriking price differential, 587 \nvolatility differential, 587 \nsummary, 588 \nValue Line Index, 579, 582 \nInflection points, 792-793 \nInsider trading, 7 45-7 46 \nInstitutional block positioning, 482-485 (see also \nMathematical applications) \nInstitutional use of market basket strategies, 556 \nInter-index spreading, 579-587 (see also Index \nspreading) \n\"Interest play\" strategy, 438-439 \nInterest rates, effects of on LEAPS, 371-37 4 \nIntermarket futures spreads, 700-704 \nIntermediate-term trading, call buying and, 102-103 \nIntramarket futures spreads, 697-700 \niShares, 638 \nJapanese Nikkei 225 Index, 532, 601 \nKicker, 136, 169 \nLEAPS (Long-term Equity AnticiPation Securities), 5, \n367-410 \nbasics, 368-369 \nexpiration date, 368 \nstandardization less, 368 \nstriking price, 369 \ntype,368 \nunderlying stock and quote symbol, 368 \nand call buying, 95 \ndefinition, 367 \ndividends, effects of, 371-37 4 \nto establish collar, 279 \nhistory, 367 \nand implied volatility, 735, 736 \nindex options, 505-506 \ninterest rates, effects of, 371-372 \nand long-term trading, 103 \noptions, 616-617 \npopularity, 367 \npricing, 369-37 4 \nrho, 864-865 \nselling, 390-403 \nassignment, early, 401-402 \ncovered writing, 390-396 \nincremental return, 391 \nrolling down, 394 \nIndex \nshort LEAPS instead of short stock, 400-402 \nstraddle selling, 402-403 \nuncovered call selling, 399-400 \nuncovered LEAPS, 396-399 \nwhipsaw, 403 \nshort-term options, three sets of comparison with, \n374-375 \nand speculative option buying, 382-390 \nbuying \"cheap,\" advantages of, 385-386 \ndelta, 387-390 \nless risk of time decay, 383-385 \nspreads using, 403-409 \nbackspreads,407-408 \nbull spread using calls, 403-404 \ncalendar spreads, 408-409 \ndiagonal, 405-407 \nstrategies, 375-382 \nbuying LEAPS as initial purchase instead of buy-\ning common stock, 378-381 \nLEAPS instead of short stock, 382 \nmargin, using, 380-381 \nprotecting existing stock holdings with LEAPS \nputs, 381-382 \nas stock substitute, 375-378 \nsummary, 409-410 \nsymbols, 26-27 \nwriting against, 91, 94 \n\"Leg\" into spread, 171 \nout of spread, 180, 207 \nout of put calendar spread, 335 \nLetter of guarantee, 43 \nLimit bid, 679 \nLimit offered, 680 \nLimit order, 28, 33 \n\"Locals,\" 509 \nLocked-in loss, 73-76 \nLocking in profits, four strategies for, 108-1 11 \nLognormal distribution of stock prices, 783-81 I \n(See also Stock prices, distribution oO \nLong-term Equity AnticiPation Securities (LEAl'Si \nSee also LEAPS \nLong-term trading, call buying and, 103 \nMaintenance margin, 509 \nMajor Market Index (XMI), 499 \nMarket basket of stocks, 531-537 (see also Stock ind,·\\ \nhedging strategies) \nMarket dynamics, nonquantifiable, as influt·11t·,· 011 \nmarket price, 15 \nMarket-makers, 22 \nMarket order, 32 \nMarket not held order, 33 \n\"Married\" put and stock for tax purposC's, !J:l I", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1058", "doc_id": "eeed7e64e55a122651b3180ae0053e3571d35fbfa8677e7ef04ca2560c50709c", "chunk_index": 0}
{"text": "992 \nOption purchase and spread, combining, 339-341 (see \nalso Spreads combining calls and puts) \nOptions: \narbitrageurs, role of, 19-21 \nrisk arbitrage, 21 \nassignment, 7, 16-17 \nanticipating, 18-22 (see also Assignment) \nmargin requirements, 15-17 \nclasses and series, 5-6 \nclosing transaction, 6 \ncommissions, 17-18 \ndefinition, 3-4 \nas derivative security, 4 \n\"European\" exercise options, 7 \nexercising, 6-7, 15-16 \nafter, 17 \nearly, due to discount, 19-20 \nearly, due to dividends on underlying stock, 20-22 \npremature, 19-22 \nholder, 6 \nin-the-money, 7, 8 \nLEAPS, 5 \nsymbols, 26-27 \nmarkets, 22 (see also Option markets) \nopen interest, 6 \nopening transaction, 6 \noption price and stock price, relationship of, 7-9 \norder entry, 32-34 \ngood-until-canceled order, 34 \ninformation, 32 \nlimit order, 33 \nmarket order, 32 \nmarket not held order, 33 \nstop-limit order, 33-34 \nstop order, 33 \nout-of-the-money, 7 \nparity, 8-9 \npremature exercise, 19-22 (see also Options, exercis\ning) \npremium, 7-8 \nprice, factors influencing, 9-15 (see also Price of \noption) \nprofits and profit graphs, 34-35 \nspecifications, four, 4 \nstandardization, 4-5 \nexpiration dates, 5 \nstriking price, 5 \nsymbology, 23-27 \nCBOE's Web site, 23 \nexpiration month code, 23 \nLEAPS, 26-27 \noption base symbol, 23 \nstock splits, 27 \nstriking price code, 24-25 \nsummary, 27 \nwraps, 25-26 \ntime value premium, 7-8, 11 \ntrading details, 27-32 \nlimit order, 28 \none-day settlement cycle, 28 \nposition limit and exercise limit, 31-32 \nrotation, 28 \nvalue, 4 \nas \"wasting\" asset, 4 \nwriter, 6 \nIndex \nOptions to buy, selecting, 101-103 (see also Call buying) \nOptions Clearing Corp. (OCC), 6, 15-16, 673 \nOptions on futures, 660-673 (see also Futures and \nfutures options) \nOptions and Treasury bills, buying, 413-421 \nadvantages, 413, 421 \nannualized risk, 416-418 \nexcessive risk, avoiding, 420-421 \nhow strategy works, 413-421 \nrisk adjustment, 418-420 \nrisk level, keeping even, 415-416 \nsummary, 421 \nsynthetic convertible bond, 414 \nOrder entry for options, 32-34 (see also Options) \nOriginal Issue Discount (OID), 592-593 \nOut-of-the-money: \ncall spread, 222-225 \ncovered writes, 43-45, 93 \ndefinition, 7 \nfor put options, 246-247 \nOutright option purchases and sales, effect of, on \nimplied volatility changes on, 757-762 \nPairs trading, 454-455 \nParity, 8-9 \nPercentile of implied volatility approach, 814-818 \ncomposite implied volatility reading, 815 \nhistorical and implied volatility, comparing, 817-818 \nPERCS (Preferred Equity Redemption Cumulative \nStock), 91, 619-637 \ncall feature, 620-622 \nredemption price, 622 \nsliding scale, 620-621 \ncovered call write, equivalent to, 622-623 \ndefinition, 619 \nlife span, 619 \nowning as equivalent to sale of naked put, 626 \nprice behavior, 623-625 \nstrategies, 625-636 \ndelta of imbedded call, using, 630-631 \nhedging PERCS with common stock, 631-6:32 \nissue price, determining, 633-634", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1060", "doc_id": "3c916a19b95d3d2cefcd240ef834e1e1e57a4c15ec239e2438bc3abea10725fa", "chunk_index": 0}
{"text": "994 \nPut option basics (continued) \nstrategies, 245-247 \ntime value premium, 246-247 \nPut option buying, 256-270 \nas alternative to short sale of stock, 256-258 \npurpose, 256 \nequivalent positions, 270 \nprotected short sale, 270 \nfollow-up action, 262-266 \ncall option, 264 \nlisted call, buying, 263 \nprofits, five tactics for locking in, 262-266 \nloss-limiting actions, 267-270 \ncalendar spread strategy, 269-270 \n\"rolling-up\" strategy, 267-269 \nmargin account required, 269 \nranking prospective purchases, 261-262 \nselection of which put to buy, 258-261 \ndelta, 260-261 \nin-the-money puts, concentrating on, 259 \nPut option strategies, 243-410 (see also under particular \nheading) \nbasics, 245-255 \nbuying, 256-270 \ncall and put strategies, similarities between, 244 \nLEAPS, 367-410 \nlisted put options newer than listed call options, 244 \nput, sale of, 292-301 \nput buying in conjunction with call purchases, \n281-291 \nput buying in conjunction with common stock own-\nership, 271-280 \nput spreads, basic, 329-335 \nratio spreads using puts, 358-366 \nspreads combining calls and puts, 336-357 \nstraddle, sale of, 302-320 \nsummary, 366 \nsynthetic stock positions created by puts and calls, \n321-328 \nPut options, assignment of, 7 \nPut spreads, basic, 329-335 \nbear spread, 329-332 \nadvantage over call bear spread, 330-332 \nas debit spread, 329 \nbull spread, 332-333 \nas credit spread, 332 \nformulae, 333 \nrisk limited, 333 \ncalendar spread, 333-335 \nbearish, 334-335 \nneutral, 334 \noption spreads, three simplest forms of, 329 \nIndex \nQualified covered calls, 961-962 \nRatio calendar combination, 364-366 (see also Ratio \nspreads using puts) \nRatio calendar spread, 222-225 (see also Calendar and \nratio spreads) \nRatio call spreads, 210-221 \nand calendar spreads, combining, 222-229 (see also \nCalendar and ratio spreads) \ncombination of bull spread and naked call write, 212 \ndefinition, 210 \nfollow-up action, 217-221 \ndelta, adjusting with, 219-221 \nequivalent stock position (ESP), using, 220-221 \nprofits, taking, 221 \nratio, reducing, 218-218 \nphilosophies, three differing, 213-217 \naltering ratio, 215-216 \nas ratio write, 213-214 \n\"delta spread,\" 213, 216-217 \nfor credits, 213, 214-215 \npreferred over ratio writes, 211-212 \nratio write, similarity to, 210 \ndissimilarity, 210-211 \nsummary, 221 \nRatio call write equivalent to naked straddle write, 306 \nRatio call writing, 146-171 \ncall spread strategies, introduction to, 168-171 \ncredit/debit spread, 170 \ndiagonal spread, 169 \nhorizontal spread, 169 \nkicker, 169 \n\"leg\" into spread, 171 \nlong/short side, 170 \nsplitting quote, 171 \nspread, definition, 168 \nspread order, 169-171 \nvertical spread, 169 \ncombination of covered call writing and naked call \nwriting, 146, 150 \ndefinition, 146 \ndelta-neutral trading, 167-168 \nfollow-up action, 158-168 \naltering ration of covered write, 160 \nclosing out write, 166-167 \ndelta, adjusting with, 160-163 \nequivalent stock position (ESP), 162-163, 167 \nposition delta, 162-163, 167 \nrolling up/down as defensive action, 160 \nstop orders, using as defensive strategy, 163-166 \n\"telescoping\" action points, 166-167 \ninvestment required, 150-151 \nand ratio call spreads, similarity to, 210", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1062", "doc_id": "a3f5c97502c8557611b3f5efdf84cf0a94c73f496de1fba7681e7f809180ca56", "chunk_index": 0}
{"text": "996 \nSIS (Stock Index return Security) (continued) \ntrack record, 598, 599 \ntrading at discount to cash value, 598-600 \ntrading at discount to guarantee price, 600-601 \n60/40 rule, 919-920 \nSPAN (Standard Portfolio Analysis of Risk), 514-515, \n667-671 \nadvantages,667 \nexample, 668, 669, 670 \nhow it works, 667-671 \nmaintenance margin, 667 \npurpose, 667 \nrisk array, 667, 668, 669 \nSpeculating in futures contracts, 655-656 \nSplitting quote, 171 \nSplitting strikes, 325-328 (see also Synthetic stock \npositions) \nSpot/spot price for futures contracts, 658 \nSpread, diagonalizing, 236-241 \nadvantage,236,241 \nbackspreads,240-241 \neven-money spread, 240 \nbear spread, 239-240 \nbull spread, 236-239 \noften improvement over normal bull spread, 239 \ndefinition, 236 \nfor any type of spread, 241 \nSpreads, 76, 168-171 (see also under particular head) \nbackspread,232-235 \ndiagonal, 240-241 \nbear, using call options, 186-190 \nbull, 110-111, 113-116, 117, 172-185 \nbutterfly, 200-209 \ncalendar, 116-117, 191-199 \ncategories, three, 169 \ndefinition, 168 \ndiagonal, 169, 236-241 (see also Spreads, \ndiagonalizing) \neven money, 240 \nhorizontal, 169 \nusing LEAPS, 403-409 (see also LEAPS) \n\"leg\" into, 171 \nout of, 180, 207 \nout-of-the-money call spread, 222-225 \nratio call, 210-221 \nreverse, 230-235 \nreverse calendar, 230-232 \nreverse ratio, 232-235 \nunequal tax treatment on, 929-930 \nvertical, 169 \nSpread order, 169-171 \nSpreads combining calls and puts, 336-357 \nbutterfly spread, 336-338 \narbitrageur, role of, 338 \nbox spread, 338 \ncommissions high, 338 \nIndex \nequivalent of completely protected straddle write, \n338 \nestablishing, four ways for, 336-338 \nstriking prices, three, 336 \ncalendar combination, 345-348, 353-354, 356-357 \nsuperior to calendar straddle, 349-350 \ncalendar straddle, 348-350, 354, 356-357 \nas neutral strategy, 349 \ncriteria for, three, 354 \ninferior to calendar combination, 349-350 \ndiagonal butterfly spread, 350-353, 354-355, 356-357 \ncriteria, four, 355 \nlegging out, 351-352 \nfollow-up action for bull or bear spreads, 341-344 \noption purchase and spread, combining, 339-341 \nbearish scenario, 341, 342 \nbullish scenario, 339-340, 342 \nselecting, 353-356 \ncriteria, five, 353-354 \nsummary, 356-357 \nStandard Portfolio Analysis of Risk (SPAN), 514-515 \nStandard & Poor (S&P): \nDepository Receipt (SPDR), 637-638 \nexpiration, 510-511 \n100 Index (OEX), 497, 500-501, 582-583 \n400 Index, 497 \n500 Futures, 532 \n500 Index (SPX), 497, 502, 507, 583, 584 \nStandard & Poor's Stock/Bond Guide, 88 \nStock: \nbuying below its market price, 299-300 \nunderlying, price of as related to option price, 9-10 \nStock index hedging strategies, 531-578 \nfollow-up strategies, 557-559 \nrolling to another month, 557-559 \nimpact on stock market, 561-565 \n\"circuit breaker\" of NYSE, 562 \nat expiration, 564-565 \nbefore expiration, 561-563 \nportfolio insurance, 563-564 \nregulatory bodies, concern of, 562 \ntrading ban, 562 \nindex, simulating, 566-574 \nhedge, monitoring, 572-573 \nhigh-capitalization stocks, using, 566-571 \nlargest-capitalization stocks, four, 567 \noptions instead of futures, using, 573-57 4 \nregression analysis, 566 \ntracking error risk, 571-572 \nindex arbitrage, 547-556 \ncommissions, 552-554 \ncomputerized method of order entry, 555-556", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1064", "doc_id": "3f99b84ad9df396fc6968c0a47b71808d39421b73fc022ac5145e14d1a44b7c4", "chunk_index": 0}
{"text": "998 \nStriking price: \nas factor influencing price, 9-10 \ncode, 24-25 \ndefinition, 3, 4 \nfractional, 29 \nstandardization, 5 \nStructured products, 589-640 \nadjustment factor, 602-604 \ncost, measuring, 605-607, 608 \nbreak-even final index value, 604-605 \nexotic options, 590 \nimbedded call, computing value of when underlying \nis trading at discount, 602 \nincome, products designed to provide, 618-639 \ncovered write of call option, resembling, 619 \nCreation Units, 638 \nDiamonds, 638 \nExchange-Traded Funds (ETFs), 637-639 (see \nalso Exchange-Traded Funds) \nHOLDRS, 639 \niShares, 638 \nNASDAQ-100 tracking stock (QQQ), 638, 639 \noptions on ETFs, 639 \nPERCS (Preferred Equity Redemption \nCumulative Stock (PERCS), 619-637 (see also \nPERCS) \nRussell 2000 Value Fund and 2000 Growth Fund, \n638 \nmore appeal for investors than for traders, 589 \n\"riskless\" ownership of stock or index, 590-618 \nannual adjustment factor, 594 \nbull spread, 608-612 \ncash value, 593-594 \nconstructs, other, 607-613 \ndividends, 594 \nequity-linked notes, 618 \nfinancial engineers, role of in structured products, \n590,607 \nimbedded call option, cost of, 594-595 \nincome tax consequences, 592-593 \nLEAPS options, 616-617 \nlist, 618 \nmultiple expiration dates, 613 \nmultiplier, 614 \noption strategies involving structured products, \n613-618 \nOriginal Issue Discount (OID), 592-593 \nphantom interest, 592 \nprice behavior p1ior to maturity, 595-596 \nSIS (Stock Index return Security), 596-601 (see \nalso SIS) \nstrike price, 592, 615-618 \nstructure, 590-593 \nwhen underlying index drops, 617 \nIndex \nsummary, 640 \nSuitability of strategy for individual investor, 3 \nSwiss franc contract for foreign currency options, 672 \nSymbology, options, 23-27 (see also Options) \nSynthetic convertible bond, 441 (see also Options and \nTreasury bills) \nSynthetic long call, 271 \nSynthetic long stock, 321-323 \nSynthetic stock positions created by puts and calls, 321-\n328 \nsplitting strikes, 325-328 \nbearishly oriented, 327-328 \nbullishly oriented, 325-327 \nprotective collar, 328 \nsummary, 328 \nsynthetic long stock, 321-323 \nsynthetic short sale, 323-325 \nleverage, 324 \n\"Synthetic\" strategies, 118 \nput, 118-121 \nTau, 859-862 \nTax considerations, put purchase, 275 \nTaxes, 908-931 \nassignment, 914-920 \napplicable stock price (ASP), 917 \nqualified covered call, 917-920, 961-962 \n\"too-deeply-in-the-money\" definition, 916 \nequity options, strategies for, 925-930 \ndeferring put holder'sshort-term gain, 928 \ndeferring short-term call gain, three tactics for, \n928 \ndifficulty of deferring gains from writing, 928-929 \nspreads, unequal tax treatment on, 929-930 \nexercise, 913-914 \nhistory, 908-909 \n\"married\" put and stock, 924 \n\"new\" stock, delivering to avoid large long-term gain, \n920-921 \n\"versus purchase\" notation 921 \noption as capital asset, 908 \nproblems, special, 922-925 (see also under particular \nproblem heading) \nprofit strategies and tax strategies, separating, 931 \nprotecting long-term gain/avoiding long-term loss, \n924-925 \nput assignment, 921-922 \nput exercise, 921 \nshort sale rule, 923-925 \nsummary, 925, 930-931 \ntax treatment, basic, 910-913 \ncall buyer, 910-911 \ncall writer, 910, 911-912", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1066", "doc_id": "7e7de33b23a5b6773accbdb4a4a675c979291efacce23aa3afef091c8ac37463", "chunk_index": 0}
{"text": "1000 \nVolatility trading, basics of (continued) \n\"fudge factor,\" 731, 733 \nimplied volatility, 727, 732-743 \nas predictor of actual volatility, 737-7 43 \nLEAPS, 735, 736 \npercentile, 734-735 \nrange, 735-737 \ntime left in option, 736-737 \nVolatility Index ($VIX), 738 \nmoving averages, 732 \nsummary, 748 \ntrading, 7 43-7 44 \nwhy volatility reaches extremes, 7 44-7 48 \nbear market in underlying stock, 746-747 \ncheap options, 747-748 \nilliquid options, 745-746 \ninsider trading, 7 45 \nsellers of volatility, danger for, 7 48 \nsupply and demand of public, 747 \nVolatility trading techniques, 812-845 \nas art and science, 812 \nsummary, 844-845 \ntrading volatility prediction, 814-837 \nbackspreads, 827, 834-836 (see also Volatility \ntrading techniques, volatility backspread) \ncalendar spread, selling, 833 \ncomposite implied volatility reading, 815 \nhistogram, construction of, 831-832 \nhistorical volatility, comparing current and past, \n821-824 \nimplied and historical volatility, comparing, 817-\n818 \npercentile of implied volatility approach, 814-817 \nprobability calculator, 824, 827-829 \nreverse calendar spread, 833-834 \nselecting strategy to use, 824-826 \nselling volatility, 826-827, 833-836 \nstock price history, using, 829-832 \nsummary, 836-837 \nvolatility chart, reading, 818-821 \nwhen volatility is out of line, determining, \n814 \nvolatility backspread, 827, 834-836, 841 \nmargin, 836 \nnot for LEAPS options, 835 \nvolatility skew, trading, 837-844 \ncollar, 840 \nIndex \ndiffering implied volatilities on same underlying \nsecurity, 837-838 \nforward/positive volatility skew, 843 \nreverse/negative volatility skew, 839-840 \nsummary, 844 \nwrong predictions, two ways for, 813 \nvolatility skew, 813 \nWarrants: \ncovered writing against, 90-91 \nrho, 872-873 \nWash sale rule, 922-923 \nWhipsaw, 403 \nWrap symbols, 25-26 \nWriter, definition, 6 \nXMI (Major Market Index), 499", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:1068", "doc_id": "4e421ba7770f0d4e9422261d9586e591d604b92475067e2e570f8f5a98b8e198", "chunk_index": 0}
{"text": "such as buying acar. You’ve been saving up for afew months, but you’re not quite ready to head to the dealership—except, one day, you drive past alocal salesroom and spot the hatchback of your dreams.\nBecause you want to buy that car, you decide to speak with the dealer and negotiate. You work out adeal that will allow you to buy the vehicle from him in two months for the price of $10,000. Because the dealer is agreeing to keep the car for you and fix the price, you will also be paying $300 to secure that option for yourself.\nThe two months start to pass and one of two things might happen:\nThe dealer opens the hood of the vehicle and discovers it has an engine system that’scompletely one of akind and was atest by the manufacturer. That makes the car ultra valuable as acollector’sitem. Under normal circumstances, the dealer would instantly double its asking price—but, because he made an agreement with you, he can’t. He is obligated to sell that car to you as long as you buy it before the two months are up. Obviously, you’re keen to exercise that right, so, you purchase the car for $10,000 and decide to sell it for $20,000—doubling your money in the process.\nThe dealer opens the trunk of the vehicle and discovers that it contains adead body. It’sremoved and the car is cleaned but the police investigation causes quite abit of damage. The value of the vehicle halves and, under normal circumstances, the dealer would slash the asking price to $5,000. However, because you entered into the agreement, the dealer must still sell you that car at the agreed price of $10,000. On the other hand, because you as the buyer are not obligated to make the purchase, you can always decide to walk away and see what the Toyota dealer has in stock instead. You won’thave lost because of the $5,000 value, but the dealer will get to keep the $300 you paid to create the opportunity for yourself in the first place.\nThat, in anutshell, is how options trading works. As the buyer of an option, you are in exactly the same position as you would be if you had gone out to buy that car. You cannot know what the future will bring—and it does have ahabit of throwing out the unexpected—but you can make adecent prediction.\nNow, let’szoom in alittle bit closer. Though options trading really is as simple as the example we just looked at, there are afew more things you need to know in more detail before we move on.\nFirst, as mentioned above, there are two types of options:\nCalls:\nThey give the right to BUY an asset at aspecified price before the time limit expires. You’ddo this, for example, if you felt confident that acertain stock was going to continue rising in price for aperiod of time. The call allows you to purchase that stock at alower price at atime when it has risen to amuch greater value.\nPuts:\nThey give the right to SELL an asset at aspecified price before the time limit expires. You’ddo this, for example, if you felt confident that acertain stock was going to continue dropping in price for aperiod of time. That would allow you to sell that stock at ahigher price at atime when it is worth awhole lot less.\nLet’stranslate what we know into atrading example so that you can see how options trading works in the real world. This time, we’ll look at aput because, as you are now aware, the example of purchasing avehicle was an illustration of acall—you obtained the right to BUY before the deadline.\nThis time, we’ll look at what might happen if you purchased aput option which would give you the right but not the obligation to SELL before adeadline. We’ll assume you’re looking at aparticular stock in your portfolio that is currently trading at $1. Knowing the market, you have predicted that it is going to drop to $0.50 within the next three months.\nYou purchase an option with atrader that will allow you to sell the stock in three months at $0.75. If, during the interim, it turns out you are correct and the stock drops to $0.50 you have made aprofit of $0.25 on the sale. If, on the other hand, you were wrong in your prediction and the stock climbs to $1.20 you have no obligation to sell it and lose that $0.20 profit.\nTo understand this example fully, it’simportant to know the difference between abuyer and aseller as it’slikely that you’ll end up filling both roles over the course of your options trading experience.\nAbuyer is NOT OBLIGATED to actually buy or sell the stock when the deadline arrives. What he or she has bought is the right to make that purchase or sale but it is not an obligation.\nAseller is OBLIGATED to buy or sell the stock when the deadline arrives. As the seller, you made apromise when the contract was agreed to and you must fulfill it when the time comes no matter what the consequences might be.\nIf follows, therefore, that you could find yourself in four very different situations during an options trading event. Let’soutline them for your reference as that is often where it can start to seem confusing.\nCall buyer\n—you have the choic", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 1}
{"text": "n the time comes no matter what the consequences might be.\nIf follows, therefore, that you could find yourself in four very different situations during an options trading event. Let’soutline them for your reference as that is often where it can start to seem confusing.\nCall buyer\n—you have the choice to buy astock at the deadline but you are not obligated to do so.\nPut buyer\n—you have the choice to sell astock at the deadline but you are not obligated to do so.\nCall seller\n—you are obligated to sell astock at the deadline and you will keep the premium that was included to secure the deal.\nPut seller\n—you are obligated to buy astock at the deadline and you will keep the premium that was included to secure the deal.\nThere are more intricacies to options trading but we’ll cover those in more detail later. First, make sure you have afull understanding of the basics—they are the essence of options trading and the heart of your experience as atrader.\nWhy Options Rather than Stocks?\nOne very good question that newcomers often ask is why atrader would want to trade in options rather than stocks. What’sthe difference? Is one better than the other?\nIt’strue that the stock market is less complicated to work with. All you really need to worry about in the case of the stock market is the direction things are heading. Down is bad for your shares but could be good for buying. Up is good for your shares and could be good for selling.\nWith stock trading, you are also seldom going to lose 100 percent of your investment if things go sideways. If you pick astock thinking it will climb but instead it plummets, you can sell quickly and lose only the difference between your initial investment and the price of that stock as you sell.\nNot so with options trading, where you will lose the lot if you make abad judgment call. Stock trading can be agreat introduction to the market but it is not as flexible and it is less likely to win big compared to an options trade.\nWhen you enter the options trading market, you quickly find out that you actually have three things to worry about—and what those things are doing is not so simple as “down is bad, up is good.” You are interested in the direction stocks are heading but you can make big money on adownward direction as easily as upward if you make the right call. Meanwhile, you are also concerned about your timing and the magnitude of the trade.\nIn anutshell, the biggest reason to choose options over stocks is that it provides you with flexibility within your own portfolio and allows you to play the market at its own game whether you are abull or abear.\nSo let’stake acloser look at options trading and its benefits, shall we?\nWhy is Options trading Worth the Risk?\nSo, what’sthe point of all this horse trading? If, while reading the previous chapters, it seemed that options trading involves alot of risk and an uncertain gain, you might be interested to know that that’snot necessarily the case. It all depends how you go about trading your options.\nWhile, yes, you can place your focus on awhole slew of risky ventures and you would stand to either lose afortune or gain even more, that’snot the only way to trade options. Let’stake alook at the advantages of options trading.\nWhen you trade in options, the uncertainty lessens. You create an option that tells you exactly how much you will either lose or gain once the deadline arrives—unlike trading in stocks, you are not at the mercy of the markets. You have confirmation from the outset as to what you will either receive or spend on aparticular date.\nOptions are more versatile than stocks and that means you can make money no matter what the state of the market is. It doesn’tmatter if stocks are dropping as it would if you were simply trading in stocks. With an option strategy, you can take advantage of what’shappening in the markets in either direction.\nYou can also use options trading as aform of security to protect your investments. That might sound strange, but it’sactually avery common strategy known as “hedging.” If, for instance, you are concerned that astock you own alarge amount of is set to drop, but you’re not completely sure, you can use an options trade to protect yourself against that possibility. You would simply buy aput that would allow you to sell that stock at agreatly reduced loss at the deadline—you wouldn’tbe obligated to make that sale if you turned out to be wrong but you can do so if your fears prove to be well founded.\nYou can also “hedge” to protect yourself against risk altogether. If it seems that the market as awhole is set to drop over the coming months, you can hedge your entire portfolio by buying exchange-traded funds. Those will actually gain value as the market drops in value—it’savery common strategy among the experts.\nThe opposite of “hedge” is to “speculate” and it’sone of the most profitable ways to invest if it’sdone properly. Beware, however, that it is also the strategy that carries the most risk. By speculat", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 2}
{"text": "e will actually gain value as the market drops in value—it’savery common strategy among the experts.\nThe opposite of “hedge” is to “speculate” and it’sone of the most profitable ways to invest if it’sdone properly. Beware, however, that it is also the strategy that carries the most risk. By speculating, you can leverage the investments you have made and you have the chance to make alot of money in the process—all for arelatively small cost.\nFinally, arguably the most important advantage of options trading is that you don’tneed to know the complicated and advanced strategies in order to prevail. Actually, it’sthe simple strategies that are very often the best. That means you can dive into options trading with the confidence that you can learn as you go without sacrificing your potential for profit.\nHow to Get Started in Options trading\nWalking you through the learning curve of options trading will always start with the most basic move you’ll need to make—setting yourself up in aposition to actually be able to trade.\nTo trade in options, you’re going to need an options account. Don’tworry, we’re going to talk awhole lot more in the coming chapters about what to do with your account once you have it. For now, it’simportant that you know your starting point and just how easy it is to reach it.\nOne thing to know before you pick your firm is that times have changed considerably over the last couple of decades when it comes to options trading. Back before the internet became such aconstant part of our lives, your brokerage firm—or, at least, your personal representative at the firm—would make your options trades on your behalf and you paid ahefty price for their services. Nowadays, however, you’ll be doing most of your trades yourself.\nCommissions for your representative is, thus, awhole lot lower than it used to be which means it won’tcost you an arm and both legs to rely on your rep in the early days of your experience with options. While you are learning, feel free to make use of your firm’sservices to place and confirm your trades if it helps you to feel more comfortable getting to know the process.\nWith that in mind, there are going to be certain things to look for when you select your firm.\nCompare commission prices to make sure you’re getting agreat deal.\nMake sure the firm has up-to-date software and is capable of setting up trades quickly and reliably to make sure you get the trades you want at the best prices.\nCheck out the hours of service to ensure the firm is compatible with your needs. In these days of online firms, you could be dealing with afirm that’sacross the ocean from the markets you have an interest in. Or you might find that afirm only makes its reps available for the length of the working day and that might not suit your own timing.\nSpeak personally with the reps at the firm because these are the people who are going to help you during the process of setting up your strategy. You want someone who is personable and knowledgeable—and, most importantly, who speaks in terms that you personally find easy to comprehend.\nTake alook at the additional services the firm supplies. Many will offer learning materials, guides, and even classes or webinars to help you hone your strategies. Even if you feel that you already know what you need to know, there’sno harm in arefresher course or alittle nugget of inspiration every once in awhile.\nOnce you select afirm, you’ll then need to consider signing a “margin agreement” with that firm. That agreement allows you to borrow money from the firm in order to purchase your stocks, which is known as “buying on margin.”\nUnderstandably, your brokerage firm is not going to allow you to buy on margin if you don’thave the financial status to pay them back. They will, therefore, run acredit check on you and ask you for information about your resources and your knowledge.\nAmargin account is not anecessity for options trading—you don’tactually use margin to purchase an option because it must be paid for in full. However, amargin account can be useful as you graduate to more advanced strategies and, in some cases, it will be obligatory. If you opt to sign amargin agreement, talk it through thoroughly with the firm as there are certain restrictions on the type of money you can use that may apply to you.\nNext, you’ll need to sign an “options agreement.” This time, it’san obligatory step. That agreement is designed to figure out how much you know about options and how much experience you have with trading them. It also aims to ensure that you are absolutely aware of the risks you take by trading options and it is to make sure that you are financially able to handle those risks.\nBy ascertaining those things, your firm can determine what level of options trading you should be aiming for. It will, therefore, approve your “trading level” and there are five levels.\nLevel 1: You may sell covered calls.\nLevel 2: You may buy calls and puts and also buy strangles, straddles, and colla", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 3}
{"text": "ascertaining those things, your firm can determine what level of options trading you should be aiming for. It will, therefore, approve your “trading level” and there are five levels.\nLevel 1: You may sell covered calls.\nLevel 2: You may buy calls and puts and also buy strangles, straddles, and collars. You may also sell puts that are covered by cash and by options on exchange-traded funds and indexes.\nLevel 3: You may utilize credit and debit spreads.\nLevel 4: You may sell “naked puts,” straddles, and strangles.\nLevel 5: You may sell “naked indexes” and “index spreads.”\nDon’tworry if you’re not sure yet what each of those things means. You will understand them by the time you finish reading this book. For now, all you need to be aware of is that your firm will determine what level is appropriate for you. As abeginner, don’tbe surprised if you only reach the first two levels.\nOnce you’ve signed the option agreement, you’ll be handed abooklet that contains amine of information about the risks and rewards within options trading. Right now, if you were to read that booklet, it would seem to be in aforeign language. By the time you finish this crash course, it will be alot more understandable—and it’svery important for your success that you do read it.\nFinally, your firm will present you with a “standardized option contract.” It’sthe same for every trader, which means you stand the same chance of success as every other person out there in the options market.\nBy trading an option, you are entering into alegal agreement that is insured by the Options Clearing Corporation, which guarantees the contract will be honored in full. Make sure you read that contract to be aware of not only the rights you have as atrader, but also the obligations you must follow in the same role.\nCongratulations, you now have an options account. That is the conduit through which you will create and implement your strategies and begin your adventure in options trading.\nLearning the Lingo\nOptions traders speak their own language. It’snot meant to confuse you, it’sjust the natural process of creating ashorthand by which one trader can converse with another more easily and thoroughly.\nOf course, it does make it difficult to plunge into the waters of options trading if you can’tspeak the language. It is alot like trying to decipher road signs in aforeign country. It makes it hard to know the right direction—or even where you’re standing right now.\nWe’re going to take alook at the common terms you’ll be dealing with as you enter the world of options trading before we begin taking adeeper look at your strategies.\nDon’tworry about trying to learn the terms by rote. They will all become clear as you forge onward. This glossary will always be available to you so that you can check on ameaning if you need to.\nStrike Price:\nAprice per share agreed upon before an option is traded. At that price, stock may be bought or sold under the terms of your option contract. This price is also known as the “exercise price.”\nBid/Ask:\nThe latest price that amarket maker has offered for an option is its “ask” price. In other words, it’swhat the seller is willing to accept for the trade. The latest amount that abuyer has offered for an option is the “bid” price.\nPremium:\nThe premium is aper-share amount paid to the seller in order to procure an option. The seller will keep that premium whether or not the buyer exercises their right to buy or sell the stock at the deadline.\nIn-the-Money:\nOften shortened to ITM, that means that the stock price is above the strike price for acall or below the strike price for aput. In other words, it is now at the right price to be traded.\nOut-of-the-Money:\nOften shortened to OTM, that means the current price is below the strike price for acall or above it for aput. Such an option is priced according to “time value.”\nAt-the-Money:\nThe strike price is equal to the current stock price.\nLong:\nIn this context, “long” is used to imply ownership. Once you purchase astock or option, you are “long” that item in your account.\nShort:\nIf you sell an option or stock that you do not actually own, you are “short” that security in your account.\nExercise:\nThe owner of the option takes advantage of the right to buy or sell what they purchased with the option by “exercising” it.\nAssigned:\nWhen an owner of an option exercises it, the seller is “assigned” and must make good on the trade. In other words, the seller must fulfill their obligation to buy or sell.\nIntrinsic Value/Time Value:\nThe intrinsic value of an option refers to how much it is ITM. Most options also include time value and that refers to how long is left until the option expires. That time has value because during that time the stock can still change in price. An OTM option has no intrinsic value because it’saloss but it does have time value because that loss might change.\nTime Decay:\nLinked to time value, that term refers to the fact that, as time ticks on, the amount of time value slowly d", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 4}
{"text": "ue because during that time the stock can still change in price. An OTM option has no intrinsic value because it’saloss but it does have time value because that loss might change.\nTime Decay:\nLinked to time value, that term refers to the fact that, as time ticks on, the amount of time value slowly decreases. At the expiration date of an option contract, the contract has NO time value and is worth only its intrinsic value.\nIndex Options/Equity Options:\nIndex options are settled by cash whereas equity options involve trading stock. The main difference between those two types of options is that an index option usually cannot be exercised before the expiration date while an equity option usually can.\nStop-Loss Order:\nThat is an order to sell either an option or astock when it reaches aparticular price. Its purpose is to set apoint at which you, as the trader, would like to get out of your position. At that price, your stop order is activated as amarket order. In other words, amarket order looks for the best available price at that moment in order to close out your position.\nThose are the most common terms you will hear used as you venture into the world of options trading. It’sworth mentioning that, as you extend your understanding, you’ll encounter more terms. However, the above terms are enough in order to help you understand your first trades.\nThe Role of the Underlying Stock\nIt’svital to understand that stocks do play afundamental role in options trading—even though they may not be what you are buying and selling. Bear in mind that an option is only apiece of paper that gives you the right to buy or sell astock. Without the stock, you would have nothing to buy or sell.\nYou might say that the stock is Oz behind the curtain, changing and moving while your attention is fixed elsewhere. Letting Oz get up to his tricks without you is abad idea. You need to be keeping an eye on your stocks just as much as you follow the options themselves.\nNot every stock is allowed to have its options traded on an options exchange. In total, you’ll find somewhere in the region of 3,600 stocks spread across twelve different exchanges, although that number changes all the time.\nWhat does that mean? Well, the exchanges have in place some very solid rules that dictate which stocks may and may not participate in options trading. You’ll find some of the biggest business names on the planet have options, and you’ll also find what are known as “penny stocks” which buy and sell for less than $3.\nIn general, penny stocks won’tdo you much good for options trading. There simply isn’tenough liquidity in such asmall price for you to bother with the effort required to trade them.\nInstead, Iwould recommend sticking with the big names—the recognizable companies such as Microsoft, Apple, Google, and McDonalds.\nAnother point to bear in mind is that there is afixed relationship between options trading and the underlying stock. One option contract will always be equal to 100 stock shares.\nIn other words, asingle contract will give you the right to buy or sell 100 shares of astock. Multiply the number of contracts involved in atrade by 100 and you’ll know how many shares are involved.\nAthird factor of that relationship between an option and its underlying stock is that whenever the stock goes up or down, in most cases so, too, will the option contract.\nBecause astock and its options are so inextricably linked, you will need to study the stock market in detail to be awhiz at options trading. You will need to be able to predict which stocks are going to head in which direction and when—only if you get that right will your trading be truly successful.\nFor that reason, alot of options traders started with the stock market, itself, and gave themselves the experience of the market’swhims before taking astep up to the next level. If you haven’tdone that, it will be worth spending amonth or more trading on the stock market. Even atheoretical portfolio that you manage and never pay apenny to invest in is ahelpful step.\nDoing that will allow you to get asense of how the market functions overall and it will familiarize you with some of the stocks you might be interested in for trading with options. The best options traders have almost asixth sense of how an underlying stock is going to perform. The only way to develop that uncanny ability is through exposure, research, and experience.\nUnderstanding the Strike Price\nWe previously touched on the idea of the strike price, but it’ssuch afundamental aspect of options trading that it bears looking at in greater detail.\nTo review, the strike price is the fixed price at which the underlying stock can either be bought or sold. When you purchase acall option, what you are purchasing is the right to buy astock at acertain price. Selling acall option means that you are selling your buyer the right to purchase astock at acertain price.\nThe strike price is an aspect of every options trade and you will want to hone in on that", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 5}
{"text": ". When you purchase acall option, what you are purchasing is the right to buy astock at acertain price. Selling acall option means that you are selling your buyer the right to purchase astock at acertain price.\nThe strike price is an aspect of every options trade and you will want to hone in on that every time. It’sthat important. Never forget that, if the underlying stock never reaches the strike price, the trade is worthless because the option will simply expire on the expiration date.\nThe difference between the current market price of the stock and the strike price of the option also represents the profit-per-share you can expect to make if you are successful.\nLet’ssay, for example, that you find two trades for astock that is currently worth $150. One has astrike price of $125 and the other has astrike price of $100.\nIn the first trade, the stock price will need to drop to $125 before you have the right to buy it or sell it (depending on whether the option is acall or abuy). In the second, it will need to drop to $100 before you have that right.\nThe value of the option is simple to calculate. It’sthe difference between the strike price and the current price of the stock. In the first of these examples, the trade has apotential worth of $25; in the second, the potential worth is $50.\nAt first glance, that would seem to mean that the second option is the one to go for because its value is so much higher. However, you also need to bear in mind that you cannot dictate what the market does.\nThat is where risk comes in. How confident are you, in this example, that the stock will plummet $50 before the expiration date of the option? If you’re as certain as it’spossible to be, it’sagreat investment. If you’re not, you stand to lose the premium you paid for the option because it will never reach the price at which you have the right to realize the trade.\nThe trade that has astrike price of $125 is, therefore, asurer bet because it’salways going to be more likely that astock will rise or fall by the smaller amount than the larger one. The trade-off, as you can see, is that you won’tmake nearly the profit you would on the riskier option, so, you have to ask yourself whether the premium you’dbe paying is worthwhile.\nBasic Trading: Selling Covered Calls\nAs beginners, most people choose to dip their toes in the complicated waters of options trading by selling covered calls. It’sarguably the most basic level of options trading and, while also not the most adrenaline-inducing, it is agreat way to find your feet before moving on to more complicated strategies.\nSelling covered calls is also likely to be an aspect of your options portfolio in the long-term. Many traders use it as asteady way of generating income and it is aconservative baseline for their account.\nAthird benefit to starting with covered calls is that it includes the majority of the knowledge and strategies that you will use as an options trader, so, it’saperfect training ground.\nUsing that strategy, you are going to be selling the right to buy underlying stocks that you own. A “covered” call is when you own the shares and, therefore, you have the sale covered.\nBefore you can begin, therefore, you will need to own at least 100 shares of astock. By writing an option on those shares, you are offering buyers the right to buy them by the expiration date if the share price hits your strike price.\nWhen abuyer takes advantage of your offer, you will receive apremium. That’syours to take home. You will never have to give it back whether the strike price is met or not and the buyer exercises their right or not. That, right there, is your reason for selling covered calls—the steady influx of cash from the premiums.\nCovered calls are also agood way to sell your stock. Aclever trader will use that strategy to clear their portfolio of shares they no longer want to own. There is an advantage to owning astock in the interim, too, because you may receive adividend. You’ll receive capital gains (the difference between the price now and the increased price at time of sale) if the stock meets your strike price when the expiration date arrives.\nOne final advantage of covered calls is that the strategy can be used in atax-deferred account or an IRA. You won’tbe taxed on the revenue from your trade until you take out money at the time of your retirement. There are caveats to that rule, of course, so you may want to book an appointment with your accountant to make sure it works for you.\nThe downside? There is always the danger that your shares skyrocket before the deadline is up and you are forced to sell them to your buyer anyway, which means you’re losing out on apotential big win. That’sthe gamble and the truth is that even that risk will even out in the end because you’ll be making money on the premiums for those trades that didn’tturn out to be abad idea.\nWhen the expiration date arrives, you will EITHER have the premium in your pocket and no shares or you will have both the", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 6}
{"text": "at’sthe gamble and the truth is that even that risk will even out in the end because you’ll be making money on the premiums for those trades that didn’tturn out to be abad idea.\nWhen the expiration date arrives, you will EITHER have the premium in your pocket and no shares or you will have both the premium and the shares because the buyer didn’tchoose to purchase them after all. Either way, you’re always walking away with something.\nSo, let’swork through selling acovered call, step by step, and take alook at every aspect of the process.\nFirst, choose astock that’salready in your portfolio and has been performing well recently. It also needs to be one that you are willing to no longer own if the buyer exercises their right to buy it.\nIn your account’sonline space, you will first bring up the underlying stock by entering its symbol. That will allow you to see its option chain—in other words, all the bids and calls currently on the table for those particular shares. Obviously, we’re interested right now in the calls. You’re going to be picking one of these offers to sell your shares.\nFirst, take alook at the premiums on those calls. Take alook at the “bid price” column. These are displayed per share, so it’sthe amount you will receive for every share that you trade on. You’ll probably find that there is ahuge range of premiums for the same stock—that’safunction of the market. To be clear on your potential profits—for every option (100 shares of one stock), you will receive the premium for every share. If, for example, the premium is listed as $2.50, you’ll make that amount for every share of the stock. If it’sasingle stock, that’s $2.50 multiplied by 100 or $250.\nYou want to focus on pulling up options afew months from now, so pick adate range about two or three months down the line. That is because the premium will increase the later the expiration date. You want to be reasonable in your expectations, however, because there are downsides to going too far out, so, afew months is usually agolden spot.\nTake alook at the other columns. Compare the “bid price” and “ask price” columns on that list of options. The bid price is the amount that atrader out there somewhere is prepared to pay to own the call option. The ask price is the amount that atrader somewhere has said they are prepared to sell that call option for. You can accept that bid price and you’ll sell your covered call instantly for that amount. Alternatively, you can instruct your broker to sell your option at acertain ask price or better. That won’tbe fulfilled immediately, but it will mean abetter return for you in the long-term if there’sabuyer out there who is willing to accept your price.\nTake alook at the list for options that are currently “in the money.” Most lists will have amark of some kind to denote the ones that are. If an option is in the money, it means that exercising it instantly will yield aprofit—although it does not factor in the cost of buying that option in the first place, i.e., the premium. As an example to illustrate this, imagine that there is acontract with astrike price of $50 and the stock is priced at $52 right now. If the buyer of the option immediately exercises their right to buy that stock, they’dmake aprofit of $2 per share. However, if the premium per share for the option was also $2, the buyer wouldn’tactually gain any net profit.\nWhat you should be looking for is acovered call contract with astrike price that’sslightly “out of the money.” You want to unload your shares at aslightly higher price than they are currently worth to make it agood purchase for your buyer and because you will make aprofit on the actual sale as well as on the premium. If the shares never reach that price, you won’thave to sell them, of course. If that happens, you can simply pocket the premium and list the shares again.\nYou can also consider acontract slightly “in the money” if the premium is high enough to offset the loss you would make on the sale. You should be calculating overall profits rather than relying on just the sale price or the premium alone. The bottom line is that you will need to calculate astrike price you’re happy to sell astock at, whether it’saloss or again, with apremium that makes the sale worthwhile.\nOnce you’ve chosen the contract that best suits your needs, you can simply enter into it and wait for the expiration date. At that time, though sometimes before, your broker will let you know whether the buyer exercised their right or that you still own the stock. Keep in mind that, if your buyer does NOT exercise their right, you have generated acertain amount of money because of the premium. When you repeat the exercise, you can factor that overall profit into your thinking to help guide you toward the next contract.\nTo sell acall option on your stock, select the “Action” that says “Sell to Open” because that is the one that applies for selling acovered call. Now, enter the number of contracts you want to sell—and rememb", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 7}
{"text": "an factor that overall profit into your thinking to help guide you toward the next contract.\nTo sell acall option on your stock, select the “Action” that says “Sell to Open” because that is the one that applies for selling acovered call. Now, enter the number of contracts you want to sell—and remember that one contract equals 100 shares.\nNow, you must choose between amarket order or alimit order. Amarket order allows the market makers to figure out the price to fill your order while alimit order allows you to choose your own price. The latter is usually the better option. Once you’ve selected it, you can decide on your price. The risk is that you might not sell for the price you pick.\nNow, enter the information for how long you want the option to appear in the marketplace. Iwould recommend selecting “day” rather than “until cancelled” because you want to be able to relist with new information if it isn’tpurchased.\nNext, set your bid price, which will likely appear under the heading “Limit Price.” Ignore the information about last sale when you are doing this as there is no way to tell when that last sale actually happened, so, it may not reflect the current bid and ask prices you should be using as aguide.\nThat’sit. Hit the order button. Your first covered sell is now in the marketplace and awaiting abuyer.\nStrategy for Selling Covered Calls\nWe’ve covered the process but what about the strategy behind covered calls? In the last chapter, we looked at the absolute basics of that strategy but an experienced trader knows there’salways going to be more to an option than meets the eye.\nThere’sawhole list of considerations that you will eventually want to bear in mind as you expand your knowledge and develop your own personal strategy. Every trader has adifferent attitude toward what works and what doesn’t. There are plenty of ways to make selling acovered call work but you’ll probably find yourself preferring one or two strategies.\nWe’ll take alook now at those considerations in more detail in order to guide you as you delve into covered calls more deeply:\nThe Market Environment:\nYou are no doubt aware that traders of stocks are happy in abull market and disgruntled in abear market. You may also know that such traders hate aflat market most of all because very little is happening and there aren’tmany big profits to be made. For you, as aseller of covered calls, the opposite is true. Ihighly recommend waiting for the market to temporarily flatten before embarking on aspate of covered call sales. That is because you’re only really interested in small changes to your share prices. If they are skyrocketing, you’re losing money on your contract. There also isn’tas much danger of the bottom falling out of the market with your stock prices plummeting at the same time which would be problematic.\nYour Underlying Stock:\nThere is nothing more important to your success than choosing the right stocks to invest in. Icannot stress strongly enough that your success will be heightened if you pick stocks that move up very slowly. You don’twant stocks that rise and fall very quickly, especially as abeginner, because they have ahabit of making surprising moves that ruin your strategy. If they drop too far, you stand to lose alot of money if you sell. If they rise too high, you lose the money you could have made if you’dsold them at the higher price. Traders who deal in risk often enjoy those stocks because they have higher premiums and achance for huge profits but that goes against the idea of selling covered calls. You’re looking for asteady income that will underpin your riskier strategies elsewhere. By all means, go for the riskier stock elsewhere in your strategy but avoid it like the plague for covered calls.\nThe Premium:\nAlways remember that the premium is your guaranteed profit. Whatever else happens, you’re going to walk away with that cash. When you factor in the cost to list the option and any commission you will lose to your broker, you’ll be able to calculate the actual profit you’ll make on apremium. Set yourself aminimum premium—anumber that you consider to be enough to provide aprofit you’ll be happy with on the assumption that it’sthe only profit you make. When you move ahead on setting the strike price, you’ll likely adjust that base figure up or down based on what you think the underlying stock is going to do before the expiration date. Remember that the premium is only one component of the overall profit you will make. If you set astrike price that means you lose the same amount of cash on selling the shares as you made with the premium, the trade wasn’tworth doing in the first place.\nThe Expiration Date:\nThere’sareason that the premiums on covered calls get higher when the expiration date is further out. It’sbecause, much like the weather forecasts we all deride on adaily basis, it gets harder and harder to predict what’sgoing to happen to ashare price the further out you go. Also, bear in mind that your money is", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 8}
{"text": "that the premiums on covered calls get higher when the expiration date is further out. It’sbecause, much like the weather forecasts we all deride on adaily basis, it gets harder and harder to predict what’sgoing to happen to ashare price the further out you go. Also, bear in mind that your money is going to be tied up until the expiration date, so, the premium will increase as anod to that sacrifice. Most investors believe that atime span of between amonth and three months works best.\nThe Strike Price:\nYou might think that the strike price you set should be based on what you, as the seller, are comfortable with but actually it’sthe opposite. You’re looking for astrike price that your buyer will feel comfortable with because otherwise they aren’tgoing to buy. That, in turn, is going to be dictated by the expiration date you set as well as the premium you’re asking for and how stable or volatile the underlying stock is. Your best bet is to put yourself in the shoes of your buyer. Would you purchase that contract? How much would you stand to gain? Set your strike price accordingly and then take alook at it from your own point of view. Would that be an acceptable profit for you? If so, you’ve hit the nail on the head.\nWith all of those factors in mind, you are likely starting to see that there is no single “correct decision” when it comes to selling covered calls. It’sgoing to take practice and concentration to figure out which ones work best for you.\nIt’salso important to note that your strategy is probably going to change as you gain experience. The more options you sell, the more you will see new and more advanced ways to take advantage of the market. For now, Iurge you to be conservative in your approach and accept that selling covered options is not going to win you your fortune but it is going to help you increase the seed money you have available to do just that.\n* * * * *\nBefore we continue, Ihave asmall favor to ask:\nCould you please take aminute of your time to write an honest review of the book?\nYour reviews are what keeps me going. Iread every single one of them, and would be\nextremely thankful\nif you choose to share your thoughts with me.\nClick Here to Leave Your Review\n* * * * *\nOutcomes of a Covered Sell\nAs we’re using the idea of selling covered calls as atrade example to help you learn the basics of options trading overall, let’snow take aclose look at what is going to happen to your option once you’ve listed it.\nThe stock increases in value:\nIf the stock moves up and hits your strike price, that means that your buyer can now exercise their right and buy the shares. The more the stock rises, the more likely it is that the buyer will do exactly that. When your goal is to sell shares, that is what you want to happen. You will pocket the premium as well as the difference between the shares as they were valued when you listed them and the value they are at on the expiration date. In other words, you will have capital gains in addition to the premium you received.\nThe stock value doesn’tmove:\nIf the shares don’tchange either up or down during the time the option is open, then they won’thit the strike price and you won’thave to sell. You will pocket the premium and can factor that into your overall profits when you relist the stock. Many options traders actually count on that outcome. It’sthe one they are hoping for because it means they make aprofit AND keep the shares. Feel free to follow the same logic but make sure your entire plan doesn’thinge on it. You don’tcontrol the market, so, you could find yourself with anasty surprise.\nThe stock drops in value:\nIf that happens, the outcome is very similar to the share price not moving at all. The difference is that you are losing money on the shares themselves all the time they are dropping. They might bounce back but, if they don’t, then the expiration date will arrive and you’ll be holding shares that are now worth alot less than they used to be and that constitutes aloss in value. If, while monitoring your option contracts, you see that astock is starting to drop, you need to prepare to take emergency action. Do that by calculating your “breakeven” price. Subtract the premium per share from the price of the share at the time you listed it. For example, if the share was worth $50 and the premium per share is $1.50, your breakeven price per share is $48.50. If it falls below that price, you can buy back your option. That is not something you should rely on or do often but it is good as an emergency action. To do that, go back to the order entry and select “Buy to Close.” Enter either the current ask price or something lower, depending how risky you want to be. Once the trade goes through, you are back in control of your shares and can either keep or sell them as you deem fit.\nAs an aside, you should know that buying back your options is actually adeliberate strategy used by some people who trade in covered calls. Doing so allows you to manage your own", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 9}
{"text": "be. Once the trade goes through, you are back in control of your shares and can either keep or sell them as you deem fit.\nAs an aside, you should know that buying back your options is actually adeliberate strategy used by some people who trade in covered calls. Doing so allows you to manage your own risk and to end trades that are likely to be disadvantageous for you so that you can list those stocks again at alater date.\nFor instance, let’ssay that your underlying stock is rising fast and you think you’re going to lose out on alot of potential profit as it continues to skyrocket. You could “roll up” your options by buying back your call at the current ask price or lower and then selling it again at ahigher strike price.\nSimply setting your stock to sell is enough to garner you aregular income with your options trading but there are other ways you can make the most of the market.\nAtypical strategy for aperson who deals in selling covered calls is to purchase astock and sell acovered call on that stock at the exact same time. It’scalled a “Buy-Write Strategy.” Your brokerage firm will almost certainly allow you to do that and may even have it listed on their online order screen for you to select.\nSo what would you be looking for if you did that?\nAstock that you would be happy to have in your share portfolio, assuming that the buyer never realized their right to purchase it.\nAstock that is showing apremium rate in the marketplace you would be happy to accept.\nAstock that is predictable in that it is rising or dipping in worth slowly over time.\nKeep your eyes firmly on the stock market over time and you will start to see those trends. You’ll also develop an eye for spotting good trades—the ones where you can make aquick profit by selling afew contracts at agood premium price.\nAsecond advanced strategy is to use options trading to get rid of stocks you don’twant to own any more. Maybe, for instance, they’ve been flat for along time and you aren’tseeing enough movement to make them worthwhile. You can set up asell that would return agood premium while allowing you to get rid of your stock at close to its current price. Instead of simply unloading them, you’dwalk away with apremium and apotentially tidy profit.\nThird, you can choose to use the “half and half” strategy. Keep some of your shares in aparticular company and sell the rest. That works well if you aren’treally sure whether you should sell them all but make sure you are keeping records of what you have done.\nStepping Up a Tier: Buying Calls\nWe’re ready to move on to the more sophisticated areas of options trading. You have tested the waters, made alittle cash, and you feel comfortable with the mechanics of the market. Now, you can start actually buying calls and begin to hopefully make some real money.\nIt’sactually simple to buy acall in terms of physically going ahead and doing it. However, it’snot quite so easy to make aprofit. You’re going to need to start small and dedicate yourself to alearning curve—and you need to understand that there is arisk involved in buying calls, so, you don’twant to stake your life savings on your efforts.\nMy advice is that you build up slowly over time rather than jumping straight in with several buys in asingle day. Be circumspect about your actions. Asmall profit is better than no profit at all. Save your riskiest ideas for when you’ve set up anest egg with your sells and you feel confident enough in your own judgment that you’re as sure as it’spossible to be that your risk will pay off.\nAs areminder, what you are actually doing when you buy acall is purchasing the right to buy the underlying stock if it reaches the strike price before the deadline. You aren’tobligated to buy it. If you choose not to, all you have lost is the premium you paid for that right.\nThe best case scenario for you, as the buyer, is that the stock suddenly starts rising at ahigh speed before the expiration date arrives. You want it to go beyond the strike price so that, when it comes time to exercise your right, you are purchasing your stock at alower price than it is now worth. Obviously, you then have the option to instantly list that stock as acovered sell, which would allow you to realize more profit in real money.\nThat final piece of the puzzle is the important one. As an options trader, you are not in the business of building astock portfolio. You don’treally want to actually own shares—you want to make aprofit on them as they pass through your hands. You want to buy them for less than they are worth and then sell them for more than they are worth if you are lucky. It’swithin those transactions that your money will be made.\nBuying calls has several advantages for you as an options trader.\nIt doesn’tcost much to get involved in the movement of aparticular stock. You only need fork out the amount for the premium. You can sit back and wait to see what the stock does before making your purchase decision based on actual information rather than o", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 10}
{"text": "al advantages for you as an options trader.\nIt doesn’tcost much to get involved in the movement of aparticular stock. You only need fork out the amount for the premium. You can sit back and wait to see what the stock does before making your purchase decision based on actual information rather than on speculating what the market will do.\nIt allows you to make use of the kinds of “tips” that market experts have abad habit of swearing by. You read the news, you’re watching the markets, and you have information that makes you think acertain stock is about to rise fast and hard. You want to take advantage of that, obviously, and options trading allows you to do so in asafe way rather than simply buying the stock. If you’re wrong, you’ll only lose your premium and you may even make asmall profit. If you purchased the stock and then it plummeted rather than rose, you stand to lose awhole lot more cash.\nBuying calls also allows you to consider shares that would ordinarily be out of your price range. You can play around with the big boys, like Walmart and Apple without putting asecond mortgage on the house. Buying options on those stocks is awhole lot less expensive than buying the stocks themselves, so, if you see something on the horizon that makes you think the trade would be worthwhile—like anew product or service, for instance, or achange in leadership—you can use call buying to get in on the game. That is called “leverage” which is the ability to control thousands of dollars in stock for just hundreds of dollars in premiums.\nOne thing to note before you start buying calls is that you’ll want to wait for the right time. You are no longer interested in aflat market. This time, you want abull market where stock prices are rising.\nWhat you are looking for is an underlying stock you have faith in. You think it’sgoing to rise in value over the next few months. Let’ssay you’ve found astock that’scurrently at $50 and you believe it will continue to rise steadily. Predicting the rate of its growth, you think it will be at $80 in two months’ time.\nWhat you would be looking for in that scenario is acall contract that would allow you to purchase shares for LESS than the $80 you think they will rise to in two months. You must also juggle the math to make sure that you will not be paying apremium that would wipe out the profit you would make.\nFor example, you might find acontract option that will allow you to buy the stock at $80 per share on the expiration date with apremium of $1 per share. You think the stock is actually going to be worth $85 on that date, so, you would actually be making aprofit of $4 per share. You would make no profit at all if the premium had been $5.\nBear in mind, of course, that you won’twalk away from acall option with cash in hand. The profit we are talking about in this case is “intrinsic value.” You can now take that stock and write acovered call on it, hopefully selling it, and making atangible profit in the process. That was what we were discussing in the previous chapter. As an options trader, you’re not looking to hold astock portfolio. You’re purchasing stocks with call contracts in order to turn around and sell for aprofit.\nStrategies for Buying Calls\nIhave urged you several times throughout this book to start paying attention to the stock market and learn how to spot trends in the ups and downs of particular shares. As you become increasingly familiar with that part of your options trading experience, you can also make use of acolumn in the trading screen itself to guide you.\nThat column is titled “Open Interest” and it represents the total amount of open contracts on aparticular underlying stock that are still running at the time you are viewing the page.\nWhat you are looking at is the supply and demand on the stock. The more open interest there is on aparticular contract, the more people believe it’sasure bet. You can also watch for sudden changes. If acall contract has 500 in that column one day and 2000 the next, it means that asignificant number of traders believe that stock is going to move in that price direction.\nThose people aren’tnecessarily right, so, it’sup to you to use your judgment. Nevertheless, it can be avery helpful addition to your tool kit when it comes to predicting the movement of the stock market and making the right decisions in your own trading.\nAt the same time, there are anumber of factors that should be guiding you as you choose the right contract. The following factors can help you:\nIn or Out of the Money:\nAs acall seller, you were mostly interested in the premium. As abuyer, you want abargain. You’ll find that the premium is cheaper the more out of the money acontract is. In other words, the further the stock needs to climb before you can call in your option, the cheaper the premium will be. That doesn’tmean it’sthe best bet. If you don’tbelieve the stock will climb that high, it doesn’tmatter how cheap the premium is as you’re not going to be able to purch", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 11}
{"text": "tract is. In other words, the further the stock needs to climb before you can call in your option, the cheaper the premium will be. That doesn’tmean it’sthe best bet. If you don’tbelieve the stock will climb that high, it doesn’tmatter how cheap the premium is as you’re not going to be able to purchase that stock. Calls that are slightly in the money are agood option for beginners and more likely to bring you amodest or sometimes larger profit.\nStock Movement:\nThere is absolutely no point buying abargain call that has astrike price higher than you believe it will go. If it never reaches that price, you’ve lost the premium you paid. Sometimes it can be worth the risk if you are reasonably sure the stock has achance of rising that high but that doesn’thappen very often.\nTime Value:\nIf you’re purchasing acontract that would require the stock to rise above aprice, it stands to reason that you need to give it enough time to do that. Premiums also are lower on short term contracts but that’sbecause there’sprobably not enough time for the stock to reach its target. Be circumspect when looking for contracts with cheap premiums. The lowest price is often not the best one. It’simportant to give your strategy breathing room, so, lean toward the calls with long enough expiration dates to allow the stock to do what you hope it will.\nSpread:\nThis is the difference between the bid and ask price and it has adirect impact on the price you will pay. Afair price usually falls somewhere between the two. The higher you pay, the more you are taking from your profit. Bear in mind that you will usually begin at aloss in your trade. If you pay $1.50 when the bid price is $1, that’sa $0.50 loss on each share. Because the whole idea is that the stock will rise in value, that’snot necessarily abig issue although it can be. As ageneral rule, if there is awide spread, you should aim for somewhere in the middle. If it’snarrow, you can probably pay the ask price without too much concern.\nTo make aprofit buying covered calls, you have to be right on all of these fronts. You need to choose the right time, the right direction, and the right contract price if you’re going to be successful. If you get one of those things wrong, you will likely lose that profit. Be aware that buying calls is where the risk comes in for options traders. That is why Ihighly recommend balancing your activity and relying on covered sells for your steady income while keeping your buying activity relatively modest.\nUnderstanding Time Value\nAt this stage, let’stake adeeper look at one of the factors influencing the price of the options you are considering. Time value, as we’ve mentioned before, is what’sleft after you take the intrinsic value away from the premium.\nIn other words, if your option is priced at $2 and the intrinsic value is $1.50—the premium minus the stock price will give the time value of $0.50. The time value will slowly bleed away as you get closer to the expiration date.\nTime value is your friend as abuyer but, as aseller, it’squite the opposite. You are on atimer from the moment you buy acall because, the closer you are to the expiration date, the less time there is left for the underlying stock to do what you want it to do and for your option to increase in its value.\nThe closer you get to the deadline, the faster the time value will trickle away. Be very aware of the time value, because it’sfar more important than alot of beginners realize. That is why you will want to factor it in very carefully to any decision you make.\nToo far out and your contract could start moving in the opposite direction again and the premium will be dauntingly high. Too close and you simply won’thave enough time to watch your stocks head for the magic value you were hoping for, leaving you out of pocket on the premium.\nAim for two to three months, plenty of time for your strategy to see fruition without risking it heading in the opposite direction or paying afortune in premiums.\nUnderstanding Volatility\nThere’sone final factor that affects the prices of contracts on afundamental basis and it’snot really something we’ve touched on so far. The volatility of acontract is, however, an incredibly important concept to grasp for an options trader.\nVolatility refers to the movement of the underlying stock. Some stocks will slowly wend their way up and down in apredictable manner and those stocks are not very volatile. Others change up and down on aday-to-day basis.\nTo sum up the effect of volatility in asingle sentence—the more volatile the stock, the more that an options trader is willing to pay for it. Avolatile stock has abetter chance of reaching astrike price and perhaps shooting far beyond it before the expiration date.\nHowever, volatility is also the most dangerous of the factors that you need to bear in mind because it’sarguably the most likely one to force you into abad decision. Avolatile stock, for example, can lead to amuch higher premium and, therefore, ahigher cont", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 12}
{"text": "far beyond it before the expiration date.\nHowever, volatility is also the most dangerous of the factors that you need to bear in mind because it’sarguably the most likely one to force you into abad decision. Avolatile stock, for example, can lead to amuch higher premium and, therefore, ahigher contract price. Unless that stock shoots through the roof, you could actually end up losing money even when you should be making it.\nOne way to estimate the volatility of astock is to take alook at what it has done in the recent past. That tells you how much it has moved up and down already, which is what some use as an indicator of how much it will move up and down in the future.\nUnfortunately, it’snot always true that the past repeats itself and you can’tpredict the future based on what’salready happened. Instead, options traders use “implied volatility” to make their guesses and that is the value that the market believes the option is worth.\nYou can see that reflected in the activity on the options for that stock. Buyers will be keen to get their hands on options before acertain event takes place, such as the announcement of anew product or arelease about the company’searnings. Because of that, options increase in price because there is implied volatility. The market thinks the stock is going to shoot up.\nYou’ll see lower demand on astock that’sflat or moving gently because there is no implied volatility and, therefore, no hurry to get in on the action. You’ll also see correspondingly low prices for options on that stock.\nVolatility is obviously agood thing. As abuyer, you want the stock to be volatile because you need it to climb to the strike price and beyond. However, there is also such athing as too much volatility. It’sat that point that contracts become popular, the prices rise, and you stand to pay more for acontract than you will ultimately profit from.\nYour broker will likely be able to provide you with aprogram that will help you determine implied volatility by asking you to enter certain factors and then calculating it for you. However, it’sonly with experience that you’ll learn how to spot astock that’sjust volatile enough to justify its higher price. Again, practice is key.\nIt’salso worth noting that alot of the risk in options trading comes from volatility largely because it’simpossible to be accurate in your estimates. What happens if an earthquake destroys acompany’sheadquarters? That stock will plummet and you had absolutely no way to see it coming.\nThat’swhy options traders are forced to accept that their fancy formulas are not going to be perfect predictors. They will help but you should still be conservative in your trading and avoid the temptation to sink everything into atrade that you believe could make your fortune thanks to its volatility.\nKeeping an Eye on Your Calls\nOnce you’ve purchased acall contract, your job is not over. In fact, it has only just begun. From now until the expiration date, you need to keep an eye on what your stock is doing to see whether it goes up, down, or nowhere at all.\nDown:\nIf the stock unexpectedly begins to move down, it’smoving further and further away from the strike price. If that trend continues, it’sgoing to mean that you can’texercise your right to buy at the expiration date and you’ve lost out. You could choose to try to sell your option to regain some of that potential loss if there’sstill time value enough to justify someone taking it off your hands. If you choose to keep it, remember that you don’tactually have to buy the stock. You are only going to lose the premium on the expiration date.\nNo Movement:\nThe stock is hovering around the strike price and is losing time value as it does. Again, you may want to think about selling the call option to reap back some of the premium. However, if you think there’sachance that things will change before the expiration date and the stock will start moving up, that’snot always agood idea. It’satough call to make because you could end up losing out on atidy profit if you don’tgive the stock breathing room to start moving. Again, remember you’ll only lose the premium if it doesn’treach the strike price or you decide not to buy.\nUp:\nHere’swhere options traders have ahabit of getting antsy. You’re watching the stock rise and it’sgone far beyond the strike price. Naturally, you want to call in the contract right away and you hit the “sell to close” button so you can sell it and bank that profit. If the stock has indeed reached the top of its curve and is about to start dropping again, that can indeed be the right call. However, you also have the option to “roll up” your call by closing out your position and moving it to one with ahigher strike price. You can also “roll over” to astrike price with alater expiration. There is athird option which is to actually exercise the right to buy that you purchased in the first place.\nExercising Your Right to Buy the Stock\nBearing in mind that an option is all about the right to", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 13}
{"text": "e with ahigher strike price. You can also “roll over” to astrike price with alater expiration. There is athird option which is to actually exercise the right to buy that you purchased in the first place.\nExercising Your Right to Buy the Stock\nBearing in mind that an option is all about the right to buy or sell astock, it might seem strange that most traders are not looking to do that. Instead, they are looking to immediately pass the stock on as asell and make aprofit by taking the premium along with the increased price of the stock from what they paid for it.\nThat’swhat you should be basing your strategy around—the idea of gaining stocks and instantly selling them back into the options market and making your profit in the process. In most cases, that’swhat you will be aiming to do.\nIt is also worth noting that some traders who buy call options never want to own the underlying stock. They are only interested in making money on the options which they can do by buying and selling options without ever owning the stock.\nNevertheless, there are still going to be times when you want to exercise your right in order to purchase the underlying stock itself. Usually, that is when you genuinely want to add aparticular stock to your portfolio. It’sup to you to decide when those times arrive.\nFirst things first. Be very aware that you will automatically exercise your right at the expiration date if the option is in the money unless you tell your broker not to take that action. That won’thappen if it’sout of the money but it’sstill imperative that you keep acalendar of your trades so that you aren’tsurprised by the sudden arrival of stocks in your portfolio that you’dcompletely forgotten about.\nIf and when you decide to exercise your right, you should almost always do it at the expiration date and not before because you’ll lose the time value if you exercise early. When you alert your broker to that decision, it’salso important to know that you cannot then change your mind—the decision is permanent.\nHow to Buy and Sell Puts\nBuying puts can be awinning strategy if done right. The stock market wouldn’tbe the stock market if it only moved in one direction. By buying puts as well as calls, you’re making the most of the market by profiting no matter which direction it’sheading. Puts are your ally during abear market.\nBuying aput means that you are going to make aprofit with astock declining in price. Just as you’re looking for astock to skyrocket in acall, you’re looking for one that will plunge in aput. The strategy is, therefore, very similar and it’sjust that you’re looking in the opposite direction.\nMost traders buy puts either because they’re speculating on astock and think they can make aprofit in the short term as that stock plummets, or because the puts can function as insurance for your overall portfolio. If you actually own astock in question, you can buy puts on it if you believe it’sat risk of heading downward.\nFor instance, let’ssay you own stock in acompany and you think the share price will drop because of the business environment. You aren’tsure, but you can make an educated guess. Simply leaving that stock sitting in your portfolio means potentially watching as its value bleeds away.\nOn the other hand, you could buy aput and give yourself the option to offload that stock if it does drop to acertain value. As the buyer, you are not obligated to sell your stock when the deadline arrives. You’re just giving yourself the option to do so. Of course, as always, you’ll lose the premium.\nThe biggest difference between buying calls and puts is that the stock market has ahabit of falling much faster than it rises. Astock can drop through the floor in just asingle day whereas it can take weeks or months to climb to magical figures.\nTo buy puts for the sake of speculation, you’ll need to master the art of spotting weaker stocks—the ones that are likely to fall. That is easiest during abear market and when the overall economic outlook is poor.\nEven the most successful companies have down times and, if you own aput contract when that happens, you stand to make money.\nWhen buying aput, you’ll need to think in reverse. The lower the strike price, the cheaper the option will be. In other words, it is the opposite of buying acall. You should also factor in the speed of the market when looking at expiration dates. If you think the stock is going to drop hard and fast, you probably want ashorter deadline. If you think it will take awhile for the full effects of the drop to realize, then you will want alonger one.\nThe most successful put strategies, at least at first, will probably be slightly in the money because you can profit from asmaller change in the underlying value. Conversely, you’ll make more money on asmaller premium with an out of the money put but you have less chance of actually making that money.\nSelling puts can be agamble. The idea behind it is that, by selling your promise to buy stocks, you are earning asteady", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 14}
{"text": "smaller change in the underlying value. Conversely, you’ll make more money on asmaller premium with an out of the money put but you have less chance of actually making that money.\nSelling puts can be agamble. The idea behind it is that, by selling your promise to buy stocks, you are earning asteady premium but you’re choosing contracts that you believe will never hit the strike price. That way, you walk away having been paid for the contract without having to actually own the underlying stock.\nIt’salso away to increase your stock portfolio and get paid for doing so. That can be useful if you think astock’sdropping price is temporary and you want to snap up afew of them before they start to rise again and you can sell them.\nBe aware, of course, that when selling aput you are obligating yourself to buy that stock if it does reach the strike price, so, it’sabad gamble if you lack the funds to do that when the expiration date arrives.\nStrategies for New Options Traders\nNow that you know the basics of options trading, you’re no doubt raring to get started with your first trades. All that remains is to introduce you to some of the strategies you now have open to you.\nFirst up is the Greeks. You’re going to see of those all over the place and they can really help you understand your chances with aparticular trade, so, it’simportant to understand what they are.\nDelta:\nThat stands for the change in price of the option when compared to the change in price of the underlying stock. For call options, it will be between 0 and 1; for put options, it will be between 0 and -1. The closer to 1 or -1, the more likely that the price of that option will increase or decrease dollar for dollar as the stock price changes. If it’sat 0.5 or -0.5, it will increase or decrease by 50 cents for every dollar of change on the stock. The further in the money the option is, the higher its delta will be. The higher the delta, the more likely your option is going to finish in the money.\nGamma:\nThat stands for the change in the delta of an option relative to the change in the price of the underlying stock. It tells you, therefore, what the rate of increase of the delta is. As abuyer, ahigh gamma is good assuming that your assumptions about what the underlying stock is going to do are correct. If you’re wrong, it can be very bad indeed because your mistake is going to work against you more quickly.\nTheta:\nThat stands for the change in the price of an option relative to how much time is left until it expires. It is directly related to the time value and will decrease as that value does. You want alow theta risk with options more than 90 days before expiration if you are long on your position because you don’twant the time value to drop. You want ahigh theta if you are short with options less than 30 days to deadline.\nVega:\nThat stands for the change in price relative to the option’schange in volatility. Premiums increase with volatility so vega will, too. Specifically, it will tell you how every 1 percent point change in the implied volatility affects the premium. If the volatility drops or disappears altogether, it’spossible that your option could lose value, so, vega is important to keep an eye on.\nNow, for some of those all-important strategies you’ve been waiting for.\nStraddling a Stock:\nIf you are good at spotting market trends, this strategy is for you. Let’ssay that you think acompany is about to have abig event or release an announcement, but you don’tknow exactly what that will do to its shares. You just think that it’sbound to affect them. You could use astraddle strategy to purchase both aput and acall option at the same strike price, setting the expiration shortly after the date of the event in question. Your breakeven point on that is going to need to factor in both trades. You need to be doubling your profit, in other words, to justify the spend on two contracts. Therefore, you’ll need to include that thought in your choice of strike price and you’ll need to watch out for volatility. You need higher implied volatility for that to work. You should also be aware that you won’tbe the only one who sees the change coming, so, the contracts could be pricey.\nThe Strangle:\nThat can be abetter way to tackle the situation we just looked at. It’sthe same idea except that the call and the put are set to different prices with the put strike price usually lower. When you do that, you will break even if the stock rises above acertain price OR drops below acertain price, “strangling” the possibilities from both ends.\nBull and Bear Spreads:\nThat strategy again tackles the question of, “What is going to happen to this stock?” It gives you asure-fire way to see some cash but with the possibility of trading away aserious profit. Again, it’sall about flexibility. In an example, for astock that’snow trading at $50, you could buy acall with astrike price of $55 and sell acall with astrike price of $60. You’ll likely pay more to buy your call than you gai", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 15}
{"text": "o see some cash but with the possibility of trading away aserious profit. Again, it’sall about flexibility. In an example, for astock that’snow trading at $50, you could buy acall with astrike price of $55 and sell acall with astrike price of $60. You’ll likely pay more to buy your call than you gain from selling the second call. Let’ssay it was $0.25 for the $55 contract and $0.60 for the $60, leaving you paying $0.35 in total to set your position. For this to work best, you’re hoping that the stock will end up somewhere between $55 and $60 at the deadline because the second contract will not be exercised and you will make aprofit. If it rises above the $60, you’ll still make aprofit but it will be capped at that exact profit if your buyer exercises their right to purchase the stock. The downside is that your stock could skyrocket to $65 and you won’tsee aprofit above the $60 but that can be acceptable if you’re looking to cut down your costs and still make aprofit. The example above is abull spread. That can also work on abear spread if you reverse the trades and sell your call lower than you buy your call.\nCash Secured Puts:\nThat can be used as away of purchasing aparticular stock at adiscount. It only works if your account has enough money to actually buy the stock because you will be obliged to do so if the option is exercised. If it isn’t, you’ve made some money because it will expire without forcing you to buy but you’ll still bank the premium in the process. Either way, assuming you really do want that stock, you win. In thats strategy, you’ll set the strike price at the exact price you’re looking to obtain that stock for. The only downside is that it could drop alot lower and at that point you really won’tfeel like you got the best bargain. Out of the money puts have abetter chance of expiring without being exercised. If you’re only looking to make profit on the premium or you’re not desperate to own the underlying stock, that can often be your best bet. If you do end up owning the stock, your usual hope is that it will change direction and you can trade it to make another profit.\nMarried Puts:\nTo do that, purchase stock and aput at the same time. That provides an insurance for you and a “floor” to protect you if that stock suddenly plunges. It will make sure you don’tlose the clothes on your back if the stock does plummet but it also has the chance to make alittle money if your timing is good and the stock price rises.\nRolling Your Positions:\nWe covered that briefly but, just as areminder, rolling your position can help you increase your profit over time. When you do that, you simply set up anew call as soon as the old one expires in the hope that the stock will continue to move in the same direction it has been doing until now. You will be looking to go up in strike price and out in time to an expiration date. It can be risky because there is no guarantee that the stock will continue to do what it has been doing, so, it’sonly worth taking the risk if you think there is areasonable chance the stock will continue to move in the same direction. If you roll aput, on the other hand, you’re going down in strike price and out in time to deadline because you want to avoid actually selling the stock. For both those alternatives, you’ll be entering abuy to close order and initiating anew contract.\nIn Conclusion\nFrom novice to initiated, you’ve now gained the basics of the knowledge that will help you enter the exciting world of options trading. It certainly isn’teverything there is to know, but you now have enough of agrounding to get started.\nFrom here on out, it’sall about practice and being conservative as you improve your understanding and develop your own strategies. Only you will know what works best for you, how much risk you want to play with, and how your personal ability to predict and determine the stock market can be best put into practice.\nAs you dip your feet into the water, you’ll start to see profits coming in and you’ll feel that buzz that all options traders enjoy. The more you trade, the more you’ll see all of the fundamental mechanics at play and the more you’ll start to connect the dots and figure out your own personality as atrader.\nYou’re in for atreat. Options trading is rewarding and exciting when done right. Remember to keep that calendar updated and to stay conservative at least in the beginning and you’ll enjoy the learning curve every step of the way!\nSpecial Thanks\nIwould like to give special thanks to all the readers from around the globe who chose to share their kind and encouraging words with me.\nKnowing even just one person found this book helpful means the world to me.\nIf you've benefited from this book at all, Iwould be honored to have you share your thoughts on it, so that others would get something valuable out of this book too.\nYour reviews are the fuel for my writing soul, and I'dbe\nforever grateful\nto see\nyour\nreview, too.\nThank you all!\nClick Here to Leave Your Rev", "source": "eBooks\\Options Trading Crash Course_\\Options Trading Crash Course_ The #1 Beginner_s Guide to Make Money with Trading Options in 7 Days or Less!.epub#section:text00000.html", "doc_id": "1a6e27eb8e42cc54840159859be725d8f4244aeba61cd8ea439f422f17a7643b", "chunk_index": 16}
{"text": "Preface\nIf the conditions are just right, extraordinary things happen when many individual pieces come together: Water molecules organize and form snowflakes; Cells arrange and create organs; Jet streams combine and cause tornadoes; Grains of sand rally and produce avalanches; Investors panic sell and induce financial crashes. Complex systems are composed of many interacting parts, and\nemergence\noccurs when these parts organize to create collective phenomena that no one part is capable of creating alone. Complex systems can be found in nearly every discipline, and the mathematics describing emergent properties is not only fascinating but indicates fundamental similarities between seemingly unrelated complex systems. The extinction of aspecies of fly due to an invasive species of frog has really nothing to do with financial markets, yet the dynamics of the fly population undergoing ecological collapse look nearly indistinguishable from that of astock undergoing economic collapse. Many physicists gravitate toward finance because physical systems and financial systems can be analyzed with similar theoretical, statistical, and computational tools. It was my interest in those mathematical connections that drew me to finance initially. However, after placing my first trade at the start of the 2020 crash, Iquickly learned the\nimportance of financial intuition as well, particularly when trading options.\nAtrader'sintuition comes from experience, but atrader can more efficiently build that intuition by supplementing market engagement with some basic trading philosophies. Many of the papers, books, and blogs Iread as anew options trader offered detailed coverage of options theory and its mathematics, but Inever encountered aresource that explicitly laid out the most essential elements of practical strategy development. Without asystem of core trading principles, applying financial theory, interpreting and analyzing data, and cultivating any sense of market intuition was challenging. However, once afoundation of options trading fundamentals was in place, overcoming the options learning curve became aconsiderably more manageable process. In my personal case, this foundation developed from conversations with my coworkers at tastytrade (most of which were debates with Anton Kulikov), watching options markets regularly, using options data and theory to build actionable strategies, and alot of trial and error. My goal in writing this book is to help new traders build their own intuitions more effectively by breaking down the philosophies that formed the basis for my own, beginning with abit of math and market theory and building from there. Nothing substitutes for experience, and investors' first options trade will likely teach them more than any book. However, it'smy hope this framework that Anton and Iorganized will allow new traders to enter the options market with confidence and gain meaningful value from their first trading experiences, in both the monetary and educational senses.\nJulia Spina", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:f06.xhtml", "doc_id": "2d66793c12480403f3c1b5f7e5ada2a7fc9f5e8842faa01aea4c09d73cba4390", "chunk_index": 0}
{"text": "Introduction: Why Trade Options?\nThe house always wins\n. This cautionary quote is certainly true, but it does not tell the entire story. From table limits to payout odds, every game in acasino is designed to give the house astatistical edge. The casino may take large, infrequent losses at the slot machines or small, frequent losses at the blackjack table, but as long as patrons play long enough, the house will inevitably turn aprofit. Casinos have long relied on this principle as the foundation of their business model: People can either bet\nagainst\nthe house and hope that luck lands in their favor or\nbe\nthe house and have probability on their side.\nUnlike casinos, where the odds are fixed against the players, liquid financial markets offer adynamic, level playing field with more room to strategize. However, similar to casinos, asuccessful trader does not rely on luck. Rather, traders' long‐term success depends on their ability to obtain aconsistent, statistical edge from the tools, strategies, and information available to them. Today'smarkets are becoming increasingly accessible to the average person, as online and commission‐free trading have basically become industry standards. Investors have access to an\nalmost unlimited selection of strategies, and options play an interesting role in this development. An option is atype of financial contract that gives the holder the right to buy or sell an asset on or before some future date, aconcept that will be explained more in the following chapter. Options have tunable risk‐reward profiles, allowing traders to reliably select the probability of profit, max loss, and max profit of aposition and potentially profit in any type of market (bullish, bearish, or neutral). These highly versatile instruments can be used to hedge risk and diversify aportfolio,\nor\noptions can be structured to give more risk‐tolerant traders aprobabilistic edge.\nIn addition to being customizable according to specific risk‐reward preferences, options are also tradable with accounts of nearly any size because they are\nleveraged\ninstruments. In the world of options, leverage refers to the ability to gain or lose more than the initial investment of atrade. An investor may pay $100 for an option and make $200 by the end of the trade, or an investor may make $100 by selling an option and lose $200 by the end of the trade. Leverage may seem unappealing because of its association with risk, but it is not inherently dangerous. When\nmisused\n, leverage can easily wreak financial havoc. However, when used responsibly, the capital efficiency of leverage is apowerful tool that enables traders to achieve the same risk‐return exposure as astock position with significantly less capital.\nThere is no free lunch in the market. Aleveraged instrument that has a 70% chance of profiting must come with some trade‐off of risk, risk which may even be undefined in some cases. This is why the core principle of sustainable options trading is risk management. Just as casinos control the size of jackpot payouts by limiting the maximum amount aplayer can bet, options traders must control their exposure to potential losses from leveraged positions by limiting position size. And just as casinos diversify risk across different games with different odds, strategy diversification is essential to the long‐term success of an options portfolio.\nBeyond the potential downside risk of options, other factors can make them unattractive to investors. Unlike equities, which are passive instruments, options require amore active trading approach due to their volatile nature and time sensitivity. Depending on the choice of strategies, options portfolios should be monitored anywhere from\ndaily to once every two weeks. Options trading also has afairly steep learning curve and requires alarger base of math knowledge compared to equities. Although the mathematics of options can easily become complicated and burdensome, for the type of options trading covered in this book, trading decisions can often be made with aselection of indicators and intuitive, back‐of‐the‐envelope calculations.\nThe goal of this book is to educate traders to make personalized and informed decisions that best align with their unique profit goals and risk tolerances. Using statistics and historical backtests, this book contextualizes the downside risk of options, explores the strategic capacity of these contracts, and emphasizes the key risk management techniques in building aresilient options portfolio. To introduce these concepts in astraightforward way, this book begins with discussion of the math and finance basics of quantitative options trading (\nChapter 1\n), followed by an intuitive explanation of implied volatility (\nChapter 2\n) and trading short premium (\nChapter 3\n). With these foundational concepts covered, the book then moves onto trading in practice, beginning with buying power reduction and option leverage (\nChapter 4\n), followed by trade construction (\nChapte", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:f09.xhtml", "doc_id": "43f9e518f08582b53999f9fff8855a7e83b0392a4da02874cb5470434bbb656c", "chunk_index": 0}
{"text": "Chapter 1\nMath and Finance Preliminaries\nThe purpose of this book is to provide aqualitative\nframework for options investing based on aquantitative\nanalysis of financial data and theory. Mathematics plays acrucial role when developing this framework, but it is predominantly ameans to an end. This chapter therefore includes abrief overview of the prerequisite math and financial concepts required to understand this book. Because this isn'tin‐depth coverage of the following topics, we encourage you to explore the supplemental texts listed in the references section for those mathematically inclined. Formulae and their descriptions are included in several sections for reference, but they are not necessary to follow the remainder of the book.\nStocks, Exchange‐Traded Funds, and Options\nFrom swaptions to non‐fungible tokens (NFTs), new instruments and opportunities frequently emerge as markets evolve. By the time this book\nreaches the shelf, the financial landscape and the instruments occupying it may be very different from when it was written. Rather than focus on awide range of instruments, this book discusses fundamental trading concepts using asmall selection of asset classes (stocks, exchange‐traded funds, and options) to formulate examples.\nAshare of\nstock\nis asecurity that represents afraction of ownership of acorporation. Stock shares are normally issued by the corporation as asource of funding, and these instruments are usually publicly traded on stock exchanges, such as the New York Stock Exchange (NYSE) and the Nasdaq. Shareholders are entitled to afraction of the company'sassets and profits based on the proportion of shares they own relative to the number of outstanding shares.\nAn\nexchange‐traded fund (ETF)\nis abasket of securities, such as stocks, bonds, or commodities. Like stocks, shares of ETFs are traded publicly on stock exchanges. Similar to mutual funds, these instruments represent afraction of ownership of adiversified portfolio that is usually managed professionally. These assets track aspects of the market such as an index, sector, industry, or commodity. For example, SPDR S&P 500 (SPY) is amarket index ETF tracking the S&P 500, Energy Select Sector SPDR Fund (XLE) is asector ETF tracking the energy sector, and SPDR Gold Trust (GLD) is acommodity ETF tracking gold. ETFs are typically much cheaper to trade than the individual assets in an ETF portfolio and are inherently diversified. For instance, ashare of stock for an energy company is subject to company‐specific risk factors, while ashare of an energy ETF is diversified over several energy companies.\nWhen assessing the price dynamics of astock or ETF and comparing the dynamics of different assets, it is common to convert price information into returns. The return of astock is the amount the stock price increased or decreased as aproportion of its value rather than adollar amount. Returns can be scaled over any time frame (daily, monthly, annual), with calculations typically calling for daily returns. The two most common types of returns are simple returns, represented as apercentage and calculated using\nEquation (1.1)\n, and log returns, calculated using\nEquation (1.2)\n. The logarithm'smathematical definition and properties are covered in the appendix for those interested, but that information is not necessary to know to follow the remainder of the book.\n(1.1)\n(1.2)\nwhere\nis the price of the asset on day\nand\nis the price of the asset the prior day. For example, an asset priced at $100 on day 1 and $101 on day 2 has asimple daily return of 0.01 (1%) and alog return of 0.00995. Simple and log returns have different mathematical characteristics (e.g., log returns are time‐additive), which impact more advanced quantitative analysis. However, these factors are not relevant for the purposes of this book because the difference between log returns and simple returns is fairly negligible when working on daily timescales. Simple daily returns are used for all returns calculations shown.\nAn\noption\nis atype of financial derivative, meaning its price is based on the value of an underlying asset. Options contracts are either traded on public exchanges (exchange‐traded options) or traded privately with little regulatory oversight (over‐the‐counter [OTC] options). As OTC options are nonstandardized and usually inaccessible for retail investors, only exchange‐traded options will be discussed in this book.\nAn option gives the holder the right (but not the obligation) to buy or sell some amount of an underlying asset, such as astock or ETF, at apredetermined price on or before afuture date. The two most common styles of options are American and European options. American options can be exercised at any point prior to expiration, and European options can only be exercised on the expiration date.\n1\nBecause American options are generally more popular than European options and offer more flexibility, this book focuses on American options.\nThe most basic types of o", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml", "doc_id": "3f519c4d8644bb886b7ea544bb01395ddc4ec86fcf8f99537e3273c4009792e5", "chunk_index": 0}
{"text": "rican options can be exercised at any point prior to expiration, and European options can only be exercised on the expiration date.\n1\nBecause American options are generally more popular than European options and offer more flexibility, this book focuses on American options.\nThe most basic types of options are calls and puts. American\ncalls\ngive the holder the right to\nbuy\nthe underlying asset at acertain price within agiven time frame, and American\nputs\ngive the holder the right to\nsell\nthe underlying asset. The contract parameters must be specified prior to opening the trade and are listed below:\nThe underlying asset trading at the spot price, or the current per share price\n.\nThe number of underlying shares. One option usually covers 100 shares of the underlying, known as aone lot.\nThe price at which the underlying shares can be bought or sold prior to expiration. This price is called the strike price\n.\nThe expiration date, after which the contract is worthless. The time between the present day and the expiration date is the contract'sduration or days to expiration (DTE).\nNote that the price of the option is commonly denoted as\nCfor calls,\nPfor puts, and\nVif the type of contract is not specified. Options traders may buy or sell these contracts, and the conditions for profitability differ depending on the choice of position. The purchaser of the contract pays the option premium (current market price of the option) to adopt the\nlong\nside of the position. This is also known as along premium trade. The seller of the contract receives the option premium to adopt the\nshort\nside of the position, thus placing ashort premium trade. The choice of strategy corresponds to the directional assumption of the trader. For calls and puts, the directional assumption is either bullish, assuming the underlying price will increase, or bearish, assuming the underlying price will decrease. The directional assumptions and scenarios for profitability for these contracts are summarized in the following table.\nTable 1.1\nThe definitions, conditions for profitability, and directional assumptions for long/short calls/puts.\nCall\nPut\nLong\nPurchase the right to buy an underlying asset\nat the strike price\nprior to the expiration date.\nProfits increase as the price of the underlying increases above the strike price\n.\nDirectional assumption: Bullish\nPurchase the right to sell an underlying asset\nat the strike price\nprior to the expiration date.\nProfits increase as the price of the underlying decreases below the strike price\n.\nDirectional assumption: Bearish\nShort\nSell the right to buy an underlying asset\nat the strike price\nprior to the expiration date.\nProfits increase as the price of the underlying decreases below the strike price\n.\nDirectional assumption: Bearish\nSell the right to sell an underlying asset\nat the strike price\nprior to the expiration date.\nProfits increase as the price of the underlying increases above the strike price\n.\nDirectional assumption: Bullish\nThe relationship between the strike price and the current price of the underlying determines the\nmoneyness\nof the position. This is equivalently the\nintrinsic value\nof aposition, or the value of the contract if it were exercised immediately. Contracts can be described as one of the following, noting that options cannot have negative intrinsic value:\nIn‐the‐money (ITM): The contract would be profitable if it was exercised immediately and thus has intrinsic value.\nOut‐of‐the‐money (OTM): The contract would result in aloss if it was exercised immediately and thus has no intrinsic value.\nAt‐the‐money (ATM): The contract has astrike price equal to the price of the underlying and thus has no intrinsic value.\nThe intrinsic value of aposition is based entirely on the type of position and the choice of strike price relative to the price of the underlying:\nCall options\nIntrinsic Value = Either\n(stock price – strike price) or 0\nITM:\nOTM:\nATM:\nPut options\nIntrinsic Value = Either\nor 0\nITM:\nOTM:\nATM:\nFor example, consider a 45 DTE put contract with astrike price of $100:\nScenario 1 (ITM): The underlying price is $95. In this case, the intrinsic value of the put contract is $5 per share.\nScenario 2 (OTM): The underlying price is $105. In this case, the put contract has no intrinsic value.\nScenario 3 (ATM): The underlying price is $100. In this case, the put is also considered to have no intrinsic value.\nThe value of an option also depends on speculative factors, driven by supply and demand. The\nextrinsic\nvalue of the option is the difference\nbetween the current market price for the option and the intrinsic value of the option. Again, consider a 45 DTE put contract with astrike price of $100 on an underlying with acurrent price per share of $105. Suppose that, due to aperiod of recent market turbulence, investors are fearful the underlying price will crash within the next 45 days and create ademand for these OTM put contracts. The surge in demand inflates the price of the put contract to $10", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml", "doc_id": "3f519c4d8644bb886b7ea544bb01395ddc4ec86fcf8f99537e3273c4009792e5", "chunk_index": 1}
{"text": "underlying with acurrent price per share of $105. Suppose that, due to aperiod of recent market turbulence, investors are fearful the underlying price will crash within the next 45 days and create ademand for these OTM put contracts. The surge in demand inflates the price of the put contract to $10 per share. Therefore, because the put contract has no intrinsic value but has amarket price of $10, the extrinsic value of the contract is $10 per share. If, instead, the price of the underlying is $95 and the price of the ITM put is still $10 per share, then the contract will have $5 in intrinsic value and $5 in extrinsic value.\nThe profitability of an option ultimately depends on both intrinsic and extrinsic factors, and it is calculated as the difference between the intrinsic value of an option and the cost of the contract. Mathematically, profit and loss (P/L) approximations for long calls and puts at exercise are given by the following equations:\n2\n(1.3)\n(1.4)\nwhere the max function simply outputs the larger of the two values. For instance,\nequals 1 while\nequals 0. The P/Ls for the corresponding short sides are merely\nEquations (1.3)\nand\n(1.4)\nmultiplied by –1. Following is asample trade that applies the long call profit formula.\nExample trade: Acall with 45 DTE duration is traded on an underlying that is currently priced at $100\n. The strike price is $105\nand the long call is currently valued at $100 per one lot ($1 per share).\nScenario 1: The underlying increases to $105 by the expiration date.\nLong call P/L:\nShort call P/L: +$100.\nScenario 2: The underlying increases to $110 by the expiration date.\nLong call P/L:\nShort call P/L: –$400.\nScenario 3: The underlying decreases to $95 by the expiration date.\nLong call P/L:\nShort call P/L: +$100.\nThe trader adopting the long position pays the seller the option premium upfront and profits when the intrinsic value exceeds the price of the contract. The short trader profits when the intrinsic value remains below the price of the contract, especially when the position expires worthless (no intrinsic value). The extrinsic value of an option generally decreases over the duration of the contract, as uncertainty around the underlying price and uncertainty around the profit potential of the option decrease. As aposition nears expiration, the price of an option converges toward its intrinsic value.\nOptions pricing clearly plays alarge role in options trading. To develop an intuitive understanding around how options are priced, understanding the mathematical assumptions around market efficiency and price dynamics is critical.\nThe Efficient Market Hypothesis\nTraders must make anumber of assumptions prior to placing atrade. Options traders must make directional assumptions about the price of the underlying over agiven time frame: bearish (expecting price to decrease), bullish (expecting price to increase), or neutral (expecting price to remain relatively unchanged). Options traders also must make assumptions about the current value of an option. If options contracts are perceived as overvalued, long positions are less likely to profit. If options contracts are perceived as undervalued, short positions are less likely to profit. These assumptions about underlying and option price dynamics are apersonal choice, but traders can formulate consistent assumptions by referring to the efficient market hypothesis (EMH). The EMH states that instruments are traded at afair price, and the current price of an asset reflects some amount of available information. The hypothesis comes in three forms:\nWeak EMH: Current prices reflect all past price information.\nSemi‐strong EMH: Current prices reflect all publicly available information.\nStrong EMH: Current prices reflect all possible information.\nNo variant of the EMH is universally accepted or rejected. The form that atrader assumes is subjective, and methods of market analysis available are limited depending on that choice. Proponents of the strong EMH posit that investors benefit from investing in low‐cost passive index funds because the market is unbeatable. Opponents believe the market is beatable by exploiting inefficiencies in the market. Traders who accept the weak EMH believe technical analysis (using past price trends to predict future price trends) is invalidated, but fundamental analysis (using related economic data to predict future price trends) is still viable. Traders who accept the semi‐strong EMH assume fundamental analysis would not yield systematic success but trading according to private information would. Traders who accept the strong EMH maintain that even insider trading will not result in consistent success and no exploitable market inefficiencies are available to anyone.\nThis book focuses on highly liquid markets, and inefficiencies are assumed to be minimal. More specifically, this book assumes asemi‐strong form of the EMH. Rather than constructing portfolios according to forecasts of future price trends, the purpo", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml", "doc_id": "3f519c4d8644bb886b7ea544bb01395ddc4ec86fcf8f99537e3273c4009792e5", "chunk_index": 2}
{"text": "ble market inefficiencies are available to anyone.\nThis book focuses on highly liquid markets, and inefficiencies are assumed to be minimal. More specifically, this book assumes asemi‐strong form of the EMH. Rather than constructing portfolios according to forecasts of future price trends, the purpose of this text is to demonstrate how trading options according to current market conditions and directional\nvolatility\nassumptions (rather than price assumptions) has allowed options sellers to consistently outperform the market.\nThis “edge” is not the result of some inherent market inefficiency but rather atrade‐off of risk. Recall the example long call trade from the previous section. Notice that there are more scenarios in which the short trader profits compared to the long trader. Generally, short premium positions are more likely to yield aprofit compared to long premium positions. This is because options are assumed to be priced efficiently and scaled according to the perceived risk in the market, meaning that long positions only profit when the underlying has large directional moves outside of expectations. As these types of events are uncommon, options contracts go unused the majority of the time and short premium positions profit more often than long positions. However, when those large,\nunexpected moves\ndo\noccur, the short premium positions are subject to potentially massive losses. The risk profiles for options are complex, but they can be intuitively represented with probability distributions.\nProbability Distributions\nTo better understand the risk profiles of short options, this book utilizes basic concepts from probability theory, specifically random variables and probability distributions. Random variables are formal stand‐ins for uncertain quantities. The probability distribution of arandom variable describes possible values of that quantity and the likelihood of each value occurring. Generally, probability distributions are represented by the symbol\n, which can be read as “the probability that.” For example,\n. Random variables and probability distributions are tools for working with probabilistic systems (i.e., systems with many unpredictable outcomes), such as stock prices. Although future outcomes cannot be precisely predicted, understanding the distribution of aprobabilistic system makes it possible to form expectations about the future, including the uncertainty associated with those expectations.\nLet'sbegin with an example of asimple probabilistic system: rolling apair of fair, six‐sided dice. In this case, if\nrepresents the sum of the dice, then\nis arandom variable with 11 possible values ranging from 2 to 12. Some of these outcomes are more likely than others. Since, for instance, there are more ways to roll asum of 7 ([1,6], [2,5], [3,4], [4,3], [5,2], [6,1]) than asum of 10 ([4,6], [5,5], [6,4]), there is ahigher probability of rolling a 7 than a 10. Observing that there are 36 possible rolls ([1,1], [1,2], [2,1], etc.) and that each is equally likely, one can use symbols to be more precise about this:\nThe distribution of\ncan be represented elegantly using ahistogram. These types of graphs display the frequency of different outcomes, grouped according to defined ranges. When working with measured data, histograms are used to estimate the true underlying\nprobability distribution of aprobabilistic system. For this fair dice example, there will be 11 bins, corresponding to the 11 possible outcomes. This histogram is shown below in\nFigure 1.1\n, populated with data from 100,000 simulated dice rolls.\nFigure 1.1\nAhistogram for 100,000 simulated rolls for apair of fair dice. This diagram shows the likelihood of each outcome occurring according to this simulation (e.g., the height of the bin ranging from 6.5 to 7.5 is near 17%, indicating that 7 occurred nearly 17% of the time in the 100,000 trials).\nDistributions like the ones shown here can be summarized using quantitative measures called\nmoments\n.\n3\nThe first two moments are mean and variance.\nMean\n(first moment): Also known as the average and represented by the Greek letter\n(mu), this value describes the central tendency of\nadistribution. This is calculated by summing all the observed outcomes\ntogether and dividing by the number of observations\n:\n(1.5)\nFor distributions based on statistical observations with\nasufficiently large number of occurrences\n, the mean corresponds to the expected value of that distribution. The expected value of arandom variable is the weighted average of outcomes and the anticipated average outcome over future trials. The expected value of arandom variable\n, denoted\n, can be estimated using statistical data and\nEquation (1.5)\n,\nor\nif the unique outcomes (\n) and their respective probabilities\nare known, then the expected value can also be calculated using the following formula:\n(1.6)\nIn the dice sum example, represented with random variable\n, the possible outcomes (2, 3, 4, …, 12) and the probability of each occurrin", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml", "doc_id": "3f519c4d8644bb886b7ea544bb01395ddc4ec86fcf8f99537e3273c4009792e5", "chunk_index": 3}
{"text": "1.5)\n,\nor\nif the unique outcomes (\n) and their respective probabilities\nare known, then the expected value can also be calculated using the following formula:\n(1.6)\nIn the dice sum example, represented with random variable\n, the possible outcomes (2, 3, 4, …, 12) and the probability of each occurring (2.78%, 5.56%, 8.33%, …, 2.78%) are known, so the expected value can be determined as follows:\nThe theoretical long‐term average sum is seven. Therefore, if this experiment is repeated many times, the mean of the observations calculated using\nEquation (1.5)\nshould yield an output close to seven.\nVariance\n(second moment): This is the measure of the spread, or variation, of the data points from the mean of the distribution. Standard deviation, represented with by the Greek letter\n(sigma), is the square root of variance and is commonly used as ameasure of uncertainty (equivalently, risk or volatility). Distributions with more variance are wider and have more uncertainty around future outcomes. Variance is calculated according to the following:\n4\n(1.7)\nWhen alarge portion of data points are dispersed far from the mean, the variance of the entire set is large, and uncertainty on measurements from that system is significant. The variance of arandom variable\nX\n, denoted\n(\nX\n), can also be calculated in terms of the expected value,\n[\nX\n]:\n(1.8)\nFor the dice sum random variable,\nD\n, the possible outcomes (2, 3, 4, …, 12) and the probability of each occurring (2.78%, 5.56%, 8.33%, …, 2.78%) are known, so the variance of this experiment is as follows:\nThis equation indicates that the spread of the distribution for this random variable is around 5.84 and the uncertainty (standard deviation) is approximately 2.4 (shown in\nFigure 1.2\n).\nOne can compare these theoretical estimates for the mean and standard deviation of the dice sum experiment to the values measured from statistical data. The calculated first and second moments from the simulated dice roll experiment are plotted in\nFigure 1.2\nfor comparison.\nObtaining adistribution average near 7.0 makes intuitive sense because 7 is the most likely sum to roll out of the possible outcomes. The standard deviation indicates that the uncertainty associated with that expected value is near 2.4. Inferring from the shape of the distribution, which has most of the probability mass concentrated near the center, one can conclude that on any given roll the outcome will most likely fall between five and nine.\nThe distribution just shown is symmetric about the mean, but probability distributions are often asymmetric. To quantify the degree of asymmetry for adistribution, the third moment is used.\nSkew\n(third moment): This is ameasure of the asymmetry of adistribution. Adistribution'sskew can be positive, negative, or zero and depends on whether the tail to the right of the mean is larger (positive skew), to the left is larger (negative skew), or equal on both sides (zero skew). Unlike mean and standard deviation, which have units defined by the random variable, skew is apure number that quantifies the degree of asymmetry according to the following formula:\n(1.9)\nFigure 1.2\nAhistogram for 100,000 simulated dice rolls with fair dice. Included is the mean of the distribution (solid line) and the standard deviation of the distribution on either side of the mean (dotted line), both calculated using the observations from the simulated experiment. The average of this distribution was 7.0 and the standard deviation was 2.4, consistent with the theoretical estimates.\nThe concept of skew and its applications can be best understood with amodification to the dice rolling example. Suppose that the dice are biased rather than fair. Let'sconsider two scenarios: apair of unfair dice with asmall number bias (two and three more likely) and apair of unfair dice with alarge number bias (four and five more likely).\nThe probabilities of each number appearing on each die for the different cases are shown in\nTable 1.2\n.\nTable 1.2\nThe probability of each number appearing on each die in the three different scenarios, one fair and two unfair.\nProbability of Number Appearing on Each Die\nDie Number\nFair\nUnfair (Small Number Bias)\nUnfair (Large Number Bias)\n1\n16.67%\n10%\n10%\n2\n16.67%\n30%\n10%\n3\n16.67%\n30%\n10%\n4\n16.67%\n10%\n30%\n5\n16.67%\n10%\n30%\n6\n16.67%\n10%\n10%\nWhen rolling the\nfair\npair and plotting the histogram of the possible sums, the distribution is symmetric about the mean and has askew of zero. However, the distributions when rolling the unfair dice are skewed, as shown in\nFigures 1.3\n(a) and (b).\nThe skew of adistribution is classified according to where the majority of the distribution mass is concentrated. Remember that the positive side is to the right of the mean and the negative side is to the left. The histogram in\nFigure 1.3\n(a) has alonger tail on the positive side and has the most mass concentrated on the negative side of the mean: This is an example of\npositive\nskew (skew = 0.45). The histogram in\nFigur", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml", "doc_id": "3f519c4d8644bb886b7ea544bb01395ddc4ec86fcf8f99537e3273c4009792e5", "chunk_index": 4}
{"text": "hat the positive side is to the right of the mean and the negative side is to the left. The histogram in\nFigure 1.3\n(a) has alonger tail on the positive side and has the most mass concentrated on the negative side of the mean: This is an example of\npositive\nskew (skew = 0.45). The histogram in\nFigure 1.3\n(b) has alonger tail on the negative side and has the majority of the mass concentrated on the positive side of the mean: This is an example of\nnegative\nskew (skew = –0.45).\nWhen adistribution has skew, the interpretation of standard deviation changes. In the example with fair dice, the expected value of the experiment is\n2.4, suggesting that any given trial will most likely have an outcome between five and nine. This is avalid interpretation because the distribution is symmetric about the mean and most of the distribution mass is concentrated around it. However, consider the distribution in the unfair example with the large number bias. This distribution has amean of 7.8 and astandard deviation of 2.0, naively suggesting that the outcome will most likely be between six and nine with the outcomes on either side being equally probable. However, because the majority of the occurrences are concentrated on the positive side of the mean (roughly 60% of occurrences), the uncertainty is not symmetric. This concept will be discussed in more detail in alater chapter, as distributions of financial instruments are commonly skewed, and there is ambiguity in defining risk under those circumstances.\nFigure 1.3\n(a) Ahistogram for 100,000 simulated dice rolls with unfair dice, biased such that smaller numbers (2 and 3) are more likely to appear on each die. (b) Ahistogram for 100,000 simulated dice rolls with unfair dice, biased such that larger numbers (4 and 5) are more likely to appear on each die.\nMathematicians and scientists have encountered some probability distributions repeatedly in theory and applications. These distributions have, in turn, received agreat deal of study. Assuming the underlying distribution of an experiment resembles awell known form can often greatly simplify statistical analysis. The normal distribution (also known as the Gaussian distribution or the bell curve) is arguably one of the most well‐known probability distributions and foundational in quantitative finance. It describes countless different real‐world systems because of aresult known as the central limit theorem. This theorem says, roughly, that if arandom variable is made by adding together many independently random pieces, then, regardless of what those pieces are, the result will be normally distributed. For example, the distribution in the two‐dice example is fairly non‐normal, being relatively triangular and lacking tails. If one considered the sum of more and more dice, each of which is an independent random variable, the distribution would gradually take on abell shape. This is shown in\nFigure 1.4\n.\nThe normal distribution is asymmetric, bell‐shaped distribution, meaning that equidistant events on either side of the center are equally likely and the skew is zero. The distribution is centered around the mean, and outcomes further away from the mean are less likely. The normal distribution has the intriguing property that 68% of occurrences fall within\nof the mean, 95% of occurrences are within\nof the mean, and 99.7% of occurrences are within\nof the mean.\nFigure 1.5\nplots anormal distribution.\nThese probabilities can be used to roughly contextualize distributions with similar geometry. For example, in the fair dice pair model, the expected value of the fair dice experiment was 7.0, and the standard deviation was 2.4. With the assumption of normality, one would infer there is roughly a 68% chance that future outcomes will fall between five and nine. The true probability is 66.67% for this random variable, indicating that the normality assumption is not exactly correct but can be used for the purposes of approximation. As more dice are added to the example, this approximation becomes increasingly accurate.\nFigure 1.4\nAhistogram for 100,000 simulated rolls with agroup of fair, six‐sided dice numbering (a) 2, (b) 4, or (c) 6.\nUnderstanding distribution statistics and the properties of the normal distribution is incredibly useful in quantitative finance. The expected return of astock is usually estimated by the mean return, and the historic risk is estimated with the standard deviation of returns (historical volatility). Stock log returns are also widely assumed to be normally distributed. Although, this is only approximately true because the overwhelming majority of stocks and ETFs have skewed returns distributions.\n5\nRegardless, this normality estimation provides aquantitative framework for expectations around future price moments. This approximation also simplifies mathematical models of price dynamics and options pricing, the most notable of which is the Black‐Scholes model.\nFigure 1.5\nAdetailed plot of the normal distribution and", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml", "doc_id": "3f519c4d8644bb886b7ea544bb01395ddc4ec86fcf8f99537e3273c4009792e5", "chunk_index": 5}
{"text": "lity estimation provides aquantitative framework for expectations around future price moments. This approximation also simplifies mathematical models of price dynamics and options pricing, the most notable of which is the Black‐Scholes model.\nFigure 1.5\nAdetailed plot of the normal distribution and the corresponding probabilities at each standard deviation mark.\nThe Black‐Scholes Model\nThe Black‐Scholes options pricing formalism revolutionized options markets when it was published in 1973. It provided the first popular quantitative framework for estimating the fair price of an option according to the contract parameters and the characteristics of the underlying. The Black‐Scholes equation models the price evolution of a European‐style option\n(an option that can only be exercised at expiration) within the context of the broader financial market. The corresponding Black‐Scholes formula uses this equation to estimate the theoretical price of that option according to its parameters.\nIt'simportant to note that the purpose of this Black‐Scholes section is\nnot\nto elucidate the underlying mathematics of the model, which can be quite complicated. The output of the model is merely atheoretical value for the fair price of an option. In practice, an option'sprice typically deviates from this value because of market speculation and supply and demand, which this model does not take into account. Rather, it is essential to have at least asuperficial grasp of the Black‐Scholes model to understand (1) the foundational assumptions of financial markets and (2) where implied volatility (agauge for the market'sperception\nof risk) comes from.\nThe Black‐Scholes model is based on aset of assumptions related to the dynamics of financial assets and the market as awhole. The assumptions are as follows:\nThe market is frictionless (i.e., there are no transaction fees).\nCash can be borrowed and lent in any amount, even fractional, at the risk‐free rate (the theoretical rate of return of an investment with no risk, amacroeconomic variable assumed to be constant).\nThere is no arbitrage opportunity (i.e., profits in excess of the risk‐free rate cannot be made without risk).\nStocks can be bought and sold in any amount, even fractional amounts.\nStocks do not pay dividends.\n6\nStock log returns follow Brownian motion with constant drift and volatility (the theoretical mean and standard deviation of annual log returns).\nA Brownian motion, or a Wiener process, is atype of stochastic process or asystem that experiences random fluctuations as it evolves with time. Traditionally used to describe the positional fluctuations of aparticle suspended in fluid at thermal equilibrium,\n7\nastandard Wiener process (denoted\nW\n(\nt\n)) is mathematically defined by the conditions in the grey box. The mathematical definition can be overlooked if preferred, as the intuition behind the mathematics is more crucial for understanding the theoretical foundation of options pricing and follows after.\n(i.e., the process initially begins at location 0).\nis almost surely continuous.\nThe increments of\n, defined as\nwhere\n, are normally distributed with mean 0 and variance\n(i.e., the steps of the Wiener process are normally distributed with constant mean of 0 and variance of\n).\nDisjoint increments of\nare independent of one another (i.e., the current step of the process is not influenced by the previous steps, nor does it influence the subsequent steps).\nSimplified, a Wiener process is aprocess that follows arandom path. Each step in this path is probabilistic and independent of one another. When disjoint steps of equal duration are plotted in ahistogram, that distribution is normal with aconstant mean and variance. Brownian motion dynamics are driven by this underlying process. These conditions can be best understood visually, which will also demonstrate why this assumption appears in the development of the Black‐Scholes model as an approximation for price dynamics.\nFigures 1.6\nand\n1.7\nillustrate the characteristics of Brownian motion, and\nFigure 1.8\nillustrates the dynamics of SPY from 2010–2015\n8\nfor the purposes of comparison.\nThe price trends of SPY in\nFigure 1.8\n(b) appear fairly similar to the Brownian motion cumulative horizontal displacements shown in\nFigure 1.6\n(c). The daily returns for SPY are more prone to outlier moves compared to the horizontal displacements of Brownian motion but share some characteristics. The symmetric geometry of the SPY returns histogram bears resemblance to the fairly normal distribution of horizontal displacements, with the tails of the distribution being more prominent as aresult of the history of large price moves.\nFigure 1.6\n(a) The 2D position of aparticle in afluid, moving with Brownian motion. The particle begins at acoordinate of\nand drifts to anew location over 1,000 steps. (b) The horizontal displacements\n9\nof the particle (i.e., the movements of the particle along the X‐axis over 1,000 steps). (c) The cumulative horizontal displac", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml", "doc_id": "3f519c4d8644bb886b7ea544bb01395ddc4ec86fcf8f99537e3273c4009792e5", "chunk_index": 6}
{"text": "n of aparticle in afluid, moving with Brownian motion. The particle begins at acoordinate of\nand drifts to anew location over 1,000 steps. (b) The horizontal displacements\n9\nof the particle (i.e., the movements of the particle along the X‐axis over 1,000 steps). (c) The cumulative horizontal displacement of the particle over 1,000 steps.\nSimilarities are clear between price dynamics and Brownian motion, but this remains ahighly simplified model of price dynamics. In reality, stock log returns are not normal and are typically skewed to the upside or downside, depending on the specific underlying. Additionally, the drift and volatility of astock are not directly observable, and it cannot be experimentally confirmed whether or not these variables are constant. Stock volatility approximated with historical return data is rarely constant with time (aphenomenon known as heteroscedasticity). Stock returns are also not typically independent of one another across time (aphenomenon known as autocorrelation), which is arequirement for this model.\nFigure 1.7\nThe distribution of the horizontal displacements of the particle over 1,000 steps. As characteristic of a Wiener process, the increments are normally distributed, have amean of zero and variance\n(which equals 1 in this case). This figure indicates that horizontal step sizes between –1 and 1 are most common, and step sizes with alarger magnitude than 1 are less common.\nFigure 1.8\nThe (a) daily returns, (b) price, and (c) daily returns histogram for SPY from 2010–2015.\nAlthough the normality assumption is not entirely accurate, making this simplification allows the development of the rest of this theoretical framework shown in the gray box. The formalism in the gray box is supplemental material for the mathematically inclined. The interpretation of the math, which is more significant, follows after. It should be noted that the Black‐Scholes model technically assumes that stock prices follow\ngeometric Brownian motion\n, which is more accurate because price movements cannot be negative. Geometric Brownian motion is aslight modification of Brownian motion and requires that the logarithm of the signal follow Brownian motion rather than\nthe signal itself. As it relates to price dynamics, this suggests that the log returns are normally distributed with constant drift (return rate) and volatility.\n10\nFor the price of astock that follows ageometric Brownian motion, the dynamics of the asset price can be represented with the following stochastic differential equation:\n11\n(1.10)\nwhere\nis the price of the stock at time\nt\n,\nis the Wiener process at time\n,\nis adrift rate, and\nis the volatility of the stock. The drift rate and volatility of the stock are assumed to be constant, and it'simportant to reiterate that neither of these variables are directly observable. These constants can be approximated using the average return of astock and the standard deviation of historical returns, but they can never be precisely known.\nThe equation states that each stock price increment\nis driven by apredictable amount of drift (with expected return\n) and some amount of random noise\n. In other words, this equation has two components: one that models\ndeterministic\nprice trends\nand one that models probabilistic price fluctuations\n. The important takeaway from this observation is that inherent uncertainty is in the price of stock, represented with the contributions from the\nWiener process. Because the increments of a Wiener process are independent of one another, it also is common to assume that the weak EMH holds at minimum, in addition to the normality of log returns.\nUsing this equation as abasis for the derivation, assuming ariskless options portfolio must earn the risk‐free rate, and rearranging terms, the Black‐Scholes equation follows:\n(1.11)\nwhere\nis the price of a European call (with adependence on\nand\n),\nis the price of the stock (with adependence on\n),\nis the risk‐free rate, and\nis the volatility of the stock. The Black‐Scholes formula can be calculated by solving the Black‐Scholes equation according to boundary conditions given by the payoff at expiration of European options. The formula, which provides the value of a European call option for anon‐dividend‐paying stock, is given by the following equation:\n(1.12)\nwhere\nis the value of the standard normal cumulative distribution function at\nand similarly for\n,\nTis the time that the option will expire (\nis the duration of the contract),\nis the price of the stock at time\nt\n,\nKis the strike price of the option, and\nand\nare given by the following:\n(1.13)\n(1.14)\nwhere\nis the volatility of the stock. If the equations seem gross, it'sbecause they are.\nAgain, the purpose of this section is not to describe the underlying mechanics of the Black‐Scholes model in detail. Rather,\nEquations (1.10)\nthrough\n(1.14)\nare included to emphasize three important points.\nThere is inherent uncertainty in the price of stock. Stock price movements are also assumed t", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml", "doc_id": "3f519c4d8644bb886b7ea544bb01395ddc4ec86fcf8f99537e3273c4009792e5", "chunk_index": 7}
{"text": "Again, the purpose of this section is not to describe the underlying mechanics of the Black‐Scholes model in detail. Rather,\nEquations (1.10)\nthrough\n(1.14)\nare included to emphasize three important points.\nThere is inherent uncertainty in the price of stock. Stock price movements are also assumed to be independent of one another and log‐normally distributed.\n12\nAn estimate for the fair price of an option can be calculated according to the price of the stock, the volatility of the stock, the risk‐free rate, the duration of the contract, and the strike price.\nThe volatility of astock, which plays an important role in estimating the risk of an asset and the valuation of an option, cannot be directly observed. This suggests that the “true risk” of an instrument can never be exactly known. Risk can only be approximated using ametric, such as historical volatility or the standard deviation of the historical returns over some timescale, typically matching the duration of the contract. Other than using apast‐looking metric, such as historical volatility to estimate the risk of an asset, one can also infer the risk of an asset from the price of its options.\nAs stated previously, the Black‐Scholes model only gives atheoretical\nestimate for the fair price of an option. Once the contract is traded on the options market, the price of the contract is often driven up or down depending on speculation and perceived risk. The deviation of an option'sprice from its theoretical value as aresult of these external factors is indicative of\nimplied volatility\n. When initially valuing an option, the historical volatility of the stock has been priced into the model. However, when the price of the option trades higher or lower than its theoretical value, this indicates that the\nperceived\nvolatility of the underlying deviates from what is estimated by historical returns.\nImplied volatility may be the most important metric in options trading. It is effectively ameasure of the\nsentiment\nof risk for agiven underlying according to the supply and demand for options contracts. For an example, suppose anon‐dividend‐paying stock currently trading at $100 per share has ahistorical 45‐day returns volatility of 20%. Suppose its call option with a 45‐day duration and astrike price of $105 is trading at\n$2 per share. Plugging these parameters into the Black‐Scholes model, this call option should theoretically be trading at $1 per share. However, demand for this position has increased the contract price significantly. For the model to return acall price of $2 per share, the volatility of this underlying would have to be 28% (assuming all else is constant). Therefore, although the historical volatility of the underlying is only 20%, the perceived risk of that underlying (i.e., the implied volatility) is actually 28%.\nTo conclude, the primary purpose of this section was not to dive into the math of the Black‐Scholes. These concepts were, instead, introduced to justify the following axioms that are foundational to this book:\nProfits cannot be made without risk.\nStock log returns have inherent uncertainty and are assumed to follow anormal distribution.\nStock price movements are independent across time (i.e., future price changes are independent of past price changes, requiring aminimum of the weak EMH).\nOptions can theoretically be priced fairly based on the price of the stock, the volatility of the stock, the risk‐free rate, the duration of the contract, and the strike price.\nThe volatility of an asset cannot be directly observed, only estimated using metrics like historical volatility or implied volatility.\nThe Greeks\nOther than implied volatility, the Greeks are the most relevant metrics derived from the Black‐Scholes model. The Greeks are aset of risk measures, and each describes the sensitivity of an option'sprice with respect to changes in some variable. The most essential Greeks for options traders are delta\n, gamma\n, and theta\n.\nDelta\nis one of the most important and widely used Greeks. It is afirst‐order\n13\nGreek that measures the expected change in the option\nprice given a $1 increase in the price of the underlying (assuming all other variables stay constant). The equation is as follows:\n(1.15)\nwhere\nVis the price of the option (acall or aput) and\nSis the price of the underlying stock, noting that ∂ is the partial derivative. The value of delta ranges from –1 to 1, and the sign of delta depends on the type of position:\nLong stock:\nis 1.\nLong call and short put:\nis between 0 and 1.\nLong put and short call:\nis between –1 and 0.\nFor example, the price of along call option with adelta of 0.50 (denoted 50\nbecause that is the total\nfor aone lot, or 100 shares of underlying) will increase by approximately $0.50 per share when the price of the underlying increases by $1. This makes intuitive sense because along stock, along call, and ashort put are all bullish strategies, meaning they will profit when the underlying price increases. Similarly, becau", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml", "doc_id": "3f519c4d8644bb886b7ea544bb01395ddc4ec86fcf8f99537e3273c4009792e5", "chunk_index": 8}
{"text": "shares of underlying) will increase by approximately $0.50 per share when the price of the underlying increases by $1. This makes intuitive sense because along stock, along call, and ashort put are all bullish strategies, meaning they will profit when the underlying price increases. Similarly, because long puts and short calls are bearish, they will take aloss when the underlying price increases.\nDelta has asign and magnitude, so it is ameasure of the\ndegree\nof\ndirectional risk\nof aposition. The sign of delta indicates the direction of the risk, and the magnitude of delta indicates the severity of exposure. The larger the magnitude of delta, the larger the profit and loss potential of the contract. This is because positions with larger deltas are closer to/deeper ITM and more sensitive to changes in the underlying price. Acontract with adelta of 1.0 (100\n) has maximal directional exposure and is maximally ITM. 100\noptions behave like the stock price, as a $1 increase in the underlying creates a $1 increase in the option'sprice per share. Acontract with adelta of 0.0 has no directional exposure and is maximally OTM. A 50\ncontract is defined as having the ATM strike.\n14\nBecause delta is ameasure of directional exposure, it plays alarge role when hedging directional risks. For instance, if atrader currently has a 50\nposition on and wants the position to be relatively insensitive to\ndirectional moves in the underlying, the trader could offset that exposure with the addition of 50 negative deltas (e.g., two 25\nlong puts). The composite position is called delta neutral.\nGamma\nis asecond‐order Greek and ameasure of the expected change in the option\ndelta\ngiven a $1 change in the underlying price. Gamma is mathematically represented as follows:\n(1.16)\nAs with delta, the sign of gamma depends on the type of position:\nLong call and long put:\n.\nShort call and short put:\n.\nIn other words, if there is a $1 increase in the underlying price, then the delta for all long positions will become more positive, and the delta for all short positions will become more negative. This makes intuitive sense because a $1 increase in the underlying pushes long calls further ITM, increasing the directional exposure of the contract, and it pushes long puts further OTM, decreasing the inverse directional exposure of the contract and bringing the negative delta closer to zero. The magnitude of gamma is highest for ATM positions and lower for ITM and OTM positions, meaning that delta is most sensitive to underlying price movements at –50\nand 50\n.\nAwareness of gamma is critical when trading options, particularly when aiming for specific directional exposure. The delta of acontract is typically transient, so the gamma of aposition gives abetter indication of the long‐term directional exposure. Suppose traders wanted to construct adelta neutral position by pairing ashort call (negative delta) with ashort put (positive delta), and they are considering using 20\nor 40\ncontracts (all other parameters identical). The 40\ncontracts are much closer to ATM (50\n) and have more profit potential than the 20\npositions, but they also have significantly more gamma risk and are less likely to remain delta neutral in the long term. The optimal choice would then depend on how much risk traders are willing to accept and their profit goals. For traders with high profit goals and alarge enough account to handle the large P/Lswings and loss potential of the trade, the 40\ncontracts are more suitable.\nTheta\nis afirst‐order Greek that measures the expected P/Lchanges resulting from the decay of the option'sextrinsic value (the difference between the current market price for the option and the intrinsic value of the option) per day. It is also commonly referred to as the time decay of the option. Theta is mathematically represented as follows:\n(1.17)\nwhere\nVis the price of the option (acall or aput) and\ntis time. The sign of theta depends on the type of position and is opposite gamma:\nLong call and long put:\n.\nShort call and short put:\n.\nIn other words, the time decay of the extrinsic value decreases the value of the long position and increases the value of the short position. For instance, along call with atheta of –5 per one lot is expected to decline in value by $5 per day. This makes intuitive sense because the holders of the contract take gradual losses as their asset depreciates with time, aresult of the value of the option converging to its intrinsic value as uncertainty dissipates. Because the extrinsic value of acontract decreases with time, the short side of the position profits with time and experiences positive time decay. The magnitude of theta is highest for ATM options and lower for ITM and OTM positions, all else constant.\nThere is atrade‐off between the gamma and theta of aposition. For instance, along call with the benefit of alarge, positive gamma will also be subjected to alarge amount of negative time decay. Consider these examples:\nPosition 1:\nA 4", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml", "doc_id": "3f519c4d8644bb886b7ea544bb01395ddc4ec86fcf8f99537e3273c4009792e5", "chunk_index": 9}
{"text": "M options and lower for ITM and OTM positions, all else constant.\nThere is atrade‐off between the gamma and theta of aposition. For instance, along call with the benefit of alarge, positive gamma will also be subjected to alarge amount of negative time decay. Consider these examples:\nPosition 1:\nA 45 DTE, 16\ncall with astrike price of $50 is trading on a $45 underlying. The long position has agamma of 5.4 and atheta of –1.3.\nPosition 2:\nA 45 DTE, 44\ncall with astrike price of $50 is trading on a $49 underlying. The long position has agamma of 7.9 and atheta of –2.2.\nCompared to the first position, the second position has more gamma exposure, meaning that the contract delta (and the contract price) is more sensitive to changes in the underlying price and is more likely to\nmove ITM. However, this position also comes with more theta decay, meaning that the extrinsic value also decreases more rapidly with time.\nTo conclude this discussion of the Black‐Scholes model and its risk measures, note that the outputs of all options pricing models should be taken with agrain of salt. Pricing models are founded on simplified assumptions of real financial markets. Those assumptions tend to become less representative in highly volatile market conditions when potential profits and losses become much larger. The assumptions and Greeks of the Black‐Scholes model can be used to form reasonable expectations around risk and return\nin most market conditions\n, but it'salso important to supplement that framework with model‐free statistics.\nCovariance and Correlation\nUp until now we have discussed trading with respect to asingle position, but quantifying the relationships between multiple positions is equally important. Covariance quantifies how two signals move relative to their means with respect to one another. It is an effective way to measure the variability between two variables. For one signal,\nX\n, with observations\nand mean\n, and another,\nY\n, with observations\nand mean\nthe covariance between the two signals is given by the following:\n(1.18)\nRepresented in terms of random variables\nXand\nY,\nthis is equivalent to the following:\n15\n(1.19)\nSimplified, covariance quantifies the tendency of the linear relationship between two variables:\nApositive\ncovariance indicates that the high values of one signal coincide with the high values of the other and likewise for the low values of each signal.\nAnegative\ncovariance indicates that the high values of one signal coincide with the low values of the other and vice versa.\nAcovariance of zero indicates that no linear trend was observed between the two variables.\nCovariance can be best understood with agraphical example. Consider the following ETFs with daily returns shown in the following figures: SPY (S&P 500), QQQ (Nasdaq 100), and GLD (Gold), TLT (20+ Year Treasury Bonds).\nFigure 1.9\n(a) QQQ returns versus SPY returns. The covariance between these assets is 1.25, indicating that these instruments tend to move similarly. (b) TLT returns versus SPY returns. The covariance between these assets is –0.48, indicating that they tend to move inversely of one another. (c) GLD returns versus SPY returns. The covariance between these assets is 0.02, indicating that there is not astrong linear relationship between these variables.\nCovariance measures the direction of the linear relationship between two variables, but it does not give aclear notion of the\nstrength\nof that relationship. Because the covariance between two variables is specific to the scale of those variables, the covariances between two sets of pairs are not comparable. Correlation, however, is anormalized covariance that indicates the direction\nand\nstrength of the linear relationship, and it is also invariant to scale. For signals\nwith standard deviations\nand covariance\n, the correlation coefficient\n(rho) is given by the following:\n(1.20)\nThe correlation coefficient ranges from –1 to 1, with 1 corresponding to aperfect positive linear relationship, –1 corresponding to aperfect negative linear relationship, and 0 corresponding to no measured linear relationship. Revisiting the example pairs shown in\nFigure 1.9\n, the strength of the linear relationship in each case can now be evaluated and compared.\nFor\nFigure 1.9\n(a), QQQ returns versus SPY returns, the correlation between these assets is 0.88, indicating astrong, positive linear relationship. For\nFigure 1.9\n(b), TLT returns versus SPY returns, the correlation between these assets is –0.43, indicating amoderate, negative linear relationship. And for\nFigure 1.9\n(c), GLD returns versus SPY returns, the correlation between these assets is 0.00, indicating no measurable linear relationship between these variables. According to the correlation values for the pairs shown, the strongest linear relationship is between SPY and QQQ because the magnitude of the correlation coefficient is largest.\nThe correlation coefficient plays ahuge role in portfolio construction, particularly from arisk managem", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml", "doc_id": "3f519c4d8644bb886b7ea544bb01395ddc4ec86fcf8f99537e3273c4009792e5", "chunk_index": 10}
{"text": "these variables. According to the correlation values for the pairs shown, the strongest linear relationship is between SPY and QQQ because the magnitude of the correlation coefficient is largest.\nThe correlation coefficient plays ahuge role in portfolio construction, particularly from arisk management perspective. Correlation quantifies the relationship between the directional tendencies of two assets. If portfolio assets have highly correlated returns (either positively or negatively), the portfolio is highly exposed to directional risk. To understand how correlation impacts risk, consider the additive property of variance. For two random variables\nwith individual variances\nand covariance\n, the\ncombined\nvariance is given by the following:\n(1.21)\nWhen combining two assets, the overall impact on the uncertainty of the portfolio depends on the uncertainties of the individual assets as well as the covariance between them. Therefore, for every new position that occupies additional portfolio capital, the covariance will increase portfolio uncertainty (high correlation), have little effect on portfolio uncertainty (correlation near zero), or reduce portfolio uncertainty (negative correlation).\nAdditional Measures of Risk\nThis chapter has introduced several measures for risk including historical volatility, implied volatility, and the option Greeks. Two additional metrics are worth noting and will appear throughout this text: beta\nand conditional\nvalue at risk (CVaR). Beta is ameasure of systematic risk and specifically quantifies the volatility of the stock relative to that of the overall market, which is typically estimated with areference asset, such as SPY. Given the market'sreturns,\n, astock with returns\nhas the following beta:\n(1.22)\nThe volatility of astock relative to the market can then be evaluated according to the following:\n: The asset tends to move more than the market. (For example, if the beta of astock is 1.5, then the asset will tend to move $1.50 for every $1 the market moves.)\n: The asset movements tend to match those of the market.\n: The asset is less volatile than the market. (For example, if the beta of astock is 0.5, then the asset will be 50% less volatile than the market.)\n: The asset has no systematic risk (market risk).\n: The asset tends to move inversely to the market as awhole.\nThis metric is essential for portfolio management, where it is used in the formulation of beta‐weighted delta. This will be covered in more detail in\nChapter 7\n.\nValue at risk (VaR) is another distribution statistic that is especially useful when dealing with heavily skewed distributions. VaR is an estimate of the potential losses for aportfolio or position over agiven time frame at aspecific likelihood level based on historical behavior. For example, aposition with adaily VaR of –$100 at the 5% likelihood level can expect to lose $100 (or more) in asingle day at most 5% of the time. This means that the bottom 5% of occurrences on the historical daily P/Ldistribution are –$100 or worse. For avisualization, see the historical daily returns distribution for SPY in\nFigure 1.10\n.\nFigure 1.10\nSPY daily returns distribution from 2010–2021. Included is the VaR at the 5% likelihood level, indicating that SPY lost at most 1.65% of its value on 95% of all days.\nFor strategies with significant negative tail skew, VaR gives anumerical estimate for the extreme loss potential according to past tendencies. To place more emphasis on the negative tail of adistribution and determine amore extreme loss estimate, traders may use CVaR, otherwise\nknown as expected shortfall. CVaR is an estimate for the expected loss of portfolio or position if the extreme loss threshold (VaR) is crossed. This is calculated by taking the average of the distribution losses past the VaR benchmark. To see how VaR and CVaR compare for SPY returns, refer to\nFigure 1.11\n.\nFigure 1.11\nSPY daily returns distribution from 2010–2021. Included are VaR and CVaR at the 5% likelihood level. A CVaR of 2.7% indicates that SPY can expect an average daily loss of roughly 2.7% on the worst 5% of days.\nThe choice between using VaR and CVaR depends on the risk profile of the portfolio or position considered. CVaR is more sensitive to tail losses and provides ametric that is more conservative from the perspective of risk, which is more suitable for the kind of instruments focused on in this book.\nNotes\n1\nIn liquid markets, which will be discussed in\nChapter 5\n, American and European options are mathematically very similar.\n2\nThe future value of the option should be used, but for simplicity, this approximates the future value as the current price of the option. The future value of the option premium is the current value of the option multiplied by the time‐adjusted interest rate factor.\n3\nPopulation calculations are used for all the moments introduced throughout this chapter.\n4\nThis is the sum of the squared differences between each data point and the distribution mean, no", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml", "doc_id": "3f519c4d8644bb886b7ea544bb01395ddc4ec86fcf8f99537e3273c4009792e5", "chunk_index": 11}
{"text": "of the option premium is the current value of the option multiplied by the time‐adjusted interest rate factor.\n3\nPopulation calculations are used for all the moments introduced throughout this chapter.\n4\nThis is the sum of the squared differences between each data point and the distribution mean, normalized by the number of data points in the set.\n5\nThe skew of the returns distribution is also used to estimate the directional risk of an asset. The fourth moment (kurtosis) quantifies how heavy the tails of areturns distribution are and is commonly used to estimate the outlier risk of an asset.\n6\nDividends can be accounted for in variants of the original model.\n7\nThis application of Wiener processes as well as their use in financial mathematics are due to them arising as the scaling limit of simple random walk. Asimple random walk is adiscrete process that takes independent\nsteps with probability\n. The scaling limit is reached by shrinking the size of the steps while speeding up their rate in such away that the process neither sits at its initial location nor runs off to infinity immediately.\n8\nNote that, unless stated or shown otherwise, the date ranges throughout this book generally end on the first of the final year. For the range shown here, the data begins on January 1, 2010 and ends on January 1, 2015.\n9\nDisplacement along the X‐axis is the difference between the current horizontal location of the particle and the previous horizontal location of the particle for each step.\n10\nSimple returns will also be approximated as normally distributed throughout this book. Although this is not explicitly implied by the Black‐Scholes model, it is afair and intuitive approximation in most cases because the difference between log returns and simple returns is typically negligible on daily timescales.\n11\ndis asymbol used in calculus to represent amathematical derivative. It equivalently represents an infinitesimal change in the variable it'sapplied to.\ndS\n(\nt\n) is merely avery small, incremental movement of the stock price at time\nt\n. ∂ is the partial derivative, which also represents avery small change in one variable with respect to variations in another.\n12\nThe log function and log‐normal distribution are both covered in the appendix.\n13\nOrder refers to the number of mathematical derivatives taken on the price of the option. Delta has asingle derivative of\nVand is first‐order. Greeks of second‐order are reached by taking aderivative of first‐order Greeks.\n14\nIn practice, the strike and underlying prices for 50Δ contracts tend to differ\nslightly\ndue to strike skew.\n15\nThe covariance of avariable with itself (e.g., Cov(X, X)) is merely the variance of the signal itself.", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c01.xhtml", "doc_id": "3f519c4d8644bb886b7ea544bb01395ddc4ec86fcf8f99537e3273c4009792e5", "chunk_index": 12}
{"text": "Chapter 2\nThe Nature of Volatility Trading and Implied Volatility\nTraders often hedge against periods of extreme market volatility (either to the upside or the downside) using options. Options are effectively financial insurance, and they are priced according to similar principles as other forms of insurance. Premiums increase or decrease according to the\nperceived\nrisk of agiven underlying (aresult of supply and demand for those contracts), just as the cost of hurricane insurance increases or decreases depending on the perceived risk of hurricanes in agiven area. To quantify the perceived risk in the market, traders use implied volatility (IV).\nImplied volatility is the value of volatility that would make the current market price for an option be the fair price for that option in agiven model, such as Black‐Scholes.\n1\nWhen options prices\nincrease\n(i.e., there is more demand for insurance), IV increases accordingly, and when options prices decrease, IV decreases. IV is, thus, aproxy for the\nsentiment\nof market risk as it relates to supply and demand for financial insurance. IV gives the perceived\nmagnitude\nof expected price movements; it is not directional.\n2\nTable 2.1\ngives anumerical example.\nTable 2.1\nTwo underlyings with the same price and put contracts on each underlying with identical parameters (number of shares, put strike, contract duration). The contract prices differ, indicating that these two instruments have different implied volatilities.\n45‐day Put Contract\nUnderlying A\nUnderlying B\nUnderlying Price\n$101\n$101\nStrike Price\n$100\n$100\nContract Price\n$10\n$5\nThe price of the put is around 10% of the stock price for underlying Aand 5% of the stock price for underlying B. This suggests that there is more perceived uncertainty associated with the price of underlying Acompared to underlying B. Equivalently, this indicates that the anticipated magnitude of future moves in the underlying price is larger for underlying Acompared to underlying B.\nDemand for options tends to increase when the historical volatility of an underlying increases unexpectedly, particularly with large moves to the downside. This means that IV tends to be positively correlated with historical volatility and negatively correlated with price. However, there are exceptions to this rule, as IV is based on the perceived risk and not on historical risk directly. IV may increase due to factors that are not directly\nrelated to price movements, such as company‐specific uncertainty (earnings reports, silly tweets from the CEO) or larger‐scale macroeconomic uncertainty (political conflict, proposed legislative measures). This also means that volatility profiles vary significantly from instrument to instrument, which will be discussed more later in the chapter.\nSimilar to historical volatility, IV gives aone standard deviation range of annual returns for an instrument. Though historical volatility represents the realized\npast volatility of returns\n, IV is the approximation for\nfuture volatility of returns\nbecause it is based on how the market is using options to hedge against future price changes. While each option for an underlying has its own implied volatility, the “overall” IV of an asset is normally calculated from 30‐day options and is arough annualized volatility forecast.\n3\nExample: An asset has aprice of $100 and an IV of 0.10 (10%). Therefore, the asset is expected to move about 10% to the upside or the downside by the end of the following year. This means the ending price will most likely be between $90 and $110.\nThe volatility forecast can also be scaled to approximate the expected price across days, weeks, months, or longer. The equations used to calculate the expected price ranges of an asset over some forecasting period are given below.\n4\n(2.1)\n(2.2)\nThese estimates of expected range will be used to formulate options strategies in future chapters. The time frame for the expected range is often scaled to match the contract duration. Most examples in this book will have aduration of 45 days to expiration (DTE) (or 33 trading days), so implied volatilities are typically multiplied by 0.35 to ensure forecasts match the duration of the contract.\nThe expected move cone is helpful to visualize this likely price range for an instrument according to market speculation. The width of the cone is calculated using\nEquation (2.2)\nand scales with the IV of the underlying. More specifically, the cones are wider in higher volatility environments and narrower when volatility is low and the expected range is tighter. Consider the expected move cones shown in\nFigure 2.1\n, corresponding to the expected price ranges for SPY.\nFigure 2.1\n(c) shows the realized price trajectory for SPY in December 2019, which stayed within its expected price range for the majority of the 45‐day duration. Prices tend to stay within their expected range more often than not, and the assumptions of the Black‐Scholes model can be used to develop atheoretical estimate for ho", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c02.xhtml", "doc_id": "77b632614a61bc4673bb1b519bca4cc8f81c774b2494c0e57b22ca3428387b3d", "chunk_index": 0}
{"text": "zed price trajectory for SPY in December 2019, which stayed within its expected price range for the majority of the 45‐day duration. Prices tend to stay within their expected range more often than not, and the assumptions of the Black‐Scholes model can be used to develop atheoretical estimate for how often that should be.\nTrading Volatility\nAn inconceivable number of factors affect prices in financial markets, which makes precisely forecasting price movements extremely difficult. Arguably, the most reliable way to form expectations around future price trends is using statistics from past price data and financial models. IV is derived from current options prices and the Black‐Scholes options pricing model, meaning that the Black‐Scholes assumptions can be used to add statistical context to the expected price range. More specifically, one can infer the likelihood of astock price remaining within its IV‐derived price range because stock returns are assumed to be normally distributed. The one standard deviation range of the normal distribution encompasses 68.2% of event outcomes, so there is theoretically a 68.2% chance the price of an equity lands within its expected range. This probability can also be generalized over any timescale using\nEquation (2.1)\n.\nFigure 2.1\n(a) The 45‐day expected move cone for SPY in early 2019. The price of SPY was roughly $275, and the IV was around 19%, corresponding to a 45‐day expected price range of ±6.7% (\nEquation (2.1)\n) or ±$18 (\nEquation (2.2)\n). (b) The 45‐day expected move cone for SPY when IV was 12%. (c) The same expected move cone as (b) with the realized price over 45 days.\nExample: An asset has aprice of $100 and an IV of 0.10 (10%). The asset price is expected to remain between $90 and $110 by the end of the following year with 68% certainty. Equivalently, the asset price is expected to remain between $96 and $104 58 days from today with 68% certainty (calculated using\nEquation (2.2)\n).\nHowever, historical data show that perceived uncertainty in the market (IV) tends to overstate the realized underlying price move more often than theory suggests. Though theory predicts that IV should overstate the realized move roughly only 68% of the time, market IV (estimated using the IV for SPY) overstated the realized move 87% of the time between 2016 and 2021. This means the price for SPY stayed within its expected price range more often than estimated. Realized moves were larger just 13% of the time, indicating that IV rarely understates the realized risk in the market. The\nexact\ndegree to which IV tends to overstate realized volatility depends on the instrument. For example, consider the IV overstatement rates of the stocks and exchange‐traded funds (ETFs) in\nTable 2.2\n.\nTable 2.2\nIV overstatement of realized moves for six assets from 2016–2021. Assets include SPY (S&P 500 ETF), GLD (gold commodity ETF), SLV (silver commodity ETF), AAPL (Apple stock), GOOGL (Google stock), AMZN (Amazon stock).\nVolatility Data (2016–2021)\nAsset\nIV Overstatement Rate\nSPY\n87%\nGLD\n79%\nSLV\n89%\nAAPL\n70%\nGOOGL\n79%\nAMZN\n77%\nDifferent assets are more or less prone to stay within their expected move range depending on their unique risk profile. Stocks are subject to single‐company risk factors and tend to be more volatile. ETFs, which contain avariety of assets, are inherently diversified and tend to be less prone to dramatic price swings. For example, the S&P 500 includes Apple, but it also includes around 499 other companies. This means that atech‐sector specific event will have abigger impact on APPL compared to SPY. Commodities like gold and silver also tend to be less volatile than individual stocks, meaning they are less prone to spikes in IV and\nhave more predictable returns. Although the IV overstatement rates differ between instruments, one can conclude that\nfear\nof large price moves is usually greater than realized price moves in the market. So, how exactly can options traders capitalize on this knowledge of IV and IV overstatement?\nLet'srevisit the example of hurricane insurance. The price for hurricane insurance is proportional to the expected cost of potential hurricane damage in the area. These prices are based on historical hurricane activity and forecasts of future events, which may underestimate, overestimate, or match the realized outcomes. People who\nsell\nhurricane insurance initially collect premiums, with the value depending on the perceived risk of home damage. During uneventful hurricane seasons, most policies go unused, and insurers keep the majority of premiums initially collected. In the unlikely event that hurricane damage is\nsignificantly\nworse than expected in an area dense with policyholders, insurers take very large losses. Insurance companies essentially make small, consistent profits the majority of the time while being exposed to large, infrequent losses.\nFinancial insurance carries asimilar risk‐reward trade‐off as sellers make small, consistent profits most of the", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c02.xhtml", "doc_id": "77b632614a61bc4673bb1b519bca4cc8f81c774b2494c0e57b22ca3428387b3d", "chunk_index": 1}
{"text": "h policyholders, insurers take very large losses. Insurance companies essentially make small, consistent profits the majority of the time while being exposed to large, infrequent losses.\nFinancial insurance carries asimilar risk‐reward trade‐off as sellers make small, consistent profits most of the time but run the risk of large losses in extreme circumstances. IV yields an approximate price range forecast for agiven underlying with 68% certainty. This means there is a 68% chance that the calls with strikes at the upper end of the expected range and puts with strikes at the lower end will both expire with no intrinsic value. For example, if traders sold one call and one put with strikes along the expected move cone, they would theoretically profit with 68% certainty. If the underlying price were to move unexpectedly to the upside or the downside, however, the traders may take substantial losses.\nUnlike sellers of hurricane insurance, options sellers have more room to strategize and more control over their risk‐reward profile. Premium sellers can choose when to sell insurance and how to construct contracts most likely to be profitable. Because IV is aproxy for the demand for options and the inflation of premium, it can be used to identify opportune times to sell insurance. Additionally, because IV can be used to estimate the most likely price range for aspecific asset, premium sellers can use IV to structure those positions so they likely expire worthless,\nlike in the previous example. Options sellers (or short premium traders) have the long‐term statistical advantage over options buyers, with the trade‐off of exposure to unlikely, potentially significant losses. Because of that long‐term statistical advantage, short premium trading is the focus of this book, with the next chapter detailing the mechanics of trading based on implied volatility.\nThe States of VIX\nSPY is frequently used as aproxy for the broader market. It is also abaseline underlying for the short options strategies in this book because it is highly diversified across market sectors and has minimal idiosyncratic risk factors. The CBOE Volatility Index (VIX) is meant to track the annualized IV for SPY and is derived from 30‐day index options. As SPY is aproxy for the broader market, the VIX, therefore, gauges the perceived risk of the broader market. For context, from 1990 to 2021, the VIX ranged from roughly 10 to apeak of just over 80 in March 2020 during the COVID‐19 pandemic.\n5\nUnlike equities, whose prices typically drift from their starting values over time, IV tends to revert back to along‐term value following acyclic trend. This is because equities are used to estimate the perceived value of acompany, sector, or commodity, but IV tracks the uncertainty sentiment of the market, which can only stay elevated for so long. During typical bull market conditions, the VIX hovers at arelatively low value at or below its average of 18.5. This is known as alull state. When market uncertainty rapidly increases for whatever reason, often in response to large sudden price changes, the VIX expands and spikes far above its steady‐state value. Once the market adjusts to the new volatility conditions or the volatile conditions dissipate, the VIX gradually contracts back to alull state. To see an example of this cycle, refer to\nFigure 2.2\n.\nFigure 2.2\nThe three phases of the VIX, using data from early 2017 to late 2018.\nWhen comparing how often the VIX is in each state, one finds the following approximate rates:\nLull (70%): IV consistently remains below or near its long‐term average. This state occurs when market prices trend upward gradually and market uncertainty is consistently low.\nExpansion (10%): IV expansion usually follows aprolonged lull period and is marked by expanding market uncertainty and typically large price moves in the underlying equity.\nContraction (20%): IV contraction follows an expansion and is marked by acontinued decline in IV. Acontraction turns into alull when IV reverts back to its long‐term average.\nLull periods are most common and tend to be much longer than the average expansion or contraction period. Since 2000, the average lull period was more than three times the length of the average expansion or contraction. When expansions do happen, the higher the IV peak, the faster the VIX contracts. For example, according to data from 2005 to 2020, when the VIX contracted from 20 to 16 points (20% decrease), it\ntook an average of 75.3 trading days to do so. However, when the VIX contracted from 70 to 56 points (also a 20% decrease), it only took an average of four trading days.\nSpikes in the VIX are generally caused by unprecedented market or worldwide events. For example, the VIX reached over 80 in November 2008 during the peak of the worldwide financial crisis and hit its all‐time high of 82.69 in March 2020 during the COVID‐19 pandemic. The VIX peak of 2020 was especially unprecedented as the first major spike due to COVID‐19 hap", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c02.xhtml", "doc_id": "77b632614a61bc4673bb1b519bca4cc8f81c774b2494c0e57b22ca3428387b3d", "chunk_index": 2}
{"text": "t or worldwide events. For example, the VIX reached over 80 in November 2008 during the peak of the worldwide financial crisis and hit its all‐time high of 82.69 in March 2020 during the COVID‐19 pandemic. The VIX peak of 2020 was especially unprecedented as the first major spike due to COVID‐19 happened on February 28, 2020 when the VIX hit 40.11. This VIX high in 2020 had not been reached since February 2018, and it followed a 96‐day lull. On March 16, 2020, the VIX hit 82.69, making the 2020 VIX expansion one of the most rapid ever recorded.\nThough contraction periods tend to be longer than expansions but much shorter than lulls, fairly long contractions tend to follow major sell‐offs or corrections. For example, the VIX contraction following the 2008 sell‐off lasted well over ayear, and the contraction following the 2020 sell‐off lasted more than 10 months. This is normally because it takes time for the market (and specific subsectors) to revert to regular conditions following such broad macroeconomic shocks.\nPremium sellers can potentially profit in any type of market, whether it be during volatility expansions (bearish), contractions (bullish/neutral), or lulls (neutral) if adopting an appropriate strategy for the volatility conditions. Generally, the most favorable trading state for selling premium is when IV contracts. This is because IV contracts when premium prices deflate, meaning that options traders who sold positions in high IV\n6\nare able to buy identical positions back in low IV at alower price, thus profiting from the difference. Volatility expansions, on the other hand, have the potential to generate significant losses for short premium traders.\nVolatility expansions tend to occur when there are large movements in the underlying price and uncertainty increases, causing options on that underlying to become more expensive. If traders sell premium during\nan expansion period once IV is\nalready elevated\n, then the traders can capitalize on higher premium prices and the increased likelihood of avolatility contraction. However, if traders sell premium during alull period, when the expected range is tight, and volatility\ntransitions\ninto an expansion period, then those traders will likely take large losses from the underlying price moving far outside the expected range. Additionally, to close their positions early, traders must buy back their options for more than they received in initial credit and incur aloss from the difference.\nShort premium traders can profit in any type of market, but the risk of significant losses for short premium traders is highest when volatility is\nlow\n. Unexpected transitions from avolatility lull to an expansion do not happen often, but when they do happen, they can be detrimental to an account. It is still necessary to trade during these low‐IV periods because IV spends the majority of the time in this state, but risk management during this period is crucial. These risk management techniques will be outlined in the upcoming chapters.\nThis cyclic trend (lull, expansion, contraction, lull) is easily observable when looking at arelatively stable volatility index, such as the VIX. However, this trend, which we will describe as IV reversion, is present in some capacity for\nall\nIV signals.\nIV Reversion\nCertain types of signals tend to revert back to along‐term value following asignificant divergence. Although this concept cannot be empirically proven or disproven, the reversion of IV is acore assumption in options trading.\n7\nThe reversion dynamics and the minimum IV level vary across instruments, but reversion is assumed to be present in\nall\nIV signals to some extent. To understand this, first consider the probability of large magnitude returns for four assets with different risk profiles: SPY, GLD, AAPL, and AMZN. Acomparison of these probabilities is shown in\nTable 2.3\n.\nTable 2.3\nRates thats different assets experienced daily returns larger than 1%, 3%, and 5% in magnitude. For example, there is a 22% chance that SPY returns more than 1% or less than –1% in asingle day (according to past data).\nProbability of Surpassing Daily Returns Magnitude (2015–2021)\nAsset\n> 1% Magnitude\n> 3% Magnitude\n> 5% Magnitude\nSPY\n22%\n3%\n0.8%\nGLD\n19%\n1%\n0.1%\nAAPL\n43%\n9%\n2%\nAMZN\n45%\n10%\n3%\nCompared to assets like SPY and GLD, AMZN and AAPL are more volatile. These tech stocks experience large daily returns roughly three times as often as SPY and roughly 10 times as often as GLD. Each of these assets is subject to unique risk factors, but all are expected to have reverting IV signals nonetheless.\nFigure 2.3\nshows these volatility profiles graphically.\nFigure 2.3\ndemonstrates how IV has tended to revert back to along‐term baseline for each of the different assets, and it also demonstrates that elevated uncertainty is\nunsustainable\nin financial markets. Events may occur that spark fear in the market and drive up the demand for insurance, but as fear inevitably dissipates and the market adapts to", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c02.xhtml", "doc_id": "77b632614a61bc4673bb1b519bca4cc8f81c774b2494c0e57b22ca3428387b3d", "chunk_index": 3}
{"text": "rt back to along‐term baseline for each of the different assets, and it also demonstrates that elevated uncertainty is\nunsustainable\nin financial markets. Events may occur that spark fear in the market and drive up the demand for insurance, but as fear inevitably dissipates and the market adapts to the new conditions, IV deflates back down. This phenomenon has significant implications for short options traders. As stated in\nChapter 1\n, it is controversial whether directional price assumptions are statistically valid or not as trading according to pricing forecasts has never been proven to consistently outperform the market. IV is assumed to eventually revert down following inflations from its stable volatility state unlike asset prices, which drift from their initial value with time. The timescale for these contractions is unpredictable, but this nonetheless indicates some statistical validity to make downward directional assumptions about volatility once it is elevated.\nFigure 2.3\nalso shows how volatility profiles vary greatly across instruments. More volatile assets like Apple and Amazon stocks have higher IV averages, twice that of SPY and gold in this case, and experience expansion events more often. Single‐company factors, such as quarterly earnings reports, pending mergers, acquisitions, and executive changes can all cause volatility spikes not seen in diversified assets and portfolios. However, this increased volatility also comes with higher credits and more volatility contraction opportunities for premium sellers.\n8\nFor an example of how the propensity for expansions and contractions differs between stocks with earnings and adiversified ETF, refer to\nFigures 2.4\n(a)–(c). Marked are the earnings report dates for each stock or the date when the company reported its quarterly profits (after‐tax net income).\nFigure 2.3\nIV indexes for different assets with their respective averages (dashed) from 2015–2021. Assets include (a) SPY (S&P 500 ETF), (b) GLD (gold commodity ETF), (c) AAPL (Apple stock), and (d) AMZN (Amazon stock).\nFigure 2.4\nImplied volatility indexes for different equities from 2017–2020 with earnings dates marked (if applicable). Assets include (a) AMZN (Amazon stock), (b) AAPL (Apple stock), and (c) SPY (S&P 500 ETF).\nWith tech stocks like AMZN and AAPL, it'scommon for IV to increase sharply prior to earnings and contract almost immediately afterward. The previous graphs show that sharp IV expansions happen less frequently with amore diversified market ETF, such as SPY. These figures indicate that when SPY does experience avolatility expansion, it generally takes much longer to contract. From 2017 to 2020, the VIX only rose above 35 two times and, in both situations, took roughly half amonth to contract down to its original level. Meanwhile, volatility levels of AMZN and AAPL rose above 40 many times and even had afew spikes above 50, or in the case of AMZN, almost 60.\nTakeaways\nIV is aproxy for the sentiment of market risk derived from supply and demand. When options prices increase, IV increases; when options prices decrease, IV decreases. IV also gives the perceived magnitude of future movement, and it is not directional.\nDemand for options tends to increase when the historical volatility of an underlying increases unexpectedly, particularly with large moves to the downside. IV tends to be positively correlated with historical volatility and negatively correlated with price, but it is ultimately based on the\nperceived\nmarket risk and not directly on price information.\nIV can be used to estimate the expected price range of an instrument. IV gives aone standard deviation\nexpected\nrange because it is based on how the market is using options to hedge against future periods of volatility.\nBecause stock returns are assumed to be normally distributed, theoretically, there is a 68.2% chance the price of an equity lands within its expected range over agiven time frame. However, historical data show that prices stay within their expected ranges more often than theoretically estimated. For example, market IV (estimated using the IV for SPY) overstated the realized move 87% of the time between 2016 and 2021.\nOptions sellers have the long‐term statistical advantage over options buyers, with the trade‐off of exposure to unlikely, potentially significant losses. Because IV is aproxy for the demand for options and the inflation of premium, it can be used to identify opportune times to sell insurance. Premium sellers can also use IV to structure positions so they are likely to expire worthless, the ideal outcome for the short position.\nVolatility profiles differ significantly between assets, but all IV signals are assumed to revert back to some long‐term value following significant diversions. Stated differently, IV tends to contract back to along‐term value following significant expansions from its lull volatility state. This phenomenon indicates that there is some degree of statistical validity when", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c02.xhtml", "doc_id": "77b632614a61bc4673bb1b519bca4cc8f81c774b2494c0e57b22ca3428387b3d", "chunk_index": 4}
{"text": "ls are assumed to revert back to some long‐term value following significant diversions. Stated differently, IV tends to contract back to along‐term value following significant expansions from its lull volatility state. This phenomenon indicates that there is some degree of statistical validity when making downward directional assumptions about volatility once it'sinflated.\nNotes\n1\nImplied volatility (IV), like historical volatility, is apercentage and pertains to log returns. It is common to represent IV as either adecimal (0.X) or percentage (X%). An IV index, which is an instrument that tracks IV and will be introduced later in this chapter, is typically represented using points (X) but should be understood as apercentage (X%).\n2\nIt is possible to get directional expected move information about an underlying by analyzing the IV across various strikes. This will be elaborated on more in the appendix.\n3\nIV yields arough approximation for the expected price range, but this is not how the expected range is typically calculated on most trading platforms. Refer to the appendix for more information about how expected range is calculated more precisely. For the time being, we are using this simplified formula since it is most intuitive.\n4\nWhen ignoring the risk‐free rate, the expected price range over\nTdays for astock with price\nSand volatility σ can be estimated by\n. The formula in\nEquation (2.2)\nis an approximation because, for small\nxvalues, ex\n≈ 1 +\nx\n. This approximation becomes less valid when\nxis large, meaning this expected range calculation is less accurate when IV is high. This will be explored more in the appendix.\n5\nNote that volatility indices, such as the VIX, will be represented using points but are meant to be understood as apercentage. For example, a VIX of 30 corresponds to an annualized implied volatility of 30%.\n6\nIt'simportant to note that the threshold for high IV is different for every asset because each instrument is subject to unique risk factors. Evaluating IV can be difficult because there is so much variability between assets, but there will be amore in‐depth discussion of this in the following chapter.\n7\nThe value that the signal reverts back to is roughly the long‐term mode of the distribution, or the volatility that has occurred most often historically.\n8\nSuch underlyings can be used for earnings plays, which will be discussed in a\nChapter 9\n.", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c02.xhtml", "doc_id": "77b632614a61bc4673bb1b519bca4cc8f81c774b2494c0e57b22ca3428387b3d", "chunk_index": 5}
{"text": "Chapter 3\nTrading Short Premium\nOptions are highly versatile instruments. They can be used to hedge the directional risk of astock, or they can be used as asource of profits. As alluded to in the example of hurricane insurance, short premium positions can be used to generate small, consistent profits for those willing to accept the tail risk. The mechanics of short premium trading are subtle, but many of the core concepts can be introduced in an intuitive way with some simple gambling analogies. For example, when using options for profit generation (i.e., not risk mitigation), the long‐term performance of long and short options can be analogized with slot machines.\nBuying Options for profit\nis like playing the slot machines. Gamblers who play enough times may hit the jackpot and receive ahuge payout. However, despite the potential payouts, most players average aloss in the long run because they are taking small losses the majority of the time. Investors who buy options are betting on large, often directional moves in the underlying asset. Those assumptions\nmay be correct and yield significant profits occasionally, but underlying prices ultimately stay within their expected ranges most of the time. This results in small, frequent losses on unused contracts and an average loss over time.\nSelling Options for profit\nis like owning the slot machines. Casino owners have the long‐run statistical advantage for every game, an edge particularly high for slots. Owners may occasionally pay out large jackpots, but as long as people play enough and the payouts are manageable, they are compensated for taking on this risk with nearly guaranteed profit in the long term. Similarly, because short options carry tail risk but provide small, consistent profits from implied volatility (IV) overstatement, then they should average aprofit in the long run if risk is managed appropriately.\nLong premium strategies have ahigh profit potential but cannot be consistently timed to ensure profit in the long term. This is because outlier underlying moves and IV expansions that benefit long premium positions are strongly linked to external events (such as natural disasters or political conflict), which are relatively difficult to reliably predict. Short premium strategies, on the other hand, profit more often and have the long‐term statistical advantage if investors manage risks appropriately.\nSimilar to the slot machine owner, ashort premium trader must reduce the impact of outlier losses to reach alarge number of occurrences (trades) and realize the positive long‐term averages. This is most effectively done by limiting position size and by adjusting portfolio exposure according to current market conditions. This chapter will, therefore, cover the following broader concepts in volatility trading:\nTrading in high IV: Identifying favorable conditions for opening short premium trades.\nNumber of occurrences: Reaching the minimum number of trades required to achieve long‐term averages.\nPortfolio allocation and position sizing: Establishing an appropriate level of risk for the given market conditions.\nActive management and efficient capital allocation: Understanding the benefits of managing trades prior to expiration.\nIV plays acrucial role in trading short premium. Remember that IV is ameasure of the\nsentiment\nof uncertainty in the market. It is aproxy for the amount of\nfear\namong premium buyers (or\nexcitement\n, depending on your personality) and ameasure of\nopportunity\nfor premium sellers. When market uncertainty increases, premium prices also increase, and premium sellers receive more compensation for being exposed to large losses. However, IV is also instrumental when managing exposure to extreme losses and establishing appropriate position sizes.\nBackground: A Note on Visualizing Option Risk\nWhen discussing the risk‐reward trade‐off of trading short premium, it is helpful to contextualize concepts and statistics with respect to aspecific strategy. The next few chapters will focus on ashort strangle\n, an options strategy consisting of ashort out‐of‐the‐money (OTM) call and ashort OTM put:\nAshort OTM call (the right to buy an asset at acertain price) has abearish directional assumption. The seller profits when the underlying price stays below the specified strike price.\nAshort OTM put (the right to sell an asset at acertain price) has abullish directional assumption. The seller profits when the underlying price stays above the specified strike price.\nThese two contracts combine to form astrangle. This is an example of an\nundefined risk\nstrategy, where the loss is theoretically unlimited. The short call has undefined risk because stock prices can increase indefinitely, meaning the potential loss to the upside is unknown. Though short puts technically cannot lose more than 100 times the strike price, this potential loss is large enough that they are also considered undefined risk. Defined risk strategies, where the maximum loss is limited by the", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c03.xhtml", "doc_id": "632245f905b1662d5acf372c053bdce8173f0564605798ed75bc4fe057cf4b6b", "chunk_index": 0}
{"text": "rease indefinitely, meaning the potential loss to the upside is unknown. Though short puts technically cannot lose more than 100 times the strike price, this potential loss is large enough that they are also considered undefined risk. Defined risk strategies, where the maximum loss is limited by the construction of the trade, have pros and cons that will be discussed in\nChapter 5\n. For simplicity, the strangle is used to formulate most examples in this book.\nStrangles have aneutral directional assumption for the contract seller, meaning it is typically profitable when the price of the underlying stays\nwithin the range defined by the short call strike and short put strike. Investors often define the strikes of astrangle according to the expected range of the underlying price (or some multiple of the expected range) over the contract duration. The one standard deviation expected range can be approximated with the current implied volatility of the underlying, as shown in\nChapter 2\n.\nFigure 3.1\nThe price of SPY in the last five months of 2019. Included is the 45‐day expected move cone calculated from the IV of SPY in December 2019. The edges of the cones are labeled according to appropriate strikes for an example strangle.\nFigure 3.1\nshows that SPY was priced at roughly $315 around December 2019, when the current IV for SPY was 12% (corresponding to a VIX level of 12). This means the price for SPY was forecasted to move between –4.2% and +4.2% over the next 45 days with a 68% certainty. This is equivalent to a 45‐day forecast of the price of SPY staying between $302 and $328 approximately. Acontract with astrike price corresponding to the\nexpected move range is approximately a 16\ncontract. In this scenario, a 45 days to expiration (DTE) short SPY call with astrike price of $328 is a –16\ncontract roughly, and a 45\nDTE short SPY put with astrike price of $302 is approximately a 16\ncontract. The two positions combined form adelta‐neutral position known as a 45 DTE 16\nSPY strangle.\n1\nThe strangle buyer and seller are making different bets:\nThe strangle buyer assumes that SPY'sprice will move beyond expectation within the next 45 days, either to the upside or the downside. More specifically, the long strangle yields profit if the price of SPY significantly increases above $328 or decreases below $302 prior to expiration.\nThe strangle seller profits if the position expires when the underlying price is within or near its expected range or if the position is closed when the contract is trading for acheaper price than when it was opened (IV contraction).\nBecause there is a 68% chance the underlying will stay within its expected range, the short position theoretically has a 68% chance of being profitable. However, since the underlying price tends to stay in its expected range more often than theoretically predicted, this results in the probability of profit (POP) of short strangles held to expiration being much higher.\nFor example, consider the profit and loss (P/L) distributions for the short 45 DTE 16\nSPY strangle in\nFigures 3.2\n(a)–(c). These distributions were generated using historical options data and are useful for visualizing the long‐term risk‐reward profile and likely trade‐by‐trade outcomes for this type of contract. Each occurrence in the histogram corresponds to the final P/Lof ashort strangle held to expiration.\n2\nP/Lcan be represented as araw dollar amount or as apercentage of initial credit (the fraction of option premium that the seller ultimately kept).\n3\nFigure 3.2\n(a) Historical P/Ldistribution (% of initial credit) for short 45 DTE 16\nSPY strangles, held to expiration from 2005–2021. (b) Historical P/Ldistribution ($) for short 45 DTE 16\nSPY strangles, held to expiration from 2005–2021. (c) The same distribution as in (b) but zoomed in near $0. The percentage of occurrences on either side of $0 have been labeled.\nFigure 3.2\n(c) shows that 81% of occurrences are\npositive\nand only 19% are\nnegative\n. This means this strategy has historically profited 81% of the time and only taken losses 19% of the time, significantly higher than the 68% POP that the simplified theory suggests. Over the long run, this strategy was\nprofitable\nand averaged a P/Lof $44 (or 28% of the initial credit) per trade. However, notice the P/Ldistributions for this strategy are highly skewed and carry significant tail risk. As shown in\nFigure 3.2\n(a), these tail losses are unlikely but could potentially amount\nto –1,000% or even –4,000% of the initial credit. In other words, if atrader receives $100 in initial credit for selling a SPY strangle, there is aslim chance of losing upward of $4,000 on that trade according to historical behavior. This is the trade‐off for the high POPs of short premium strategies.\nThe possibility of outlier losses should not be surprising because placing ashort premium trade is betting against large, unexpected price swings. For arelatively stable asset like SPY, these types of swings rarely happen. When t", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c03.xhtml", "doc_id": "632245f905b1662d5acf372c053bdce8173f0564605798ed75bc4fe057cf4b6b", "chunk_index": 1}
{"text": ". This is the trade‐off for the high POPs of short premium strategies.\nThe possibility of outlier losses should not be surprising because placing ashort premium trade is betting against large, unexpected price swings. For arelatively stable asset like SPY, these types of swings rarely happen. When they do, things can fly off the handle rapidly, such as during the 2008 recession or 2020 sell‐off. Consequently, the most important goals for ashort premium trader are to profit consistently enough to cover moderate, more likely losses and to construct aportfolio that can survive those unlikely extreme losses.\nBackground: A Note on Quantifying Option Risk\nApproximating the historical risk of astock or exchange-traded fund (ETF) is relatively straightforward. Equity log returns distributions are fairly symmetric and resemble anormal distribution, thus justifying that standard deviation of returns (historical volatility) be used to approximate historical risk. However, ashort option P/Ldistribution is highly skewed and subject to substantial outlier risk. Due to this more complex risk profile, using option P/Lstandard deviation as alone proxy for risk\nsignificantly\nmisrepresents the true risk of the strategy. Therefore, the following metrics will be used to more thoroughly discuss the risk of short options: standard deviation of P/L, skew, and conditional value at risk (CVaR).\n4\nThe standard deviation of P/Lencompasses the range that the\nmajority\nof endings P/Ls fall within for agiven strategy historically. The standard deviation for financial strategies is commonly interpreted relative to the normal distribution, where one standard deviation accounts for 34% of the distribution on either side of the mean. For options P/Ldistributions, however, the one standard deviation of P/Ltypically\naccounts for more than 68% of the total occurrences and the density of occurrences is not symmetric about the mean. Again, consider the P/Ldistribution for the short 45 DTE 16\nSPY strangle.\nFigure 3.3\nHistorical P/Ldistribution ($) for 45 DTE 16\nSPY strangles, held to expiration from 2005–2021. The distribution has been zoomed in near the mean (solid line), and the percentage of occurrences within\nof the mean has been labeled.\nFor 45 DTE 16\nSPY strangles from 2005–2021, the average P/Lwas $44, and the standard deviation of P/Lwas $614. As shown in\nFigure 3.3\n, the one standard deviation range accounts for nearly 96% of all occurrences, significantly higher than the\nrange for the normal distribution. Additionally, because the distribution is highly asymmetric, the P/Ls in the\nrange are less likely than the P/Ls in the\nrange. Due to these factors, the interpretation of standard deviation as ameasure of risk must be adjusted. Standard deviation\noverestimates\nthe magnitude of the most likely losses (e.g., a $500 loss is unlikely, but the standard deviation range does not clarify that) and does not account\nnegative tail risk. It does yield arange for the\nmost likely\nprofits and losses on atrade‐by‐trade basis for agiven strategy. Therefore, traders can generally form more reliable P/Lexpectations for strategies with alower P/Lstandard deviation.\nSkew and CVaR\nare used to estimate the historical tail risk of astrategy. As covered in\nChapter 1\n, skew is ameasure of the asymmetry of adistribution. Strategies with alarger magnitude of negative skew in their P/Ldistribution have more historical outlier loss exposure. CVaR gives an estimate of the potential loss of aposition over agiven time frame at aspecific likelihood level based on historical behavior. CVaR can be used to approximate the magnitude of an expected worst‐case loss and contextualize skew. For example, consider the two example short strangles outlined in\nTable 3.1\n.\nTable 3.1\nTwo example short strangles. For Strangle A, CVaR estimates losing at least $200 at most 5% of the time. In this example, the time frame for this loss has not been specified, but one may assume the time frame is identical for both strategies.\nRisk Factors\nStrangle A\nStrangle B\nSkew\n–5.0\n–1.0\nCVaR (5%)\n–$200\n–$2,000\nStrangle Ahas alarger magnitude of negative skew, indicating that this strategy is more susceptible to tail risk and outlier losses compared to Strangle B. However, there is 10 times more capital at risk in an extreme loss scenario for Strangle Bcompared to Strangle Aperhaps because the underlying for Strangle Bis more expensive. Generally speaking, strategies with less skew are preferable because those strategies are less susceptible to large, unpredictable losses and perform more consistently. However, the optimal trade ultimately depends on the acceptable amount of per‐trade capital at risk according to the trader'spersonal preferences.\nAlso note it is difficult to accurately model outlier loss events because they happen rarely. P/Ldistributions can give an\nidea\nof the magnitude of extreme losses, but these statistics are averaged over abroad range of market conditions and volatility environm", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c03.xhtml", "doc_id": "632245f905b1662d5acf372c053bdce8173f0564605798ed75bc4fe057cf4b6b", "chunk_index": 2}
{"text": "ng to the trader'spersonal preferences.\nAlso note it is difficult to accurately model outlier loss events because they happen rarely. P/Ldistributions can give an\nidea\nof the magnitude of extreme losses, but these statistics are averaged over abroad range of market conditions and volatility environments. They are\nnot necessarily representative of outlier risk at the present time. Buying power reduction (BPR), which will be covered in the next chapter, yields an estimate for the worst‐case loss of atrade according to current market conditions. Similar to implied volatility, BPR is aforward‐looking metric designed to encompass the most likely scope of losses for an undefined risk position.\nTrading in High IV\nSelling premium once IV is elevated comes with several advantages. Before that discussion, there are subtleties to note when evaluating “how high” the IV of an asset is. Contextualizing the current IV for an asset like SPY is somewhat straightforward because it has awell‐known and widely available IV index. The VIX has historically ranged from approximately 10 to 90, has an average of roughly 18, is typically below 20, and rarely surpasses 40. Therefore, atrader can intuitively interpret alevel of 15 as fairly low and alevel of 35 as fairly high relative to the long‐term behavior of the VIX. But how do traders contextualize the current IV relative to ashorter timescale, such as the last year? And how do traders contextualize the current IV for aless popular IV index with atotally different risk profile? For example, is 35 high for VXAZN, the IV index for AMZN?\nOne way to gauge the degree of IV elevation with respect to some timescale is by converting raw implied volatility into arelative measure such as IV percentile (IVP). IVP is the percentage of days in the past year where the IV was\nbelow\nthe current IV level, calculated with the following equation. Note that 252 is the number of trading days in ayear.\n(3.1)\nIVP ranges from 0% to 100%, with ahigher number indicating ahigher relative IV. This metric normalizes raw IV to put the current level in context, and unlike raw IV, it is comparable between assets. For example, consider the raw IV indexes and the corresponding IVP values for SPY and AMZN shown in\nFigure 3.4\n.\nFigure 3.4\nThe VIX (solid) and VXAZN (dashed) from 2015–2016. Labeled are the IVP values for each index at the end of 2015. When the VIX was roughly 18 SPY had an IVP of 74%, and VXAZN was roughly 36 AMZN had an IVP of 67%.\nAt the end of 2015, the VIX was near its long‐term average of 18 and would have been considered low. However, market IV was below average for the majority of 2015, and a VIX level of 18 was higher than nearly 74% of occurrences from the previous year. A SPY IVP of 74% indicates that IV is fairly elevated relative to the recent market conditions, suggesting that volatility may contract following this expansion period. Comparatively, the volatility index for AMZN at the end of 2015 was 37. This is significantly higher than the VIX at the time but is actually\nless elevated\nrelative to its volatility history from the past year according to the AMZN IVP of 67%. SPY and AMZN have dramatically different volatility profiles, with VXAZN frequently exceeding 35 and the VIX rarely doing so. This makes raw IV apoor metric for comparing relative volatility and ametric like IVP necessary.\nAnother commonly used relative volatility metric is IV rank (IVR), which compares the current IV level to the historical implied volatility range for that underlying. It is calculated according to the following formula:\n(3.2)\nSimilar to IVP, IVR normalizes raw IV on a 0% to 100% scale and is comparable between assets. IVR gives abetter direct metric for evaluating the price of an option compared to IVP. However, IVP is more robust than IVR because IVR is more sensitive to outlier moves and prone to skew.\nBoth metrics are suitable for practical decision making because they assist traders with evaluating current volatility levels and selecting asuitable strategy/underlying for those conditions. They are also useful for identifying suitable, high IV underlyings for aportfolio because most assets do not have well‐known volatility indices. However, both metrics are fairly unstable, sensitive to timescale, and can be skewed by prolonged outlier events such as sell‐offs. Raw IV, assuming that the characteristics of the volatility profile are well understood, is generally amore stable and reliable metric for analyzing long‐term trends. Because most studies throughout this book use SPY as abaseline underlying and span several years, raw IV will be used rather than arelative metric.\nAs previously mentioned, trading short premium when IV is elevated comes with the added benefits of higher credits and more profit potential for sellers. This is shown in\nFigure 3.5\n, which includes average credits for 16\nSPY strangles from 2010–2020 in different volatility environments.\nTrading short premium in elevated IV is an ef", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c03.xhtml", "doc_id": "632245f905b1662d5acf372c053bdce8173f0564605798ed75bc4fe057cf4b6b", "chunk_index": 3}
{"text": "hort premium when IV is elevated comes with the added benefits of higher credits and more profit potential for sellers. This is shown in\nFigure 3.5\n, which includes average credits for 16\nSPY strangles from 2010–2020 in different volatility environments.\nTrading short premium in elevated IV is an effective way to capitalize on higher premium prices and the increased likelihood of asignificant volatility contraction. Trading when credits are higher also means common losses tend to be larger (as adollar amount), but the exposure to outlier risk actually tends to be\nlower\nwhen IV is elevated compared to when it'scloser to equilibrium. This may seem counterintuitive: If market uncertainty is elevated and there is higher perceived risk, wouldn'tshort premium strategies carry more outlier risk? Although moves in the underlying tend to be more dramatic when IV is high, the expected range adjusts to account for the new volatility almost immediately, which in many cases reduces the risk of an outlier loss. To understand this, consider\nFigures 3.6\n(a) and (b), showing extreme losses for 16\nSPY strangles from 2005–2021, with an emphasis on the 2008 recession.\nFigure 3.5\nSPY IV from 2010–2020. The average prices for 45 DTE 16\nSPY strangles are labeled at different VIX levels: 10–20, 20–30, and 30–40. When the VIX was between 30 and 40, the average initial credit per one lot for the 16\nSPY strangle was roughly 42% higher than when the VIX was between 10 and 20.\nAshort 16\nSPY strangle rarely incurs aloss over $1,000. From 2005–2021, this occurred less than 1% of the time. However,\n84%\nof these losses occurred when the VIX was below 25. During the initial IV expansion of the 2008 recession (late August to early October), strangles incurred these large losses approximately 56% of the time. Notice in\nFigure 3.6\nthat these extreme losses were confined to the initial IV expansion (when the VIX increased from roughly 20 to 35). This is because the market was not anticipating the large downside moves of the recession, as reflected by the VIX being near its long‐term average of 18. Because these large swings happened when the expected move range was tight, the historical volatility of the market well exceeded its expected range, and long strangles were highly profitable. Once market uncertainty adjusted to the new conditions and initial credits and expected ranges increased to reflect the perceived risks, the outlier losses for short strangles diminished.\nFigure 3.6\n(a) SPY IV from 2005–2021. Labeled are the extreme losses for 45 DTE 16\nSPY strangles held to expiration, meaning losses that are worse than $1,000. (b) The same figure as shown in (a) but zoomed in to 2008–2010, during the 2008 recession.\nThese unexpected periods of high market volatility are the primary source of extreme loss for short premium positions. These events typically happen when there are large price swings in the underlying and the expected move range is tight (low IV). These extreme expansion events are rare, and trading short premium once IV is elevated tends to reduce this type of exposure. Another way to demonstrate this concept is to consider the amount of skew in the P/Ldistribution of the 16\nSPY strangle at different IV levels.\nFigures 3.7\n(a)–(d) illustrate that strangle P/Ldistributions have less negative skew and smaller tail losses as IV increases. This means that, historically, the exposure\nto negative tail risk was much higher when the VIX was closer to the lower end of its range compared to when the VIX already expanded. The P/Ldistribution becomes more symmetric as IV increases, indicated by the decreasing magnitude of negative skew. This means that higher IV conditions facilitate more dependable profit and loss expectations than lower IV conditions. As an important note, observe that there are significantly fewer occurrences when the VIX was over 35 (afew hundred occurrences) compared to when the VIX was between 0 and 25 (thousands of occurrences). This brings us to the next point to consider: How often should one trade?\nFigure 3.7\nHistorical P/Ldistributions for 45 DTE 16\nSPY strangles, held to expiration from 2005–2021: (a) Occurrences when the VIX is between 0 and 15 (1,603 occurrences total), (b) Occurrences when the VIX is between 15 and 25 (1,506 occurrences total). (c) Occurrences when the VIX is between 25 and 35 (416 occurrences total). (d) Occurrences when the VIX is above 35 (228 occurrences total).\nNumber of Occurrences\nTable games at acasino typically have maximum bet sizes. The house has the statistical edge for every game in the casino, but the house will not necessarily profit from that edge unless patrons bet\noften\n. In blackjack, the house has an edge of 0.5% if the player'sstrategy is statistically optimized. So, if gamblers wager $100,000 on blackjack throughout the night, they should lose approximately $500 to the house after asufficiently large number of hands. If the opponent plays 10 hands at $10,000 per hand, they", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c03.xhtml", "doc_id": "632245f905b1662d5acf372c053bdce8173f0564605798ed75bc4fe057cf4b6b", "chunk_index": 4}
{"text": "ck, the house has an edge of 0.5% if the player'sstrategy is statistically optimized. So, if gamblers wager $100,000 on blackjack throughout the night, they should lose approximately $500 to the house after asufficiently large number of hands. If the opponent plays 10 hands at $10,000 per hand, they may win eight hands, three hands, or even all 10 hands. In this case, the variance of potential outcomes is fairly large, and the casino may have to pay fairly large payouts. However, if the opponent plays 1,000 hands at $100 per hand, it is more likely the player'sloss will amount to the expected $500.\nBy capping bet sizes, the casino aims to increase the number of occurrences from asingle gambler so the house is more likely to reach long‐run averages for each game, aconsequence of the law of large numbers and the central limit theorem. When asmall\nnumber of events is randomly sampled from aprobability distribution repeatedly and the averages of those samples are compared, the variance of those averages tends to be quite large. But as the number of occurrences increases, the variance of the averages decreases and the sampled means converge to the expected value of the distribution.\n5\nJust as the casino aims to realize the long‐term edge of table games by capping bet sizes and increasing the number of plays, short premium traders should make many small trades to maximize their chances of realizing the positive long‐run expected averages of short premium strategies. For an example of why this is crucial, refer again to the P/Ldistribution of the 16\nSPY strangle.\nFigure 3.8\nHistorical P/Ldistribution for 45 DTE 16\nSPY strangles, held to expiration from 2005–2021. The dotted line is the long‐term average P/Lof this strategy.\nThis strategy, shown in\nFigure 3.8\n, has an average P/Lper trade of roughly $44 and a POP of 81%. However, these long‐term averages were calculated using roughly 3,750 trades. Calculating averages with alarge pool of data provides the least amount of statistical error but does not model the occurrences retail traders can realistically achieve. What P/Lwould short premium traders have averaged if they only placed 10 trades from 2005 to 2021? 100 trades? 500 trades?\nFigure 3.9\nshows aplot of average P/Ls for acollection of sample portfolios, each with adifferent number of trades randomly selected from the P/Ldistribution of the 16\nSPY strangle.\nFigure 3.9\nP/Laverages for portfolios with\nNnumber of trades, randomly sampled from the historical P/Ldistribution for 45 DTE 16\nSPY strangles, held to expiration from 2005–2021. The variance among these portfolio averages is very large when asmall number of trades are sampled. As more trades are sampled, the averages converge to the long‐term average P/Lof this strategy.\nAs you can see, when asmall number of trades is sampled, 10 for example, the average P/Lranges from roughly –$900 to $200. This means that if two traders randomly traded 10 short strangles from 2005 to 2021, one trader may have profited by $2,000, and the other may have lost $9,000. As the number of occurrences increases, the variance of P/Laverages among these sample portfolios decreases, and the averages converge toward the long‐run expected value of this strategy. In other words, if two traders randomly traded 1,000 short strangles from 2005 to 2021, it would be fairly likely for both to average a P/Lnear $44 per trade, the historical long‐term average P/Lof this strategy.\nNumber of occurrences is acritical factor in achieving long‐term averages, and the minimum number of occurrences needed varies with the specific strategy'sstandard deviation of P/L. For practical purposes, aminimum of roughly 200 occurrences is necessary to reach long‐run\naverages, and more is better. This puts short premium traders in abit of apredicament because, although trading short premium in high IV is ideal, high IV environments are very uncommon as shown in\nTable 3.2\n.\nTable 3.2\nHow often the VIX fell in agiven range from 2005–2021.\nVIX Data (2005–2021)\nVIX Range\n% of Occurrences\n0–15\n43%\n15–25\n40%\n25–35\n11%\n35+\n6%\nThe VIX is at the low end of its range 43% of the time and below 18.5, its long‐term average, the majority of the time. From 2005–2021, the VIX was only above 35 roughly 6% of the time, which does not leave much opportunity for trading short premium in very high IV. To optimize the likelihood of reaching the favorable long‐term expected values of this strategy, it is clearly necessary to trade in non‐ideal, low volatility conditions. The next section covers how to trade in all market conditions while mitigating the outlier risk in low volatility environments, specifically by maintaining small position sizes and limiting the capital exposed to outlier losses.\nPortfolio Allocation and Position Sizing\nIn practice, short premium traders must strike abalance between being exposed to large losses and reaching asufficient number of occurrences. Trading in high IV tends to carry less exposure to outlier r", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c03.xhtml", "doc_id": "632245f905b1662d5acf372c053bdce8173f0564605798ed75bc4fe057cf4b6b", "chunk_index": 5}
{"text": "izes and limiting the capital exposed to outlier losses.\nPortfolio Allocation and Position Sizing\nIn practice, short premium traders must strike abalance between being exposed to large losses and reaching asufficient number of occurrences. Trading in high IV tends to carry less exposure to outlier risk compared to trading in low IV, but trading in low IV is still profitable on average. Unlike long stocks, which are only profitable during bullish conditions, short options may be profitable in bullish, bearish, or neutral conditions and spanning all volatility environments. For the 16\nSPY strangle from 2005–2021, for example, the majority of occurrences were profitable in all IV ranges. (See\nTable 3.3\n.)\nTable 3.3\nThe POPs and average P/Ls in different IV ranges for 45 DTE 16\nSPY strangles, held to expiration from 2005–2021.\n16\nSPY Strangle Data (2005–2021)\nVIX Range\nPOP\nAverage P/L\n0–15\n82%\n$20\n15–25\n78%\n$7\n25–35\n86%\n$159\n35+\n89%\n$255\nBy trading short options strategies in all IV environments, profits accumulate more consistently, and the minimum number of occurrences is more achievable. To manage exposure to outlier risk throughout these environments, it'sessential\nto keep position sizes small and limit the total amount of portfolio capital allocated to short premium positions, which can be scaled according to the current outlier risk. The percentage of portfolio capital allocated to short premium strategies should generally range from 25% to 50%, with the remaining capital either kept in cash or alow‐risk passive investment.\n6\nThis is because allocating less than 25% severely limits upside growth, while allocating more than 50% may not leave enough capital for aportfolio to recover from an outlier loss event. Because the exposure to outlier risk tends to be higher when IV is low, scaling allocation down in low IV protects portfolio capital from the tail exposure of unexpected market volatility. Once IV increases, scaling short premium capital allocation up increases the potential to profit from higher credits, larger profits, and reduced outlier risk.\nTable 3.4\nGuidelines for allocating portfolio capital according to market IV.\nVIX Range\nMax Portfolio Allocation\n0–15\n25%\n15–20\n30%\n20–30\n35%\n30–40\n40%\n40+\n50%\nAportfolio should not be overly concentrated in short options strategies for the given market conditions, and the capital allocated to short premium should\nalso\nnot be overly concentrated in asingle position. An appropriately sized position should not occupy more than 5% to 7% of portfolio capital. The exact percentage varies depending on the POP of the strategies used, and this will be covered in more detail in\nChapter 8\n.\nTo understand why it'scrucial to limit capital exposure and beneficial to scale portfolio allocation according to IV, look at aworst‐case scenario: the 2020 sell‐off. The 2020 sell‐off produced historic losses for short premium positions. From late February to late March 2020, the price of SPY crashed by roughly 34%. For 45 DTE 16\nSPY strangles, the most extreme losses recorded for this position occurred throughout this time. A 16\nSPY strangle opening on February 14, 2020, and expiring on March 20, 2020, had a P/Lper one lot of roughly –$8,974, the worst recorded loss in 16 years for this type of contract. If traders allocated different percentages of a $100,000 portfolio to short SPY strangles beginning with this worst‐case loss, how would those portfolios perform in regular market conditions compared to highly volatile conditions like the 2020 sell‐off? Compare three portfolio allocation strategies: allocation by IV guidelines (25–50%), amore conservative allocation (constant 15%), and amore aggressive allocation (constant 65%).\n7\nUnsurprisingly, the portfolios perform markedly differently in regular conditions compared to the 2020 sell‐off. From 2017 to February of 2020, the aggressive portfolio dramatically outperformed the conservative and IV‐allocated portfolios. Throughout this three‐year period, the conservative portfolio grew by 13% and the IV‐allocated portfolio by 28%, and the aggressive portfolio increased by 78%. Comparatively, from 2017–2020, SPY grew by 50%. This means that a $100,000 portfolio fully allocated to SPY shares would have outperformed the conservative and IV-allocated portfolios but underperformed the aggressive portfolio, though it would have required significantly more capital than any of them.\nFigure 3.10\n(a) Performances from 2017 to 2021, through the 2020 sell‐off. Each portfolio has different amounts of capital allocated to approximately 45 DTE 16\nSPY strangles that are closed at expiration and reopened at the beginning of the expiration cycle. The portfolios are (a) IV‐allocated (solid), conservative (dashed), and aggressive (hashed). (b) SPY price from 2017 to 2021. (c) VIX throughout the same time frame.\nUpon the onset of the highly volatile market conditions of 2020, the highly exposed aggressive portfolio was immediately wiped out. The conserva", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c03.xhtml", "doc_id": "632245f905b1662d5acf372c053bdce8173f0564605798ed75bc4fe057cf4b6b", "chunk_index": 6}
{"text": "lios are (a) IV‐allocated (solid), conservative (dashed), and aggressive (hashed). (b) SPY price from 2017 to 2021. (c) VIX throughout the same time frame.\nUpon the onset of the highly volatile market conditions of 2020, the highly exposed aggressive portfolio was immediately wiped out. The conservative and IV‐allocated portfolios were also impacted by significant losses and declined by 35% and 24%, respectively, from February to March 2020. In all the previous scenarios, each portfolio experienced some degree of loss during the extreme market conditions of the 2020 sell‐off. The important thing to note is that portfolios with less capital exposure and position concentration ultimately had the capital to recover following these losses. Following the 2020 sell‐off, the conservative\nportfolio recovered by 7% and the IV‐allocated by 20% because this portfolio was able to capitalize on the high IV and higher credits of the sell‐off recovery.\nFor profit goals to be reached\nconsistently\n, it'scrucial to construct aportfolio that is robust in every type of market. Ahighly exposed portfolio takes extraordinary profits in more regular market conditions, but there is ahigh risk of going under in the rare event of asell‐off or major correction. Amore conservative portfolio is well suited for extreme market conditions, but upside profits are limited the majority of the time. Comparatively, scaling capital allocation according to market IV is an effective way to capitalize on higher profits when IV is high, protect capital from outlier losses when IV is low, and achieve reasonable growth with lower capital requirements than purchasing equities directly. More importantly, limiting capital exposure and maintaining appropriate position sizes are arguably the most effective ways to minimize the impact from extreme events. These concepts will be explored in more detail in\nChapter 7\n.\nActive Management and Efficient Capital Allocation\nUp until now, this book has discussed option risk and profitability for contracts held to expiration. However, short premium traders can also close, or manage, their positions early by purchasing long options with the same underlying, strike, and date of expiration. This can often be profitable as aresult of partial theta decay and IV contractions, and it also tends to reduce P/Lvariability per trade. Options tend to have more P/Lfluctuations in the second half of the contract duration compared to the first half, aresult of increasing gamma risk. Gamma, as discussed in earlier chapters, is ameasure of how sensitive acontract'sdelta is to changes in the price of the underlying. Gamma increases for near‐the‐money options as expiration approaches, meaning that delta (and, therefore, the price sensitivity of the option) becomes more unstable in response to moves in the underlying toward the end of the contract.\nManaging short positions actively, such as closing atrade prior to expiration and redeploying capital to new positions, is one way to reduce the P/Lswings throughout the trade duration, as well as the per‐trade\nloss potential and ending P/Lstandard deviation. Early management strategies will not necessarily reduce risk in the long term because the cumulative losses of many shorter‐term trades may exceed the single loss of alonger‐term trade, but they do make per‐trade loss potentials more reasonable. This strategy effectively allows traders to assess the viability of atrade before P/Lswings become more extreme and assess whether it is an efficient use of portfolio capital to remain in the trade. Compare how the P/Ls of 45 DTE 16\nSPY strangles are distributed when the contracts are held to expiration versus managed around halfway to expiration (21 DTE).\nTable 3.5\nComparison of management strategies for 45 DTE 16\nSPY strangles from 2005–2021 that are held to expiration and managed early. Statistics include POP, average P/L, standard deviation of P/L, and CVaR at the 5% likelihood level.\n16\nSPY Strangle Statistics (2005–2021)\nStatistics\nHeld to Expiration\nManaged at 21 DTE\nPOP\n81%\n79%\nAverage P/L\n$44\n$30\nAverage Daily P/L\n$1.29\n$1.60\nStandard Deviation of P/L\n$614\n$260\nCVaR (5%)\n–$1,535\n–$695\nAccording to the statistics in\nTable 3.5\n, strangles managed at 21 DTE carry significantly less negative tail risk and P/Lstandard deviation on atrade‐by‐trade basis than strangles held to expiration. Additionally, although early‐managed contracts collect less on average per trade, they actually average\nmore\nprofit on adaily basis and allow for more occurrences due to the shorter duration.\nManaging trades early has several benefits, most of which will be covered in\nChapter 6\n. Much of this decision depends on the acceptable amount of capital to risk on asingle trade and whether it is an efficient use of capital to remain in the existing trade. Notice from this example that managed trades take 24 days (21 days remaining on a 45‐day duration trade corresponds to an elapsed duration of 24 days) to profit $30 o", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c03.xhtml", "doc_id": "632245f905b1662d5acf372c053bdce8173f0564605798ed75bc4fe057cf4b6b", "chunk_index": 7}
{"text": "acceptable amount of capital to risk on asingle trade and whether it is an efficient use of capital to remain in the existing trade. Notice from this example that managed trades take 24 days (21 days remaining on a 45‐day duration trade corresponds to an elapsed duration of 24 days) to profit $30 on average and held contracts 45 days to make $44 on average. Trades may accumulate the majority of their profit potential well before expiration,\ndepending on the market and staying in the position for the remainder of the duration may limit upside potential. Closing trades prior to expiration and redeploying capital to anew position in the same underlying is an effective method for increasing the number of occurrences in agiven time frame. Redeploying that capital to aposition in adifferent underlying with more favorable characteristics (such as higher IV) can be amore efficient use of capital and can offer elements of risk reduction in certain situations. Taking an active approach to investing and trade management provides more control over portfolio capital allocation and the flexibility to modify trades given new information.\nTakeaways\nCompared to long premium strategies, short premium strategies yield more consistent profits and have the long‐term statistical advantage. The trade‐off for receiving consistent profits is exposure to large and sometimes undefined losses, which is why the most important goals of ashort premium trader are to (1) profit consistently enough to cover moderate and more likely losses and (2) to construct aportfolio that can survive unlikely extreme losses.\nUnexpected periods of high market volatility are the primary source of extreme loss for short premium positions. These events are highly unlikely but typically happen when large price swings occur in the underlying while the expected move range is tight (low IV). Trading short premium once IV is elevated is one way to consistently reduce this exposure.\nThe profitability of short options strategies depends on having alarge number of occurrences to reach positive statistical averages. At minimum, approximately 200 occurrences are needed for the average P/Lof astrategy to converge to long‐term profit targets and more is better.\nAlthough trading short premium in high IV is ideal, high IV environments are somewhat uncommon. This means that short premium traders must strike abalance between being exposed to large losses and reaching asufficient number of occurrences. Trading short options strategies in all IV environments accumulates profits more\nconsistently and makes it more likely to reach the minimum number of occurrences. To manage exposure to outlier risk when adopting this strategy, it'sessential to maintain small position sizes and limit the amount of capital allocated to short premium positions. This strategy can also be improved by scaling the amount of capital allocated to short premium according to the current market conditions.\nManaging positions actively is one way to reduce P/Luncertainty on atrade‐by‐trade basis, use capital more efficiently, and achieve more occurrences in agiven time frame. The choice of whether to close aposition early and redeploy capital depends on the acceptable amount of capital to risk on asingle trade and whether it is an efficient use of capital to remain in the existing trade. These concepts will be explored more in\nChapter 6\n.\nNotes\n1\nThese are approximate strikes for the 16Δ SPY strangle calculated using the equation from\nChapter 2\n. The actual strikes for a 16Δ SPY strangle are calculated using more complex estimations for expected range, which will be touched on in the appendix.\n2\nIt is difficult to make aone‐to‐one comparison between equity returns and option P/Ls because these instruments operate over different timescales. The closest option analog to an equity returns distribution is adistribution for the ending P/Ls of aparticular strategy.\n3\nStatistics represented as apercentage of initial credit are more representative of long‐term values than those represented with dollars. Equity prices drift with time, meaning the prices for their options do as well. Normalizing P/Lstatistics by the initial credit makes them more robust to changes in time but also makes comparisons between strategies less intuitive. This book will often represent option statistics in dollars, but remember these statistics are averaged over fairly long time frames.\n4\nThese are past‐looking risk metrics. Metrics of forward‐looking risk include implied volatility and buying power reduction (BPR), which will be covered in the following chapter. Forward‐looking metrics are the focus of this book and more relevant in applied trading, but past‐looking metrics are still included for the sake of completeness and education.\n5\nSpecifically, the standard deviation of the average of\nnindependent occurrences is\ntimes the standard deviation of asingle occurrence.\n6\nMore specifically, the portfolio capital being referred to here is", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c03.xhtml", "doc_id": "632245f905b1662d5acf372c053bdce8173f0564605798ed75bc4fe057cf4b6b", "chunk_index": 8}
{"text": "Chapter 4\nBuying Power Reduction\nHaving discussed the nature of implied volatility (IV) and the general risk‐reward profile of short premium positions, it'stime to introduce some elements of short volatility trading in practice. Because short options are subject to significant tail risk, brokers must reserve acertain amount of capital to cover the potential losses of each position. The capital required to place and maintain ashort premium trade is called the buying power reduction (BPR), and the total amount of portfolio capital available for trading is the portfolio buying power.\nBPR is the amount of capital required to be set aside in the account to insure ashort option position, similar to escrow. BPR is used to evaluate short premium risk on atrade‐by‐trade basis in two ways:\nBPR acts as afairly reliable metric for the worst‐case loss for an undefined risk position in current market conditions.\nBPR is used to determine if aposition is appropriate for aportfolio with acertain buying power.\nThough BPR is the option counterpart of stock margin, the distinction between the two\ncannot be overstated\n, as short options positions can never be traded with borrowed money. BPR is\nnot\nborrowed money nor does it accrue interest. It is\nyour\ncapital that is out of play for the duration of the short option trade. Margin, mostly used for stock trading, is money borrowed from brokers to purchase stock valued beyond the cash in an account. Interest\ndoes\naccrue on margin (usually between a 5% to 7% annual rate), and traders are required to pay back the margin plus interest regardless of whether the stock trade was profitable. Margin and BPR are conceptually different: Margin amplifies stock purchasing power, and BPR lowers purchasing power to account for the additional risk of short options.\nThe definition of BPR and its usage differs depending on whether the strategy is long or short and whether the strategy has defined or undefined risk. For long options, the maximum loss is simply the cost of the option, so that is the BPR. Defining the BPR for short options is more complicated, particularly for undefined risk positions, because the loss is theoretically unlimited. Defined risk trades, which will be covered in the next chapter, are short premium trades with aknown maximum loss. These are simply short premium contracts (undefined risk trades) combined with cheaper, long premium contracts that will cap the excess losses when the underlying price moves past the further strike. BPR\nis\nthe maximum loss for adefined risk strategy, but only an estimate for maximum loss for an undefined risk trade. Because the undefined risk case is more complicated, this chapter explains the BPR as it relates to undefined risk strategies, specifically short strangles.\nUp until now, options trading has predominantly been discussed within the context of strangles, an undefined risk strategy with limited gain and theoretically unlimited loss. In this case, the BPR is calculated such that it is unlikely that the loss of aposition will exceed that threshold. More specifically, BPR is intended to account for roughly 95% of potential losses with exchange-traded fund (ETF) underlyings and 90% of potential losses with stock underlyings.\n1\nThe historical effectiveness of BPR for an ETF underlying is seen in\nFigure 4.1\nby looking at losses for 45 days to expiration (DTE) 16\nSPY strangle from 2005–2021.\nFigure 4.1\nLoss as a % of BPR for 45 DTE 16\nSPY strangles held to expiration from 2005–2021.\nIn this example, most losses ranged from 0% to 20% of the BPR. Roughly 95% of all these losses were accounted for by the BPR when this position was held to expiration, as expected. Though BPR did not always capture the full extent of realized losses, it is an effective proxy for worst‐case loss on atrade‐by‐trade basis in most cases. This metric works fairly well for SPY strangles, but strangles with more volatile underlyings and strangles with tighter strikes may be more likely to have losses that breach BPR (hence the 90% efficacy rate for stocks).\nBPR corresponds to the capital required to place atrade, and that quantity varies depending on the specific strategy. The BPR for short strangles can be approximated as 20% of the price of the underlying, but mathematically, BPR depends on three variables: the stock price,\nput/call prices, and the put/call strike prices.\n2\nBecause the strangle is composed of the short out‐of‐the‐money (OTM) call and short OTM put, the BPR required to sell astrangle is simply the larger of the short put BPR and the short call BPR. The short call/put BPR is the largest of three different values:\n, which is the expected loss from a 20% move in the underlying price.\n, which is the expected loss from a 10% strike breach.\n, which ensures that there is aminimum BPR for cheap options.\nAs BPR is intended to encompass the largest likely loss for an undefined risk contract, the largest of these values is taken. This can be mathematically represen", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c04.xhtml", "doc_id": "dd2b5b9271db2af5f7be21fc156e8c798d8505348eb08a6de1ce24d0290a5841", "chunk_index": 0}
{"text": "the underlying price.\n, which is the expected loss from a 10% strike breach.\n, which ensures that there is aminimum BPR for cheap options.\nAs BPR is intended to encompass the largest likely loss for an undefined risk contract, the largest of these values is taken. This can be mathematically represented using the\nmax\nfunction, which takes the largest of the given values:\n(4.1)\n(4.2)\nCombining these formulas, the BPR of the strangle is given by:\n(4.3)\nClearly, this equation is hairy, but using some numerical examples, one can infer how strangle BPR and, therefore, option risk changes with more intuitive variables, such as the historical and implied volatility of the underlying. Consider three potential strangle trades outlined in\nTable 4.1\n.\nTable 4.1\nThree examples of approximate 45 DTE 16\nstrangle trades with different parameters and the resulting BPR.\nScenario A\nScenario B\nScenario C\nStock Price\n$150\n$150\n$300\nCall Strike\n$160\n$175\n$320\nPut Strike\n$140\n$130\n$280\nCall Price\n$1\n$2\n$2\nPut Price\n$1\n$2\n$2\nBPR\n$2,000\n$1,750\n$4,000\nIV\n20%\n45%\n20%\nThe underlying in Scenario Bis priced the same as that of Scenario A, but the strikes for the 16\nstrangle are further apart (consistent with ahigher implied volatility). The underlying in Scenario Cis twice as expensive as the underlyings in Scenarios Aand B, but the IV in Scenario Cis the same as that of Scenario A.\nBecause the BPR is higher in Scenario Ccompared to Scenario A (but the implied volatility and contract delta are the same), traders can deduce that strangle BPR tends to increase with the price of the underlying.\nTechnically\n, BPR is inversely correlated with option price, but the BPR still tends to increase with the price of the underlying because more expensive instruments have larger volatilities (as adollar amount) and, therefore, higher potential losses. BPR also decreases as the IV of the underlying increases, and both relationships can be seen in\nFigure 4.2\nlooking at BPR for 45 DTE 16\nSPY strangles from 2005–2021.\nThese charts show astrong linear relationship between BPR and underlying price and aslightly messier inverse relationship between BPR and underlying IV. This relationship is largely driven by the strikes moving further OTM for afixed\nas IV increases. BPR tends to decrease exponentially as the IV of the underlying increases, and because BPR is arough estimate for worst‐case loss, this relationship illustrates how the magnitude of potential outlier losses tends to decrease when IV increases.\n3\nFigure 4.2\nData from 45 DTE 16\nSPY strangles from 2005–2021. (a) BPR as afunction of underlying price. (b) BPR as afunction of underlying IV.\nShort premium positions carry higher credits and larger profit potentials when IV is high, but the reduction in BPR also allows more short premium positions to be placed compared to when IV is low. Because average profit and loss (P/L) is higher on atrade‐by‐trade basis\nand\nmore potentially profitable positions can be opened, it is essential to reserve alarge percentage of portfolio buying power for high IV conditions. This additionally justifies increasing the percentage of portfolio capital allocated to short premium BPR as IV increases. These crucial high‐IV profits improve portfolio performance but also cushion potential future losses. Historically, when the VIX has been over 40 compared to under 15, the same amount of capital has covered the BPR of roughly twice as many 16Δ SPY strangles. The difference between the number of short premium trades allowed in these two volatility environments is even larger when taking portfolio allocation guidelines into account. For context, consider the scenarios outlined in\nTable 4.2\n.\nTable 4.2\nTwo portfolios with the same net liquidity but different amounts of market volatility, using SPY strangle data from 2005–2021.\nScenario A\nScenario B\nNet Portfolio Liquidity\n$100,000\n$100,000\nCurrent VIX\n> 40\n< 15\nPortfolio Allocation\n$50,000\n$25,000\nApprox. 16\nSPY Strangle BPR\n$1,500\n$3,300\nMax Number of Strangles\n33\n7\nIt'simportant to note that BPR can be used to compare the capital at risk for variations of the same type of strategy, but it\ncannot\nbe used to compare the risk between defined risk strategies and undefined risk strategies. For example, if the BPR required to trade ashort strangle with underlying Awas twice the BPR required to trade ashort strangle with underlying Band otherwise had identical parameters, we can conclude that Ais twice as risky as B. This is avalid comparison because we are considering two trades with the same risk profile, but BPR\ncannot\nbe used to compare strategies with different risk profiles (say, ashort strangle versus ashort put) because it does not account for factors like the probability of profit or the probability of incurring alarge loss. This subtlety will be discussed in more detail in the following chapter.\nUnderstanding BPR is crucial when transitioning from options theory to applied options trading because it corresponds to the actual c", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c04.xhtml", "doc_id": "dd2b5b9271db2af5f7be21fc156e8c798d8505348eb08a6de1ce24d0290a5841", "chunk_index": 1}
{"text": "count for factors like the probability of profit or the probability of incurring alarge loss. This subtlety will be discussed in more detail in the following chapter.\nUnderstanding BPR is crucial when transitioning from options theory to applied options trading because it corresponds to the actual capital requirements of trading short options. BPR is also necessary to discuss the capital efficiency of options (option leverage) in entirety. Consider astock trading at $100 with avolatility of 20%, and suppose atrader wanted to invest in this asset with abullish directional assumption. The trader could achieve abullish directional exposure to this underlying in afew different ways as shown with the examples in\nTable 4.3\n.\nTable 4.3\nExample trades that offer bullish directional exposure. Assume that the 50\n(ATM) call and put contracts have 45 DTE durations and cover 100 shares of stock.\nStrategy\nCapital Required\nMax Profit\nMax Loss\nProbability of Profit (POP)\n50 Shares of Long Stock\n$5,000\n∞\n$5,000\n50%\nLong 50\nCall\n$280\n∞\n$280\n30%\nShort 50\nPut\n$2,000 (BPR)\n$280\n$9,720\n60%\nIn this one‐to‐one comparison, the effects of option leverage are clear because the long call position achieves the same profit potential as the long stock position with 94% less capital at risk. The short put position is capable of losing several times the initial investment of the trade but has ahigher POP than the long stock position and requires 60% less capital. Suppose that the price of the stock increases to $105 after 45 days. The resulting profits and corresponding returns for these different positions is given below:\nLong stock:\nLong ATM call:\nShort ATM put:\nIn this example, the long call position was able to achieve 88% of the long stock profit with 94% less capital, and the short put position was able to achieve 12%\nmore\nprofit than the long stock position with 60% less capital.\nTakeaways\nBecause short premiums are subject to significant tail risk, brokers must reserve capital to cover the potential losses of each position. This capital is called BPR. The total amount of portfolio capital available for trading is called portfolio buying power.\nBPR is used to evaluate short premium risk on atrade‐by‐trade basis in two ways: BPR is afairly reliable metric for worst‐case loss of an undefined risk position, and BPR is used to determine if aposition is appropriate for aportfolio based on its buying power.\nFor long options, BPR is the cost of the option. For short strangles, the BPR is roughly 20% of the price of the underlying. BPR for short options encompasses roughly 95% of potential losses for ETF underlyings and 90% of losses for stock underlyings.\nStrangle BPR tends to increase linearly with the price of the underlying because more expensive instruments have larger volatilities (as adollar amount) and, therefore, higher potential losses. There is an inverse relationship between strangle BPR and underlying IV; more specifically, it approximately decreases exponentially as the IV of the underlying increases. This demonstrates the advantages of trading short when IV is high because more short strangles can be opened with the same amount of capital as in low IV, and the outlier loss potential is generally lower.\nBPR can be used to compare capital at risk for variations of the same strategy, but it cannot be used to compare the risk of different strategies with different risk profiles.\nThe leveraged nature of options allows traders to achieve adesired risk‐return profile with significantly less capital than an equivalent stock position.\nNotes\n1\nThis statistic will vary with the IV of the underlying, but this is asuitable approximation for general cases.\n2\nThis is the FINRA (Financial Industry Regulatory Authority) regulatory minimum. Brokers typically follow this formula, but occasionally (especially when IV is very high) they will increase the capital requirements for contracts on specific underlyings.\n3\nThis relationship between BPR and IV is specific to strangles. The next chapter discusses how these relationships may differ for certain defined risk strategies.", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c04.xhtml", "doc_id": "dd2b5b9271db2af5f7be21fc156e8c798d8505348eb08a6de1ce24d0290a5841", "chunk_index": 2}
{"text": "Chapter 5\nConstructing a Trade\nThis book has covered anumber of topics but how does one tie all these concepts together and actually build atrade? Options are unique in that they have\ntunable\nrisk‐reward profiles, and the type of strategy and choice of contract parameters hugely impact the characteristics of that profile. This chapter describes some common short premium strategies and how varying each contract feature tends to alter the risk‐reward properties of ashort position. Some basic guidelines are also included, but the ideal trade selection ultimately depends on personal profit goals, loss tolerances, account size, and the existing positions in aportfolio. Each new trade should complement existing positions, ideally contributing some degree of diversification to the overall risk profile. However, first this chapter outlines the mechanics of building individual trades; portfolio management will be discussed later.\nThe general procedure for constructing atrade can be summarized as follows:\nChoose an asset universe.\nChoose an underlying.\nChoose acontract duration.\nChoose adefined or undefined risk strategy.\nChoose adirectional assumption.\nChoose adelta.\nAll these factors impact the overall profile of atrade, and strategies are rarely constructed in alinear manner. Traders build trades according to their personal preferences and the size of their account, making the process of constructing aposition unique. For instance, if the priority is an\nundefined risk\ntrade, the choice of underlying will have more constraints. If the priority is trading aparticular underlying under acertain directional assumption\n, the delta and the risk definition will have more constraints.\nChoose an Asset Universe\nBefore choosing an underlying, it'simportant to start with an appropriate asset universe or aset of tradable securities with desirable characteristics. The assets suitable for retail options trading must have highly liquid options markets, meaning the contracts for the security can be easily converted into cash without significantly affecting market price. To understand why liquidity is crucial, consider an example of an\nilliquid\nasset, such as ahouse. Selling ahome at fair market value in asaturated housing market requires significant time and effort. Sellers run the additional risk of having to reduce the asking price significantly to secure abuyer quickly. Options illiquidity carries risk for similar reasons, and selectively trading assets with liquid options markets ensures that contract orders will be filled efficiently and at afair market price.\nOptions liquidity is not equivalent to underlying liquidity. An underlying is considered liquid if it has the following characteristics:\nAhigh daily volume, meaning many shares traded daily (>1 million).\nAtight bid‐ask spread, meaning asmall difference between the maximum abuyer is willing to pay and the minimum aseller is willing to take (<0.1% of the asset price).\nSome examples of liquid underlyings include AMZN, IBM, SPY, and TSLA, as shown in\nTable 5.1\nbelow.\nTable 5.1\nPricing, bid‐ask spread, and daily volume data for different equities collected on February 10, 2020, at 1 p.m.\nAsset\nPrevious Closing Price\nBid‐Ask Spread\nSpread/Close (% of Closing Price)\nDaily Trading Volume\nAMZN\n$3,322.94\n$0.32\n0.01%\n1,240,935\nIBM\n$121.98\n$0.05\n0.04%\n2,484,505\nSPY\n$390.51\n$0.02\n0.005%\n16,619,920\nTSLA\n$863.42\n$0.51\n0.06%\n9,371,760\nIt is relatively straightforward to verify underlying liquidity using daily volume and bid‐ask spread as apercentage of closing price. However, aliquid underlying may not have an equally liquid options market. Sufficiently liquid options underlyings must have\ncontract prices\nwith tight bid‐ask spreads and high daily volumes. The options selection should also offer flexible time frames and strike prices. An underlying with aliquid options market is thus classified by the following properties:\nAhigh open interest or volume across strikes (at least afew hundred per strike).\nAtight bid‐ask spread (<1% of the contract price).\nAvailable contracts with several strike prices and expiration dates.\nOptions liquidity ensures that traders have awide selection of contracts to choose from and that short premium positions can be opened (i.e., contracts can be sold to abuyer) easily. Additionally, liquidity minimizes the risk of being stuck in aposition because it allows traders to close short premium positions (i.e., identical contracts can be bought back) quickly.\nThe asset universe presented in this book is equity‐based and mostly consists of stock and exchange‐traded fund (ETF) underlyings, recalling that astock represents ashare of ownership for asingle company, and an ETF tracks aspecific set of securities, such as asector, commodity, or market index. However, asset universes are generally product indifferent and can include any instruments with liquid options that present opportunities, such as commodities, digital currencies, and futures.\nChoose an Underlying\nThe", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c05.xhtml", "doc_id": "594ec2b0fcb5292b052ce100d806a34b970e0ab11b45d2aafecc3d419f1eb9a7", "chunk_index": 0}
{"text": "tracks aspecific set of securities, such as asector, commodity, or market index. However, asset universes are generally product indifferent and can include any instruments with liquid options that present opportunities, such as commodities, digital currencies, and futures.\nChoose an Underlying\nThe choice of underlying from auniverse of sufficiently liquid assets is somewhat arbitrary, but traders often choose to trade short options on instruments for apreferred company, sector, or market under specific directional beliefs. Though this is aperfectly fine way to trade, it'salso important to select an underlying with an appropriate amount of risk for agiven account size. The two broad classes of instruments in the example asset universe, stocks and ETFs generally have different volatility profiles, and there are pros and cons to trading each, summarized in\nTable 5.2\n.\nTable 5.2\nGeneral pros and cons for stock and ETF underlyings.\nStocks\nETFs\nPros\nCons\nPros\nCons\nTend to have options with higher credits and higher profit potentials\nFrequent high implied volatility (IV) conditions\nSingle‐company risk factors\nEarnings and dividend risk\nTend to have options with higher buying power reductions (BPRs)\nInherently diversified across sectors or markets\nTend to have options with lower BPRs and are still highly liquid\nLimited selection compared to stocks\nHigh IV conditions are not common\nWhen choosing an underlying, the capital requirement of the trade is alimiting factor. Asingle position should generally occupy no more than 5% to 7% of portfolio capital, meaning that stock underlyings may not be suitable for small accounts because they are more expensive to trade. However, since selling premium when IV is elevated has several benefits, stock underlyings may be preferable underlyings in certain circumstances. As stocks are subject to company‐ and sector‐specific risks, they tend to have higher IVs compared to ETFs and tend to present elevated IV opportunities more often. Note that if trading stock options, investors should also be aware of the contextual information (e.g., earnings reports dates, company announcements) that may be driving these periods of IV inflation because it may impact the\nstrategy choice.\n1\nThis practice is less important when trading options with ETF underlyings.\nThe additional risk factors (coupled with the fact that liquid stocks are often more expensive than ETFs) result in stock options generally having much larger profit and loss (P/L) swings throughout the contract duration, more ending P/Lvariability, and more tail risk. If the capital requirements of the trade are not excessive and the IV of the underlying is favorable, then these will be the next factors to consider. Overall, stock options are usually riskier but also carry ahigher profit potential than ETF options. Consider the statistics outlined in\nTable 5.3\n.\nTable 5.3\nOptions P/Land probability of profit (POP) statistics 45 days to expiration (DTE) 16\nstrangles with six different underlyings, held to expiration, from 2009–2020. Assets include SPY (S&P 500 ETF), GLD (gold commodity ETF), SLV (silver commodity ETF), AAPL (Apple stock), GOOGL (Google stock), and AMZN (Amazon stock).\n16\nStrangle Statistics, Held to Expiration (2009–2020)\nUnderlying\nAverage Profit\nAverage Loss\nPOP\nETFs\nSPY\n$160\n–$297\n82%\nGLD\n$125\n–$424\n83%\nSLV\n$33\n–$103\n81%\nStocks\nAAPL\n$431\n–$1,425\n76%\nGOOGL\n$1,108\n–$2,886\n80%\nAMZN\n$1,041\n–$2,215\n78%\nThe tolerance for P/Lswings, ending P/Lvariability, and tail exposure depends mostly on account size and personal risk preferences. If atrade approximately satisfies those preferences and the constraints previously stated, then the choice of underlying is somewhat irrelevant because of aconcept called product indifference. Because IV is derived from option price, if two assets have the same IV, their options will have roughly the same price (as apercentage of underlying price).\nConsequently, one underlying will not give more edge with respect to options pricing inefficiencies compared to another, provided they have similarly liquid options markets. To visualize this, consider the example in\nTable 5.4\n.\nTable 5.4\nTwo sample options underlyings with the same IV but differing stock and put prices.\nOption Parameters\nScenario A\nScenario B\nStock Price\n$100\n$200\nIV\n33%\n33%\n45 DTE 16\nPut Price\n$1\n$2\nIn Scenario A, the put is $1 (1% of the underlying price). Due to the efficient nature of options pricing, the short put in Scenario Bwill also cost 1% of the underlying price, as both assets have the same IV. Product indifference suggests that no one (liquid) underlying is inherently superior to another, merely that there are proportional trade‐offs among different assets. The high‐risk, high‐reward nature of stocks is not inherently better or worse than the relatively stable nature of ETFs, but some assets may be more suitable for an individual trader than others. We can, thus, conclude that the choice of an underlying essentially depen", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c05.xhtml", "doc_id": "594ec2b0fcb5292b052ce100d806a34b970e0ab11b45d2aafecc3d419f1eb9a7", "chunk_index": 1}
{"text": "e‐offs among different assets. The high‐risk, high‐reward nature of stocks is not inherently better or worse than the relatively stable nature of ETFs, but some assets may be more suitable for an individual trader than others. We can, thus, conclude that the choice of an underlying essentially depends on five main factors (in order of significance):\nThe liquidity of the options market\nThe BPR of the trade relative to account size\n2\nThe IV of the underlying\n3\nThe preferred magnitude of P/Lswings, ending P/Lvariability, and tail exposure per trade\nThe preferred company, sector, or market exposure\nChoose a Contract Duration\nThere are many ways to choose acontract duration, but this book approaches this process from aqualitative perspective. The three primary goals when choosing acontract duration are summarized as follows:\nUsing portfolio buying power effectively.\nMaintaining consistency and reaching alarge number of occurrences.\nSelecting asuitable time frame given contextual information.\nIt is essential to determine what contract duration is the most effective use of portfolio buying power without exceeding risk tolerances. Premium prices tend to be more sensitive to changes in underlying price (higher gamma) for contracts that are near expiration (5 DTE) compared to contracts that are far from expiration (120 DTE). Consequently, short‐term contracts tend to have significant P/Ls swings for alarger portion of their duration compared to longer‐term contracts, which initially have more moderate P/Lswings and gradually become more volatile. Most contracts also tend to exhibit an increase in P/Linstability as they near expiration, which is also aconsequence of higher gamma. The gamma of acontract tends to increase throughout acontract'sduration, usually the result of the underlying price drifting closer to one of the strangle strikes over time.\nFigure 5.1\nillustrates these concepts by comparing the standard deviation of daily P/Ls for different durations of the same type of contract.\nAll of these strangles exhibit adecrease in P/Lswings right before expiration. This is because options rapidly lose their extrinsic value near expiration, presuming they are not in‐the‐money (ITM), which is usually the case because 16Δ options often expire worthless. Near expiration, this exponential decline in premium from theta decay outweighs the magnitude of the P/Lswings.\nThe P/Lswings at the beginning of the contract vary greatly based on the contract duration. On day seven, the daily P/Lfor the 15 DTE contract has ahigh variance, and the 30 DTE, 45 DTE, and 60 DTE contracts have much lower P/Lswings around the seven‐day mark. This is because the 16\nstrikes in the 15 DTE contract are much closer to the at‐the‐money (ATM) than the 16\nstrikes in the 30+ DTE contracts. This is shown numerically in\nTable 5.5\n.\n4\nFigure 5.1\nStandard deviation of daily P/Ls (in dollars) for 16\nSPY strangles with various durations from 2005–2021. Included are durations of (a) 15 DTE, (b) 30 DTE, (c) 45 DTE and (d) 60 DTE.\nTable 5.5\nillustrates how the 16\nstrikes are closer to the stock price for the 15 DTE contract compared to longer duration strangles. Therefore, small changes in the price of the underlying will have alarger impact on the option'sdelta compared to contracts with longer durations and further out strike prices. The 30+ DTE contracts tend to experience larger P/Lswings once they near expiration because the underlying price often drifts toward one of the strikes over time.\nLonger contract durations, because their P/Lswings are manageable for alonger period of time, give traders more time to assess the trade and adjust to changes in market conditions. However, trade durations that are too long are not necessarily effective uses of buying power because they do not allow for as many occurrences and take alonger time to generate profits. To summarize, longer‐term contracts, which don'ttypically experience large changes in P/Luntil the latter half of their duration, tie up buying power for along time without generating significant profit most of that time. By comparison, shorter‐term contracts exhibit volatile P/Lswings for the majority of their duration and leave little time to react to new conditions. Amiddle ground contract duration, one between 30 and 60 days on amonthly expiration cycle,\n5\nis considered asuitable use of buying power. Middle ground durations offer aperiod of manageable P/Lswings while providing afair amount of daily premium decay and areasonable timescale for profit. This buffer time allows traders to evaluate the viability of atrade before P/Lswings become more volatile. It also allows traders to incorporate different trade management strategies, which will be covered in the next chapter.\nTable 5.5\nData for 16\nSPY strangles with different durations from April 20, 2021. The first row is the distance between the strike for a 16\nput and the price of the underlying for different contract durations (i.e., if the price of the", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c05.xhtml", "doc_id": "594ec2b0fcb5292b052ce100d806a34b970e0ab11b45d2aafecc3d419f1eb9a7", "chunk_index": 2}
{"text": "anagement strategies, which will be covered in the next chapter.\nTable 5.5\nData for 16\nSPY strangles with different durations from April 20, 2021. The first row is the distance between the strike for a 16\nput and the price of the underlying for different contract durations (i.e., if the price of the underlying is $100 and the strike for a 16\nput is $95, then the put distance is ($100 – $95)/$100 = 5%). The second row is the distance between the strike for a 16\ncall and the price of the underlying for different contract durations.\n16\nSPY Option Distance from ATM\nOption Type\n15 DTE\n30 DTE\n45 DTE\nPut Distance\n3.9%\n6.5%\n8.0%\nCall Distance\n2.4%\n3.9%\n4.9%\nAnother important factor to consider when choosing acontract duration is consistency and the number of occurrences. Consistently choosing similar contract time frames increases the number of occurrences and simplifies portfolio management because expiration and management times will roughly align for the majority of short premium trades in aportfolio. As discussed in\nChapter 3\n, alarge number of occurrences is required to reduce the variance of portfolio averages and maximize the likelihood of realizing long‐term expected values.\nFor profit and risk expectations to be dependable, it is essential to choose contract durations (and management strategies) that allow for areasonable number of occurrences and to do so consistently. Therefore, it'sgood practice to choose acontract time frame that is convenient to maintain and short enough to allow for several trades to be placed throughout the trading year, presuming the duration maintains amanageable amount of tail risk exposure.\nThe final major factor when choosing acontract duration is contextual information, particularly when trading stock options. Contextual information, such as an approaching election, earnings report date, or forecasted natural disaster cannot necessarily be used to consistently forecast price direction, but it may indicate apredictable change in price volatility. There is, therefore, utility in taking contextual information into account when choosing acontract time frame. This will be discussed in more detail in\nChapter 9\n.\nChoose Defined or Undefined Risk\nLong options strategies are defined risk trades, as the maximum loss is capped by the price of the contract. Short options positions may have defined or undefined risk profiles.\nDefined risk strategies have afixed maximum loss, but capping downside risk has drawbacks. Undefined risk strategies have unlimited downside risk, meaning the maximum loss on atrade-by-trade basis is potentially unlimited. The pros and cons of defined and undefined risk strategies are outlined in\nTable 5.6\n.\nTable 5.6\nComparison of defined and undefined risk strategies.\nUndefined Risk\nDefined Risk\nPros\nCons\nPros\nCons\nHigher POPs\nHigher profit potentials\nUnlimited downside risk\nHigher BPRs (more expensive to trade)\nLimited downside risk\nLower BPRs (less expensive to trade)\nLower POPs\nLower profit potentials\nCan run into liquidity issues\naa\nDefined risk trades, because they consist of short premium and long premium contracts, require more contracts to be filled than equivalent undefined risk trades. There is, therefore, ahigher risk that adefined risk order will be unable to close at agood price compared to an equivalent undefined risk position.\nDefined risk strategies have aknown maximum loss (i.e., the BPR of the trade) and will typically have alower BPR than an undefined risk strategy with similar parameters (underlying, contract duration, strikes). Although defined risk positions expose less capital than equivalent undefined risk positions, this does not imply they carry less risk.\nRecall from the discussion of option risk in\nChapter 3\nthat there are several ways to quantify the risk of an options strategy. Though defined risk strategies avoid carrying\noutlier risk\n, they are more likely to lose most or all their BPR when losses do occur. It's, therefore,\nessential\nto recognize that BPR is mathematically and functionally different for defined and undefined risk trades, and it\ncannot\nbe used as acomparative risk metric between them. This will be discussed later in the chapter.\nDue to the differences in POP and profit potential between risk profiles, the maximum amount of portfolio capital allocated should differ depending on whether the strategy is defined or undefined risk. For undefined risk strategies, traders are compensated for the significant tail risk with high profit potentials and high POPs. It is generally recommended that undefined risk strategies constitute the majority of portfolio capital allocated to short premium strategies. More specifically,\nat least\n75% of allocated capital should be in undefined risk strategies (with amaximum of 7% allocated per trade) and at most 25% of allocated capital should be in defined risk strategies (with amaximum of 5% allocated per trade). For anumerical example, consider the allocation scenarios for a $100,000 portfoli", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c05.xhtml", "doc_id": "594ec2b0fcb5292b052ce100d806a34b970e0ab11b45d2aafecc3d419f1eb9a7", "chunk_index": 3}
{"text": "of allocated capital should be in undefined risk strategies (with amaximum of 7% allocated per trade) and at most 25% of allocated capital should be in defined risk strategies (with amaximum of 5% allocated per trade). For anumerical example, consider the allocation scenarios for a $100,000 portfolio described in\nTable 5.7\n.\nTable 5.7\nPortfolio allocation for defined and undefined risk strategies with a $100,000 portfolio at different VIX levels.\nVIX Level\nMaximum Portfolio Allocation\nMinimum Undefined Risk Allocation\nMaximum Defined Risk Allocation\n20\n$30,000\n$22,500 ($7,000 max BPR per trade)\n$7,500 ($5,000 max BPR per trade)\n40\n$50,000\n$37,500 ($7,000 max BPR per trade)\n$12,500 ($5,000 max BPR per trade)\nThese differences will be elaborated on in the next section, but to summarize, the following five factors are generally the most important to consider when comparing defined and undefined risk trades:\nThe amount of BPR required for atrade relative to the net liquidity of the portfolio.\nThe likelihood of profiting from aposition.\nThe preferred amount of downside risk.\nThe preferred ending P/Lvariability and preferred magnitude of P/Lswings throughout the contract duration.\nThe profit targets.\nDefined risk trades typically require less capital, have more moderate P/Lswings throughout the trade, and have less ending P/Lstandard deviation compared to undefined risk trades. Consequently, defined risk trades may be preferable for small accounts and relatively new traders. Undefined risk trades are statistically favorable and have, therefore, been the focus of this book. However, the following section discusses how to construct defined risk trades that behave like undefined risk trades while offering protection against extreme losses. For these types of strategies, and only these types of strategies, defined risk trades can be substituted for undefined risk trades in the portfolio allocation guidelines.\nChoose a Directional Assumption\nAfter choosing acontract underlying, duration, and risk profile, the next steps are determining the directional assumption for the price of the underlying asset and selecting astrategy consistent with that belief and the preferred risk profile. The directional assumption may be bullish, bearish or neutral, and the optimal choice is subjective and depends on one'sinterpretation of the efficient market hypothesis (EMH). Recall that the EMH assumes that current prices reflect some degree of available information and comes in three main forms:\nWeak EMH: Current prices reflect all past price information.\nSemi‐strong EMH: Current prices reflect all publicly available information.\nStrong EMH: Current prices reflect all possible information.\nEach form of the EMH implies some degree of limitation with respect to price predictability:\nWeak EMH: Past price information cannot be used to consistently predict future price information, which invalidates technical analysis.\nSemi‐strong EMH: Any publicly available information cannot be used to consistently predict future price information, which invalidates fundamental analysis.\nStrong EMH: No information can be used to consistently predict future price information, which invalidates insider trading.\nNo form of the EMH is universally accepted or rejected, and the ideal form to trade under (if any) depends on personal preference. This book takes asemi‐strong approach to market predictability, assuming equity and option prices effectively reflect available information and that few directional assumptions are valid (e.g., the market trends bullish in the long term). As volatility reverts back to along‐term value following significant deviations, it is more valid to make directional assumptions on IV once it'sinflated rather than directional assumptions around equity prices. This book, therefore, typically focuses on directionally\nneutral\nstrategies, such as the short strangle, because these types of positions profit from changes in volatility and time and are relatively insensitive to price changes. However, that is apersonal choice. Multiple strategies are outlined in\nTable 5.8\n.\nFor reasons discussed in earlier chapters, all these strategies perform best in high IV. However, the POPs of these trades remain relatively high in all volatility environments, justifying that some percentage of capital should be allocated in all IV conditions.\nTo elaborate on the differences between defined and undefined risk, compare statistics for the two neutral strategies: the iron condor and the strangle. An iron condor consists of ashort out-of-the-money (OTM) vertical call spread and ashort OTM vertical put spread (introduced in\nTable 5.8\n). This trade is effectively ashort strangle paired with along strangle having strikes that are further OTM (typically called wings). As with strangles, iron condors are profitable when the underlying price stays within the range defined by the short strikes or when there is asignificant IV contraction or time decay. For example,", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c05.xhtml", "doc_id": "594ec2b0fcb5292b052ce100d806a34b970e0ab11b45d2aafecc3d419f1eb9a7", "chunk_index": 4}
{"text": "ort strangle paired with along strangle having strikes that are further OTM (typically called wings). As with strangles, iron condors are profitable when the underlying price stays within the range defined by the short strikes or when there is asignificant IV contraction or time decay. For example, a 16\nstrangle can be turned into a 16\niron condor with 10\nwings\n6\nwith the addition of along call and along put with the same duration, further from OTM (the long contracts are 10\nin this case). An example of an iron condor is shown in\nTable 5.9\nand\nFigure 5.2\n.\nTable 5.8\nExamples of popular short options strategies with the same delta of approximately 20.\na\nStrategy\nComposition\nDefined or Undefined Risk\nDirectional Assumption\nPOP\nb\nNaked Option\nShort OTM put\nUndefined\nBullish\n80%\nShort OTM call\nUndefined\nBearish\n80%\nVertical Spread\nShort OTM put, long further OTM put\nDefined\nBullish\n77%\nShort OTM call, long further OTM put\nDefined\nBearish\n77%\nStrangle\nShort OTM put, short OTM call\nUndefined\nNeutral\n70%\nIron Condor\nShort OTM vertical call spread, short OTM vertical put spread\nDefined\nNeutral\n60%\na\nThe directional assumption will be flipped for the long side of anon‐neutral position. For along neutral position, the assumption is that the underlying price will move outside of the price range defined by the contract strikes. The POP of the long side is given by 1 – (short POP).\nb\nThese POPs are approximate. The POP of adefined risk strategy depends heavily on the choice of long delta(s). Contracts with wider long deltas will generally have higher POPs. This will be explored more later in the chapter.\nThe long wings of the iron condor cap the maximum loss as either the difference between the strike prices of the vertical put spread or vertical call spread (whichever is greater) times the number of shares in the contract (typically 100) minus the net credit. The maximum loss of the short iron condor is equivalently the BPR required to open the trade.\nIt can be summarized by the following formula:\n(5.1)\nContinuing with the same example as shown in\nTable 5.9\n, we apply this formula to calculate some statistics for these two trades in\nTable 5.10\n.\nTable 5.9\nExample of a 16\nSPY strangle and a 16\nSPY iron condor with 10\nwings when the price of SPY is $315 and its IV is 12%. All contracts must have the same duration.\nContract Strikes\n16\nStrangle\n16\nIron Condor with 10\nWings\nLong Call Strike\n‐‐‐\n$332\nShort Call Strike\n$328\n$328\nShort Put Strike\n$302\n$302\nLong Put Strike\n‐‐‐\n$298\nThe short strikes were approximated with the expected range formula and the long strikes for the iron condor wings were approximated with the Black‐Scholes formula. Underlyings are often subject to strike skew, not to be confused with distribution skew, which neither of these methods really consider. This means that the strikes (both long and short) are typically not equidistant (as adollar amount) from the price of the underlying although they were approximated in this example as such. This concept will be explored more later in the chapter.\nFigure 5.2\nGraphical representation of the iron condor described in\nTable 5.9\n. The 10\nwings correspond to long strikes that are $17 from ATM, which is further OTM than the 16\nshort strikes that are $13 from ATM.\nTable 5.10\nInitial credits for the 16\nSPY strangle and the 16\nSPY iron condor with 10\nwings outlined in\nTable 5.9\n. Because the difference between the vertical call spread strikes ($332–$328) and the vertical put spread strikes ($302–$298) is the same ($4), this value is used when calculating the maximum loss.\nContract Credits\n16\nStrangle\n16\nIron Condor with 10\nWings\nLong Call Debit\n‐‐‐\n−$69\nShort Call Credit\n$122\n$122\nShort Put Credit\n$108\n$108\nLong Put Debit\n‐‐‐\n−$57\nNet Credit\n$230\n$104\nMax Loss\n∞\nBPR\n$5,000\n$296\nThe choice of wing width depends on personal profit targets and the threshold for extreme loss. Large losses generally occur once the long put or call strikes are breached by the price of the underlying, so wings that are further from ATM are exposed to larger outlier moves but are more likely to be profitable. Wings that are closer to ATM are more expensive but also reduce the maximum loss of atrade. To summarize, wings that are further out yield iron condors with alarger profit potential and ahigher probability of profit but also larger possible losses. For some numerical examples, refer to the statistics in\nTable 5.11\n.\nTable 5.11\nStatistical comparison of 45 DTE 16\nSPY iron condors with different wing widths, held to expiration from 2005–2021. Wings that have asmaller delta are further from ATM compared to wings with alarger delta. Included are 45 DTE 16\nSPY strangle statistics held to expiration from 2005–2021 for comparison.\n16\nIron Condor Statistics (2005–2021)\n16\nStrangle Statistics (2005–2021)\nStatistics\n5\nWings\n10\nWings\n13\nWings\nPOP\n79%\n75%\n73%\n81%\nAverage P/L\n$35\n$15\n$6\n$44\nStandard Deviation of P/L\n$251\n$132\n$74\n$614\nConditional Value at Risk (CVaR) (5%)\n−$771\n−$399\n−$220\n−$1,535", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c05.xhtml", "doc_id": "594ec2b0fcb5292b052ce100d806a34b970e0ab11b45d2aafecc3d419f1eb9a7", "chunk_index": 5}
{"text": "ion from 2005–2021 for comparison.\n16\nIron Condor Statistics (2005–2021)\n16\nStrangle Statistics (2005–2021)\nStatistics\n5\nWings\n10\nWings\n13\nWings\nPOP\n79%\n75%\n73%\n81%\nAverage P/L\n$35\n$15\n$6\n$44\nStandard Deviation of P/L\n$251\n$132\n$74\n$614\nConditional Value at Risk (CVaR) (5%)\n−$771\n−$399\n−$220\n−$1,535\nIf the account size allows for it, it is preferable to trade iron condors with\nwide wings\n, which have more tail risk than narrow iron condors but are historically more profitable. While iron condors with narrow wings have POPs near 70%, wide iron condors may have POPs of nearly 80%, as shown in\nTable 5.11\n. Wider iron condors, although they have higher BPR requirements, are also less likely to reach max loss than tighter iron condors when losses do occur.\nDefined risk strategies tend to have lower POPs and profit potentials compared to undefined risk strategies as shown by the strangle statistics included for reference. The iron condor has roughly athird of the profit potential as the strangle on average (in the case of 10Δ wings), but it also has roughly athird of the P/Lstandard deviation and significantly less tail exposure. Also, as in the wide iron condor example, defined risk trades can be constructed to have similar POPs as an undefined risk strategy while still offering protection from outlier losses. Defining risk in low IV, particularly with strategies that have high POPs, is one way to manage the outlier loss exposure while capitalizing on the benefits of short premium. Defined risk strategies also come with the added benefit of being significantly cheaper to trade, which is another reason they may be amore effective use of portfolio buying power when IV is low. For anumeric reference, consider the BPR statistics in\nTable 5.12\n.\nTable 5.12\nAverage BPR comparison of 45 DTE 16\nSPY strangles and 45 DTE 16\nSPY iron condors with 10\nwings when held to expiration using data from 2005–2021.\nSPY Strangle and Iron Condor BPRs (2005–2021)\nVIX Range\nStrangle BPR\nIron Condor BPR\na\n0–15\n$3,270\n$363\n15–25\n$2,641\n$426\n25–35\n$2,261\n$585\n35–45\n$1,648\n$553\n45+\n$1,445\n$615\na\nIron condors with static dollar wings (e.g., $10 wings, $20 wings) have BPRs that decrease with IV as seen with strangles. Iron condors with dynamic wings that change with variables, such as IV (e.g., 10\n, 5\n) have BPRs that increase with IV. Recall that the iron condor BPR is the widest short spread width minus the initial credit. Therefore, as IV increases, the widest width increases faster than the initial credit, so the BPR increases with IV.\nDefined risk strategies\nwith high POPs\ncan account for agreater percentage of portfolio allocation than defined risk strategies with lower POPs. Previously, we stated that at least 75% of allocated capital should be in undefined risk strategies (with amaximum of 7% allocated per trade) and at most 25% of allocated capital should be in defined risk strategies (with amaximum of 5% allocated per trade). However, adefined risk strategy with a POP comparable to an undefined risk strategy can share undefined risk portfolio buying power, which protects capital from extreme losses while still allowing for consistent profits. Once IV expands, traders can then transition to strangles to capitalize on the higher credits and reduced outlier risk.\nIt'scrucial to reiterate that BPR\ncannot\nbe used to compare risk between strategies with different risk profiles. For instance, refer back to the example in\nTable 5.10\n. The strangle requires roughly 17 times more buying power than the iron condor, but this is not to say that the risk of the strangle is equivalent to the risk of 17 iron condors. The strangle is more likely to be profitable and much less likely to lose the entire BPR because that would require amuch larger move in the underlying (20%) compared to the iron condor (5%). Very wide iron condors have similar risk profile to strangles, but it is generally good practice to avoid directly comparing defined and undefined risk strategies using buying power.\nChoosing a Delta\nRecall that delta is ameasure of\ndirectional exposure\n. According to the mathematical definition derived from the Black‐Scholes model, it represents the expected change in the option price given a $1 increase in the price of the underlying (assuming all other variables stay constant).\n7\nFor example, if the price of an underlying increases by $1, the price for along call option with adelta of 0.50 (denoted as 50\n) will increase by approximately $0.50 per share, and the price for along put option with adelta of –0.50 (denoted as –50\n, or just 50\nwhen the sign is clear from context) will decrease by approximately $0.50 per share.\n8\nThe delta of acontract additionally represents the\nperceived\nrisk of that option in terms of shares of equity. More specifically, delta corresponds to the number of shares required to hedge the directional exposure of that option according to market sentiment.\nThis book frequently references the 16\nSPY strangle, which is adelt", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c05.xhtml", "doc_id": "594ec2b0fcb5292b052ce100d806a34b970e0ab11b45d2aafecc3d419f1eb9a7", "chunk_index": 6}
{"text": "ionally represents the\nperceived\nrisk of that option in terms of shares of equity. More specifically, delta corresponds to the number of shares required to hedge the directional exposure of that option according to market sentiment.\nThis book frequently references the 16\nSPY strangle, which is adelta neutral trade consisting of ashort 16\nput directionally hedged with ashort 16\ncall. Delta neutral positions profit from factors such as decreases in IV and time decay rather than directional changes in the underlying. When originally presented in\nChapter 3\n, the short strike prices were related to the expected range, and therefore, strike prices were shown to be equidistant from the price of the underlying as in\nFigure 5.3\n.\nThe strikes in this example were derived from the expected move range approximation shown in\nChapter 2\n. However, in practice the strikes for a 16\nSPY put/call are calculated from real‐time supply and demand and are often subject to\nstrike skew\n. Revisit the example from\nTable 5.5\nto see an example of this.\nTable 5.5\nshows that the put strikes are much further from the price of the underlying compared to the call strikes even though the call and put contracts are both 16\n. According to market demand, put contracts further OTM have equivalent risk as call contracts less OTM. This skew results from market fear to the\ndownside\n, meaning the market fears larger extreme moves to the downside more than extreme moves to the upside.\n9\nAs delta is based on the market'sperception of risk, strikes for agiven delta are skewed according to that perception. But not all instruments will have the same degree of skew. Stocks like AAPL and GOOGL have fairly equidistant strikes, but market indexes and commodities (e.g., gold and oil) tend to have downside skew, otherwise known as put skew. Assets like GME (GameStop) and AMC (entertainment company) developed upside skew, otherwise known as call skew, during 2020.\nFigure 5.3\nThe price of SPY in the last 5 months of 2019. Included is the 45‐day expected move cone calculated from the IV of SPY in December 2019, where the strike for the 16\ncall is $328 and the strike for the 16\nput is $302.\nBecause delta is ameasure of perceived risk in terms of share equivalency, the chosen delta is going to significantly impact the risk‐reward\nprofile of atrade. Positions with larger deltas (closer to −100\nor +100\n) are more sensitive to changes in the price of the underlying compared to positions with smaller deltas (closer to 0). To observe how this impacts per‐trade performance, consider the statistics for 45 DTE SPY strangles with different deltas outlined in\nTables 5.13\n–\n5.15\n.\nTable 5.13\nStatistical comparison of 45 DTE SPY strangles of different deltas, held to expiration from 2005–2021.\nSPY Strangle Statistics (2005–2021)\nStatistics\n16\n20\n30\nPOP\n81%\n76%\n68%\nAverage P/L\n$44\n$49\n$54\nStandard Deviation of P/L\n$614\n$659\n$747\nCVaR (5%)\n−$1,535\n−$1,673\n−1,931\nTable 5.14\nAverage BPRs of 45 DTE SPY strangles with different deltas, sorted by IV from 2005–2021.\nSPY Strangle BPRs (2005–2021)\nVIX Range\n16\n20\n30\n0–15\n$3,270\n$3,366\n$3,573\n15–25\n$2,641\n$2,756\n$3,014\n25–35\n$2,261\n$2,415\n$2,794\n35–45\n$1,648\n$1,715\n$2,058\n45+\n$1,445\n$1,421\n$1,520\nTable 5.15\nProbability of incurring aloss exceeding the BPR for 45 DTE SPY strangles of different deltas, held to expiration from 2005–2021.\nSPY Strangle Statistics (2005–2021)\nStrangle Delta\nProbability of Loss Greater Than BPR\n16\n0.90%\n20\n0.93%\n30\n1.0%\nPositions with higher deltas have larger P/Lswings throughout the contract duration, more ending P/Lvariability, higher BPRs and lower POPs compared to positions with lower deltas. However, higher delta positions also carry higher credits and larger profit potentials overall. Positions with lower deltas achieve smaller profits more often and are lower risk than higher delta trades. Positions with lower deltas also tend to have higher thetas as apercentage of the option value, meaning they may reach profit targets more quickly than positions with higher deltas (not shown in these tables).\nThe optimal choice of delta depends on the personal profit goals and, most importantly, personal risk tolerances. ITM options (options with adelta magnitude larger than 50) generally carry more directional risk and an insufficient amount of theta (expected daily profits due to time decay) than what is suitable for ashort premium trade. OTM options are typically better candidates. When trading short premium, contract deltas between 10\nand 40\nare typically large enough to achieve reasonable growth but small enough to have manageable P/Lswings, moderate standard deviation of ending P/L, and moderate outlier risk. More risk‐tolerant traders generally trade options over 25\nand more risk‐averse traders will trade under 25\n. When IV increases and options become cheaper to trade, more risk‐tolerant traders may also scale delta\nup\nto capitalize on the larger credits across the entire options chain. It is also good practi", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c05.xhtml", "doc_id": "594ec2b0fcb5292b052ce100d806a34b970e0ab11b45d2aafecc3d419f1eb9a7", "chunk_index": 7}
{"text": "sk‐tolerant traders generally trade options over 25\nand more risk‐averse traders will trade under 25\n. When IV increases and options become cheaper to trade, more risk‐tolerant traders may also scale delta\nup\nto capitalize on the larger credits across the entire options chain. It is also good practice to re‐center the deltas of existing positions when IV increases because increases in IV cause the strike price for agiven delta to move\nfurther away\nfrom the spot price. To see an example of this, consider\nTable 5.16\n.\nTable 5.16\nComparison of strike prices for two 30 DTE 16\ncall options with the same underlying price but different IVs.\nExample Parameters for a 30 DTE 16\nCall Option\nIV\nUnderlying Price\nStrike Price\n10%\n$100\n$103\n50%\n$100\n$117\nThe strike price for a 16\ncall is $17 away from the price of the underlying when the IV is 50%, compared to $3 away when the IV is 10%.\nThis is because an increase in IV indicates an increase in the expected range for the underlying price. When this expected range becomes larger, contracts with strikes further away from the current price of the underlying are in higher demand than in lower IV conditions. This demand increases the premiums of those contracts and consequently the perceived risk. When IV increases, it is good practice to close existing positions and reopen them with adjusted strikes that better reflect the new volatility conditions.\nTakeaways\nConstructing atrade has six major steps, and the ideal choices are based on account size and the personal profit goals, risk tolerances, and market assumptions. The primary factors to consider are the asset universe, the underlying, the contract duration, the risk profile of the strategy, the directional assumption, and the delta.\nTraders should choose assets with highly liquid options markets, consisting of contracts that can be easily converted into cash without asignificant impact on market price. Liquid options markets have ahigh volume across strikes, tight bid‐ask spreads, and available contracts with several strike prices and expiration dates.\nIn an equity‐focused asset universe, traders have two main choices of equity underlyings: stocks and ETFs. Options with stock underlyings tend to have higher credits, higher profit potentials, and more frequent high IV conditions, but they also have single‐company risks and cost more to trade than options with ETF underlyings. ETFs are inherently diversified and are cheaper than stocks while being very liquid, but fewer choices are available and high IV conditions are less common.\nAsuitable contract duration should use buying power effectively, allow for consistency and areasonable number of occurrences, and reflect the timescale of contextual events, such as upcoming earnings reports and forecasted natural disasters. Contract durations ranging from 30 to 60 days are generally asuitable use of portfolio buying power, offering manageable P/Lvolatility and areasonable timescale for profit.\nShort premium strategies may have defined or undefined risk. Undefined risk trades have higher POPs and higher profit potentials but also unlimited downside risk and higher BPRs, making them more expensive to trade. Defined risk strategies have limited downside risk and lower BPRs but also lower POPs and lower profit potentials with possible liquidity issues. High‐POP defined risk strategies, such as wide iron condors, can occupy the capital reserved for undefined risk trades, and this is aparticularly good strategy when IV is low. Trading high‐POP defined risk trades in low IV and transitioning to undefined risk in high IV is an effective way to protect capital from outlier moves while profiting consistently.\nTraders must choose one of three directional assumptions for the underlying price: bullish, bearish, and neutral. The optimal choice is subjective and depends on individual interpretation of the EMH, which assumes current prices reflect some degree of available information.\nThe delta of acontract represents the perceived risk of the option in terms of shares of equity, making the choice of delta based on personal risk tolerances and profit goals. Ahigher delta OTM contract is closer to ATM and more sensitive to changes in underlying price, meaning that these positions are generally riskier but have higher profit potentials. Lower delta OTM contracts are further from ATM and have more moderate P/Lswings throughout the contract with lower ending P/Lstandard deviation generally. When trading short premium, ITM contracts are generally not suitable due to their high directional risks and low thetas. Contracts between 10\nand 40\nare generally large enough to achieve areasonable amount of growth but small enough to have manageable P/Lswings and moderate ending P/Lvariability.\nNotes\n1\nIV inflation specifically due to earnings is the basis for atype of strategy called an earnings play. Earnings plays will be discussed in\nChapter 9\nand for now will not be part of stock options discussions.\n2\nThi", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c05.xhtml", "doc_id": "594ec2b0fcb5292b052ce100d806a34b970e0ab11b45d2aafecc3d419f1eb9a7", "chunk_index": 8}
{"text": "t small enough to have manageable P/Lswings and moderate ending P/Lvariability.\nNotes\n1\nIV inflation specifically due to earnings is the basis for atype of strategy called an earnings play. Earnings plays will be discussed in\nChapter 9\nand for now will not be part of stock options discussions.\n2\nThis will be explored more later in this chapter and in\nChapter 7\n, when covering the portfolio allocation guidelines in more detail.\n3\nIn practice, IV is often interpreted according to the IV percentile or IV rank of the underlying. This is amore common trading metric because traders are rarely deeply familiar with the IV dynamics of different assets, and it is essential to include arange of assets in abalanced portfolio.\n4\nThe put distance and call distance are not symmetric. This is due to strike skew, which will be discussed later in this chapter and in the appendix.\n5\nCommon options expiration dates are divided into weekly, monthly, and quarterly cycles. Contracts with\nmonthly\nexpirations cycles are preferable because they are consistently liquid across liquid underlyings. For highly liquid assets, any expiration cycle is acceptable.\n6\nRecall that smaller deltas are further from ATM than larger deltas.\n7\nFor contracts with deltas between approximately 10 and 40, delta can also be used as avery\nrough proxy for the probability that an option will expire ITM. For instance, a 25\nput has about a 25% chance of expiring ITM, meaning that there is a 75% POP for the short put. A 16\nstrangle is composed of a 16\nput and a 16\ncall, so there is approximately a 32% chance that it will expire ITM (consistent with the 68% POP for the short strangle).\n8\nDelta is between 0 and 1 for long calls and between –1 and 0 for long puts. For short calls and short puts, the numbers are flipped.\n9\nThis is mainly the result of the history of extreme market crashes, such as the 1987 Black Monday crash, the 2008 housing crisis, and the 2020 sell‐off. Prior to 1987, the put and call strikes of the same delta were much closer to equidistant.", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c05.xhtml", "doc_id": "594ec2b0fcb5292b052ce100d806a34b970e0ab11b45d2aafecc3d419f1eb9a7", "chunk_index": 9}
{"text": "Chapter 6\nManaging Trades\nOptions traders can hold aposition to expiration or close it prior to expiration (active management). Compared to holding acontract until expiration, an active management strategy should be considered for the following reasons:\nIt allows for more occurrences over agiven time frame (if capital is redeployed).\nIt may allow for amore efficient use of portfolio buying power (if capital is redeployed).\nIt tends to reduce risk on atrade‐by‐trade basis.\nTrades can be managed in any number of ways, but similar to choosing acontract duration,\nconsistency\nis essential for reaching alarge number of occurrences and realizing favorable long‐term averages. This book advocates for adopting asimple management strategy that is easily maintainable:\nClosing atrade at afixed point in the contract duration.\nClosing atrade at afixed profit or loss target.\nSome combination of these strategies.\nThis chapter discusses different management strategies, compares trade‐by‐trade performance, and elaborates on the major factors to consider when choosing appropriate position management. Because management strategies impact the proportion of initial credit traders ultimately collect, the statistics will often be represented as an initial credit percentage rather than dollars. This chapter also predominantly focuses on undefined risk strategy management. Many of these principles also apply to defined risk positions, but defined risk positions are generally more forgiving from the perspective of trade management because they occupy asmaller percentage of portfolio buying power and have limited loss potential.\nManaging According to DTE\nAs mentioned in\nChapters 3\nand\n5\n, trade profit and loss (P/L) swings tend to become more volatile as options approach expiration. For astrangle, this increase generally results from the price of the underlying drifting toward one of the strikes throughout the contract duration. Consequently, closing atrade prior to expiration, whether at afixed point in the contract duration or at aspecific profit or loss target, tends to reduce ending P/Lstandard deviation and outlier risk exposure on atrade‐by‐trade basis. Managing trades actively also frees portfolio buying power from existing positions, which can then be allocated more strategically as opportunities arise. The freed capital can be redeployed to the same type of initial position (increasing the number of occurrences)\n1\nor\nto anew position with more favorable short premium conditions (which may be amore efficient use of buying power).\nManaging atrade according to days to expiration (DTE), such as closing aposition halfway to expiration, offers the benefits described previously and is straightforward to execute. This technique has aclear management timeline and requires minimal portfolio supervision, particularly when portfolio positions have comparable durations.\nThe choice of management time greatly affects the profit potential and outlier risk exposure of atrade because trades managed closer to expiration are more likely to be profitable and have larger profits on average but are generally exposed to more tail risk. The trade‐by‐trade statistics shown in\nTable 6.1\ncompare the performance of different management times for 45 DTE 16\nSPY strangles.\nTable 6.1\nStatistics for 45 DTE 16\nSPY strangles from 2005–2021 managed at different times in the contract duration.\n16\nSPY Strangle Statistics (2005–2021)\nManagement DTE\nProbability of Profit (POP)\nAverage P/L\nAverage Daily P/L\nP/L Standard Deviation\nConditional Value at Risk (CVaR) (5%)\n40 DTE\n67%\n2.3%\n$0.23\n73%\n–206%\n30 DTE\n73%\n10%\n$1.75\n88%\n–212%\n21 DTE\n79%\n21%\n$1.60\n96%\n–283%\n15 DTE\n78%\n25%\n$1.51\n105%\n–304%\n5 DTE\na\n82%\n33%\n$1.34\n185%\n–514%\nExpiration\n81%\n28%\n$1.29\n247%\n–708%\na\nStrangles managed at 5 DTE seem to outperform strangles held to expiration because they have ahigher POP and average P/Lbut lower P/Lvolatility and less tail risk. These results are specific to this strategy and data set, and were likely skewed by significant historical events. This trend is not generalizable across strategies, including the one presented in this table.\nTable 6.1\nshows that managing atrade prior to expiration is less likely to profit but also has less P/Lstandard deviation and less tail risk, and it also collects more daily, on average, compared to holding to expiration. These statistics also demonstrate that management time generally carries atrade‐off among profit potential, loss potential, and the number of occurrences. Compared to trades managed earlier in the contract duration, trades managed later have larger profits and losses and also allow for fewer occurrences. As early‐managed positions accommodate more occurrences and average more P/Lper day than positions held to expiration, closing positions prior to expiration and redeploying capital to new positions is generally amore efficient use of capital compared to extracting more extrinsic value from an existing position.\nIf adopting this", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c06.xhtml", "doc_id": "6857e7a3e67e27feac9135adfec9f482ee99167a05775a19515b8bb434600a45", "chunk_index": 0}
{"text": "ommodate more occurrences and average more P/Lper day than positions held to expiration, closing positions prior to expiration and redeploying capital to new positions is generally amore efficient use of capital compared to extracting more extrinsic value from an existing position.\nIf adopting this strategy, choose amanagement time that satisfies individual trade‐by‐trade risk tolerances, offers asuitable profit\npotential, and occupies buying power for areasonable amount of time. Remember that selling premium in any capacity carries tail risk exposure even when aposition is closed almost immediately (see the 40 DTE results in\nTable 6.1\n). To achieve adecent amount of long‐term profit and justify the tail loss exposure, consider closing trades around the contract duration midpoint.\nManaging According to a Profit or Loss Target\nCompared to allowing atrade to expire, managing aposition according to aprofit target simplifies profit expectations and tends to reduce per‐trade P/Lvariance. Closing limit orders can be set by atrader and automatically executed by the broker, but this management strategy still requires some active maintenance. This is because trades may never reach the predetermined profit benchmark and may require alternative management prior to expiration. Additionally, there is some subtlety in choosing the profit target because that choice significantly impacts the profit and loss potential of atrade, as shown in\nTables 6.2\nand\n6.3\n.\nManaging at aprofit threshold or expiration generally carries more P/Lstandard deviation and outlier risk exposure on atrade‐by‐trade basis than managing at 21 DTE, although it also comes with higher POPs and higher per‐trade profit potentials depending on the profit benchmark. Short options are highly likely to reach low profit targets early in the contract duration when P/Lswings and tail risk are both fairly low. Therefore, managing atrade according to alow profit target yields ahigher strategy POP, lower P/Lstandard deviation, and less outlier risk compared to managing at ahigh profit target. However, despite the higher average daily P/Ls, setting the profit threshold\ntoo low\ndoes not allow traders to collect asufficient credit to justify the inherent tail risk of the position. Average P/Ls are well below the given profit target in all cases due to the tail loss potential. When using a 25% target, for example, the contract failed to reach the target only 4% of the time. Still, those losses were significant enough to bring down the P/Laverage by more than half. If this management strategy is adopted, aprofit threshold between 50% and 75% of the initial credit is suitable to realize areasonable amount of long‐term average profit and reduce the impact of outlier losses. Additionally, because these mid‐range profit targets tend to be reached near the contract midpoint or shortly after, these benchmarks also allow for areasonable number of occurrences.\n2\nTable 6.2\nStatistics for 45 DTE 16\nSPY strangles from 2005–2021 managed at different profit targets. If the profit target is not reached during the contract duration, the strangle expires. The final row includes statistics for 45 DTE 16\nSPY strangles managed around halfway to expiration (21 DTE) as areference.\n16\nSPY Strangle Statistics (2005–2021)\nProfit Target\nPOP\nAverage P/L\nP/L Standard Deviation\nProbability of\nReaching Target\nCVaR (5%)\n25% or Exp.\n96%\n11%\n191%\n96%\n−522%\n50% or Exp.\n91%\n16%\n236%\n90%\n−654%\n75% or Exp.\n84%\n22%\n245%\n80%\n−699%\n100% (Exp.)\n81%\n28%\n247%\n52%\n−708%\n21 DTE\n79%\n21%\n96%\nN/A\n−283%\nThese tests did not account for whether a P/Ltarget was reached throughout the trading day, but rather whether atarget was reached by the end of the trading day. Therefore, these statistics are not entirely representative of this management technique.\nTable 6.3\nAverage daily P/Land average duration for the contracts and management strategies described in\nTable 6.2\n.\n16\nSPY Strangle Statistics (2005–2021)\nProfit Target\nAverage Daily P/L Over Average Duration\nAverage Duration (Days)\n25% or Exp.\n$1.75\n15\n50% or Exp.\n$1.67\n24\n75% or Exp.\n$1.49\n34\n100% (Exp.)\n$1.29\n44\n21 DTE\n$1.60\n24\nThese tests did not account for whether a P/Ltarget was reached throughout the trading day, but rather whether atarget was reached by the end of the trading day. Therefore, these statistics are not entirely representative of this management technique. Additionally, because there can be significant variability in when acontract reaches acertain profit threshold, daily P/Lestimates were derived from data over the average duration of the trade.\nJust as trades can be managed according to afixed profit target, they can also be managed according to afixed loss limit (astop loss). Defining aloss limit is trickier because option P/Lswings are highly volatile. Small loss limits are reached commonly, but trades are also likely to recover. Implementing avery small loss limit may significantly limit upside growth and make losses more likely. To understa", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c06.xhtml", "doc_id": "6857e7a3e67e27feac9135adfec9f482ee99167a05775a19515b8bb434600a45", "chunk_index": 1}
{"text": "ed loss limit (astop loss). Defining aloss limit is trickier because option P/Lswings are highly volatile. Small loss limits are reached commonly, but trades are also likely to recover. Implementing avery small loss limit may significantly limit upside growth and make losses more likely. To understand this, see\nTable 6.4\n.\nTable 6.4\nStatistics for 45 DTE 16\nSPY strangles from 2005–2021 managed at different loss limits. If the loss limit is not reached during the contract duration, the strangle expires. The final two rows reference other management strategies for comparison.\n16\nSPY Strangle Statistics (2005–2021)\nLoss Limits\nPOP\nAvg P/L\nP/L Standard Deviation\nProb. of Reaching Target\nCVaR (5%)\n−50% or Exp.\n58%\n21%\n90%\n40%\n−168%\n−100% or Exp.\n69%\n25%\n110%\n25%\n−238%\n−200% or Exp.\n76%\n27%\n131%\n13%\n−338%\n−300% or Exp.\n79%\n27%\n149%\n8%\n−450%\n−400% or Exp.\n79%\n27%\n160%\n6%\n–536%\nNone (Exp.)\n81%\n28%\n247%\nN/A\n−708%\n21 DTE\n79%\n21%\n96%\nN/A\n−283%\n50% Profit or Exp.\n91%\n16%\n236%\n90%\n−654%\nThese tests did not account for whether or not a P/Lamount was reached throughout the trading day, but rather whether it was reached by the end of the trading day. Therefore, these statistics are not entirely representative of this management technique.\nUsing alow stop loss threshold, –50% for example, results in lower P/Lstandard deviation and outlier risk compared to holding the contract to expiration. However, in this case, losses are more common and occur roughly 42% of the time since it is not uncommon for options to reach this loss threshold, although many positions ultimately recover prior to expiration (note the higher POPs for larger limits). Implementing astop loss also does not necessarily eliminate\nall\ntail risk exceeding that threshold. For example, despite having astop loss of –50%, asudden implied volatility (IV) expansion or underlying price change may cause daily loss\nto increase from –25% to –75%, resulting in the closure of the trade but with afinal P/Lpast the loss threshold. Because upside potential is limited and some degree of tail exposure exists with avery small stop loss, amid‐range stop loss of at least –200% is practical.\n3\nUsing astop loss and otherwise holding to expiration generally has ahigher profit and larger loss potential than managing at the duration midpoint but tends to carry less tail risk than managing at areasonable profit target. For more active trading, stop losses are not typically used alone but rather combined with another management strategy.\nComparing Management Techniques and Choosing a Strategy\nThe strangle management strategies presented thus far are relatively straightforward. These techniques can be ranked according to loss potential (from highest to lowest) and quantified using CVaR and P/Lstandard deviation of the positions studied:\nHold until expiration.\nManage at aprofit target between 50% and 75%.\nManage at aloss limit of –200%.\nManage at 21 DTE (halfway to expiration).\nRemember that consistency and ease of implementation are important factors to consider when choosing amanagement strategy. For traders who are comfortable with active trading, strategies can be combined and more precisely tuned according to individual preferences. For instance, suppose atrader of 45 DTE 16\nSPY strangles wants amanagement strategy with ahigh POP, moderate P/Lstandard deviation, and moderate outlier exposure. One possibility is managing at 50% of the initial credit\nor\nat 21 DTE, whichever occurs first. The statistics for this strategy are outlined in\nTable 6.5\n.\nTable 6.5\nStatistics for 45 DTE 16\nSPY strangles from 2005–2021 managed either at 50% of the initial credit\nor\n21 DTE, whichever comes first. Statistics for other strategies are given for comparison and ranked by CVaR.\n16\nSPY Strangle Statistics (2005–2021)\nManagement Strategy\nPOP\nAverage P/L\nAverage Daily P/L\nP/L Standard Deviation\nCVaR (5%)\n21 DTE\n79%\n21%\n$1.60\n96%\n–283%\n21 DTE or 50% Profit\n81%\n18%\n$1.67\n96%\n–288%\n–200% Loss or Exp.\n76%\n27%\nN/A\n131%\n–338%\n50% Profit or Exp.\n91%\n16%\n$1.67\n236%\n–654%\nNone (Exp.)\n81%\n28%\n$1.29\n247%\n–708%\nIn this example, the duration and profit targets are moderate, resulting in acombined strategy with smaller but slightly more likely profits than 21 DTE management and significantly less loss potential than 50% profit management. This may be appealing to risk‐averse traders because it eliminates alarge fraction of the historic losses and significantly reduces tail exposure with the benefit of aslightly higher POP and higher average daily P/L.\nWhen choosing amanagement strategy, know that all management strategies come with trade‐offs among POP, average P/L, P/Lstandard deviation, and loss potential. How these factors are weighted depends on individual goals:\nFor\nlikely\nprofits, profit potential must be smaller or exposure to outlier losses must be larger.\nFor\nlarge\nprofits, there must be fewer occurrences or more exposure to outlier losses.\nFor asmall\nloss potential, profit potential must be smaller or profi", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c06.xhtml", "doc_id": "6857e7a3e67e27feac9135adfec9f482ee99167a05775a19515b8bb434600a45", "chunk_index": 2}
{"text": "ors are weighted depends on individual goals:\nFor\nlikely\nprofits, profit potential must be smaller or exposure to outlier losses must be larger.\nFor\nlarge\nprofits, there must be fewer occurrences or more exposure to outlier losses.\nFor asmall\nloss potential, profit potential must be smaller or profits must be less likely.\nFor aqualitative comparison of the different strategies, see\nTable 6.6\n.\nAs mentioned, asuitable management strategy depends on individual preferences for trading engagement, per‐trade P/Lpotential, P/Llikelihood and number of occurrences. Following are example scenarios highlighting different management profiles:\nTable 6.6\nQualitative comparison of different management strategies.\nManagement Strategy\n21 DTE\n50% or Exp.\n–200% or Exp.\nExp.\nConvenience\nMed\nHigh\na\nHigh\nHigh\nPOP\nMed\nHigh\nMed\nMed\nPer‐Trade Loss Potential\nLow\nHigh\nLow\nHigh\nPer‐Trade Profit Potential\nMed\nLow\nHigh\nHigh\nNumber of Occurrences\nMed\nMed\nLow\nLow\na\nIf limit orders are used, profit target management is very convenient.\nFor passive traders with portfolios that can accommodate more outlier risk, it may make more sense to use only astop loss and otherwise hold trades to expiration to extract as much extrinsic value from existing positions as possible.\nActive traders with portfolios that can accommodate more outlier risk may manage general positions at afixed profit target and close higher‐risk, higher‐reward trades halfway to expiration.\nVery active traders may manage all undefined risk contracts at either 50% of the initial credit\nor\nhalfway through the contract duration because this method prioritizes moderating outlier risk and achieving likely profits of reasonable size.\nGenerally speaking, an active management approach is more suitable for retail traders because more occurrences can be achieved in agiven time frame, it is amore efficient use of capital, average daily profits are higher, and the per‐trade loss potential is lower. It'scritical to reiterate that this risk is on atrade‐by‐trade\nbasis. Short premium losses happen infrequently and are often caused by unexpected events, making it difficult to precisely compare long‐term performance of strategies of varying timescales. The next section discusses in more detail why comparing the long‐term risks for management strategies is not straightforward.\nA Note about Long‐Term Risk\nAs mentioned previously, contracts tend to have more volatile P/Lswings as the contract approaches expiration. Managing trades prior to expiration, therefore, tends to have lower P/Lstandard deviation and outlier risk exposure on atrade‐by‐trade basis compared to holding the contract to expiration. But it'scritical to note that this reduction in risk on atrade‐by‐trade basis\ndoes not necessarily translate to areduction in risk on along‐term basis\n. Though early management techniques reduce loss magnitude\nper trade\n, inherent risk factors arise from alarger number of occurrences. Consequently, one management strategy may have lower per‐trade exposure compared to another, but it may have more\ncumulative\nlong‐term risk. Consider the scenarios outlined in\nFigures 6.1\nand\n6.2\n. Each scenario compares the performances of two portfolios, each with $100,000 of capital invested. Both portfolios consist of short 45 DTE 16\nSPY strangles continuously traded, but the trades in one portfolio are managed halfway to expiration (21 DTE) and the trades in the other are managed at expiration. The unique market conditions in each scenario affect the performance of each management strategy.\n4\nThe IV expansion during the 2020 sell‐off was one of the largest and most rapid expansions recorded in the past 20 years, producing historic losses for SPY strangles. Due to the timing and duration of this volatility expansion, 45 DTE contracts opened in February and closed at the end of the March expiration cycle experienced the majority of the expansion and were\nespecially\naffected. Shown in\nFigure 6.1\n, the portfolio of contracts held to expiration was immediately wiped out by this extreme market volatility, and the portfolio of early‐managed contracts incurred alarge drawdown of roughly 40% but ultimately survived. This scenario demonstrates how the loss potential for contracts held to expiration is significantly larger than for contracts managed early. However, this does not necessarily mean that holding to expiration results in more cumulative loss long term.\nFigure 6.1\n(a) Two portfolios, each with $100,000 in capital invested, trading short 45 DTE 16\nSPY strangles from February 2020 to January 2021. One portfolio consists of strangles managed at 21 DTE (dashed line), and the other consists of strangles held until expiration (solid line). (b) The VIX from February 2020 to January 2021.\nFigure 6.2\n(a) Two portfolios, each with $100,000 in capital invested, trading short 45 DTE 16\nSPY strangles from September 2018 to September 2019. One portfolio consists of strangles managed at 21 DTE (dashed line), and the other consists", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c06.xhtml", "doc_id": "6857e7a3e67e27feac9135adfec9f482ee99167a05775a19515b8bb434600a45", "chunk_index": 3}
{"text": "solid line). (b) The VIX from February 2020 to January 2021.\nFigure 6.2\n(a) Two portfolios, each with $100,000 in capital invested, trading short 45 DTE 16\nSPY strangles from September 2018 to September 2019. One portfolio consists of strangles managed at 21 DTE (dashed line), and the other consists of strangles held until expiration (solid line). (b) The VIX from September 2018 to September 2019.\nThese same strategies perform quite differently near the end of 2018 when the market experienced smaller, more frequent IV expansions. During this period, the 21 DTE management time for 45 DTE contracts consistently landed on IV peaks during this cycle of market volatility, causing the early‐managed portfolio to incur several consecutive losses. Comparatively, the 45 DTE expiration cycles were just long enough to evade these smaller peaks and the portfolio of contracts held to expiration had much stronger performance overall. This scenario demonstrates how having lower per‐trade loss potential does not guarantee stronger long‐term performance or smaller drawdowns.\nComparing the long‐term risks of strategies that occur over different timescales is complicated. These examples show potential trading strategies during unique macroeconomic conditions, but any number of factors could have impacted the realized experience of someone trading during these periods. For instance, if people began trading short 45 DTE 16\nSPY strangles on February 3, 2020, they would have had afinal P/Lof –$717 if they managed at 21 DTE and afinal P/Lof –$8,087 if they held the contract to expiration. If they instead began trading the same strategy\none month later\non March 4, 2020, they would have had afinal P/Lof –$2,271 if they managed at 21 DTE and afinal P/Lof $518 if they held the contract to expiration. Strangle risk and performance, particularly during periods of extreme market volatility, are highly sensitive to changes in timescale and IV. There is as much variation in how people choose contract duration, manage positions, and apply stop losses as there are traders. This makes it difficult to model how people\nwould realistically trade\nin astatistically rigorous way and, consequently, creates complications when evaluating the long‐term risk of different management strategies.\nRather than factor in long‐term risk when selecting amanagement strategy, the choice should ultimately be based on the following criteria:\nConvenience/consistency.\nCapital allocation preferences and desired number of occurrences.\nAverage P/Land outlier loss exposure\nper trade\n.\nTakeaways\nTraders should choose aconsistent\nmanagement strategy to increase the number of occurrences and the chances of achieving favorable long‐term averages. Some management strategies include closing atrade at afixed point in the contract duration, closing atrade at afixed profit or loss target, or some combination of the two.\nCompared to trades managed early in the contract duration, trades managed later have larger profits and losses, higher POPs, and allow for fewer occurrences. Early‐managed positions accommodate more occurrences and average more P/Lper day than positions held to expiration. Closing positions prior to expiration and redeploying capital to new positions is generally amore efficient use of capital compared to extracting more extrinsic value from an existing position.\nIf managing according to DTE, consider closing trades around the contract duration midpoint to achieve adecent amount of long‐term profit and justify the tail loss exposure of short premium.\nTo realize reasonable profits and reduce outlier losses, consider aprofit threshold between 50% and 75% of the initial credit. Aprofit or loss target that is too small (say 25% of initial credit) reduces average P/Land per‐trade profit potential, and aprofit or loss target that is too large does little to mitigate outlier risk.\nIf implementing astop loss, amid‐range stop loss threshold of at least −200% is practical because there is limited upside potential and still some degree of tail exposure with avery low stop loss.\nAsuitable management strategy depends on an individual'spreferences for trade engagement, per‐trade average P/L, per‐trade outlier risk exposure, and the number of occurrences. Managing undefined risk contracts at 50% of the initial credit or halfway through the contract duration generally achieves reasonable, consistent profits and moderate outlier risk for those more comfortable with active trading. This policy of trading small and trading often also allows for more occurrences.\nComparing long‐term risks of trade management strategies is complicated because unexpected events, such as the 2020 sell‐off, affect short premium strategies differently depending on the contract duration. For this reason, compare the risk and rewards of different strategies on atrade‐by‐trade basis and choose one based on convenience and consistency, capital allocation preferences, tail exposure preferences, and profit goals", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c06.xhtml", "doc_id": "6857e7a3e67e27feac9135adfec9f482ee99167a05775a19515b8bb434600a45", "chunk_index": 4}
{"text": "ect short premium strategies differently depending on the contract duration. For this reason, compare the risk and rewards of different strategies on atrade‐by‐trade basis and choose one based on convenience and consistency, capital allocation preferences, tail exposure preferences, and profit goals.\nThe concepts outlined in this chapter are specific to undefined risk positions. These management principles can also be applied to defined risk positions, but defined risk positions are generally more forgiving because they have limited loss potential. It is not as essential to manage defined risk losses because the maximum loss is known, and in some cases, it may be better to allow adefined risk trade more time to recover rather than close the position at aloss.\nNotes\n1\nThis technique is commonly known as rolling.\n2\nFor defined risk positions, aprofit target of roughly 50% or lower is more suitable because P/Lswings are less volatile and higher profit targets are less likely to be reached.\n3\nStop losses are not suitable for defined risk strategies. As defined risk strategies have afixed maximum loss, it is best to allow defined risk losers to expire rather than manage them at aspecific loss threshold. This gives the position more opportunity to recover.\n4\nOptions portfolio backtests should be taken with agrain of salt. Options are highly sensitive to changes in timescale, meaning that aconcurrent portfolio with strangles opened on slightly different days, closed on slightly different days, or with slightly different durations may have performed quite differently than the ones shown here.", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c06.xhtml", "doc_id": "6857e7a3e67e27feac9135adfec9f482ee99167a05775a19515b8bb434600a45", "chunk_index": 5}
{"text": "Chapter 7\nBasic Portfolio Management\nWhether adopting an equity, option, or hybrid portfolio, building aportfolio is nontrivial. Identifying asuitable collection of elements, calculating optimal portfolio weights, and maintaining that balance easily becomes hairy. Though countless ways to approach this process exist, the portfolio management tactics discussed in this book are fairly back‐of‐the‐envelope and divided between two chapters. This chapter covers\nnecessary\nguidelines in portfolio management, and the following chapter covers advanced portfolio management including\nsupplementary\ntechniques for portfolio optimization. Basic portfolio management includes the following concepts:\nCapital allocation guidelines\nDiversification\nMaintaining portfolio Greeks\nCapital Allocation and Position Sizing\nThe purpose of the dynamic allocation guidelines first introduced in\nChapter 3\nis to limit portfolio tail exposure while also allowing for reasonable long‐term growth by scaling capital allocation according to the current risks and opportunities in the market. Recall that the amount of portfolio buying power allotted to short premium positions, such as short strangles and short iron condors, should range from 25% to 50%, depending on the current market volatility, with the remaining capital either kept in cash or alow‐risk passive investment. Of the amount allocated to short premium, at least 75% should be reserved for undefined risk trades (with less than 7% of portfolio buying power allocated to asingle position) and at most 25% reserved for defined risk strategies (with less than 5% of portfolio buying power allocated to asingle position), although there are exceptions for high probability of profit (POP), defined risk strategies. It'sworth mentioning that it is not always feasible to strictly abide by the position size caps of 5% to 7%. If aportfolio has only $10,000 in buying power and implied volatility (IV) is low (i.e., VIX<15), this rule limits the maximum per‐trade buying power reduction (BPR) to $700 for an undefined risk trade at atime when BPRs tend to be high. This guideline would severely limit the opportunities available for small accounts. Though total portfolio allocation guidelines\nmust\nbe followed, there is more leniency for the per‐trade allocation guidelines in smaller accounts.\nThese guidelines limit the amount of capital exposed to outlier losses, but how capital is allocated depends on personal profit goals and loss tolerances. An options portfolio is typically composed of two types of positions: core and supplemental. Core positions are usually high‐POP trades with moderate profit and loss (P/L) standard deviation. These types of positions should offer consistent, fairly reliable profits and reasonable outlier exposure although they will vary by risk tolerance. Consider the following examples:\nRiskier core position: a 45 days to expiration (DTE) 20\nstrangle (undefined risk trade) with adiversified exchange‐traded fund (ETF) underlying, such as SPY or QQQ.\nMore conservative core position: a 45 DTE 16\nSPY iron condor with 6\nwings (high‐POP, defined risk trade) with adiversified ETF underlying, such as SPY or QQQ.\nCore positions should comprise the majority of aportfolio and be diversified across sectors to develop more reliable portfolio profit and loss expectations and resilience to market volatility. Supplemental positions are not necessarily dependable sources of profit but rather tools for market engagement. These positions are typically higher‐risk, higher‐reward trades meant to capitalize on dynamic opportunities in the market. Some examples of supplemental positions include earnings trades (which will be discussed in more detail in\nChapter 9\n) or strangles with stock underlyings, such as a 45 DTE 16\nAAPL strangle. When trading stock underlyings, defined risk supplemental positions would be suitable for more risk‐averse traders. These types of positions have significantly more P/Lvariability than positions with ETF underlyings, resulting in more per‐trade profit potential and more loss potential with less dependable profit and loss expectations.\nThe expected returns, P/Lvariability, and tail exposure of aportfolio overall primarily depend on the types of core positions, types of supplemental positions, and the ratio of core positions to supplemental positions. Portfolios for more risk‐tolerant traders may include alarger percentage of supplemental positions. However, mitigating tail risk remains the highest priority, particularly if the portfolio underlyings are not diversified well. This is why, generally speaking, at most 25% of the capital allocated to short premium should go toward supplemental positions. For example, if the VIX is valued at 45 and 50% of portfolio buying power is allotted to short premium positions (per the allocation guidelines), then at most 25% of the 50% portfolio buying power (or 12.5%) should be allocated to supplemental positions. See\nTable 7.1\nfor some nume", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c07.xhtml", "doc_id": "e320f42542cae560fca789da1cd4a02582186f5494529ef5bb712f6315a873b2", "chunk_index": 0}
{"text": "mental positions. For example, if the VIX is valued at 45 and 50% of portfolio buying power is allotted to short premium positions (per the allocation guidelines), then at most 25% of the 50% portfolio buying power (or 12.5%) should be allocated to supplemental positions. See\nTable 7.1\nfor some numerical context.\nCompared to core positions, such as SPY or QQQ strangles, the supplemental positions above have significantly more profit potential, loss potential, and tail risk exposure. The average profit is larger partially as the result of supplemental underlying assets having higher per share prices. This was the case with GOOGL and AMZN, which cost more than the other equity underlyings throughout the entire backtest period. However, these instruments also carry larger profit potentials as option underlyings because they are subject to company‐specific risk factors that often inflate the values of their respective options. This was particularly the case with AAPL, which had alower\nper share value than SPY, QQQ, and GLD throughout this backtest period but more option volatility.\nTable 7.1\nStatistics for 45 DTE 16\nstrangles from 2011–2020, managed at expiration. Included are examples for core and supplemental position underlyings.\n16\nStrangle Statistics (2011–2020)\nUnderlying\nPOP\nAverage Profit\nAverage Loss\nConditional Value at Risk (CVaR) (5%)\nCore\nSLV\n84%\n$32\n−$88\n−$201\nQQQ\n74%\n$109\n−$183\n−$454\nSPY\n80%\n$162\n−$320\n−$800\nGLD\n81%\n$119\n−$456\n−$1,100\nSupplemental\nAAPL\n74%\n$425\n−$1,443\n−$4,771\nGOOGL\n80%\n$1,174\n−$2,955\n−$6,593\nAMZN\n77%\n$1,235\n−$2,513\n−$6,810\nThese statistics do not account for IV or stock‐specific factors, such as earnings or dividends.\nDue to these single‐stock risk factors and the variance reflected in the option P/Ls, stocks are generally unsuitable underlyings for core positions. Their high profit potentials make them appealing supplemental position underlyings for opportunistic investors, but mitigating the tail risk exposure from supplemental positions is key for portfolio longevity. The most effective way to accomplish this is by strictly limiting the portfolio capital allocated to high‐risk positions.\nTo summarize, core positions should provide somewhat reliable expectations around P/Land be diversified across sectors. Supplemental positions should comprise asmaller percent of aportfolio because they bring higher profit potentials but also more risk. Diversification, particularly when trading options, is another crucial risk management strategy that can significantly reduce portfolio P/Lvariability and outlier exposure.\nThe Basics of Diversification\nAll financial instruments are subject to some degree of risk, with the risk profiles of some instruments being more flexible than others. Asingle equity has an immutable risk profile, and an option'srisk profile can be\nadjusted according to multiple parameters. However in either scenario, traders are subject to the risk factors of the particular position. When trading aportfolio\nof assets, atrader may offset the risks of individual positions using complementary positions. Spreading portfolio capital across avariety of assets is known as diversification.\nRisk is divided into two broad categories: idiosyncratic and systemic. Idiosyncratic risk is specific to an individual asset, sector, or position and can be minimized using diversification. For example, aportfolio containing only Apple stock is subject to risk factors specific to Apple and the tech sector. Some of those risks can be offset with the addition of an uncorrelated or inversely correlated asset, such as acommodity ETF like GLD. In this more diversified scenario, some hypothetical company‐specific risk factors causing AAPL stock to depreciate may be reduced by the performance of GLD, which has relatively independent dynamics.\nComparatively, systemic risk is inherent to the market as awhole and cannot be diversified away. All traded assets are subject to systemic risk because every economy, market, sector, and company has the potential to fail. No amount of diversification will ever remove that element of uncertainty. Instead, the purpose of diversification is to construct arobust portfolio with minimal sensitivity to company‐, sector‐, or market‐specific risk factors.\nThe process of building adiversified portfolio depends on the types of assets comprising the target portfolio. For an equity portfolio, the most effective way to diversify against idiosyncratic risk is to distribute portfolio capital across assets that have low or inversely correlated price movements. This is because the primary concern when trading equities is the directional movement of the underlying, specifically to the downside. Diversifying portfolio assets, typically using instruments for avariety of companies, sectors, and markets, reduces some of this directional concentration and improves the stability of the portfolio.\nTo understand the effectiveness of diversification by this method, consider the example outli", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c07.xhtml", "doc_id": "e320f42542cae560fca789da1cd4a02582186f5494529ef5bb712f6315a873b2", "chunk_index": 1}
{"text": "nside. Diversifying portfolio assets, typically using instruments for avariety of companies, sectors, and markets, reduces some of this directional concentration and improves the stability of the portfolio.\nTo understand the effectiveness of diversification by this method, consider the example outlined next.\nTable 7.2\nshows different portfolio allocation percentages for two equity portfolios,\nTable 7.3\nshows the correlation of the assets in both portfolios, and\nFigure 7.1\nshows the comparative performance of the two portfolios. The historical directional tendencies are often estimated using the correlation coefficient,\nwhich quantifies the strength of the historical linear relationship between two variables. Recall that the correlation coefficient ranges from –1 to 1, with 1 corresponding to perfect positive correlation, –1 corresponding to perfect inverse correlation, and 0 corresponding to no measured correlation.\nTable 7.2\nTwo sample portfolios, each containing some percentage of market ETFs for reliable portfolio growth (SPY, QQQ), low volatility assets for diversification (GLD, TLT), and high volatility assets for increased profit potential (AMZN, AAPL).\n% Portfolio Allocation\nPortfolio A\nPortfolio B\nMarket ETFs\n40%\n50%\nLow Volatility Assets\n50%\n0\nHigh Volatility Assets\n10%\n50%\nThese portfolio weights were determined intuitively and not by any particular quantitative methodology. This example demonstrates the effectiveness of diversification rather than providing aspecific framework for achieving diversification in equity portfolios.\nTable 7.3\nThe five‐year correlation history for the assets in Portfolios Aand B. Though these relationships fluctuate with time over short timescales, they are assumed to remain relatively constant long term.\nCorrelation (2015–2020)\nSPY\nQQQ\nGLD\nTLT\nAMZN\nAAPL\nMarket\nSPY\n1.0\n0.89\n−0.13\n−0.33\n0.62\n0.64\nETFs\nQQQ\n0.89\n1.0\n−0.12\n−0.26\n0.75\n0.74\nLow\nVolatility\nGLD\n−0.13\n−0.12\n1.0\n0.39\n−0.12\n−0.11\nAssets\nTLT\n−0.33\n−0.26\n0.39\n1.0\n−0.18\n−0.22\nHigh\nVolatility\nAMZN\n0.62\n0.75\n−0.12\n−0.18\n1.0\n0.50\nAssets\nAAPL\n0.64\n0.74\n−0.11\n−0.22\n0.50\n1.0\nTable 7.2\noutlines two portfolios: Portfolio Ais arelatively diversified portfolio with conservative risk tolerances and moderate profit expectations, while Portfolio Bis arisk tolerant and fairly concentrated portfolio.\nTable 7.3\nshows how the elements in Portfolio B (SPY, QQQ, AMZN, AAPL) have fairly high mutual historic correlations and therefore similar\ndirectional tendencies. Comparatively, half of Portfolio Ais allocated to low volatility assets that are uncorrelated or inversely correlated with the market ETFs and high volatility assets. Therefore, due to the diversifying contributions of those relatively independent assets, Portfolio Ais less sensitive to outlier market events.\nFigure 7.1\nshows how these portfolios would have performed from 2020–2021, importantly including the 2020 sell‐off and subsequent recovery.\nFigure 7.1\nPerformance comparison for Portfolios Aand Bfrom 2020 to 2021. Each portfolio begins with $100,000 in initial capital.\nHistoric correlations have become\nstronger\nduring financial crashes and sell‐offs. Stated differently, assets have become more correlated or more inversely correlated during volatile market periods. The correlations in\nTable 7.2\n, therefore,\nunderestimate\nthe correlation magnitudes that would have been measured from 2020–2021.\nAs aresult of the COVID‐19 pandemic, market ETFs and highly correlated assets, such as large cap tech stocks incurred significant drawdowns. Portfolio B, half of which was high volatile tech stocks, crashed by roughly 25% from February to late March 2020. Comparatively,\nPortfolio Astill experienced massive drawdowns but only declined by 14% during the same period. Portfolio Bis significantly more exposed to market volatility than Portfolio A, resulting in amore rapid, but unstable recovery following the 2020 sell‐off. Throughout this year, Portfolio Bgrew by roughly 90% from its minimum in March while Portfolio Awas growing by 44%, but Portfolio Bwas nearly twice as volatile. Nondiversified portfolios are generally more sensitive to sector‐ or market‐specific fluctuations compared to diversified portfolios. Diversifying aportfolio across asset classes reduces position concentration risk and tends to reduce loss potential in the event of turbulent market conditions. However,\nFigure 7.1\nshows how more volatile, higher‐risk portfolios can pay off with higher profits.\nDue to their complex risk profiles, options are inherently more diversified relative to one another compared to their equity counterparts. Unlike equities, where the primary concern is directional risk, several factors may affect option P/L:\nDirectional movement in the underlying price.\nChanges in IV.\nChanges in time to expiration.\nBecause exposure to each of these variables can be controlled according to the contract parameters, varying factors, such as duration/management time, underlying, and strategy creates an additio", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c07.xhtml", "doc_id": "e320f42542cae560fca789da1cd4a02582186f5494529ef5bb712f6315a873b2", "chunk_index": 2}
{"text": "t option P/L:\nDirectional movement in the underlying price.\nChanges in IV.\nChanges in time to expiration.\nBecause exposure to each of these variables can be controlled according to the contract parameters, varying factors, such as duration/management time, underlying, and strategy creates an additional reduction in P/Lcorrelation that is not possible when trading equities exclusively. However, diversifying against directional risk of the underlyings remains most essential from the perspective of risk management, particularly outlier risk management. Diversifying against nondirectional risk by varying strategy or contract duration is supplemental.\nTo understand why it is so essential to diversify the option underlyings of aportfolio, consider two market ETFs: SPY and QQQ. These assets have historically had highly correlated price dynamics and IV dynamics, as shown in the correlation matrix in\nTable 7.4\n.\nThe equity underlyings and IV indices are highly correlated, meaning that IV expansion events and outlier price moves tend to happen simultaneously for these two assets. When such events do occur, short premium positions with these two underlyings may experience simultaneous tail losses. To get an idea of how often these positions have incurred simultaneous outlier losses historically, refer to the strangle statistics shown in\nTable 7.5\n.\nTable 7.4\nHistoric correlations between two market ETFs (SPY, QQQ) and the correlations between their implied volatility indices (VIX, VXN) from 2011 to 2020. Also included is the correlation between each market index and the respective VIX, for reference.\nEquity Price and IV Index Correlation (2011–2020)\nSPY\nQQQ\nVIX\nVXN\nEquities\nSPY\n1.0\n0.89\n−0.80\nQQQ\n0.89\n1.0\n−0.76\nVolatility\nVIX\n−0.80\n1.0\n0.89\nIndices\nVXN\n−0.76\n0.89\n1.0\nTable 7.5\nThe probability of outlier losses (worse than 200% of the initial credit) occurring simultaneously for 16\nSPY strangles and 16\nQQQ strangles from 2011 to 2020. All contracts have approximately the same duration (45 DTE), start date, and expiration date. The diagonal entries (SPY Strangle‐SPY Strangle, QQQ Strangle‐QQQ Strangle) indicate the probability of astrategy incurring an outlier loss individually, and the off‐diagonal entries correspond to the probability of the pair incurring outlier losses simultaneously.\nProbability of Loss Worse than 200% (2011–2020)\nSPY Strangle\nQQQ Strangle\nSPY Strangle\n5.8%\n3.9%\nQQQ Strangle\n3.9%\n8.7%\nTable 7.5\nshows that it is reasonably unlikely for the pair of strategies to incur outlier losses simultaneously having occurred only 3.9% of\nthe time. However, if these events were completely independent, then these compound losses would have occurred less than 1% of the time:\n. Additionally, when considering the outlier loss probability for each strategy on an individual basis, the effects of trading strangles with correlated underlyings becomes abit clearer.\nFor example, the probability of a SPY strangle incurring an outlier loss is 5.8%. What is the probability a QQQ strangle will incur asimultaneous outlier loss given that a SPY strangle has taken an outlier loss? To calculate this, one can use conditional probability.\n1\nIn other words, SPY strangles and QQQ strangles may only have simultaneous outlier losses 3.9% of the time, but when a SPY strangle incurs an outlier loss, there is a\n67%\nchance\nthat a QQQ strangle also will.\n2\nGenerally, the probability of acompound loss is fairly low, but when one short premium position takes aloss there is often ahigh likelihood an equivalent position with acorrelated underlying will experience aloss of comparable magnitude. Because the loss potential of these compound occurrences is so large, it is essential to diversify underlying equities and maintain appropriate position sizes for correlated options to reduce the likelihood and impact of compounding outlier losses.\nNow consider two market ETFs (SPY and QQQ) and two diversifying ETFs that have been uncorrelated or inversely correlated to the market (GLD, TLT). The historic correlations are shown in\nTable 7.6\nand the probability of outlier losses occurring simultaneously are shown in\nTable 7.7\n.\nTable 7.6\nHistoric correlations among two market ETFs (SPY and QQQ), agold ETF (GLD), and abond ETF (TLT) from 2011 to 2020.\nEquity Price Correlation (2011–2020)\nSPY\nQQQ\nGLD\nTLT\nSPY\n1.0\n0.89\n−0.03\n−0.41\nQQQ\n0.89\n1.0\n−0.04\n−0.34\nGLD\n−0.03\n−0.04\n1.0\n0.23\nTLT\n−0.41\n−0.34\n0.23\n1.0\nTable 7.7\nThe probability of outlier losses (worse than 200% of the initial credit) occurring simultaneously for different types of 16\nstrangles held to expiration from 2011 to 2020. All contracts have approximately the same duration (45 DTE), open and close dates. The diagonal entries correspond to the probability of the specific strategy incurring an outlier loss individually, and the off‐diagonal entries correspond to the probability of the pair incurring outlier losses simultaneously.\nProbability of Loss Worse than 200% for Different Strangles (2011–2020)\nS", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c07.xhtml", "doc_id": "e320f42542cae560fca789da1cd4a02582186f5494529ef5bb712f6315a873b2", "chunk_index": 3}
{"text": "he diagonal entries correspond to the probability of the specific strategy incurring an outlier loss individually, and the off‐diagonal entries correspond to the probability of the pair incurring outlier losses simultaneously.\nProbability of Loss Worse than 200% for Different Strangles (2011–2020)\nSPY\nQQQ\nGLD\nTLT\nSPY\n5.8%\n3.9%\n2.1%\n1.9%\nQQQ\n3.9%\n8.7%\n1.9%\n1.7%\nGLD\n2.1%\n1.9%\n12%\n4.8%\nTLT\n1.9%\n1.7%\n4.8%\n12%\nAgain, it is relatively unlikely for any pair to incur simultaneous outlier losses, but this table shows the significant reduction in the\nconditional\noutlier probability when the underlying assets are uncorrelated or inversely correlated. Consider the following:\nIf a SPY strangle incurs an outlier loss, there is a 67% chance of acompounding loss with a QQQ strangle.\nIf a SPY strangle incurs an outlier loss, there is a 36% chance of acompounding loss with a GLD strangle.\nIf a QQQ strangle incurs an outlier loss, there is a 20% chance of acompounding loss with a TLT strangle.\nCompound losses still occur when the underlying assets have low or inversely correlated price movements, but this reduction in likelihood is crucial nonetheless. Having aportfolio that includes uncorrelated or inversely correlated assets is particularly meaningful during periods of unexpected market volatility when most assets develop astronger correlation to the market and there are widespread expansions in IV. Though options can be diversified with respect to several variables, diversifying the underlying assets is one of the most effective ways to reduce the impact of outlier events on aportfolio. Because diversification does not entirely remove the risk of compounding outlier losses, so maintaining small position sizes (at most 5% to 7% of portfolio capital allocated to asingle position) remains critical.\nMaintaining Portfolio Greeks\nThe Greeks form aset of risk measures that quantify different dimensions of exposure for options. Each contract has its own specific set of Greeks, but some Greeks have the convenient property of being additive across positions with different underlyings. Consequently, these metrics can be used to summarize the various sources of risk for aportfolio and guide adjustments. The following portfolio Greeks will be the focus of this section:\nBeta‐weighted delta (\n): Recall from\nChapter 1\nthat beta is ameasure of systematic risk and specifically quantifies the directional tendency of the stock relative to that of the overall market. Stocks with positive correlation to the market have positive beta and stocks with negative correlation have negative beta.\nis similar to delta, which is the expected change in the option price given a $1 change in the price of the underlying. When delta is beta‐weighted, the adjusted value corresponds to the expected change in the option price given a $1 change in some reference index, such as SPY.\nTheta (\n): The decline in an option'svalue due to the passage of time, all else being equal. This is generally represented as the expected decrease in an option'svalue per day.\nMaintaining the balance of these two variables is crucial for the long‐term health of ashort options portfolio.\nrepresents the amount of directional exposure aposition has relative to some index rather than the underlying itself. The cumulative portfolio\ndelta represents the overall directional exposure of the portfolio relative to the market assuming that the beta index is amarket ETF like SPY. Normalizing delta according to astandard underlying allows delta to be additive across all portfolio positions. This\ncannot\nbe done with unweighted delta because $1 moves across different underlyings are not comparable, i.e., trying to add deltas of different positions is like adding inches and ounces. For example, a 50\nsensitivity to underlying Aand a 25\nsensitivity to underlying Bdoes not imply a 75\nsensitivity to anything, unless Aand Bhappen to be perfectly correlated.\nneutral portfolios are attractive to short premium traders because the portfolio is relatively insensitive to changes in the market, and profit is primarily driven by changes in IV and time. Adopting\nneutrality also simplifies aspects of the diversification process because anear‐zero\nindicates low directional market exposure. As the delta of aposition drifts throughout the contract duration, the overall delta of the portfolio is skewed. To maintain\nneutrality, existing positions can be re‐centered (where the current trade is closed and reopened with anew delta), existing positions can be closed entirely, or new positions can be added. The most appropriate strategy depends on the current portfolio theta.\nTheta is also additive across positions because the units of theta are identical for all options ($/day). Because short premium traders consistently profit from time decay, the total theta across positions gives areliable estimate for the expected daily growth of the portfolio. The theta ratio (\n) estimates the expected daily profit per unit of capital f", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c07.xhtml", "doc_id": "e320f42542cae560fca789da1cd4a02582186f5494529ef5bb712f6315a873b2", "chunk_index": 4}
{"text": "s of theta are identical for all options ($/day). Because short premium traders consistently profit from time decay, the total theta across positions gives areliable estimate for the expected daily growth of the portfolio. The theta ratio (\n) estimates the expected daily profit per unit of capital for ashort premium portfolio. Options portfolios are subject to significant tail risk, so the expected daily profit should be significantly higher than aportfolio passively invested in the market to justify that risk. Therefore, one can determine the benchmark profit goals of an equivalent short options portfolio by referring to the daily P/Lperformance of apassively invested SPY portfolio as shown below in\nTable 7.8\n.\nTable 7.8\nDaily performance statistics for five portfolios passively invested in SPY from 2011–2021. Each portfolio has $100,000 in initial capital, and the amount of capital allocated in each portfolio ranges from 25% to 50%.\nSPY Allocation Percentage\nDaily Portfolio P/L (2011–2021)\n25%\n0.013%\n30%\n0.015%\n35%\n0.017%\n40%\n0.020%\n50%\n0.025%\nFrom 2011–2021, apassively invested SPY portfolio collected between 0.013% and 0.025% daily depending on the percentage of capital allocated. In other words, these portfolios had daily profits between $13 and $25 per $100,000 of capital over the past 10 years (\n). However, the expected daily profit per unit of capital for ashort options portfolio should be\nsignificantly\nhigher than this benchmark. For most traders, the minimum theta ratio should range from 0.05% to 0.1% of portfolio net liquidity to justify the tail risks of short premium. In other words, short premium portfolios should have adaily expected profit between $50 and $100 per $100,000 of portfolio buying power from\ndecay.\nThe theta ratio should not exceed 0.2%. Ahigher theta ratio is preferable, but it should not be too high due to hidden gamma risk. Gamma (\n) is the expected change in the option'sdelta given a $1 change in the price of the underlying. Delta neutral positions are rarely gamma neutral, and if the gamma of aposition is especially high, then the delta of the trade is highly sensitive to changes in the underlying price and is generally unstable. Aposition with high delta sensitivity can easily affect the overall\nneutrality of aportfolio.\nThe gammas of different derivatives cannot be compared across underlyings for similar reasons as to why raw delta cannot be compared across underlyings. Gamma cannot be accurately beta‐weighted as delta can; however, apositive relationship\nbetween gamma and theta presents asolution to this problem. Positions with large amounts of theta, such as trades with strikes that are close to at‐the‐money (ATM) or trades that are near expiration, typically also have large amounts of gamma risk. Because theta is additive across portfolio positions, the theta ratio is the most direct indicator of excessive gamma risk. This relationship between gamma and theta also demonstrates how short premium traders must balance the profitability of time decay with the P/Lfluctuations resulting from gamma.\nTo summarize, the theta ratio for an options portfolio should range from 0.05% to 0.1% and should not exceed 0.2%. Based on the theta ratio and the amount of capital currently allocated, existing positions should then be re‐centered, short premium positions should be added, or short premium positions should be removed. Given these benchmarks for expected daily profits, the procedure for modifying portfolio positions can be summarized as follows:\nIf aproperly allocated, awell‐diversified portfolio is\nneutral but does not provide asufficient amount of theta, then the positions in the portfolio should be reevaluated. In this case, perhaps some defined risk trades should be replaced with undefined risk trades or undefined risk positions should be rolled to higher deltas. New delta neutral positions can also be added, such as strangles and iron condors, for example. IV and theta are also highly correlated, meaning that higher IV underlyings could also be considered if theta is too low. These measures can be reversed if the portfolio has too much theta exposure while being\nneutral.\nIf the theta ratio is too low (<0.1%), then either existing positions should be re‐centered/tightened or new short premium positions should be added.\nIf the\nis too large and positive (bullish), then add new negative\npositions (e.g., add short calls on positive beta underlyings or add short puts on negative beta underlyings).\nIf the\nis too large and negative (bearish), then add new positive\npositions (e.g., add short puts on positive beta underlyings).\nIf the theta ratio is too large (>0.2%), then either existing positions should be re‐centered/widened or short premium positions should be removed.\nIf the\nis too large and positive (bullish), then remove positive\npositions (e.g., remove short puts on positive beta underlyings).\nIf the\nis too large and negative (bearish), then remove negative\npositions (e.g., remo", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c07.xhtml", "doc_id": "e320f42542cae560fca789da1cd4a02582186f5494529ef5bb712f6315a873b2", "chunk_index": 5}
{"text": "itions should be re‐centered/widened or short premium positions should be removed.\nIf the\nis too large and positive (bullish), then remove positive\npositions (e.g., remove short puts on positive beta underlyings).\nIf the\nis too large and negative (bearish), then remove negative\npositions (e.g., remove short calls on positive beta underlyings).\nIf aproperly allocated, well-diversified portfolio provides asufficient amount of theta but is not\nneutral, then existing positions should be reevaluated. For example, skewed positions could be closed and re‐centered or replaced with new delta-neutral positions that offer comparable amounts of theta.\nTakeaways\nThe amount of portfolio buying power allotted to short premium positions should range from 25% to 50% depending on the current market volatility, with the remaining capital either kept in cash or alow‐risk passive investment. Of the amount allocated, at least 75% should be reserved for undefined risk trades (with no more than 7% allocated to asingle position), and at most 25% should be reserved for defined risk strategies (with no more than 5% allocated to asingle position). The total portfolio allocation guidelines\nmust\nbe followed, but there is more leniency for the per‐trade allocation guidelines, especially in smaller accounts.\nAn options portfolio is typically composed of two types of positions: core and supplemental. Core positions are usually high‐POP trades with moderate P/Lvariance that offer consistent profits and reasonable outlier exposure. Supplemental positions are not necessarily dependable sources of profit but rather tools for market engagement. At most 25% of the capital allocated to short premium should go toward supplemental positions.\nUnlike equity portfolios, options portfolios can be diversified with respect to multiple variables, such as duration/management time, underlying, and strategy. Diversifying the underlyings of an options portfolio remains the most essential diversification tool for portfolio risk management, particularly outlier risk management.\nBeta‐weighted delta (\n) represents the amount of directional exposure aposition has relative to some index rather than the underlying itself. Portfolio theta (\n) represents the expected daily growth of the portfolio. The minimum theta ratio for an options portfolio should range from 0.05% to 0.1% and should not exceed 0.2%. Maintaining the balance of these two Greeks ensures the risk‐reward profile of an options portfolio remains as close to the target as possible.\nNotes\n1\nFor an introduction to conditional probability, refer to the appendix.\n2\nA 67% conditional probability of acompound loss is very high but lower than the compound loss probability when trading the equivalent equities. SPY and QQQ are\nhighly\ncorrelated and experience near‐identical drawdowns in periods of market turbulence. Therefore, that these options incur compound outlier losses only 70% of the time demonstrates the inherent diversification of options alluded to earlier.", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c07.xhtml", "doc_id": "e320f42542cae560fca789da1cd4a02582186f5494529ef5bb712f6315a873b2", "chunk_index": 6}
{"text": "Chapter 8\nAdvanced Portfolio Management\nHaving covered the necessary basics of portfolio management, this chapter discusses supplemental optimization techniques for traders who can accommodate more active trading. The capital allocation guidelines, underlying diversification, and Greeks of aportfolio are essential to maintain and are relatively straightforward to employ. This chapter will introduce some less essential strategies:\nAdditional option diversification techniques.\nWeighting assets according to probability of profit (POP).\nAdvanced Diversification\nAs stated in the previous chapter, one of the biggest strategic differences between equity portfolios and options portfolios is the ability to diversify\nrisk with respect to factors other than price. Diversifying with respect to the underlying is the most effective way to reduce the effect of outlier events on aportfolio. Diversifying with respect to other variables, such as time and strategy, requires more active management but tends to reduce the profit and loss (P/L) correlation between positions. For example, consider the per‐day standard deviation of P/Lfor SPY strangles with different durations as shown in\nFigure 8.1\n.\nFigure 8.1\nStandard deviation of daily P/Ls (in dollars) for 16\nSPY strangles with various durations from 2005–2021. Included are durations of (a) 15 days to expiration (DTE), (b) 30 DTE, (c) 45 DTE, and (d) 60 DTE.\nShort premium trades tend to have more volatile P/Lswings as they approach expiration, aresult of the position becoming more sensitive to changes in time and underlying price (larger gamma and theta). Because contracts with different durations have varying sensitivities to these\nfactors at agiven time, diversifying the timescales of portfolio positions reduces the correlations among their P/Ldynamics. Because trading consistent contract durations is important for reaching many occurrences, the most effective way to diversify with respect to time is by trading contracts with consistent durations but avariety of expiration dates. This strategy achieves an assortment of contract durations in aportfolio at agiven time without compromising the number of occurrences. Despite its efficacy, diversification with respect to time will not be thoroughly covered in this chapter because it is difficult to maintain conveniently and consistently.\nStrategy diversification, while not as essential as underlying diversification, is another risk management technique that is more straightforward than time diversification. This method effectively spreads portfolio capital across different risk profiles while maintaining the same directional assumption for agiven underlying (or ahighly correlated underlying). This lets traders capitalize on the directional dynamics of an asset while protecting aproportion of portfolio capital from outlier losses. To see an example of the diversification potential for this method, consider abacktest of three different portfolios. Each portfolio contains some combination of two directionally neutral SPY strategies: strangles and iron condors. The performance of these portfolios in this long‐term backtest is shown in\nFigure 8.2\nand analyzed in\nTable 8.1\n. The purpose of this backtest is not to demonstrate the profit or loss potential associated with combining SPY strangles and iron condors but rather to illustrate the possible effects of strategy diversification on portfolio risk according to one sample of outcomes.\nThe impact of diversification is immediately clear, particularly when emphasizing the drawdowns of the 2020 sell‐off. Strangles and iron condors experienced massive drawdowns in early 2020 even though defined risk trades are lower‐risk, lower‐reward trades. The cumulative drawdowns as apercentage of portfolio capital are approximately the same across all three portfolios (roughly 150%). However, the drawdowns as araw dollar amount were significantly larger for the strangle portfolio compared to the combined portfolio. During more regular market conditions, the combined portfolio also had amuch larger POP and profit potential than the iron condor portfolio and less P/Lvariability and outlier risk than the strangle portfolio.\nFigure 8.2\nCumulative P/Lof three different portfolios containing some combination of SPY strangles and SPY iron condors, held to expiration from 2005–2021. The strangle portfolio contains 10 strangles, the combined portfolio contains five strangles and five iron condors, and the iron condor portfolio contains 10 iron condors. All contracts are traded once per expiration cycle, opened at the beginning of the expiration cycle and closed at expiration. These positions have the same short delta (16\n), approximately the same duration (45 DTE), and the same open and close dates. The long strikes of the iron condors are roughly 10\n.\nThis example demonstrates how diversifying portfolio capital across defined and undefined risk strategies lets atrader capitalize on the directional tendencies", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c08.xhtml", "doc_id": "8a27c7278dd09014dfe47bf2b4eb6432b6fbb5e05fe75e657f13baa13e81ab80", "chunk_index": 0}
{"text": "ta (16\n), approximately the same duration (45 DTE), and the same open and close dates. The long strikes of the iron condors are roughly 10\n.\nThis example demonstrates how diversifying portfolio capital across defined and undefined risk strategies lets atrader capitalize on the directional tendencies of an underlying asset (or several highly correlated underlyings) while protecting afraction of capital from unlikely outlier events. However, this example combines strategies in ahighly simplified way as market implied volatility (IV), capital allocation guidelines, alternative management techniques, and strategy‐specific factors are not considered. In practice, defined and undefined risk strategies reach P/Ltargets at different rates and often require different management strategies. The percentage of capital allocated to asingle position also depends on anumber of factors, including the buying power reduction (BPR) of the trade (maximum of 5% for defined risk trades and 7% for undefined risk) and the correlation with the existing positions in aportfolio. For traders interested in amore quantitative approach to positional capital allocation, allocation weights can be estimated from the probability of profit of the strategy.\nTable 8.1\nStatistical analysis of the three portfolios illustrated in\nFigure 8.2\n. The first four statistics (POP, average P/L, standard deviation of P/L, and conditional value at risk (CVaR)) gauge portfolio performance during more regular market conditions (2005–2020). The final column gives the worst‐case drawdown from the 2020 sell‐off (the cumulative losses from February to March 2020).\n2005–2020\n2020 Sell‐Off\nPortfolio Type\nPOP\nAverage P/L\nStandard Deviation of P/L\nCVaR (5%)\nWorst‐Case Drawdowns\nStrangle\n76%\n$379\n$1,803\n−$5,174\n−$77,520\nCombined\n75%\n$221\n$1,275\n−$3,648\n−$45,080\nIron Condor\n67%\n$64\n$799\n−$2,324\n−$12,640\nBalancing Capital According to POP\nThe proportion of capital to allocate to aposition can be estimated from the POP of the strategy. An appropriate percentage of buying power can be estimated using the following formula, derived from the Kelly Criterion:\n1\n(8.1)\nwhere\nris the annualized risk‐free rate of return, DTE is days to expiration or the contract duration (in calendar days), and POP is the\nprobability of profit of the strategy.\n2\nApproximating the risk‐free rate is not straightforward because it is an unobservable market‐wide constant, but the long‐term bond rate is commonly used as aconservative estimate. For the remainder of this chapter, the risk‐free rate will be estimated at roughly 3% for the sake of simplicity. To see some examples of portfolio allocation percentages calculated using this equation, see\nTable 8.2\n.\nTable 8.2\nPOPs and allocation percentages of buying power for 45 DTE 16\nSPY, QQQ, and GLD strangles from 2011–2018.\nStrangle Statistics (2011–2018)\nPOP\nAllocation Percentages\nSPY Strangle\n79%\n1.4%\nQQQ Strangle\n73%\n1.0%\nGLD Strangle\n84%\n1.9%\nThe equation above suggests that the amount of portfolio buying power allocated to these positions should range from 1.0% to 1.9%, but those calculations don'ttake correlations between positions into account. Strategies with perfectly correlated underlyings should be counted against the same percentage of portfolio capital because\nEquation (8.1)\nrequires that trades be independent of one another. In this example, because SPY and QQQ are highly correlated to each other but mutually uncorrelated with GLD, GLD strangles can occupy an entire 1.9% of portfolio buying power, and SPY strangles and QQQ strangles\ncombined\nshould occupy around 1.4% (the larger of the two allocation percentages). Because SPY and QQQ are not perfectly correlated, this is aconservative lower bound.\nOverall, these allocation percentages are fairly low because the Kelly Criterion advocates for placing many small, uncorrelated bets. When aiming to allocate between 25% and 50% of portfolio buying power, strictly abiding by these bet sizes is somewhat impractical; there just aren'tenough uncorrelated underlyings. The value of the risk‐free rate\nprovides aconservative\nestimate for the ideal capital allocation, so scaling these percentages up and adopting amore aggressive approach is justified. To scale up these percentages without violating the capital allocation guidelines, these bet sizes can be used as aheuristic to estimate\nproportions\nof capital allocation rather than the explicit percentages. For example, rather than allocating according to POP weights, amore heuristic approach would be as follows:\nAccording to initial estimates, 1.4% of portfolio buying power should be allocated to SPY strangles and 1.9% to GLD strangles.\nDividing by 1.9, these weights correspond to aratio of approximately 0.74:1.0.\nThis means that SPY strangles should occupy roughly 0.74 times the portfolio buying power of GLD strangles.\nIf the maximum per‐trade allocation of 7% goes toward GLD strangles, then approximately 5.2% (derived from\n) should be allocated to SPY", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c08.xhtml", "doc_id": "8a27c7278dd09014dfe47bf2b4eb6432b6fbb5e05fe75e657f13baa13e81ab80", "chunk_index": 1}
{"text": "weights correspond to aratio of approximately 0.74:1.0.\nThis means that SPY strangles should occupy roughly 0.74 times the portfolio buying power of GLD strangles.\nIf the maximum per‐trade allocation of 7% goes toward GLD strangles, then approximately 5.2% (derived from\n) should be allocated to SPY strangles.\nTo continue this example, suppose that the capital allocated to SPY strangles is further split between SPY strangles and QQQ strangles. Although these underlyings are correlated, splitting capital between these positions achieves more diversification than allocating the entire 5.2% to one underlying. This process can also be estimated using the POP weights:\nAccording to initial estimates, 1.4% of portfolio buying power should be allocated to SPY strangles and 1.0% to QQQ strangles.\nDividing by 2.4% (from\n), these weights correspond to aratio of approximately 0.58:0.42.\nThis means that SPY strangles should occupy 58% of the capital allocation and QQQ strangles should occupy 42%.\nIf amaximum of 5.2% can be allocated toward these positions, then 3.0% of portfolio capital should go toward SPY strangles and 2.2% to QQQ strangles.\nThis scaling formula, when combined with position sizing caps of the capital allocation guidelines, allows traders to construct portfolio weights that scale with the POP of astrategy without overexposing\ncapital to outlier risk. These two concepts form asimple but effective basis for options portfolio construction.\nConstructing a Sample Portfolio\nThroughout this section, simplified capital allocation guidelines, option diversification, and POP‐weighting are combined to create asample portfolio. The sample portfolio shown here will be constructed using data from January 2011 to January 01, 2018 and backtested with data from January 02, 2018 to September 2019. This backtest will focus on implementing some of the portfolio construction techniques outlined in\nChapters 7\nand 8. This sample portfolio has six different core positions (all strangles), each occupying aconstant amount of portfolio capital determined by the POP‐weight scaling method described in the previous section. The following three simplifications are made for ease of analysis and understanding:\nNeither market IV nor underlying IV will be considered. Scaling portfolio allocation up when market IV increases is an effective way to capitalize on higher premium prices, as is focusing on underlyings with inflated implied volatilities. Because aconstant 30% of portfolio capital will be allotted to the same short premium positions throughout this backtest, profit potential will be significantly limited. Therefore, the focus of this analysis is risk management.\nThis study only uses strangles with exchange‐traded fund (ETF) underlyings instead of acombination of strategies. This makes the portfolio approximately delta neutral and eliminates the need to justify specific directional assumptions or risk profiles for individual assets. By disregarding stock underlyings, stock‐specific binary events, such as earnings and dividends do not apply. This also means that the added profit potential from supplemental positions (which tend to be higher risk and include stock underlyings) will not be accounted for in this backtest.\nRather than managing trades at fixed profit targets, all the trades shown in this backtest will be approximately opened on the first of the month and closed at the end of the month.\nStep 1:\nIdentify suitable underlyings using past data. Core positions should have moderate P/Lstandard deviations and well‐diversified\nunderlying assets. ETFs, such as the ones in\nTable 8.3\n, are viable candidates for core position underlyings. Though the market ETFs are highly correlated, asufficient number of uncorrelated and inversely correlated assets can achieve areasonable reduction in idiosyncratic risk.\nTable 8.3\nCorrelations between different ETFs from 2011–2018. Included are two market ETFs (SPY, QQQ), agold ETF (GLD), abond ETF (TLT), acurrency ETF (FXE ‐ Euro), and autilities ETF (XLU).\nCorrelation (2011–2018)\nSPY\nQQQ\nGLD\nTLT\nFXE\nXLU\nMarket ETFs\nSPY\n1.0\n0.88\n−0.02\n−0.44\n0.16\n0.49\nQQQ\n0.88\n1.0\n−0.03\n−0.36\n0.12\n0.35\nDiversifying ETFs\nGLD\n−0.02\n−0.03\n1.0\n0.19\n0.34\n0.08\nTLT\n−0.44\n−0.36\n0.19\n1.0\n−0.03\n−0.04\nFXE\n0.16\n0.12\n0.34\n−0.03\n1.0\n0.18\nXLU\n0.49\n0.35\n0.08\n−0.04\n0.18\n1.0\nStep 2:\nCalculate the percentage of portfolio capital that should be allocated to each position. These percentages can be estimated with\nEquation (8.1)\nand scaled according to the methodology described in the previous section, as shown in\nTable 8.4\n.\nThe core positions shown in\nTable 8.4\nare high‐POP, have moderate P/Lstandard deviation, and have well‐diversified underlyings, and the allocation amounts are below the 7% per‐trade buying power maximum. The total portfolio buying power allocated to short premium amounts to 30%, which is close enough to the minimum 25% to suffice for this backtest. With the portfolio initialized using data from 2011 to early 2018,", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c08.xhtml", "doc_id": "8a27c7278dd09014dfe47bf2b4eb6432b6fbb5e05fe75e657f13baa13e81ab80", "chunk_index": 2}
{"text": "erlyings, and the allocation amounts are below the 7% per‐trade buying power maximum. The total portfolio buying power allocated to short premium amounts to 30%, which is close enough to the minimum 25% to suffice for this backtest. With the portfolio initialized using data from 2011 to early 2018, it can now be backtested on new data from early 2018 to late 2019, bearing in mind that this test does not take dynamic management or implied volatility into account. The results of backtesting this sample portfolio are shown in\nFigure 8.3\nand\nTable 8.5\n.\n3\nInterestingly,\nTable 8.5\nshows that the equity portfolio was the most volatile of the three and experienced the largest worst‐case drawdown despite having less tail exposure than the options portfolios. The POP‐weighted portfolio performed more consistently and had significantly less per‐trade standard deviation than either of the other two, with per‐trade POP matching the equal‐weight portfolio and average P/Lcomparable to the equity portfolio. Despite consisting of undefined risk strategies, the POP‐weighted portfolio had nearly half the P/Lvariability and worst‐case loss as the equity portfolio throughout the backtest period. The equal‐weight strangle portfolio also underperformed compared to the POP‐weighted portfolio although not experiencing any more P/Lvariance or severe drawdowns compared to acomparable portfolio of equities. To reiterate, the performance of both strangle portfolios can be further optimized by increasing the allocation percentage according to market volatility (which can be done with the addition of uncorrelated short premium positions) or by incorporating more complex management strategies. Still, this simplified backtest illustrates the impact of incorporating the risk management techniques of capital allocation, diversification, and POP‐weighted allocation.\nTable 8.4\nCore position statistics for 45 DTE 16\nstrangles from 2011–2018. The allocation ratio is the allocation percentages normalized such that the largest bet size is set to 1.0. The portfolio weights are determined by multiplying the allocation ratio by 7% (the maximum per‐trade allocation percentage). The adjusted portfolio weights show how portfolio capital is split across assets that are highly correlated.\nCore Position Statistics (2011–2018)\nPOP\nAllocation Percentages\nSPY Strangle\n79%\n1.4%\nQQQ Strangle\n73%\n1.0%\nGLD Strangle\n84%\n1.9%\nTLT Strangle\n78%\n1.3%\nFXE Strangle\n83%\n1.8%\nXLU Strangle\n81%\n1.6%\nAllocation Ratio\nSPY/QQQ:GLD:TLT:FXE:XLU\n0.74:1.0:0.68:0.95:0.84\nPortfolio Weights\nSPY/QQQ:GLD:TLT:FXE:XLU\n5.2%:7.0%:4.8%:6.7%:5.9%\nAdjusted Portfolio Weights\nSPY:QQQ:GLD:TLT:FXE:XLU\n3.0%:2.2%:7.0%:4.8%:6.7%:5.9%\nFigure 8.3\nPortfolio performance of three different portfolios from early 2018 until September of 2019. Each portfolio has $200,000 in initial capital with 30% of the portfolio capital allocated. This initial amount of $200,000 allows at least one trade for each type of position, as $100,000 in initial capital does not. The 30% SPY equity portfolio (a) has 30% allocated to shares of SPY. The 30% equally‐weighted strangle portfolio (b) has 5% allocated to each of the six types of strangles, and the 30% POP‐weighted portfolio (c) has the 30% weighted according to the percentages in\nTable 8.4\n. All contracts have the same delta (16\n), identical durations (roughly 45 DTE), and the same open and close dates. For the sake of comparison, the trades in the equity portfolio are opened on the first of each month and closed at the end of each month.\nTable 8.5\nPortfolio backtest performance statistics for the three portfolios described in\nFigure 8.3\nfrom 2018–2019.\nPortfolio Performance Comparison (2018–2019)\nPortfolio Type\nPOP\nAverage P/L\nStandard Deviation of P/L\nWorst Loss\nSPY Equity\n60%\n$285\n$2,879\n−$6,319\nEqual‐Weight\n67%\n$26\n$2,440\n−$6,117\nPOP‐Weighted\n67%\n$268\n$1,610\n−$3,561\nThe\nheuristic derived from the Kelly Criterion provides agood guide for how much capital should be allocated to atrade when initializing aportfolio, indicating that more capital should be allocated to higher POP trades and less capital should be allocated to less reliable trades. However, this method does not provide athorough structure for dynamic portfolio management. At different points in time, trades often reach profit or loss targets, require strike re‐centering, or present new opportunities. Traders can simplify the complex management process by, for example, choosing the same contract duration or management strategy for all trades in aportfolio. However, aframework for navigating these dynamic circumstances is still necessary, and this is where the portfolio Greeks and the re‐balancing protocol outlined in\nChapter 7\nare particularly useful.\nTakeaways\nOptions can be diversified with respect to anumber of variables, but diversifying the equity underlyings of an options portfolio remains the most essential for portfolio risk management. Traders who can accommodate more involvement and are intereste", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c08.xhtml", "doc_id": "8a27c7278dd09014dfe47bf2b4eb6432b6fbb5e05fe75e657f13baa13e81ab80", "chunk_index": 3}
{"text": "ed in\nChapter 7\nare particularly useful.\nTakeaways\nOptions can be diversified with respect to anumber of variables, but diversifying the equity underlyings of an options portfolio remains the most essential for portfolio risk management. Traders who can accommodate more involvement and are interested in further diversification can also diversify positions with respect to time and strategy.\nDiversification with respect to time tends to reduce the correlations between portfolio positions because contracts respond differently to changes in time, volatility, and underlying price depending on their duration. The most effective way to diversify with respect to time without compromising occurrences is by trading contracts with consistent durations but avariety of expiration dates. This strategy is difficult to maintain consistently, however, particularly when multiple management strategies are used.\nDiversifying portfolio capital across defined and undefined risk strategies allows traders to capitalize on the directional tendencies of an underlying asset while protecting afraction of capital from unlikely outlier events. If implementing this diversification technique, note that defined and undefined risk strategies typically reach P/Ltargets at different rates and often require different management strategies.\nThe percentage of capital allocated to asingle position can be calculated from the POP of the strategy and the correlation between existing portfolio positions. The percentage of portfolio capital allocated to asingle position can be estimated using\nEquation (8.1)\n; however, this percentage can also be scaled up because the risk‐free rate yields avery conservative estimate.\nNotes\n1\nFor an introduction to the Kelly Criterion, refer to the appendix.\n2\nThe POPs used throughout this chapter are calculated from historic options data. Options data are ideal for statistical analyses but inaccessible to most people. Trading platforms often provide the theoretical POP of astrategy, which can substitute measured POP for these calculations.\n3\nThis backtest demonstrates one specific outcome out of many possible when trading short premium. The goal of this backtest is to demonstrate how one sample portfolio performs relative to other portfolios with similar characteristics under these specific circumstances.", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c08.xhtml", "doc_id": "8a27c7278dd09014dfe47bf2b4eb6432b6fbb5e05fe75e657f13baa13e81ab80", "chunk_index": 4}
{"text": "Chapter 9\nBinary Events\nTo this point, this book has highlighted unpredictable implied volatility (IV) expansions and their impact on short premium portfolios. However, traders can expect acertain class of IV expansions and contractions with near certainty. These expected volatility dynamics are the result of\nbinary events\n. Abinary event is aknown\nupcoming event affecting aspecific asset (or group of assets) that is\nanticipated\nto create alarge price move. Though price variance is\nexpected\nto increase, it may or may not actually do so depending on the outcome of the binary event.\n1\nSome examples of binary events include company earnings reports (motivating earnings trades), new product announcements, oil market reports, elections, and Federal Reserve announcements pertaining to the broader market.\nBecause the date of the anticipated price swing is known, there is typically significant demand for contracts expiring on or after the binary event for that underlying asset. This increased demand results in an increase in the asset's IV, which usually contracts back to nonevent levels immediately after the outcome is known. This trend is shown in\nFigure 9.1\n.\nThe impact from abinary event volatility expansion differs from that of unexpected periods of market volatility because the options approaching binary events are priced to reflect the expectation of large moves in the underlying. However, the high credits and immediate volatility contractions that often result from binary events do not necessarily translate into higher (or even likely) profits for short premium positions. This is because the\nmagnitude\nof the price move following the outcome of the binary event is unpredictable, and it may meet or diverge from expectations. On average, the market response to abinary event tends to be quite large, causing the short options strategies that capitalize on these conditions to be\nhighly\nvolatile and not necessarily profitable in the long run. This phenomenon also follows from the efficient market hypothesis (EMH), as the well‐understood nature of binary events challenges any consistent edge for these types of strategies.\nThere is no strong evidence that buying or selling premium around binary events provides aconsistent edge with respect to probability of profit (POP) or average profit and loss (P/L) because alot of the IV overstatement edge is lost in the large moves following abinary event. However, binary event trades are avery time‐efficient use of capital because volatility contractions happen more rapidly and predictably than in more regular market conditions. Binary event trades may also be attractive to risk‐tolerant traders as asource of market engagement. During earnings season, asingle week may present up to 20 high‐risk/high‐reward opportunities for earnings trades. Binary event trades can also be educational for new traders wanting to learn how to adjust positions in rapidly changing, high volatility conditions outside of sell‐offs. These types of trades, as they take place under unique circumstances, are structured and managed differently than typical core or supplemental positions.\nFigure 9.1\nIV indexes for different stocks from 2017–2020. Assets include (a) AMZN (Amazon stock) and (b) AAPL (Apple stock).\nOption Strategies for Binary Events\nBecause binary event trades are highly volatile and have no strong evidence of along‐term statistical edge, they should only occupy spare portfolio capital and their position size should be kept\nexceptionally\nsmall. For example, if atrader'susual position size for an AAPL strangle is afive‐lot (five calls and five puts, each written for 100 shares of stock), then an AAPL earnings strangle may comprise aone‐ or two‐lot. Additionally, underlyings for binary event trades are typically stocks, with quarterly earnings reports being the most common type of binary event. Binary event trades take place over much shorter timescales than more typical trades and must be carefully monitored. Earnings trades, for example, are typically opened the day before earnings and closed the day following earnings. This strategy limits downside risk and capitalizes on the majority of the volatility contraction, which tends to occur immediately after the binary event.\nThe long‐term success of binary event trades is difficult to verify because there are relatively few occurrences, resulting in high statistical uncertainty. AAPL, for example, has only reported earnings roughly 100 times since the mid 1990s. The Federal Reserve holds press conferences just eight times per year, and large‐scale elections take place once every two or four years. For trading strategies not built around earnings, there are thousands of data points and the statistics are more representative of long‐term expectations (the central limit theorem at work). Therefore, working with this small number of data points can yield an\nidea\nof how binary events trades have performed in the past, but they should be taken with a", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c09.xhtml", "doc_id": "845334131edb6252577edf491a6339109bd50ea4aa86603fd92d97aef7354773", "chunk_index": 0}
{"text": "re are thousands of data points and the statistics are more representative of long‐term expectations (the central limit theorem at work). Therefore, working with this small number of data points can yield an\nidea\nof how binary events trades have performed in the past, but they should be taken with alarge grain of salt.\nTables 9.1\n–\n9.3\ndemonstrate how earnings trades for three different tech companies have performed over 15 years.\nThere is clearly significant variability in strategy performance for these three different underlyings. To reiterate, high statistical uncertainty makes it difficult to make definitive conclusions about the success of earnings trades, but some consistent trends are observable. Earnings trades are highly sensitive to changes in time. This is evidenced by the significant differences in the per‐trade statistics further from the earnings announcement and demonstrates why binary event trades must be closely monitored. The\nmajority\nof earnings trades are usually profitable, but do not necessarily average aprofit in the long term because of the high per‐trade standard deviation. Per‐trade variance and tail exposure also tend to increase the longer the trade is held, indicating why these types of trades should be relatively short term. This is why generally, binary event trades, such as earning trades, are closed the day following the binary event.\nTable 9.1\nStatistics for 45 days to expiration (DTE) 16\nAAPL strangles from 2005–2020. Trades are opened the day before an earnings report and closed either one, five, 10, or 20 days after earnings.\nAAPL Strangle Statistics (2005–2020)\nDay Position Is Closed Relative to Earnings\nPOP\nAverage P/L\nStandard Deviation of P/L\nConditional Value at Risk (CVaR) (5%)\nDay After\n72%\n$85\n$203\n–$405\n5 Days After\n70%\n$43\n$400\n–$1,027\n10 Days After\n61%\n$60\n$408\n–$1,025\n20 Days After\n56%\n−$34\n$660\n–$1,976\nTable 9.2\nStatistics for 45 DTE 16\nAMZN strangles from 2005–2020. Trades are opened the day before an earnings report and closed either one, five, 10, or 20 days after earnings.\nAMZN Strangle Statistics (2005–2020)\nDay Position Is Closed Relative to Earnings\nPOP\nAverage P/L\nStandard Deviation of P/L\nCVaR (5%)\nDay After\n65%\n$99\n$803\n–$1,927\n5 Days After\n65%\n$85\n$842\n–$2,154\n10 Days After\n72%\n$1\n$1,446\n–$4,416\n20 Days After\n76%\n$78\n$1,540\n–$4,477\nTable 9.3\nStatistics for 45 DTE 16\nGOOGL strangles from 2005–2020. Trades are opened the day before an earnings report and closed either one, five, 10, or 20 days after earnings.\nGOOGL Strangle Statistics (2005–2020)\nDay Position Is Closed Relative to Earnings\nPOP\nAverage P/L\nStandard Deviation of P/L\nCVaR (5%)\nDay After\n75%\n–$60\n$1,320\n–$4,639\n5 Days After\n67%\n–$113\n$1,358\n–$4,724\n10 Days After\n65%\n–$122\n$1,275\n–$3,675\n20 Days After\n71%\n–$2\n$1,584\n–$4,909\nTakeaways\nAbinary event is aknown upcoming event affecting aspecific asset (or group of assets) that is anticipated to create alarge price move. This anticipation creates demand for options contracts expiring on or after the binary event and an increase in the IV of the asset. IV typically contracts back to nonevent levels immediately after the outcome is known.\nThe high credits and immediate volatility contractions resulting from binary events do not necessarily translate to large or consistent short premium profits because the magnitude of the market response is unpredictable. Binary events trades are generally highly volatile and undependable sources of profit but can be used for market engagement or an educational experience for new traders.\nBinary event trades should only occupy spare portfolio capital and their position size should be kept\nexceptionally\nsmall. Binary event trades should also take place over much shorter timescales than more typical trades, and they must be carefully monitored.\nNote\n1\nThe term binary is used to describe systems that can exist in one of two possible states (on/off, yes/no). In this context, abinary event is atype of event where price changes either remain within expectations or exceed expectations.", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c09.xhtml", "doc_id": "845334131edb6252577edf491a6339109bd50ea4aa86603fd92d97aef7354773", "chunk_index": 1}
{"text": "Chapter 10\nConclusion and Key Takeaways\nSuccessful traders do not rely on luck. Rather, the long‐term success of traders depends on their ability to obtain aconsistent, statistical edge from the tools, strategies, and information available. This book introduces the core concepts of options trading and teaches new traders how to capitalize on the versatility and capital efficiency of options in apersonalized and responsible way. Options are fairly complicated instruments, but this book aims to lessen the learning curve by focusing on the most essential aspects of applied options trading. The detailed framework laid out in this book can be summarized succinctly in the following key takeaways:\nImplied volatility (IV) is aproxy for the sentiment of market risk derived from supply and demand for financial insurance. When options prices increase, IV increases; when options prices decrease, IV decreases. IV gives the perceived magnitude of future movements and is not directional. It can also be used to approximate the one\nstandard deviation expected price range of an asset (although this does not take strike skew into account). The CBOE Volatility Index (VIX) is meant to track the IV for the S&P 500 and is used as aproxy for the perceived risk of the broader market. The VIX, like all volatility signals, is assumed to revert down following significant expansions, which indicates some statistical validity in making downward directional assumptions about volatility once it is inflated.\nCompared to long premium strategies, short premium strategies yield more consistent profits and have the long‐term statistical advantage. The trade‐off for receiving consistent profits is exposure to large and sometimes undefined losses, which is why the two most important goals of ashort premium trader are to profit consistently enough to cover moderate, more likely losses and to construct aportfolio that can survive unlikely extreme losses.\nThe profitability of short options strategies depends on having alarge number of occurrences to reach positive statistical averages, aconsequence of the law of large numbers and the central limit theorem. At minimum, approximately 200 occurrences are needed for the average profit and loss (P/L) of astrategy to converge to long‐term profit targets and more is better.\nExtreme losses for short premium positions are highly unlikely but typically happen when price swings in the underlying are large while the expected move range is tight (low IV). Because large price movements in low IV are rare and difficult to reliably model, the most effective way to reduce this exposure is to trade short premium once IV is elevated.\nAlthough high volatility environments are ideal for short premium positions, short premium positions have high probability of profits (POPs) and some statistical edge in all volatility environments. Additionally, because volatility is low the majority of the time, trading short options strategies in\nall\nIV environments allows traders to profit more consistently and increases the number of occurrences. To manage exposure to outlier risk when adopting this strategy, it is essential to maintain small position sizes and limit the amount of capital allocated to short premium positions, especially when IV is\nlow. This strategy can be further improved by scaling the amount of capital allocated to short premium according to the current market conditions.\nVIX Range\nMaximum Portfolio Allocation\n0–15\n25%\n15–20\n30%\n20–30\n35%\n30–40\n40%\n40+\n50%\nBuying power reduction (BPR) is the amount of portfolio capital required to place and maintain an option trade. The BPR for long options is merely the cost of the contract, and the BPR for short options is meant to encompass at least 95% of the potential losses for exchange‐traded fund (ETF) underlyings and 90% of the potential losses for stock underlyings. BPR is used to evaluate short premium risk on atrade‐by‐trade basis in two ways: BPR is afairly reliable metric for the worst‐case loss of an undefined risk position, and BPR is used to determine if aposition is appropriate for aportfolio based on its buying power. Adefined risk trade should not occupy more than 5% of portfolio buying power and an undefined risk trade should not occupy more than 7%, with exceptions allowed for small accounts. The formulae for BPR are complicated and specific to the type of strategy, but the BPR for short strangles is approximately 20% of the price of the underlying. BPR can be used to compare the risk for variations of the same strategy (e.g., strangle on underlying Aversus strangle on underlying B), but it cannot be used to compare risk for strategies with different risk profiles (e.g., strangle on underlying Aversus iron condor on underlying A).\nTraders trade according to their personal profit goals, risk tolerances, and market beliefs, but it is generally good practice to be aware of the following:\nOnly trade underlyings with liquid options markets to minimize illiquidity", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c10.xhtml", "doc_id": "3ced95c9b16786767bb8daa4858800171eecac898e1a60cf8aa52f94f2152327", "chunk_index": 0}
{"text": "(e.g., strangle on underlying Aversus iron condor on underlying A).\nTraders trade according to their personal profit goals, risk tolerances, and market beliefs, but it is generally good practice to be aware of the following:\nOnly trade underlyings with liquid options markets to minimize illiquidity risk.\nThe choice of underlying is somewhat arbitrary, but it'simportant to select an underlying with an appropriate level of risk. Stock underlyings tend to be higher‐risk, higher‐reward than ETF underlyings. This means stock underlyings present high IV opportunities more frequently, but they have more tail loss exposure and are more expensive to trade.\nChoose acontract duration that is an efficient use of buying power, allows for consistency, offers areasonable number of occurrences, has manageable P/Lswings throughout the duration, and has moderate ending P/Lvariability. Durations between 30 and 60 days are suitable for most traders.\nCompared to defined risk trades, undefined risk trades have higher POPs, higher profit potentials, unlimited downside risk, and higher BPRs. High‐POP defined risk trades, such as wide iron condors, have comparable risk profiles to undefined risk trades while also offering protection from extreme losses. Such trades can be better suited for low IV conditions compared to undefined risk trades and are allowed to occupy undefined risk portfolio capital.\nContracts with higher deltas are higher-risk, higher-reward than contracts with lower deltas. When trading premium, consider contracts between 10Δ and 40Δ, which is large enough to achieve areasonable amount of growth but small enough to have manageable P/Lswings and ending P/Lvariability.\nWhen choosing amanagement strategy, the primary factors to consider are convenience and consistency, capital allocation preferences, desired number of occurrences, per‐trade average P/L, and per‐trade exposure. Early‐managed positions have lower per‐trade P/Ls but less tail risk than positions held to expiration. Because managing early also accommodates more occurrences and averages more P/Lper day, closing positions prior to expiration and redeploying capital to new positions is generally amore efficient use of capital compared to extracting more value from an existing position.\nIf managing according to days to expiration (DTE), consider closing trades around the contract duration midpoint to achieve adecent amount of long‐term profit and justify the tail loss exposure.\nIf managing an undefined position according to aprofit target, choosing atarget between 50% and 75% of the initial credit allows for reasonable profits while also reducing the potential magnitude of outlier losses. Choosing aprofit target that is too low reduces average P/L, and choosing aprofit target that is too high does little to mitigate outlier risk. Profit targets for defined risk positions can be lower because they are generally less volatile.\nIf combining strategies, managing undefined risk contracts at either 50% of the initial credit or halfway through the contract duration generally achieves reasonable, consistent profits and moderates outlier risk.\nIf implementing astop loss, amid‐range stop loss threshold of at least −200% of the initial credit is practical. If the stop loss is too small (−50% for example), losses are more likely since options have significant P/Lvariance, although they often recover. It'salso important to note that stop losses do not guarantee amaximum loss in cases of rapid price movements, so stop losses are typically paired with another management strategy unless trading passively. Stop losses are generally not suitable for defined risk strategies.\nMaintaining the capital allocation guidelines is crucial for limiting tail exposure and achieving areasonable amount of long‐term growth:\nThe amount of portfolio buying power allotted to short premium positions, such as short strangles and short iron condors, should range from 25% to 50% depending on the current market volatility, with the remaining capital either kept in cash or alow‐risk passive investment. [refer to Takeaway 5].\nOf the amount allocated to short premium, at least 75% should be reserved for undefined risk trades (with less than 7% of portfolio buying power allocated to asingle position) and at most 25% reserved for defined risk strategies (with less than 5% of portfolio buying power allocated to asingle position) [refer to Takeaway 6].\nGenerally speaking, at most 25% of the capital allocated to short premium should go toward supplemental positions, or higher-risk, higher-reward trades that are tools for market engagement. The remainder should go toward core positions or trades with high POPs and moderate P/Lvariation that offer consistent profits and reasonable outlier exposure.\nDiversifying the underlyings of an options portfolio (i.e., trading acollection of assets with low correlations) is one of the most essential diversification tools for portfolio risk management, particularly outl", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c10.xhtml", "doc_id": "3ced95c9b16786767bb8daa4858800171eecac898e1a60cf8aa52f94f2152327", "chunk_index": 1}
{"text": "nd moderate P/Lvariation that offer consistent profits and reasonable outlier exposure.\nDiversifying the underlyings of an options portfolio (i.e., trading acollection of assets with low correlations) is one of the most essential diversification tools for portfolio risk management, particularly outlier risk management. Strategy diversification and duration diversification, though not as essential as underlying diversification, are other straightforward risk management techniques.\nThe Greeks form aset of risk measures that quantify different dimensions of exposure for options. Each contract has its own specific set of Greeks, but some Greeks are additive across positions with different underlyings. Consequently, these metrics can be used to summarize the various sources of risk for aportfolio and guide adjustments. Two key Greeks are beta‐weighted delta (\n) and theta (\n). Beta‐weighted delta represents the amount of directional exposure aposition has relative to some index rather than the underlying itself. Theta represents the expected decrease in an option'svalue per day.\nneutral portfolios are attractive to investors because they are relatively insensitive to directional moves in the market and profit from changes in IV and time.\nBecause short‐premium traders consistently profit from time decay, the total theta across positions gives areliable estimate for the expected daily growth of ashort options portfolio. The minimum theta ratio (\n) for an options portfolio should range from 0.05% to 0.1% and should not exceed 0.2% because this indicates excessive risk. If aportfolio is not meeting these theta ratio guidelines, then the positions should be adjusted as follows:\nIf aproperly allocated, well‐diversified portfolio is\nneutral but does not provide asufficient amount of theta, then the positions in the portfolio should be reevaluated. In this case, perhaps some defined risk trades should be replaced with undefined risk trades or undefined risk positions be rolled to higher deltas. New delta neutral positions can also be added, such as strangles and iron condors, for example. IV and theta are also highly correlated, meaning that higher IV underlyings could also be considered if theta is too low. These measures can be reversed if the portfolio has too much theta exposure while being\nneutral.\nIf the theta ratio is too low (<0.1%) and the portfolio is not\nneutral, then either existing positions should be re‐centered or tightened or new short premium positions should be added.\nIf the\nis too large and positive (bullish), then add new negative\npositions (e.g., add short calls on positive beta underlyings or add short puts on negative beta underlyings).\nIf the\nis too large and negative (bearish), then add new positive\npositions (e.g., add short puts on positive beta underlyings).\nIf the theta ratio is too large (>0.2%) and the portfolio is not\nneutral, then either existing positions should be re‐centered or widened or short premium positions should be removed.\nIf the\nis too large and positive (bullish), then remove positive\npositions (e.g., remove short puts on positive beta underlyings).\nIf the\nis too large and negative (bearish), then remove negative\npositions (e.g., remove short calls on positive beta underlyings).\nIf aproperly allocated, well‐diversified portfolio provides asufficient amount of theta but is not βΔ neutral, then existing positions should be reevaluated. For example, skewed positions could be closed and re‐centered or replaced with new delta-neutral positions that offer comparable amounts of theta.\nBinary event trades, such as trades around quarterly earnings reports, should be traded cautiously, only occupy spare portfolio capital, and their position size should be kept exceptionally small. Binary event trades must be carefully monitored and typically take place over much shorter timescales than more typical trades. They are often opened the day before abinary event and closed the day after.\nOptions trading is not for everyone. However, for traders who are prepared to understand the complex risk profiles of options, comfortable accepting acertain level of exposure, and willing to commit the time to active trading, short premium strategies can offer aprobabilistic edge and the potential to profit in any type of market. There is no “right” way to trade these instruments; all traders have unique profit goals and risk tolerances. It is our hope that this book will guide traders to make informed decisions that best align with their personal objectives.", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:c10.xhtml", "doc_id": "3ced95c9b16786767bb8daa4858800171eecac898e1a60cf8aa52f94f2152327", "chunk_index": 2}
{"text": "Appendix\nI. The Logarithm, Log‐Normal Distribution, and Geometric Brownian Motion,\nwith contributions from Jacob Perlman\nFor the following section, let\nbe the initial value of some asset or collection of assets and\nthe value at time\n. Given the goals of investing, the most obvious statistic to evaluate an investment or portfolio is the profit or loss:\n. However, according to the efficient market hypothesis (EMH), assets should be judged relative to their initial size, represented using returns,\n.\nThe returns of the asset from time 0 to time\ncan also be written in terms of each individual return over that time frame. More specifically, for an integer\n, if\nthen the returns,\n, can be split into atelescoping\n1\nproduct.\n(A.1)\nThe EMH states that each term in this product should be independent and similarly distributed. The central limit theorem, and many other powerful tools in probability theory, concern long\nsums\nof independent random variables. To apply these tools to this telescoping product of random variables, it first must be converted into asum of random variables. Logarithms offer aconvenient way to accomplish this.\nLogarithmic functions are aclass of functions with wide applications in science and mathematics. Though there are several equivalent definitions, the simplest is as the inverse of exponentiation. If\nand\nare positive numbers, and\n, then\n(read as “the log base\nof\n”) is the number such that\n. For example,\ncan be equivalently written as\n.\nThe choice of base is largely arbitrary, only affecting the logarithm by aconstant multiple. If\nis another possible base, then\n. In mathematics, the most common choice is Euler'sconstant, aspecial number:\n. Using this constant as abase results in the\nnatural logarithm\n, denoted\n. The justification for this choice largely comes down to notational convenience, such as when taking derivatives:\n. In this example, as\n, using\navoids the accumulation of cumbersome and not particularly meaningful constant factors.\nAs\n, logarithms have the useful property\n2\ngiven by:\n(A.2)\nThis property transforms the telescoping product given above into asum of small independent pieces, given by the following equation:\n(A.3)\nThe central limit theorem states that if arandom variable is made by adding together many independently random pieces, then the result will be normally distributed. One can, therefore, conclude that log returns are normally distributed. Observe the following:\n(A.4)\nThis suggests that stock prices follow alog‐normal distribution or adistribution where the logarithm of arandom variable is normally distributed. Within the context of Black‐Scholes, this implies that stock log‐returns evolve as Brownian motion (normally distributed), and stock prices evolve as geometric Brownian motion (log‐normally distributed). The log‐normal distribution is more appropriate to describe stock prices because the log‐normal distribution cannot have negative values and is skewed according to the volatility of price, as shown in the comparisons in\nFigure A.1\n.\nII. Expected Range, Strike Skew, and the Volatility Smile\nThe majority of this book refers to expected range approximated with the following equation:\n(A.5)\nFor astock trading at current price\nwith volatility\nand risk‐free rate\n, the Black‐Scholes theoretical\nprice range at afuture time\nfor this asset is given by the following equation:\n(A.6)\nThe equation in (\nA.5\n) is avalid approximation of this formula when\nis small, which follows from the mathematical relation\n. Generally speaking, (\nA.5\n) is avery rough approximation for expected range, and it becomes less accurate in high volatility conditions, when\nis larger.\nThough (\nA.5\n) still yields areasonable, back‐of‐the‐envelope estimate for expected range, the one standard deviation expected move range is calculated on most trading platforms according to the following:\n(A.7)\nFigure A.1\nComparison of the log‐normal distribution (a) and the normal distribution (b). The mean and standard deviation of the normal distribution are the exponentiated parameters of the log‐normal distribution.\nAccording to the EMH, this is simply the expected future price displacement, i.e., price of at‐the‐money (ATM) straddle, with additional terms (prices of near ATM strangles) to counterbalance the heavy tails pulling the expected value beyond the central 68%. To see how this formula compares with the (\nA.5\n) approximation, consider the statistics in\nTable A.1\n.\nTable A.1\nExpected 30‐day price range approximations for an underlying with aprice of $100 and implied volatility (IV) of 20%. According to the Black‐Scholes model, the per‐share prices for the 30‐day options are $4.58 for the straddle, $3.64 for the strangle one strike from ATM, and $2.85 for the strangle two strikes from ATM.\n30‐Day Expected Price Range Comparison\nEquation (A.5)\nEquation (A.7)\n$5.73\n$4.13\nCompared to\nEquation (A.5)\n,\nEquation (A.7)\nis amore attractive way to calculate expected range on trading platforms because it is computation", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:b01.xhtml", "doc_id": "064f3cefa7dab90dc71878273416b59ea239261853cdad44a51c09600a832b79", "chunk_index": 0}
{"text": "rangle one strike from ATM, and $2.85 for the strangle two strikes from ATM.\n30‐Day Expected Price Range Comparison\nEquation (A.5)\nEquation (A.7)\n$5.73\n$4.13\nCompared to\nEquation (A.5)\n,\nEquation (A.7)\nis amore attractive way to calculate expected range on trading platforms because it is computationally simpler and independent of arigid mathematical model. However, neither of these expected range calculations take\nskew\ninto account.\nWhen comparing contracts across the options chain, an interesting phenomenon commonly observed is the\nvolatility smile\n. According to the Black‐Scholes model, options with the same underlying and duration should have the same implied volatility, regardless of strike price (as volatility is aproperty of the underlying). However, because the market values each contract differently and implied volatility is derived from from options prices, the implied volatilities across strikes often vary. Avolatility smile appears when the implied volatility is lowest for contracts near ATM and increases as the strikes move further out‐of‐the‐money (OTM). Similarly, avolatility smirk (also known as volatility skew) is aweighted volatility smile, where the options with lower strikes tend to have higher IV than options with higher strikes. The opposite of the volatility smirk is described as forward skew, which is relatively rare, having occurred, for example, with GME in early 2021. For an example of volatility skew, consider the SPY 30 days to expiration (DTE) OTM option data shown in\nFigure A.2\n.\nFigure A.2\nVolatility curve for OTM 30 DTE SPY calls and puts, collected on November 15, 2021, after the close.\nThe volatility curve in\nFigure A.2\nis clearly asymmetric around the ATM strike, with the options with lower strikes (OTM puts) having higher IVs than options with higher strikes (OTM calls). This type of curve is useful for analyzing the perceived value of OTM contracts. Compared to ATM volatility, OTM puts are generally overvalued while OTM calls are generally undervalued until very far OTM (near $510). This suggests that traders are willing to pay ahigher premium to protect against downside risk compared to upside risk.\nThis is an example of put skew, aconsequence of put contracts further from ATM being perceived as equivalently risky as call contracts closer to ATM.\nTable A.2\nreproduces data from\nChapter 5\n.\nTable A.2\nData for 16\nSPY strangles with different durations from April 20, 2021. The first row is the distance between the strike for a 16\nput and the price of the underlying for different DTEs (i.e., if the price of the underlying is $100 and the strike for a 16\nput is $95, then the put distance is [$100 – $95]/$100 = 5%). The second row is the distance between the strike for a 16\ncall and the price of the underlying for different contract durations.\n16\nSPY Option Distance from ATM\nOption Type\n15 DTE\n30 DTE\n45 DTE\nPut Distance\n3.9%\n6.5%\n8.0%\nCall Distance\n2.4%\n3.9%\n4.9%\nThis skew results from market fear to the\ndownside\n, meaning the market fears larger extreme moves to the downside more than extreme moves to the upside. According to the EMH, the skew has already been priced into the current value of the underlying. Hence, the put skew implies that the market views large moves to the downside as more likely than large moves to the upside but small moves to the upside as being the most likely outcome overall. For agiven duration, the strikes for the 16\nputs and calls approximately correspond to the one standard deviation expected range of that asset over that time frame. For example, since SPY was trading at approximately $413 on April 20, 2021, the 30‐day expected price move to the upside was $16 and the expected price move to the downside was $27 according to the 16\noptions.\nIII. Conditional Probability\nConditional probability is mentioned briefly in this book, but it is an interesting concept in probability theory worthy of ashort discussion. Conditional probability is the probability that an event will occur, given that another event occurred. Consider the following examples:\nGiven that the ground is wet, what is the probability that it rained?\nGiven that the last roll of afair die was six, what is the probability that the next roll will also be asix?\nGiven that SPY had an up day yesterday, what is the probability it will have an up day tomorrow?\nAnalyzing probabilities conditionally looks at the likelihood of agiven outcome within the context of known information. For events\nand\nthe conditional probability\n(read as the probability of\n, given\n) is calculated as follows:\n(A.8)\nwhere\nis the probability that event\noccurs and\nis the probability that\nand\noccur. For example, suppose\nis the event that it rains on any given day and\n(20% chance of rain). Suppose\nis the event that there is atornado on any given day, there is a 1% chance of atornado occurring on any given day, and tornados never happen without rain, meaning that\n. Therefore, given that it is arainy day, we have the following", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:b01.xhtml", "doc_id": "064f3cefa7dab90dc71878273416b59ea239261853cdad44a51c09600a832b79", "chunk_index": 1}
{"text": "ent that it rains on any given day and\n(20% chance of rain). Suppose\nis the event that there is atornado on any given day, there is a 1% chance of atornado occurring on any given day, and tornados never happen without rain, meaning that\n. Therefore, given that it is arainy day, we have the following probability that atornado will appear:\nIn other words, atornado is five times more likely to appear if it is raining than under regular circumstances.\nIV. The Kelly Criterion,\nderivation courtesy of Jacob Perlman\nThe Kelly Criterion is aconcept from information theory and was originally created to analyze signal transmission through noisy communication channels. It can be used to determine the optimal theoretical bet size for arepeated game, presuming the odds and payouts are known. The Kelly bet size is the fraction of the bankroll that maximizes the expected long‐term growth rate of the game, more specifically the logarithm of wealth. For agame with probability\nof winning\nand aprobability\nof losing 1 (the full wager), the Kelly bet size is given as follows:\n(A.9)\nThis is the theoretically optimal fraction of the bankroll to maximize the expected growth rate of the game. Abrief justification for this formula follows from the paper listed in Reference 4.\nConsider agame with probability\nof winning\nand aprobability\nof losing the full wager. If aplayer has\nin starting wealth and bets afraction of that wealth,\n, on this game, the player'sgoal is to choose avalue of\nthat maximizes their wealth growth after\nbets.\nIf the player has\nwins and\nlosses in the\nplays of this game, then:\nOver many bets of this game, the log‐growth rate is then given by the following:\nfollowing from the law of large numbers\nThe bet size that maximizes the long‐term growth rate corresponds to\n.\nThe Kelly Criterion can also be applied to asset management to determine the theoretically optimal allocation percentage for atrade with known (or approximated) probability of profit (POP) and edge. More specifically, for an option with agiven duration and POP, the optimal fraction of the bankroll to allocate to this trade is approximately:\n(A.10)\nwhere\nis the risk‐free rate and\nis the duration of the trade in years. The derivation for this equation is outlined as follows:\nFor agame with probability\nof winning\nand aprobability\nof losing 1 unit, the expected change in bankroll after one play is given by\n.\nFor an investment of time\nwith the risk‐free rate given by\n, the expected change in value is estimated by\n, derived from the future value of the game with continuous compounding. Assuming that\nis small, then\n.\nFor the bet to be fairly priced, the change in the bankroll should also equal\n. Therefore, if\n, the odds for this trade can be estimated as\n.\nUsing this value for\nin the Kelly Criterion formula, one arrives at the following:\nThis then yields the approximate optimal proportion of bankroll to allocate to agiven trade, substituting\nfor\nand POP for\n.\nNotes\n1\nSo called because adjacent numerators and denominators cancel, allowing the long product to be collapsed like atelescope.\n2\nStated abstractly, logarithms are the group homomorphisms between\nand\n.", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:b01.xhtml", "doc_id": "064f3cefa7dab90dc71878273416b59ea239261853cdad44a51c09600a832b79", "chunk_index": 2}
{"text": "Glossary of Common Tickers, Acronyms, Variables, and Math Equations\nTicker\nFull Name\nSPY\nSPDR S&P 500\nXLE\nEnergy Select Sector SPDR Fund\nGLD\nSPDR Gold Trust\nQQQ\nInvesco QQQ ETF (NASDAQ‐100)\nTLT\niShares 20+ Year Treasury Bond ETF\nSLV\niShares Silver Trust\nFXE\nEuro Currency ETF\nXLU\nUtilities ETF\nAAPL\nApple Stock\nGOOGL\nGoogle Stock\nIBM\nIBM Stock\nAMZN\nAmazon Stock\nTSLA\nTesla Stock\nVIX\nCBOE Volatility Index (implied volatility for the S&P 500)\nGVZ\nCBOE Gold Volatility Index\nVXAPL\nCBOE Equity VIX On Apple\nVXAZN\nCBOE Equity VIX On Amazon\nVXN\nCBOE NASDAQ‐100 Volatility Index\nAcronym\nFull Name\nNYSE\nNew York Stock Exchange\nETF\nExchange‐Traded Fund\nDTE\nDays to Expiration\nEMH\nEfficient Market Hypothesis\nITM\nIn‐the‐Money\nOTM\nOut‐of‐the‐Money\nATM\nAt‐the‐Money\nP/L\nProfit and Loss\nIV\nImplied Volatility\nVaR\nValue at Risk\nCVaR\nConditional Value at Risk\nPOP\nProbability of Profit\nBPR\nBuying Power Reduction\nIVP\nIV Percentile\nIVR\nIV Rank\nNFT\nNon‐Fungible Tokens\nVariable Symbol\nVariable Name/Definition\nSpot/stock price: the price of the underlying\nContract price: the price of the option, noting that\nCis used if the contract is acall and\nPis used in the case of puts\nStrike price: the price at which the holder of an option can buy or sell an asset on or before afuture date\nRisk‐free rate of return: the theoretical rate of return of ariskless asset\nMean: the central tendency of adistribution\nStandard deviation: the spread of adistribution; also used as ameasure of uncertainty or risk\nVolatility: the standard deviation of log‐returns for an asset; akey input in options pricing\nDelta: the expected change in an option'sprice given a $1 increase in the price of the underlying\nGamma: the expected change in an option'sdelta given a $1 change in the price of the underlying\nTheta: the expected time decay of an option'sextrinsic value in dollars per day\nBeta: the volatility of the stock relative to that of the overall market\nBeta‐weighted delta: the expected change in an option'sprice given a $1 change in some reference index\nEquation Number\nEquation\n1.1\nSimple Returns\n1.2\nLog Returns\n1.3\nLong Call P/L\n1.4\nLong Put P/L\n1.5\nPopulation Mean\n1.6\nExpected Value\n1.7\nPopulation Variance\n1.8\nVariance\n1.9\nSkew\n1.15\nDelta\n1.16\nGamma\n1.17\nTheta\n1.18\nPopulation Covariance\n1.19\nCovariance\n1.20\nCorrelation Coefficient\n1.21\nAdditive Property of Variance\n1.22\nBeta\n2.1\n±1σ Expected Range Approximation (%)\n2.2\n±1σ Expected Range Approximation ($)\n3.1\nIV Percentile (IVP)\n3.2\nIV Rank (IVR)\n4.1\nShort Put BPR\n4.2\nShort Call BPR\n4.3\nShort Strangle BPR\n5.1\nShort Iron Condor BPR\n8.1\nApproximate Kelly Allocation Percentage", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:b02.xhtml", "doc_id": "5171cc7f706c9de0bbb3a8ae3e0ed2efebdeb105186ad7209060f54053fa6777", "chunk_index": 0}
{"text": "s,\n37\nnegative covariance,\n36\npositive covariance,\n35\nCumulative horizontal displacement,\n25f\nCumulative horizontal displacements,\n24\nDaily P/Ls, standard deviation,\n150f\nDaily returns, distribution,\n39f\n,\n40f\nDays to expiration (DTE), management usage,\n118\n–120\nDefined risk, selection,\n102\n–104\nDefined risk strategies,\n152\nmaximum loss,\n102\nBPR, usage,\n84\nlimitation,\n59\nP/Ltargets, attainment,\n153\nPOP, usage,\n110\nportfolio allocation,\n103t\nrisk, comparison,\n89\nselection,\n94\nshort premium allocation,\n173\nstop losses, unsuitability,\n173\nundefined risk strategies, comparison,\n102t\n,\n109\navoidance,\n110\nDelta (Δ),\n31\n–32,\n106t\nbasis,\n112\nbeta‐weighted delta,\n38\n,\n144\n–145,\n148\n,\n174\ncontract delta,\n33\n–35,\n79\n,\n111\n,\n114\nimplied volatility (IV), equivalence,\n87\ncontract risk,\n172\ncontract usage,\n32\ndirectional exposure measurement,\n111\ndrift,\n145\nlevel,\n114\nmagnitude,\n32\n,\n114\nnegative delta/positive delta,\n33\nneutral position,\n33\n,\n61\n,\n146\n,\n156\nneutral positions\nprofit,\n111\nnormalization,\n145\nperceived risk measure,\n112\n–113\nraw delta, comparisons (impossibility),\n146\n–147\nre‐centering,\n114\nscaling up,\n114\nselection,\n94\n,\n111\n–115\noptimum, factors,\n114\nsensitivity,\n146\nsign,\n32\nvalue, range,\n32\nDerivatives, gamma comparison (impossibility),\n146\n–147\nDeterministic price trends,\n28\n–29\nDice rolls, histogram,\n13\n,\n14f\n,\n17f\n,\n19f\n,\n21f\nDirectional assumption, selection,\n94\n,\n104\n–110\nDirectional exposure (measurement), delta (usage),\n111\nDirectional risk, degree (measure),\n32\nDistributions\nasymmetry (measure), skew (usage),\n65\nmean (histogram),\n17e\nnormal distribution,\n22f\n,\n44\n–45,\n180f\nskew,\n16\n–18,\n20\n,\n39\nstatistics, understanding,\n21\n–22\nDiversification,\n136\n–144,\n158\neffectiveness, understanding,\n137\n–138\ntime diversification,\n151\ntools,\n173\nDividends payment, avoidance,\n23\nDownside risk\namount, preference,\n104\nlimitation, absence,\n102\nDownside skew,\n112\nEarly‐managed contracts,\n126\n,\n129\noccurrences allowance,\n80\nEarly‐managed portfolio, losses,\n129\nEarly‐management strategies,\n80\nEarnings dates, marking,\n54f\nEarnings report,\n115\ndates,\n53\n,\n96\n,\n102\nimpact,\n43\ninclusion,\n163\nquarterly earnings report (single‐company factors),\n52\n,\n166\n,\n175\nEfficient market hypothesis (EMH),\n11\n–13,\n177\n–178,\n183\nbinary events, relationship,\n164\nforms,\n11\n–12,\n104\n–105\ninterpretation,\n104\n,\n116\nEquities\nimplied volatility indexes,\n54f\npricing/bid‐ask spread/volume data,\n95t\ntrading,\n137\n,\n140\nEuropean call options,\n29\nEuropean options, expiration (payoff),\n29\nEuropean‐style option (price evolution), Black‐Scholes equation (relationship),\n23\nEvents\noutcomes,\n44\n–45\nsampling, probability distribution (usage),\n72\nExchange‐traded funds (ETFs),\n5\n–7,\n36\n,\n157\nBPR, historical effectiveness,\n84\ncorrelations,\n157t\ndiversification,\n53\n–54,\n134\nhistorical risk, approximation,\n63\nIV overstatement rates,\n46\nmarket ETFs,\n139\n–142,\n145\n,\n157\nvolatility assets, correlation,\n139\nskewed returns distribution,\n22\nstability,\n98\nunderlyings,\n95\n,\n135\n,\n137\n,\n172\nadvantages/disadvantages,\n96t\nlosses,\n84\n,\n171\nstrangles, usage,\n156\nusage,\n97\nvolatility profiles, differences,\n96\nExpected move cones,\n44\n,\n45f\n,\n60f\nExpected move range,\n179\nExpected price range,\n45f\nExpected range,\n58\n,\n179\n–183\nadjustment,\n68\n–69\ncalculation,\n43\n–45,\n47\n,\n179\n,\n181\nestimates,\n44\nincrease,\n115\nshort strike prices, relationship,\n111\ntightness,\n51\nunderlying price expected range,\n60\n–61\nExternal events, outlier underlying moves/IV expansions (relationship),\n58\nFinancial derivative, options (comparison),\n7\nFinancial insurance, risk‐reward trade‐off,\n47\nGamma (\nΓ\n),\n31\n,\n33\ncomparison, impossibility,\n146\n–147\nincrease,\n79\nmagnitude,\n33\nrisk,\n146\n–147\nGaussian distribution (bell curve),\n20\nGeometric Brownian motion, Black‐Scholes model (relationship),\n27\n–28\nGLD returns, SPY returns (contrast),\n36f\nGreeks,\n31\n–35.\nSee also\nDelta\n;\nGamma\n;\nSigma\n;\nTheta\nassumptions,\n35\nbalance,\n148\noption Greeks,\n38\nportfolio Greeks,\n160\nmaintenance,\n133\n,\n144\n–147\nrisk measures,\n174\nHeteroscedasticity,\n26\nHigh implied volatility (high IV)\nshort premium trading,\n75\ntrading,\n66\n–72,\n75\nHistogram\ndaily returns/prices,\n27f\ndice rolls,\n14f\n,\n17f\n,\n19f\n,\n21f\nHistorical distribution,\n73f\nHistorical P/Ldistribution,\n62f\n,\n64f\n,\n71f\nHistorical returns, standard deviation,\n28\n,\n30\nHistorical tail risk, estimation,\n65\nHistorical volatility,\n21\n–22,\n38\nincrease,\n42\nmarket historical volatility,\n69\nrepresentation,\n43\nstock historical volatility,\n30\nunderlying historical volatility,\n31\nusage,\n30\n,\n63\nHistoric risk, estimation,\n21\n–22\nHorizontal displacements, distribution,\n26f\nHurricane insurance\nprice, proportion,\n47\nsellers, strategic room,\n47\n–48\nIdiosyncratic risk,\n137\nIlliquid asset, example,\n94\nIlliquidity risk, minimization,\n171\nImplied volatility (IV),\n3\n,\n38\n,\n41\n,\n83\n,\n169\n–170,\n181\nbasis,\n48\nBPR\ncomparison,\n66\ninverse volatility,\n87\ncontract delta, equivalence,\n87\ncontraction,\n50\nconversion,\n66\ncorrelation,\n42\n–43\ndecrease/increase,\n42\n–43,\n87\n,\n89\nderivation,\n44\n–45\ndifferences,\n42t\nen", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:b04.xhtml", "doc_id": "405636de0612fba63872148a18418ff2f0adfe0bd2998f79fb20d64fe75bc373", "chunk_index": 1}
{"text": "liquidity risk, minimization,\n171\nImplied volatility (IV),\n3\n,\n38\n,\n41\n,\n83\n,\n169\n–170,\n181\nbasis,\n48\nBPR\ncomparison,\n66\ninverse volatility,\n87\ncontract delta, equivalence,\n87\ncontraction,\n50\nconversion,\n66\ncorrelation,\n42\n–43\ndecrease/increase,\n42\n–43,\n87\n,\n89\nderivation,\n44\n–45\ndifferences,\n42t\nenvironments, short option strategies (trading),\n76\nexpansion,\n58\n,\n122\n–123,\n163\nindexes,\n53f\n,\n54f\n,\n165f\nindication,\n30\nIV‐derived price range,\n44\n–45\nlong‐term baseline reversion,\n52\nmetric, importance,\n30\n–31\noverstatement,\n46\n,\n46t\n,\n164\nprofits,\n58\nrates,\n47\npeak, increase,\n49\nprice range forecast,\n47\nranges,\n76t\nrealized risk measurement,\n46\nreversion,\n51\n–54\nsignals, capacity,\n51\nsource,\n23\nSPY annualized implied volatility (tracking),\n48\nSPY implied volatility,\n69f\nstandard deviation range,\n43\ntracking,\n48\ntrading (volatility trading concept),\n58\nunderlying IV,\n60\n,\n86\n,\n88f\nusage,\n41\n,\n134\nImplied volatility percentile (IVP),\n66\n–68\nImplied volatility rank (IVR),\n68\nIncrements, distribution,\n26f\nInsider trading,\n12\n,\n105\nIn‐the‐money (ITM),\n99\ncontract description,\n9\nITM put, price,\n10\nlong calls ITM,\n33\nmovement,\n34\n–35\noptions, directional risk,\n114\npositions,\n34\nrelationship,\n32\nIron condors,\n105\n,\n110t\n,\n151\ncap, long wings,\n106\n,\n108\ndrawdowns, experience,\n151\nnarrow wings, POP (presence),\n109\nneutral SPY strategies,\n151\nprofit potential,\n109\nrepresentation,\n107f\nrisk,\n110\nshort iron condor BPR,\n108\nshort iron condors, range,\n134\n,\n173\nstatistical comparison,\n109t\nunderlying strangle, contrast,\n171\nwide iron condors,\n116\n,\n172\nwide wings, inclusion (trading),\n109\nwings, inclusion,\n106\nKelly Criterion\napplication,\n185\nbuying power percentage,\n153\nderivation,\n184\n–186\nformula,\n186\nheuristic derivation,\n160\nuncorrelated bets,\n154\nLaw of large numbers,\n72\n,\n170\n,\n185\nLiquidity\nimportance, understanding,\n94\nnet liquidity,\n89t\noptions liquidity,\n94\n–95\nportfolio net liquidity,\n104\n,\n145\ntheta ratio/net portfolio liquidity,\n145\nLog‐normal distribution,\n177\ncomparison,\n180f\nskew,\n179\nstock prices, relationship,\n179\nLog returns\nequation,\n7\nstandard deviation,\n23\nLong call,\n32\n,\n34\naddition,\n106\ndirectional assumption,\n8t\noption, price,\n32\n,\n111\nP/L,\n10\n–11\nposition,\n33\nprofit potential,\n90\nLong premium\ncontracts, impact,\n84\npositions, profit yield (comparison),\n12\nstrategies,\n58\n,\n170\ntrade,\n8\nLong put,\n32\n,\n34\naddition,\n106\ndirectional assumption,\n8t\noption, price,\n111\nP/L,\n10\n–11\nposition,\n33\nLong stock,\n32\nLong strikes,\n207f\nLoss\nincurring, probability,\n113t\ntargets,\n122t\n,\n123\nLow‐loss targets, attainment,\n122\nManagement\nP/Ltarget, usage,\n120\n–124\ntechniques,\n123\n–126,\n152\ntimeline, usage,\n118\n–119\nManagement strategies,\n121t\n,\n122t\n,\n158\naverage daily P/Land average duration,\n121t\nimpact/comparison,\n79\n–80,\n80t\n,\n102\nlong‐term risks,\n126\n,\n129\nperformance, scenarios (impact),\n126\nqualitative comparison,\n125t\nselection,\n172\nusage,\n117\n–118\nManagement time, selection,\n119\n,\n129\nMargin, BPR (contrast),\n84\nMarket\nconditions, risk/return expectations,\n35\nexposure,\n98\nfrictionlessness,\n23\nhistorical volatility,\n69\nimplied volatility (IV),\n76t\n,\n152\nperceived uncertainty,\n46\ntrader beliefs,\n171\n–172\nuncertainty sentiment, IV tracking,\n48\nvolatility amounts, differences,\n89t\nMarket ETFs,\n139\n–142,\n145\n,\n157\nhistoric correlations,\n141t\n,\n143t\npercentage,\n138t\nvolatility assets, correlation,\n139\nMarket risk\nsentiment, IV proxy,\n42\nsentiment, IV proxy (usage),\n169\n–170\nMaximum per‐trade BPR, limitation,\n134\nMean (moment),\n14\n–15\nMiddle ground contract duration,\n101\nMid‐range stop loss,\n123\n,\n130\n,\n173\nMoments,\n14\n–22\nNear‐the‐money options, gamma (increase),\n79\nNegative covariance,\n36\nNon‐dividend‐paying stock, trading,\n30\n–31\nNon‐fungible tokens (NFTs),\n5\nNormal distribution\ncomparison,\n180f\nmean/standard deviation,\n180f\nplot,\n22f\nstandard deviation range,\n44\n–45\nOccurrences,\n62f\n,\n71f\n,\n101\ncompound occurrences, loss potential,\n142\nconcentration,\n20\nconsistency,\n117\ndensity,\n64\nearly‐managed contract allowance,\n80\nfinal P/L, correspondence,\n61\ngoal,\n125\n–126,\n151\nincrease,\n117\nP/Ldistribution,\n39\nreduction/increase,\n72\n,\n89\n,\n124\nstandard deviation range,\n64\nVIX level, contrast,\n67\nOccurrences, number,\n58\n,\n72\n–76,\n99\nattainment,\n99\ncompromise, absence,\n151\nincrease,\n81\n,\n101\n–102,\n118\npresence,\n15\n,\n126\n,\n129\ntrade‐off,\n119\nvolatility trading concept,\n58\nOff‐diagonal entries,\n141t\nOptions,\n5\n–6\nbuying, profit,\n57\n–58\ncapital efficiency, BPR (relationship),\n90\ndemand,\n42\n–43\nfair price (estimation), Black‐Scholes model (usage),\n30\n,\n42\nfinancial derivative, comparison,\n7\nGreeks,\n38\nilliquidity, risk,\n94\nleverage, effects (clarity),\n90\nliquidity,\n94\n–95\nmarket, liquidity,\n98\nP/Lstandard deviation, usage,\n73\nP/Lstatistics,\n97t\nprice, BPR (inverse correlation),\n87\nprofitability,\n10\nrisk, visualization,\n59\n–63\ntraders, assumptions,\n11\ntypes,\n7\nunderlyings, sample,\n98t\nOptions trading,\n84\n,\n97\n,\n102\n,\n169\n,\n175\ncasinos, usage,\n1\n–2\ndiversification, importance,\n136\nETF underlyings, usage,\n97\ngamma, awareness (importan", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:b04.xhtml", "doc_id": "405636de0612fba63872148a18418ff2f0adfe0bd2998f79fb20d64fe75bc373", "chunk_index": 2}
{"text": "cs,\n97t\nprice, BPR (inverse correlation),\n87\nprofitability,\n10\nrisk, visualization,\n59\n–63\ntraders, assumptions,\n11\ntypes,\n7\nunderlyings, sample,\n98t\nOptions trading,\n84\n,\n97\n,\n102\n,\n169\n,\n175\ncasinos, usage,\n1\n–2\ndiversification, importance,\n136\nETF underlyings, usage,\n97\ngamma, awareness (importance),\n33\nimplied volatility\nmetric,\n30\n–31\nreversion,\n51\nlearning curve/math knowledge,\n3\noption theory, transition,\n90\nprofitability, option pricing (impact),\n11\nquantitative options trading,\n3\nretail options trading, assets (suitability),\n94\nrisk management, relationship,\n2\nusage, market performance,\n12\nOutlier losses,\n142\ncapital exposure, limitation,\n134\nprobability,\n141t\nOutlier risk\ncarrying, avoidance,\n103\nreduction,\n76\nOut‐of‐the‐money (OTM)\ncontract description,\n9\npositions,\n34\nvolatility curve,\n182f\nOver‐the‐counter (OTC) options,\n7\nPassive investment, daily performance statistics,\n146t\nPassive traders,\n125\nPerceived risk (measurement), delta (usage),\n112\n–113\nPersonal profit goals,\n171\n–172\nPer‐trade allocation percentage,\n158t\nPer‐trade standard deviation,\n158\n,\n166\nPer‐trade statistics, differences,\n166\nPer‐trade variance,\n167\nP/Ltargets, attainment,\n153\nPortfolio\naverages, variance,\n74f\nbacktest performance statistics,\n159t\nconcentration excess, avoidance,\n77\nconstruction,\n12\n,\n156\n–160\ncumulative P/L,\n152f\ndelta skew,\n145\nexpected loss, CVaR estimate,\n40\nGreeks,\n149\n,\n160\nmaintenance,\n133\n,\n144\n–147\nnet liquidity,\n89t\n,\n104\n,\n146\npassive investment, daily performance statistics,\n146t\nperformance,\n159f\ncomparison,\n139f\nP/Laverages,\n74f\nPOP‐weighted portfolio,\n157\n–158\nrisk management, diversification tools,\n173\nstatistical analysis,\n153t\nPortfolio allocation,\n109\ndefined/undefined risk strategies,\n103t\nguidelines, usage,\n89\n,\n104\n,\n134\npercentages,\n137\n–138,\n138t\n,\n154\n,\n154t\nposition sizing, relationship,\n75\n–79\nscaling,\n77\n,\n156\nstrategies, comparison,\n77\nusage,\n103\nvolatility trading concept,\n58\nPortfolio buying power,\n83\n,\n89\n,\n134\nallotment/allocation,\n134\n–135,\n154\n–155,\n157\ndefined risk position occupation,\n118\nexpected profit,\n146\nundefined risk strategy occupation,\n110\nusage,\n99\n,\n109\n,\n117\nPortfolio capital\nallocation\ncontrol,\n81\nguidelines, market IV (impact),\n76t\namount, BPR (relationship),\n171\ndiversification,\n152\ninvestment,\n127f\n,\n128f\nPortfolio management,\n3\n,\n93\n,\n149\nback‐of‐the‐envelope tactics,\n133\nbeta (\nβ\n) metric, importance,\n38\ncapital allocation,\n134\n–136\ncapital balancing, POP (usage),\n153\n–156\nconcepts,\n133\nconstruction,\n156\n–160\ndiversification, usage,\n136\n–144,\n149\n–153\nportfolio Greeks, maintenance,\n144\n–147\nposition sizing,\n134\n–136\nsimplification,\n101\nPositional capital allocation, quantitative approach,\n153\nPositions\ncore position statistics,\n158t\ndelta drift,\n145\ndelta level,\n114\nexpected loss, CVaR estimate,\n40\nintrinsic value,\n9\nITM, relationship,\n32\nlong side/short side, adoption,\n8\nmanagement,\n118\nP/Lcorrelation, reduction,\n150\nPOP‐weighting,\n156\nprofiting, likelihood,\n104\nsizing\ncapital allocation, relationship,\n134\n–136\nportfolio allocation, relationship,\n75\n–79\nvolatility trading concept,\n58\nPositive covariance,\n35\nPremium sellers, profit,\n50\nPremium, trading,\n172\nPrice dynamics\nBlack‐Scholes model approximation,\n24\nBrownian motion, comparison,\n25\n–26\nPrice predictability (limitation), EMH implications,\n105\nProbabilistic system, probability distribution,\n14\nProbability distribution,\n13\n–22\nasymmetry,\n16\nevents sampling,\n72\nGaussian distribution (bell curve),\n20\nmean (moment),\n14\n–15\nnormal distribution,\n20\nskew (moment),\n16\n–22\nvariance (moment),\n15\n–16\nProbability of profit (POP),\n89\n,\n164\n,\n185\nasset weighting,\n149\nbuying power, allocation percentages,\n154t\ncapital, balancing,\n153\n–156\ndecrease,\n114\ndependence,\n77\nheuristic,\n160\nIV ranges,\n76t\nlevel, elevation,\n61\n,\n90\n,\n105\n,\n108\n–109,\n120\n,\n123\n–124,\n151\npercentage,\n62\n,\n73\n,\n109\nPOP‐weighted allocation,\n158\nPOP‐weighted portfolio,\n157\n–158,\n159t\nPOP‐weight scaling method,\n156\npositions, POP‐weighting,\n156\nprofit potential, differences,\n103\nselection,\n2\nstatistics,\n80t\n,\n97t\n,\n153t\ntrade‐off,\n63\ntrades, level (elevation),\n134\nusage,\n110\n,\n149\n,\n153\n,\n185\n–186\nweights, usage,\n155\nyield,\n121\nProduct indifference,\n97\n–98\nProfitability, considerations,\n8t\nProfit and loss (P/L)\naverage daily P/L,\n121t\naverage P/L,\n76t\n,\n164\naverages,\n74f\ncumulative P/L,\n152f\ndaily P/Ls, standard deviation,\n150f\ndistribution skew,\n62\n–63\nexpectations,\n135\nfrequency,\n124\nhistorical distribution,\n73f\nhistorical P/Ldistribution,\n62f\n,\n64f\n,\n71f\nIV ranges,\n76t\nper‐day standard deviation,\n150\nstandard deviation,\n134\n,\n153t\n,\n157\ncarrying,\n120\n–121\ncore position usage,\n156\n–157\nreduction,\n118\n–119,\n122\n,\n126\ntrade‐offs,\n124\nusage,\n63\n–65,\n74\n–75,\n80t\n,\n99\n,\n100t\n,\n123\nswings,\n79\n,\n97\nmagnitude,\n98\ntolerance,\n97\n–98\nProfit potential, POP\ndifferences,\n103\nlevel, elevation,\n151\nProfit targets,\n104\n,\n120t\n,\n123\nPut options,\n9\nPut prices, differences,\n98t\nPut skew,\n112\nPuts (option type),\n7\nQQQ\nreturns, SPY returns (contrast),\n36f\n,\n37\nstr", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:b04.xhtml", "doc_id": "405636de0612fba63872148a18418ff2f0adfe0bd2998f79fb20d64fe75bc373", "chunk_index": 3}
{"text": "4\n–75,\n80t\n,\n99\n,\n100t\n,\n123\nswings,\n79\n,\n97\nmagnitude,\n98\ntolerance,\n97\n–98\nProfit potential, POP\ndifferences,\n103\nlevel, elevation,\n151\nProfit targets,\n104\n,\n120t\n,\n123\nPut options,\n9\nPut prices, differences,\n98t\nPut skew,\n112\nPuts (option type),\n7\nQQQ\nreturns, SPY returns (contrast),\n36f\n,\n37\nstrangles, outlier losses,\n142\nQuantitative options trading,\n3\nQuarterly earnings report (single‐company factors),\n52\n,\n166\n,\n175\nRandom variable, probability distribution,\n13\nRealized moves, IV overstatement,\n46t\nRealized risk (measurement), IV (usage),\n46\nRealized volatility, IV overstatement,\n46\nReference index, usage,\n144\nRelative volatility, metrics,\n66\n–68\nRetail options trading, assets (suitability),\n94\nReturns\ndistributions skews,\n22\npast volatility/future volatility,\n43\nstandard deviation,\n21\n–22\nusage,\n63\nRisk\napproximation,\n30\ncategories,\n137\nmeasures,\n38\n–40\nminimization, liquidity (impact),\n95\nreduction, trade‐by‐trade basis,\n117\nsentiment, measure,\n30\n–31\ntolerances,\n171\n–172\ntrade‐off,\n12\nRisk‐free rate,\n29\napproximation,\n154\nvalue, usage,\n154\n–155\nRisk management,\n2\n–3,\n37\n,\n140\n,\n156\nimportance,\n51\nstrategy/technique,\n136\n,\n151\n,\n158\n,\n174\nRisk‐reward trade‐off,\n59\nSector exposure,\n98\nSector‐specific risk,\n96\nSell‐offs\n2020 sell‐off, performances (2017‐2021),\n78f\nvolatility conditions,\n164\nSemi‐strong EMH,\n12\n,\n104\n–105\nShort call,\n32\n,\n34\naddition,\n147\n,\n175\nBPR,\n86\ndirectional assumption,\n8t\nP/L,\n10\n–11\nposition,\n33\nremoval,\n175\nshort put, pairing,\n33\nstrike,\n60\nundefined risk,\n59\nShort‐call/put BPR,\n86\nShort iron condors, range,\n134\n,\n173\nShort options\nP/Ldistribution skew,\n63\ntrading, capital requirements,\n90\nShort option strategies,\n106t\nprofitability, factors,\n170\ntrading,\n76\n,\n170\nShort premium\nallocation,\n173\ncapital allocation, scaling up,\n76\npositions, losses (unlikelihood),\n170\nrisk (evaluation), BPR (usage),\n83\nstrategies, POP trade‐off,\n63\ntraders, profit,\n51\nShort premium trading,\n48\n,\n114\nbenefits,\n68\nimplied volatility\nelevation, impact,\n71\nimportance,\n59\nmechanics,\n57\nrisk‐reward trade‐off,\n59\nShort put,\n34\naddition,\n147\n,\n174\n–175\nBPR,\n86\nbullish strategy,\n32\ndirectional assumption,\n8t\nposition,\n33\nremoval,\n175\nstrike,\n60\nShort strangles, POP level (elevation),\n61\nShort strike prices, expected range (relationship),\n111\nShort volatility trading,\n83\nSigma (\nσ\n),\n15\nSingle‐company factors,\n52\n–53\nSingle company risk factors, impact,\n46\nSkew,\n68\namount, consideration,\n71\ncontextualization,\n65\ndistribution skew,\n16\n–18,\n20\n,\n39\nlog‐normal distribution skew,\n179\nmagnitude, decrease,\n72\nmoment,\n16\n–22\nP/Ldistribution skew,\n62\n–63\nportfolio delta skew,\n145\npure number,\n17\nreduction,\n71\n–72\nreturns distribution skews,\n22\nstrike skew,\n111\n–112,\n179\n–183\ntail skew, usage,\n39\nusage,\n65\n–66\nvolatility skew (volatility smirk),\n181\nSPDR S&P 500 (SPY)\nannualized implied volatility, tracking,\n48\ndaily returns distribution,\n39f\n,\n40f\nexpected move cone,\n45f\nexpected price ranges,\n44\nhistogram, daily returns/prices,\n27f\nimplied volatility (IV),\n69f\n,\n70f\niron condors, wings (inclusion),\n107t\n–110t\nneutral SPY strategies,\n151\nprice,\n112f\nchange,\n60f\n,\n78f\ntrends,\n24\nreturns, QQQ/TLT/GLD returns (contrast),\n36f\n,\n37\ntrading level,\n183\nSPDR S&P 500 (SPY) strangles,\n64f\n,\n73f\nBPR loss,\n85f\ndata (2005‐2021),\n88f\n,\n89t\ndeltas (differences), statistical comparison,\n113t\ndurations, differences,\n183t\nexample,\n107t\ninitial credits,\n108t\nmanagement\nstatistics,\n119t\n,\n120t\n,\n122t\n,\n124t\n,\n125t\nstrategies, comparison,\n80t\noutlier losses,\n142\nP/Lper‐day standard deviation,\n150\nstability,\n63\nVIX level labeling,\n69f\nStandard deviation,\n20\n–21\ndaily P/Ls, standard deviation,\n150\nestimates,\n16\nexpected move range,\n179\nexpected range,\n60\nstrikes, correspondence,\n183\nhistogram,\n17f\nhistorical returns, standard deviation,\n28\n,\n30\nindication,\n16\ninterpretation,\n18\n–19,\n64\n–65\nlog returns, standard deviation,\n23\nnormal distribution usage,\n180f\nper‐trade standard deviation,\n158\n,\n166\nP/Lper‐day standard deviation,\n150\nP/Lstandard deviation,\n63\n–65,\n74\n–75,\n80t\n,\n99\n,\n100t\n,\n134\n,\n153t\n,\n157\ncarrying,\n120\n–121\nreduction,\n118\n–119,\n122\n,\n126\ntrade‐offs,\n124\nusage,\n123\nprobabilities,\n22f\nrange, sigma (\nσ\n),\n37\n,\n43\n–45,\n64\n–65\nrepresentation,\n15\nreturns, standard deviation,\n21\n–22\nsigma (\nσ\n),\n15\nusage,\n63\n–65\nSteady‐state value,\n48\nStocks,\n5\n–6\nhistorical risk, approximation,\n63\nhistorical volatility,\n30\nIV overstatement rates,\n46\nliquidity,\n94\n–95\nlog returns,\n23\noptions, trading,\n96\n–97\nprices\ndifferences,\n98t\nlog‐normal distribution, relationship,\n179\nskewed returns distributions,\n22\nstock‐specific binary events,\n156\ntrading,\n90\n,\n179\nmargin, usage,\n84\nunderlyings\nadvantages/disadvantages,\n96t\ntrading,\n135\nvolatility profiles, differences,\n96\nStop loss,\n122\napplication,\n129\nimplementation,\n122\n,\n130\n,\n173\nmid‐range stop loss,\n123\n,\n130\n,\n173\nthreshold, usage,\n122\n–123\nusage,\n123\n–125\nStraddles\nATM straddle, price,\n181\ntrades, BPR result,\n87t\nStrangles,\n105\nbuyer assumption,\n61\ndrawdowns, experience,\n151\ndurations, differen", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:b04.xhtml", "doc_id": "405636de0612fba63872148a18418ff2f0adfe0bd2998f79fb20d64fe75bc373", "chunk_index": 4}
{"text": "ifferences,\n96\nStop loss,\n122\napplication,\n129\nimplementation,\n122\n,\n130\n,\n173\nmid‐range stop loss,\n123\n,\n130\n,\n173\nthreshold, usage,\n122\n–123\nusage,\n123\n–125\nStraddles\nATM straddle, price,\n181\ntrades, BPR result,\n87t\nStrangles,\n105\nbuyer assumption,\n61\ndrawdowns, experience,\n151\ndurations, differences,\n101t\nmagnitude,\n65\nmanagement strategies,\n123\nneutral SPY strategies,\n151\nP/Ldistributions, skew/tail losses,\n71\n–72\nsale, BPR requirement,\n86\nseller, profit,\n61\nshort strangle BPR,\n86\nstatistics,\n167t\nmanagement,\n122t\n,\n136t\ntrades, examples,\n87t\ntrading, effects,\n142\nusage,\n156\nStrategy‐specific factors,\n152\n–153\nStrike skew,\n111\n–112,\n179\n–183\nStrikes\nlong strikes,\n107f\nprices, comparison,\n114t\nrange,\n104\nstandard deviation, expected range (correspondence),\n183\nStrong EMH,\n12\n,\n104\n–105\nSupplemental positions,\n134\nSwaptions,\n5\nSystemic risk,\n137\nTail exposure\nlimitation, capital allocation guidelines (maintenance),\n173\nmagnitude,\n98\nTail losses\nCVaR sensitivity,\n40\nreduction,\n71\n–72\nTail risk,\n83\n,\n103\n,\n121\n,\n145\nacceptance,\n57\ncarrying,\n58\n,\n62\n,\n120\nelimination,\n122\n–123\nexposure,\n102\n,\n135\nhistorical tail risk, estimation,\n65\nincrease,\n97\n,\n108\n–109,\n119\ninherent tail risk, justification,\n121\nmitigation,\n135\n–136\nnegative tail risk,\n65\n,\n72\n,\n80\nTail skew, usage,\n39\nTheta (\nΘ\n),\n31\n,\n34\n,\n144\n,\n174\nadditivity,\n145\n–147\nratio, size (reaction),\n147\ntheta ratio/net liquidity,\n174\ntheta ratio/net portfolio liquidity,\n145\nTime diversification,\n151\nTLT returns, SPY returns (contrast),\n36f\nTrade‐by‐trade basis,\n79\n–80,\n117\n,\n125\n–126\nTrade‐by‐trade performance, comparison,\n118\nTrade‐by‐trade risk tolerances,\n119\n–120\nTrades\nBPR,\n98\nbullish directional exposure,\n90t\nmanagement,\n3\n,\n80\n–81,\n117\n–118\nstrategies, usage,\n101\nmaximum loss, reduction,\n108\nTrades, construction,\n93\nasset universe, selection,\n94\n–95\ncontract duration, selection,\n99\n–102\ndefined risk, selection,\n102\n–104\ndelta, selection,\n111\n–115\ndirectional assumption, selection,\n104\n–110\nprocedure,\n94\nundefined risk, selection,\n102\n–104\nunderlying, selection,\n96\n–98\nTrading\nengagement, preferences,\n124\nmechanics,\n48\nplatforms, usage,\n179\n,\n181\nstrategies,\n129\n,\n166\nUncertainty sentiment, IV tracking,\n48\nUndefined risk\ncapital allocation, sharing,\n110\nselection,\n102\n–104\nUndefined risk strategies,\n59\n,\n152\nBPR, relationship,\n84\n,\n103\ndefined risk strategies, comparison,\n102t\n,\n109\navoidance,\n110\ndownside risk, limitation (absence),\n102\ngain, limitation,\n84\nloss, limitation (absence),\n59\n,\n84\nmanagement, focus,\n118\nP/Ltargets, attainment,\n153\nportfolio allocation,\n103t\nrisk, comparison,\n89\nselection,\n94\nshort premium allocation,\n173\ntrader compensation,\n103\nUnderlying\nhistorical volatility,\n31\nincrease,\n42\nimplied volatility (IV),\n98\noption underlyings, sample,\n98t\nselection,\n94\n,\n96\n–98\nstrangle, iron condor (contrast),\n171\nUnderlying price\nBPR function,\n88f\nexpected range,\n60\n–61,\n181t\nUpside skew,\n112\nValue at risk (VaR).\nSee\nConditional value at risk\nCVaR, contrast,\n40\ndistribution statistic,\n39\ninclusion,\n39f\n,\n40f\nVariance\nmoment,\n15\n–16\nper‐trade variance,\n166\n–167\nVolatility\ncurve,\n182\nexpansions,\n50\n–51\nforecast,\n43\nrealized volatility, IV overstatement,\n46\nreversion,\n105\nsmile,\n179\n–183\nsmirk (volatility skew),\n181\ntrading,\n41\n,\n44\n–48,\n58\nVolatility assets, market ETFs (correlation),\n139\nVolatility index (VIX) (CBOE volatility index),\n51\n,\n60\n,\n78f\n2008 sell‐off,\n50\n,\n63\n2020 sell‐off,\n50\n,\n63\n,\n77\n,\n78f\ncomparison,\n89\ncontraction,\n50\ncontracts, acceleration,\n49\ncorrelations,\n141t\nexpansion,\n48\nincrease,\n54\nIVP labeling,\n67f\nlevels,\n127f\n,\n128f\ndifferences,\n103t\nSPY strangles, labeling,\n69f\nlong‐term average,\n67\n,\n69\nlong‐term behavior,\n66\nlull/expansion/contraction,\n49\noccurrences, relationship,\n71f\nphases,\n49f\nrange,\n48\n,\n66\n,\n72\n,\n171\nreduction/increase,\n69\n,\n134\nfrequency,\n75t\nspikes, causes,\n50\nstates,\n48\n–51\nvaluation,\n135\nVXAZN\nIVP values labeling,\n67f\nlevel,\n66\nWeak EMH,\n11\n,\n29\n,\n31\n,\n104\n–105\nWide iron condors,\n116\n,\n172\nWide wings, usage,\n109\nWiener process,\n29\nBlack‐Scholes model, relationship,\n23\n–26\nincrements, distribution,\n26f\nWings,\n105", "source": "eBooks\\The Unlucky Investor_s Guide to Options Trading\\The Unlucky Investor_s Guide to Options Trading.epub#section:b04.xhtml", "doc_id": "405636de0612fba63872148a18418ff2f0adfe0bd2998f79fb20d64fe75bc373", "chunk_index": 5}
{"text": "Foreword\nThe past several years have brought about aresurgence in market volatility and options volume unlike anything that has been seen since the close of the twentieth century. As markets have become more interdependent, interrelated, and international, the U.S. listed option markets have solidified their place as the most liquid and transparent venue for risk management and hedging activities of the world’slargest economy. Technology, competition, innovation, and reliability have become the hallmarks of the industry, and our customer base has benefited tremendously from this ongoing evolution.\nHowever, these advances can be properly tapped only when the users of the product continue to expand their knowledge of the options product and its unique features. Education has always been the driver of growth in our business, and it will be the steward of the next generation of options traders. Dan Passarelli’snew and updated book\nTrading Option Greeks\nis anecessity for customers and traders alike to ensure that they possess the knowledge to succeed and attain their objectives in the high-speed, highly technical arena that the options market has become.\nThe retail trader of the past has given way to anew retail trader of the present—one with an increased level of technology, support, capital treatment, and product selection. The impact of the staggering growth in such products as the CBOE Holdings’ VIX options and futures, and the literally dozens of other products tied to it, have made the volatility asset class anew, unique, and permanent pillar of today’soption markets.\nDan’supdated book continues his mission of supporting, preparing, and reinforcing the trader’sunderstanding of pricing, volatility, market terminology, and strategy, in away that few other books have been able. Using aperspective forged from years as an options market maker, professional trader, and customer, Dan has once again provided aresource for those who wish to know best how the option markets behave today, and how they are likely to continue to behave in the future. It is important to understand not only what happens in the options space, but also\nwhy\nit happens. This book is intended to provide those answers. Iwish you all the best in your trading!\nWilliam J. Brodsky\nChairman and CEO Chicago Board Options Exchange", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00006.html", "doc_id": "18a6a75482a3a573e0a0462e4bf7de3cda3f555d4774e5c1e6e4ef4dc3b52765", "chunk_index": 0}
{"text": "Preface\nI’ve always been fascinated by trading. When Iwas young, I’dsee traders on television, in their brightly colored jackets, shouting on the seemingly chaotic trading floor, and I’dmarvel at them. What awonderful job that must be! These traders seemed to me to be very different from the rest of us. It’sall so very esoteric.\nIt is easy to assume that professional traders have closely kept secrets to their ways of trading—something that secures success in trading for them, but is out of reach for everyone else. In fact, nothing could be further from the truth. If there are any “secrets” of professional traders, this book will expose them.\nTrue enough, in years past there have been some barriers to entry to trading success that did indeed make it difficult for nonprofessionals to succeed. For example, commissions, bid-ask spreads, margin requirements, and information flow all favored the professional trader. Now, these barriers are gone. Competition among brokers and exchanges—as well as the ubiquity of information as propagated on the Internet—has torn down those walls. The only barrier left between the Average Joe and the options pro is that of knowledge. Those who have it will succeed; those who do not will fail.\nTo be sure, the knowledge held by successful traders is not that of what will happen in the future; it is the knowledge of how to manage the uncertainty. No matter what our instincts tell us, we do not know what will happen in the future with regard to the market. As Socrates put it, “The only true wisdom is in knowing you know nothing.” The masters of option trading are masters of managing the risk associated with what they don’tknow—the risk of uncertainty.\nAs an instructor, I’ve talked to many traders who were new to options who told me, “Imade atrade based on what Ithought was going to happen. Iwas right, but my position lost money!” Choosing the right strategy makes all the difference when it comes to mastery of risk management and ultimate trading success. Knowing which option strategy is the right strategy for agiven situation comes with knowledge and experience.\nAll option strategies are differentiated by their unique risk characteristics. Some are more sensitive to directional movement of the underlying asset than others; some are more affected by time passing than others. The exact exposure positions have to these market influences determines the success of individual trades and, indeed, the long-term success of the trader who knows how to exploit these risk characteristics. These option-value sensitivities can be controlled when atrader understands the option greeks.\nOption greeks are metrics used to measure an option’ssensitivity to influences on its price. This book will provide the reader with an understanding of these metrics, to help the reader truly master the risk of uncertainty associated with option trading.\nSuccessful traders strive to create option positions with risk-reward profiles that benefit them the most in agiven situation. Atrader’sobjectives will dictate the right strategy for the right situation. Traders can tailor aposition to fit aspecific forecast with respect to the time horizon; the degree of bullishness, bearishness, neutrality, or volatility in the underlying stock; and the desired amount of leverage. Furthermore, they can exploit opportunities unique to options. They can trade option greeks. This opens the door to many new opportunities.\nA New Direction\nTraders, both professional and retail, need ways to act on their forecasts without the constraints of convention. “Get long, or do nothing” is no longer aviable business model for people active in the market. “Up is good; down is bad” is burned into traders’ minds from the beginning of their market education. This concept has its place in the world of investing, but becoming an active trader in the option market requires thinking in anew direction.\nMarket makers and other expert option traders look at the market differently from other traders. One fundamental difference is that these traders trade all four directions: up, down, sideways, and volatile.\nTrading Strategies\nBuying stock is atrading strategy that most people understand. In practical terms, traders who buy stock are generally not concerned with the literal ownership stake in acorporation, just the opportunity to profit if the stock rises. Although it’simportant for traders to understand that the price of astock is largely tied to the success or failure of the corporation, it’sessential to keep in mind exactly what the objective tends to be for trading astock: to profit from changes in its price. Abullish position can also be taken in the options market. The most basic example is buying acall.\nAbearish position can be taken by trading stock or options, as well. If traders expect the value of astock they own to fall, they will sell the stock. This eliminates the risk of losses from the stock’sfalling. If the traders do not own the stock that they", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00007.html", "doc_id": "affae435b66be6cf752dd1c208c968e0f8c4ec76689232de3f862cb7fd74a9f9", "chunk_index": 0}
{"text": "et. The most basic example is buying acall.\nAbearish position can be taken by trading stock or options, as well. If traders expect the value of astock they own to fall, they will sell the stock. This eliminates the risk of losses from the stock’sfalling. If the traders do not own the stock that they think will decline, they can take amore active stance and short it. The short-seller borrows the stock from aparty that owns it and then sells the borrowed shares to another party. The goal of selling stock short is to later repurchase the shares at alower price before returning the stock to its owner. It is simply reversing the order of “buy low/sell high.” The risk is that the stock rises and shares have to be bought at ahigher price than that at which they were sold. Although shorting stock can lead to profits when the market cooperates, in the options market, there are alternative ways to profit from falling prices. The most basic example is buying aput.\nAtrader can use options to take abullish or bearish position, given adirectional forecast. Sideways, nontrending stocks and their antithesis, volatile stocks, can be traded as well. In the later market conditions, profit or loss can be independent of whether the stock rises or falls. Opportunity in option trading is not necessarily black and white—not necessarily up and down. Option trading is nonlinear. Consequently, more opportunities can be exploited by trading options than by trading stock.\nOption traders must consider the time period in question, the volatility expected during this period, interest rates, and dividends. Along with the stock price, these factors make up the dynamic components of an option’svalue. These individual factors can be isolated, measured, and exploited. Incremental changes in any of these elements as measured by option greeks provide opportunity for option traders. Because of these other influences, direction is not the only tradable element of aforecast. Time, volatility, interest rates—these can all be traded using option greeks. These factors and more will all be discussed at great length throughout this book.\nThis Second Edition of\nTrading Option Greeks\nThis book addresses the complex price behavior of options by discussing option greeks from both atheoretical and apractical standpoint. There is some tactical discussion throughout, although the objective of this book is to provide education to the reader. This book is meant to be less ahow-to manual than ahow-come tutorial.\nThis informative guide will give the retail trader alook inside the mind of aprofessional trader. It will help the professional trader better understand the essential concepts of his craft. Even the novice trader will be able to apply these concepts to basic options strategies. Comprehensive knowledge of the greeks can help traders to avoid common pitfalls and increase profit potential.\nMuch of this book is broken down into adiscussion of individual strategies. Although the nuances of each specific strategy are not relevant, presenting the material this way allows for adiscussion of very specific situations in which greeks come into play. Many of the concepts discussed in asection on one option strategy can be applied to other option strategies.\nAs in the first edition of\nTrading Option Greeks\n, Chapter 1 discusses basic option concepts and definitions. It was written to be areview of the basics for the intermediate to advanced trader. For newcomers, it’sessential to understand these concepts before moving forward.\nAdetailed explanation of option greeks begins in Chapter 2. Be sure to leave abookmark in this chapter, as you will flip to it several times while reading the rest of the book and while studying the market thereafter. Chapter 3 introduces volatility. The same bookmark advice can be applied here, as well. Chapters 4 and 5 explore the minds of option traders. What are the risks they look out for? What are the opportunities they seek? These chapters also discuss direction-neutral and direction-indifferent trading. The remaining chapters take the reader from concept to application, discussing the strategies for nonlinear trading and the tactical considerations of asuccessful options trader.\nNew material in this edition includes updated examples, with more current price information throughout many of the chapters. More detailed discussions are also included to give the reader adeeper understanding of important topics. For example, Chapter 8 has amore elaborate explanation of the effect of dividends on option prices. Chapter 17 of this edition has new material on strategy selection, position management, and adjusting, not featured in the first edition of the book.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00007.html", "doc_id": "affae435b66be6cf752dd1c208c968e0f8c4ec76689232de3f862cb7fd74a9f9", "chunk_index": 1}
{"text": "CHAPTER 1\nThe Basics\nTo understand how options work, one needs first to understand what an option is. An option is acontract that gives its owner the right to buy or the right to sell afixed quantity of an underlying security at aspecific price within acertain time constraint. There are two types of options: calls and puts. Acall gives the owner of the option the right to buy the underlying security. Aput gives the owner of the option the right to sell the underlying security. As in any transaction, there are two parties to an option contract—abuyer and aseller.\nContractual Rights and Obligations\nThe option buyer is the party who owns the right inherent in the contract. The buyer is referred to as having along position and may also be called the holder, or owner, of the option. The right doesn’tlast forever. At some point the option will expire. At expiration, the owner may exercise the right or, if the option has no value to the holder, let it expire without exercising it. But he need not hold the option until expiration. Options are transferable—they can be traded intraday in much the same way as stock is traded. Because it’suncertain what the underlying stock price of the option will be at expiration, much of the time this right has value before it expires. The uncertainty of stock prices, after all, is the raison d’être of the option market.\nAlong position in an option contract, however, is fundamentally different from along position in astock. Owning corporate stock affords the shareholder ownership rights, which may include the right to vote in corporate affairs and the right to receive dividends. Owning an option represents strictly the right either to buy the stock or to sell it, depending on whether it’sacall or aput. Option holders do not receive dividends that would be paid to the shareholders of the underlying stock, nor do they have voting rights. The corporation has no knowledge of the parties to the option contract. The contract is created by the buyer and seller of the option and made available by being listed on an exchange.\nThe party to the contract who is referred to as the option seller, also called the option writer, has ashort position in the option. Instead of having aright to take aposition in the underlying stock, as the buyer does, the seller incurs an obligation to potentially either buy or sell the stock. When atrader who is long an option exercises, atrader with ashort position gets\nassigned\n. Assignment means the trader with the short option position is called on to fulfill the obligation that was established when the contract was sold.\nShorting an option is fundamentally different from shorting astock. Corporations have aquantifiable number of outstanding shares available for trading, which must be borrowed to create ashort position, but establishing ashort position in an option does not require borrowing; the contract is simply created. The strategy of shorting stock is implemented statistically far less frequently than simply buying stock, but that is not at all the case with options. For every open long-option contract, there is an open short-option contract—they are equally common.\nOpening and Closing\nTraders’ option orders are either opening or closing transactions. When traders with no position in aparticular option buy the option, they buy to open. If, in the future, the traders wish to eliminate the position by selling the option they own, the traders enter asell to close order—they are closing the position. Likewise, if traders with no position in aparticular option want to sell an option, thereby creating ashort position, the traders execute asell-to-open transaction. When the traders cover the short position by buying back the option, the traders enter abuy-to-close order.\nOpen Interest and Volume\nTraders use many types of market data to make trading decisions. Two items that are often studied but sometimes misunderstood are volume and open interest. Volume, as the name implies, is the total number of contracts traded during atime period. Often, volume is stated on aone-day basis, but could be stated per week, month, year, or otherwise. Once anew period (day) begins, volume begins again at zero. Open interest is the number of contracts that have been created and remain outstanding. Open interest is arunning total.\nWhen an option is first listed, there are no open contracts. If Trader Aopens along position in anewly listed option by buying aone-lot, or one contract, from Trader B, who by selling is also opening aposition, acontract is created. One contract traded, so the volume is one. Since both parties opened aposition and one contract was created, the open interest in this particular option is one contract as well. If, later that day, Trader Bcloses his short position by buying one contract from Trader C, who had no position to start with, the volume is now two contracts for that day, but open interest is still one. Only one contract exists; it was traded twice. I", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00010.html", "doc_id": "bddd77dcdce439ffc28aeaa5194bc3062143bfcde7870d841d88a7a8dd3e4fce", "chunk_index": 0}
{"text": "his particular option is one contract as well. If, later that day, Trader Bcloses his short position by buying one contract from Trader C, who had no position to start with, the volume is now two contracts for that day, but open interest is still one. Only one contract exists; it was traded twice. If the next day, Trader Cbuys her contract back from Trader A, that day’svolume is one and the open interest is now zero.\nThe Options Clearing Corporation\nRemember when Wimpy would tell Popeye, “I’ll gladly pay you Tuesday for ahamburger today.” Did Popeye ever get paid for those burgers? In acontract, it’svery important for each party to hold up his end of the bargain—especially when there is money at stake. How does atrader know the party on the other side of an option contract will in fact do that? That’swhere the Options Clearing Corporation (OCC) comes into play.\nThe OCC ultimately guarantees every options trade. In 2010, that was almost 3.9 billion listed-options contracts. The OCC accomplishes this through many clearing members. Here’show it works: When Trader Xbuys an option through abroker, the broker submits the trade information to its clearing firm. The trader on the other side of this transaction, Trader Y, who is probably amarket maker, submits the trade to his clearing firm. The two clearing firms (one representing Trader X’sbuy, the other representing Trader Y’ssell) each submit the trade information to the OCC, which “matches up” the trade.\nIf Trader Ybuys back the option to close the position, how does that affect Trader Xif he wants to exercise it? It doesn’t. The OCC, acting as an intermediary, assigns one of its clearing members with acustomer that is short the option in question to deliver the stock to Trader X’sclearing firm, which in turn delivers the stock to Trader X. The clearing member then assigns one of its customers who is short the option. The clearing member will assign the trader either randomly or first in, first out. Effectively, the OCC is the ultimate counterparty to both the exercise and the assignment.\nStandardized Contracts\nExchange-listed options contracts are standardized, meaning the terms of the contract, or the contract specifications, conform to acustomary structure. Standardization makes the terms of the contracts intuitive to the experienced user.\nTo understand the contract specifications in atypical equity option, consider an example:\nBuy 1 IBM December 170 call at 5.00\nQuantity\nIn this example, one contract is being purchased. More could have been purchased, but not less—options cannot be traded in fractional units.\nOption Series, Option Class, and Contract Size\nAll calls or puts of the same class, the same expiration month, and the same strike price are called an\noption series\n. For example, the IBM December 170 calls are aseries. Options series are displayed in an option chain on an online broker’suser interface. An option chain is afull or partial list of the options that are listed on an underlying.\nOption class\nmeans agroup of options that represent the same underlying. Here, the option class is denoted by the symbol IBM—the contract represents rights on International Business Machines Corp. (IBM) shares. Buying one contract usually gives the holder the right to buy or to sell 100 shares of the underlying stock. This number is referred to as\ncontract size\n. Though this is usually the case, there are times when the contract size is something other than 100 shares of astock. This situation may occur after certain types of stock splits, spin-offs, or stock dividends, for example. In the minority of cases in which the one contract represents rights on something besides 100 shares, there may be more than one class of options listed on astock.\nAfairly unusual example was presented by the Ford Motor Company options in the summer of 2000. In June 2000, Ford spun off Visteon Corporation. Then, in August 2000, Ford offered shareholders achoice of converting their shares into (a) new shares of Ford plus $20 cash per share, (b) new Ford stock plus fractional shares with an aggregate value of $20, or (c) new Ford stock plus acombination of more new Ford stock and cash. There were three classes of options listed on Ford after both of these changes: Frepresented 100 shares of the new Ford stock; XFO represented 100 shares of Ford plus $20 per share ($2,000) plus cash in lieu of $1.24; and FOD represented 100 shares of new Ford, 13 shares of Visteon, and $2,001.24.\nSometimes these changes can get complicated. If there is ever aquestion as to what the underlying is for an option class, the authority is the OCC. Alot of time, money, and stress can be saved by calling the OCC at 888-OPTIONS and clarifying the matter.\nExpiration Month\nOptions expire on the Saturday following the third Friday of the stated month, which in this case is December. The final trading day for an option is commonly the day before expiration—here, the third Friday of December. There are usually at least", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00010.html", "doc_id": "bddd77dcdce439ffc28aeaa5194bc3062143bfcde7870d841d88a7a8dd3e4fce", "chunk_index": 1}
{"text": "OPTIONS and clarifying the matter.\nExpiration Month\nOptions expire on the Saturday following the third Friday of the stated month, which in this case is December. The final trading day for an option is commonly the day before expiration—here, the third Friday of December. There are usually at least four months listed for trading on an option class. There may be atotal of six months if Long-Term Equity AnticiPation Securities\n®\nor LEAPS\n®\nare listed on the class. LEAPS can have one year to about two-and-a-half years until expiration. Some underlyings have one-week options called Weeklys\nSM\nlisted on them.\nStrike Price\nThe price at which the option holder owns the right to buy or to sell the underlying is called the strike price, or exercise price. In this example, the holder owns the right to buy the stock at $170 per share. There is method to the madness regarding how strike prices are listed. Strike prices are generally listed in $1, $2.50, $5, or $10 increments, depending on the value of the strikes and the liquidity of the options.\nThe relationship of the strike price to the stock price is important in pricing options. For calls, if the stock price is above the strike price, the call is in-the-money (ITM). If the stock and the strike prices are close, the call is at-the-money (ATM). If the stock price is below the strike price the call is out-of-the-money (OTM). This relationship is just the opposite for puts. If the stock price is below the strike price, the put is in-the-money. If the stock price and the strike price are about the same, the put is at-the-money. And, if the stock price is above the put strike, it is out-of-the-money.\nOption Type\nThere are two types of options: calls and puts. Calls give the holder the right to buy the underlying and the writer the obligation to sell the underlying. Puts give the holder the right to sell the underlying and the writer the obligation to buy the underlying.\nPremium\nThe price of an option is called its premium. The premium of this option is $5. Like stock prices, option premiums are stated in dollars and cents per share. Since the option represents 100 shares of IBM, the buyer of this option will pay $500 when the transaction occurs. Certain types of spreads may be quoted in fractions of apenny.\nAn option’spremium is made up of two parts: intrinsic value and time value. Intrinsic value is the amount by which the option is in-the-money. For example, if IBM stock were trading at 171.30, this 170-strike call would be in-the-money by 1.30. It has 1.30 of intrinsic value. The remaining 3.70 of its $5 premium would be time value.\nOptions that are out-of-the-money have no intrinsic value. Their values consist only of time premium. Sometimes options have no time value left. Options that consist of only intrinsic value are trading at what traders call\nparity\n. Time value is sometimes called\npremium over parity\n.\nExercise Style\nOne contract specification that is not specifically shown here is the exercise style. There are two main exercise styles: American and European. American-exercise options can be exercised, and therefore assigned, anytime after the contract is entered into until either the trader closes the position or it expires. European-exercise options can be exercised and assigned only at expiration. Exchange-listed equity options are all American-exercise style. Other kinds of options are commonly European exercise. Whether an option is American or European has nothing to with the country in which it’slisted.\nETFs, Indexes, and HOLDRs\nSo far, we’ve focused on equity options—options on individual stocks. But investors have other choices for trading securities options. Options on baskets of stocks can be traded, too. This can be accomplished using options on exchange-traded funds (ETFs), index options, or options on holding company depositary receipts (HOLDRs).\nETF Options\nExchange-traded funds are vehicles that represent ownership in afund or investment trust. This fund is made up of abasket of an underlying index’ssecurities—usually equities. The contract specifications of ETF options are similar to those of equity options. Let’slook at an example.\nOne actively traded optionable ETF is the Standard & Poor’s Depositary Receipts (SPDRs or Spiders). Spider shares and options trade under the symbol SPY. Exercising one SPY call gives the exerciser along position of 100 shares of Spiders at the strike price of the option. Expiration for ETF options typically falls on the same day as for equity options—the Saturday following the third Friday of the month. The last trading day is the Friday before. ETF options are American exercise. Traders of ETFs should be aware of the relationship between the price of the ETF shares and the value of the underlying index. For example, the stated value of the Spiders is about one tenth the stated value of the S&P 500. The PowerShares QQQ ETF, representing the Nasdaq 100, is about one fortieth the stated value of the Nasdaq 100.\nI", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00010.html", "doc_id": "bddd77dcdce439ffc28aeaa5194bc3062143bfcde7870d841d88a7a8dd3e4fce", "chunk_index": 2}
{"text": "e relationship between the price of the ETF shares and the value of the underlying index. For example, the stated value of the Spiders is about one tenth the stated value of the S&P 500. The PowerShares QQQ ETF, representing the Nasdaq 100, is about one fortieth the stated value of the Nasdaq 100.\nIndex Options\nTrading options on the Spiders ETF is aconvenient way to trade the Standard & Poor’s (S&P) 500. But it’snot the only way. There are other option contracts listed on the S&P 500. The SPX is one of the major ones. The SPX is an index option contract. There are some very important differences between ETF options like SPY and index options like SPX.\nThe first difference is the underlying. The underlying for ETF options is 100 shares of the ETF. The underlying for index options is the numerical value of the index. So if the S&P 500 is at 1303.50, the underlying for SPX options is 1303.50. When an SPX call option is exercised, instead of getting 100 shares of something, the exerciser gets the ITM cash value of the option times $100. Again, with SPX at 1303.50, if a 1300 call is exercised, the exerciser gets $350—that’s 1303.50 minus 1300, times $100. This is called\ncash settlement\n.\nMany index options are European, which means no early exercise. At expiration, any long ITM options in atrader’sinventory result in an account credit; any short ITMs result in adebit of the ITM value times $100. The settlement process for determining whether a European-style index option is in-the-money at expiration is alittle different, too. Often, these indexes are a.m. settled. A.m.-settled index options will have actual expiration on the conventional Saturday following the third Friday of the month. But the final trading day is the Thursday before the expiration day. The final settlement value of the index is determined by the opening prices of the components of the index on Friday morning.\nHOLDR Options\nLike ETFs, holding company depositary receipts also represent ownership in abasket of stocks. The main difference is that investors owning HOLDRs retain the ownership rights of the individual stocks in the fund, such as the right to vote shares and the right to receive dividends. Options on HOLDRs, for all intents and purposes, function much like options on ETFs.\nStrategies and At-Expiration Diagrams\nOne of the great strengths of options is that there are so many different ways to use them. There are simple, straightforward strategies like buying acall. And there are complex spreads with creative names like jelly roll, guts, and iron butterfly. Aspread is astrategy that involves combining an option with one or more other options or stock. Each component of the spread is referred to as aleg. Each spread has its own unique risk and reward characteristics that make it appropriate for certain market outlooks.\nThroughout this book, many different spreads will be discussed in depth. For now, it’simportant to understand that all spreads are made up of acombination of four basic option positions: buy call, sell call, buy put, and sell put. Understanding complex option strategies requires understanding these basic positions and their common, practical uses. When learning options, it’shelpful to see what the option’spayout is if it is held until expiration.\nBuy Call\nWhy buy the right to buy the stock when you can simply buy the stock? All option strategies have trade-offs, and the long call is no different. Whether the stock or the call is preferable depends greatly on the trader’sforecast and motivations.\nConsider along call example:\nBuy 1 INTC June 22.50 call at 0.85.\nIn this example, atrader is bullish on Intel (INTC). He believes Intel will rise at least 20 percent, from $22.25 per share to around $27 by June expiration, about two months from now. He is concerned, however, about downside risk and wants to limit his exposure. Instead of buying 100 shares of Intel at $22.25—atotal investment of $2,225—the trader buys 1 INTC June 22.50 call at 0.85, for atotal of $85.\nThe trader is paying 0.85 for the right to buy 100 shares of Intel at $22.50 per share. If Intel is trading below the strike price of $22.50 at expiration, the call will expire and the total premium of 0.85 will be lost. Why? The trader will not exercise the right to buy the stock at a $22.50 if he can buy it cheaper in the market. Therefore, if Intel is below $22.50 at expiration, this call will expire with no value.\nHowever, if the stock is trading above the strike price at expiration, the call can be exercised, in which case the trader may purchase the stock below its trading price. Here, the call has value to the trader. The higher the stock, the more the call is worth. For the trade to be profitable, at expiration the stock must be trading above the trader’sbreak-even price. The break-even price for along call is the strike price plus the premium paid—in this example, $23.35 per share. The point here is that if the call is exercised, the effective purchase price", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00010.html", "doc_id": "bddd77dcdce439ffc28aeaa5194bc3062143bfcde7870d841d88a7a8dd3e4fce", "chunk_index": 3}
{"text": "For the trade to be profitable, at expiration the stock must be trading above the trader’sbreak-even price. The break-even price for along call is the strike price plus the premium paid—in this example, $23.35 per share. The point here is that if the call is exercised, the effective purchase price of the stock upon exercise is $23.35. The stock is literally bought at the strike price, which is $22.50, but the premium of 0.85 that the trader has paid must be taken into account.\nExhibit 1.1\nillustrates this example.\nEXHIBIT 1.1\nLong Intel call.\nExhibit 1.1\nis an at-expiration diagram for the Intel 22.50 call. It shows the profit and loss, or P&(L), of the option if it is held until expiration. The X-axis represents the prices at which INTC could be trading at expiration. The Y-axis represents the associated profit or loss on the position. The at-expiration diagram of any long call position will always have this same hockey-stick shape, regardless of the stock or strike. There is always alimit of loss, represented by the horizontal line, which in this case is drawn at −0.85. And there is always aline extending upward and to the right, which represents effectively along stock position stemming from the strike.\nThe trade-offs between along stock position and along call position are shown in\nExhibit 1.2\n.\nEXHIBIT 1.2\nLong Intel call vs. long Intel stock.\nThe thin dotted line represents owning 100 shares of Intel at $22.25. Profits are unlimited, but the risk is substantial—the stock\ncan\ngo to zero. Herein lies the trade-off. The long call has unlimited profit potential with limited risk. Whenever an option is purchased, the most that can be lost is the premium paid for the option. But the benefit of reduced risk comes at acost. If the stock is above the strike at expiration, the call will always underperform the stock by the amount of the premium.\nBecause of this trade-off, conservative traders will sometimes buy acall rather than the associated stock and sometimes buy the stock rather than the call. Buying acall can be considered more conservative when the volatility of the stock is expected to rise. Traders are willing to risk acomparatively small premium when alarge price decline is feared possible. Instead, in an interest-bearing vehicle, they harbor the capital that would otherwise have been used to purchase the stock. The cost of this protection is acceptable to the trader if high-enough price advances are anticipated. In terms of percentage, much higher returns\nand losses\nare possible with the long call. If the stock is trading at $27 at expiration, as the trader in this example expected, the trader reaps a 429 percent profit on the $0.85 investment ([$27 − 23.35] / $0.85). If Intel is below the strike price at expiration, the trader loses 100 percent.\nThis makes call buying an excellent speculative alternative. Those willing to accept bigger risk can further increase returns by purchasing more calls. In this example, around 26 Intel calls—representing the rights on 2,600 shares—can be purchased at 85 cents for the cost of 100 shares at $22.25. This is the kind of leverage that allows for either alower cash outlay than buying the stock—reducing risk—or the same cash outlay as buying the stock but with much greater exposure—creating risk in pursuit of higher returns.\nSell Call\nSelling acall creates the obligation to sell the stock at the strike price. Why is atrader willing to accept this obligation? The answer is option premium. If the position is held until expiration without getting assigned, the entire premium represents aprofit for the trader. If assignment occurs, the trader will be obliged to sell stock at the strike price. If the trader does not have along position in the underlying stock (anaked call), ashort stock position will be created. Otherwise, if stock is owned (acovered call), that stock is sold. Whether the trader has aprofit or aloss depends on the movement of the stock price and how the short call position was constructed.\nConsider anaked call example:\nSell 1 TGT October 50 call at 1.45\nIn this example, Target Corporation (TGT) is trading at $49.42. Atrader, Sam, believes Target will continue to be trading below $50 by October expiration, about two months from now. Sam sells 1 Target two-month 50 call at 1.45, opening ashort position in that series.\nExhibit 1.3\nwill help explain the expected payout of this naked call position if it is held until expiration.\nEXHIBIT 1.3\nNaked Target call.\nIf TGT is trading below the exercise price of 50, the call will expire worthless. Sam keeps the 1.45 premium, and the obligation to sell the stock ceases to exist. If Target is trading above the strike price, the call will be in-the-money. The higher the stock is above the strike price, the more intrinsic value the call will have. As aseller, Sam wants the call to have little or no intrinsic value at expiration. If the stock is below the break-even price at expiration, Sam will still have aprofit. Here", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00010.html", "doc_id": "bddd77dcdce439ffc28aeaa5194bc3062143bfcde7870d841d88a7a8dd3e4fce", "chunk_index": 4}
{"text": ", the call will be in-the-money. The higher the stock is above the strike price, the more intrinsic value the call will have. As aseller, Sam wants the call to have little or no intrinsic value at expiration. If the stock is below the break-even price at expiration, Sam will still have aprofit. Here, the break-even price is $51.45—the strike price plus the call premium. Above the break-even, Sam has aloss. Since stock prices can rise to infinity (although, for the record, Ihave never seen this happen), the naked call position has unlimited risk of loss.\nBecause ashort stock position may be created, anaked call position must be done in amargin account. For retail traders, many brokerage firms require different levels of approval for different types of option strategies. Because the naked call position has unlimited risk, establishing it will generally require the highest level of approval—and ahigh margin requirement.\nAnother tactical consideration is what Sam’sobjective was when he entered the trade. His goal was to profit from the stock’sbeing below $50 during this two-month period—not to short the stock. Because equity options are American exercise and can be exercised/assigned any time from the moment the call is sold until expiration, ashort stock position cannot always be avoided. If assigned, the short stock position will extend Sam’speriod of risk—because stock doesn’texpire. Here, he will pay one commission shorting the stock when assignment occurs and one more when he\nbuys back\nthe unwanted position. Many traders choose to close the naked call position before expiration rather than risk assignment.\nIt is important to understand the fundamental difference between buying calls and selling calls. Buying acall option offers limited risk and unlimited reward. Selling anaked call option, however, has limited reward—the call premium—and unlimited risk. This naked call position is not so much bearish as\nnot bullish\n. If Sam thought the stock was going to zero, he would have chosen adifferent strategy.\nNow consider acovered call example:\nBuy 100 shares TGT at $49.42\nSell 1 TGT October 50 call at 1.45\nUnlimited\nand\nrisk\nare two words that don’tsit well together with many traders. For that reason, traders often prefer to sell calls as part of aspread. But since spreads are strategies that involve multiple components, they have different risk characteristics from an outright option. Perhaps the most commonly used call-selling spread strategy is the covered call (sometimes called acovered write\nor abuy-write\n). While selling acall naked is away to take advantage of a “not bullish” forecast, the covered call achieves adifferent set of objectives.\nAfter studying Target Corporation, another trader, Isabel, has aneutral to slightly bullish forecast. With Target at $49.42, she believes the stock will be range-bound between $47 and $51.50 over the next two months, ending with October expiration. Isabel buys 100 shares of Target at $49.42 and sells 1 TGT October 50 call at 1.45. The implications for the covered-call strategy are twofold: Isabel must be content to own the stock at current levels, and—since she sold the right to buy the stock at $50, that is, a 50 call, to another party—she must be willing to sell the stock if the price rises to or through $50 per share.\nExhibit 1.4\nshows how this covered call performs if it is held until the call expires.\nEXHIBIT 1.4\nTarget covered call.\nThe solid kinked line represents the covered call position, and the thin, straight dotted line represents owning the stock outright. At the expiration of the call option, if Target is trading below $50 per share—the strike price—the call expires and Isabel is left with along position of 100 shares\nplus\n$1.45 per share of expired-option premium. Below the strike, the buy-write always outperforms simply owning the stock by the amount of the premium. The call premium provides limited downside protection; the stock Isabel owns can decline $1.45 in value to $47.97 before the trade is aloser. In the unlikely event the stock collapses and becomes worthless, this limited downside protection is not so comforting. Ultimately, Isabel has $47.97 per share at risk.\nThe trade-off comes if Target is above $50 at expiration. Here, assignment will likely occur, in which case the stock will be sold. The call can be assigned before expiration, too, causing the stock to be\ncalled away\nearly. Because the covered call involves this obligation to sell the sock at the strike price, upside potential is limited. In this case, Isabel’sprofit potential is $2.03. The stock can rise from $49.42 to $50—a $0.58 profit—plus $1.45 of option premium.\nIsabel does not want the stock to decline too much. Below $47.97, the trade is aloser. If the stock rises too much, the stock is sold prematurely and upside opportunity is lost. Limited reward and unlimited risk. (Technically, the risk is not unlimited—the stock can only go to zero. But if the stock drops from $49.42 to zer", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00010.html", "doc_id": "bddd77dcdce439ffc28aeaa5194bc3062143bfcde7870d841d88a7a8dd3e4fce", "chunk_index": 5}
{"text": "stock to decline too much. Below $47.97, the trade is aloser. If the stock rises too much, the stock is sold prematurely and upside opportunity is lost. Limited reward and unlimited risk. (Technically, the risk is not unlimited—the stock can only go to zero. But if the stock drops from $49.42 to zero in ashort time, the risk will certainly feel unlimited.) The covered call strategy is for aneutral to moderately bullish outlook.\nSell Put\nSelling aput has many similarities to the covered call strategy. We’ll discuss the two positions and highlight the likenesses. Chapter 6 will detail the nuts and bolts of why these similarities exist.\nConsider an example of selling aput:\nSell 1 BA January 65 put at 1.20\nIn this example, trader Sam is neutral to moderately bullish on Boeing (BA) between now and January expiration. He is not bullish enough to buy BA at the current market price of $69.77 per share. But if the shares dropped below $65, he’dgladly scoop some up. Sam sells 1 BA January 65 put at 1.20. The at-expiration diagram in\nExhibit 1.5\nshows the P&(L) of this trade if it is held until expiration.\nEXHIBIT 1.5\nBoeing short put.\nAt the expiration of this option, if Boeing is above $65, the put expires and Sam retains the premium of $1.20. The obligation to buy stock expires with the option. Below the strike, put owners will be inclined to exercise their option to sell the stock at $65. Therefore, those short the put, as Sam is in this example, can expect assignment. The break-even price for the position is $63.80. That is the strike price minus the option premium. If assigned, this is the effective purchase price of the stock. The obligation to buy at $65 is fulfilled, but the $1.20 premium collected makes the purchase effectively $63.80. Here, again, there is limited profit opportunity ($1.20 if the stock is above the strike price) and seemingly unlimited risk (the risk of potential stock ownership at $63.80) if Boeing is below the strike price.\nWhy would atrader short aput and willingly assume this substantial risk with comparatively limited reward? There are anumber of motivations that may warrant the short put strategy. In this example, Sam had the twin goals of profiting from aneutral to moderately bullish outlook on Boeing and buying it if it traded below $65. The short put helps him achieve both objectives.\nMuch like the covered call, if the stock is above the strike at expiration, this trader reaches his maximum profit potential—in this case 1.20. And if the price of Boeing is below the strike at expiration, Sam has ownership of the stock from assignment. Here, astrike price that is lower than the current stock level is used. The stock needs to decline in order for Sam to get assigned and become long the stock. With this strategy, he was able to establish atarget price at which he would buy the stock. Why not use alimit order? If the put is assigned, the effective purchase price is $63.80 even if the stock price is above this price. If the put is not assigned, the premium is kept.\nAconsideration every trader must make before entering the short put position is how the purchase of the stock will be financed in the event the put is assigned. Traders hoping to acquire the stock will often hold enough cash in their trading account to secure the purchase of the stock. This is called acash-secured put\n. In this example, Sam would hold $6,380 in his account in addition to the $120 of option premium received. This affords him enough free capital to fund the $6,500 purchase of stock the short put dictates. More speculative traders may be willing to buy the stock on margin, in which case the trader will likely need around 50 percent of the stock’svalue.\nSome traders sell puts without the intent of ever owning the stock. They hope to profit from alow-volatility environment. Just as the short call is anot-bullish stance on the underlying, the short put is anot-bearish play. As long as the underlying is above the strike price at expiration, the option premium is all profit. The trader must actively manage the position for fear of being assigned. Buying the put back to close the position eliminates the risk of assignment.\nBuy Put\nBuying aput gives the holder the right to sell stock at the strike price. Of course, puts can be apart of ahost of different spreads, but this chapter discusses the two most basic and common put-buying strategies: the long put and the protective put. The long put is away to speculate on abearish move in the underlying security, and the protective put is away to protect along position in the underlying security.\nConsider along put example:\nBuy 1 SPY May 139 put at 2.30\nIn this example, the Spiders have had agood run up to $140.35. Trader Isabel is looking for a 10 percent correction in SPY between now and the end of May, about three months away. She buys 1 SPY May 139 put at 2.30. This put gives her the right to sell 100 shares of SPY at $139 per share.\nExhibit 1.6\nshows Isabel’s P&(L) if the", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00010.html", "doc_id": "bddd77dcdce439ffc28aeaa5194bc3062143bfcde7870d841d88a7a8dd3e4fce", "chunk_index": 6}
{"text": "ave had agood run up to $140.35. Trader Isabel is looking for a 10 percent correction in SPY between now and the end of May, about three months away. She buys 1 SPY May 139 put at 2.30. This put gives her the right to sell 100 shares of SPY at $139 per share.\nExhibit 1.6\nshows Isabel’s P&(L) if the put is held until expiration.\nEXHIBIT 1.6\nSPY long put.\nIf SPY is above the strike price of 139 at expiration, the put will expire and the entire premium of 2.30 will be lost. If SPY is below the strike price at expiration, the put will have value. It can be exercised, creating ashort position in the Spiders at an effective price of $136.70 per share. This price is found by subtracting the premium paid, 2.30, from the strike price, 139. This is the point at which the position breaks even. If SPY is below $136.70 at expiration, Isabel has aprofit. Profits will increase on atick-for-tick basis, with downward movements in SPY down to zero. The long put has limited risk and substantial reward potential.\nAn alternative for Isabel is to short the ETF at the current price of $140.35. But ashort position in the underlying may not be as attractive to her as along put. The margin requirements for short stock are significantly higher than for along put. Put buyers must post only the premium of the put—that is the most that can be lost, after all.\nThe margin requirement for short stock reflects unlimited loss potential. Margin requirements aside, risk is avery real consideration for atrader deciding between shorting stock and buying aput. If the trader expects high volatility, he or she may be more inclined to limit upside risk while leveraging downside profit potential by buying aput. In general, traders buy options when they expect volatility to increase and sell them when they expect volatility to decrease. This will be acommon theme throughout this book.\nConsider aprotective put example:\nThis is an example of asituation in which volatility is expected to increase.\nOwn 100 shares SPY at 140.35\nBuy 1 SPY May139 put at 2.30\nAlthough Isabel bought aput because she was bearish on the Spiders, adifferent trader, Kathleen, may buy aput for adifferent reason—she’sbullish but concerned about increasing volatility. In this example, Kathleen has owned 100 shares of Spiders for some time. SPY is currently at $140.35. She is bullish on the market but has concerns about volatility over the next two or three months. She wants to protect her investment. Kathleen buys 1 SPY May 139 put at 2.30. (If Kathleen bought the shares of SPY and the put at the same time, as aspread, the position would be called amarried put.)\nKathleen is buying the right to sell the shares she owns at $139. Effectively, it is an insurance policy on this asset.\nExhibit 1.7\nshows the risk profile of this new position.\nEXHIBIT 1.7\nSPY protective put.\nThe solid kinked line is the protective put (put and stock), and the thin dotted line is the outright position in SPY alone, without the put. The most Kathleen stands to lose with the protective put is $3.65 per share. SPY can decline from $140.35 to $139, creating aloss of $1.35, plus the $2.30 premium spent on the put. If the stock does not fall and the insuring put hence does not come into play, the cost of the put must be recouped to justify its expense. The break-even point is $142.65.\nThis position implies that Kathleen is still bullish on the Spiders. When traders believe astock or ETF is going to decline, they sell the shares. Instead, Kathleen sacrifices 1.6 percent of her investment up front by purchasing the put for $2.30. She defers the sale of SPY until the period of perceived risk ends. Her motivation is not to sell the ETF; it is to hedge volatility.\nOnce the anticipated volatility is no longer aconcern, Kathleen has achoice to make. She can let the option run its course, holding it to expiration, at which point it will either expire or be exercised; or she can sell the option before expiration. If the option is out-of-the-money, it may have residual time value prior to expiration that can be recouped. If it is in-the-money, it will have intrinsic value and maybe time value as well. In this situation, Kathleen can look at this spread as two trades—one that has declined in price, the SPY shares, and one that has risen in price, the put. Losses on the ETF shares are to some degree offset by gains on the put.\nMeasuring Incremental Changes in Factors Affecting Option Prices\nAt-expiration diagrams are very helpful in learning how aparticular option strategy works. They show what the option’sprice will ultimately be at various prices of the underlying. There is, however, acaveat when using at-expiration diagrams. According to the Options Industry Council, most options are closed before they reach expiration. Traders not planning to hold an option until it expires need to have away to develop reasonable expectations as to what the option’sprice will be given changes that can occur in factors affecting the option’", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00010.html", "doc_id": "bddd77dcdce439ffc28aeaa5194bc3062143bfcde7870d841d88a7a8dd3e4fce", "chunk_index": 7}
{"text": "CHAPTER 2\nGreek Philosophy\nMy wife, Kathleen, is not an options trader. Au contraire. However, she, like just about everyone, uses them from time to time—though without really thinking about it. She was on eBay the other day bidding on apair of shoes. The bid was $45 with three days left to go. She was concerned about the price rising too much and missing the chance to buy them at what she thought was agood price. She noticed, though, that someone else was selling the same shoes with abuy-it-now price of $49—agood-enough price in her opinion. Kathleen was effectively afforded acall option. She had the opportunity to buy the shoes at (the strike price of) $49, aright she could exercise until the offer expired.\nThe biggest difference between the option in the eBay scenario and the sort of options discussed in this book is transferability. Actual options are tradable—they can be bought and sold. And it is the contract itself that has value—there is one more iteration of pricing.\nFor example, imagine the $49 opportunity was acoupon or certificate that guaranteed the price of $49, which could be passed along from one person to another. And there was the chance that the $49-price guarantee could represent adiscount on the price paid for the shoes—maybe abig discount—should the price of the shoes rise in the eBay auction. The certificate guaranteeing the $49 would have value. Anyone planning to buy the shoes would want the safety of knowing they were guaranteed not to pay more than $49 for the shoes. In fact, some people would even consider paying to buy the certificate itself if they thought the price of the shoes might rise significantly.\nPrice vs. Value: How Traders Use Option-Pricing Models\nLike in the common-life example just discussed, the right to buy or sell an underlying security—that is, an option—can have value, too. The specific value of an option is determined by supply and demand. There are several variables in an option contract, however, that can influence atrader’swillingness to demand (desire to buy) or supply (desire to sell) an option at agiven price. For example, atrader would rather own—that is, there would be higher demand for—an option that has more time until expiration than ashorter-dated option, all else held constant. And atrader would rather own acall with alower strike than ahigher strike, all else kept constant, because it would give the right to buy at alower price.\nSeveral elements contribute to the value of an option. It took academics many years to figure out exactly what those elements are. Fischer Black and Myron Scholes together pioneered research in this area at the University of Chicago. Ultimately, their work led to a Nobel Prize for Myron Scholes. Fischer Black died before he could be honored.\nIn 1973, Black and Scholes published apaper called “The Pricing of Options and Corporate Liabilities” in the\nJournal of Political Economy\n, that introduced the Black-Scholes option-pricing model to the world. The Black-Scholes model values European call options on non-dividend-paying stocks. Here, for the first time, was awidely accepted model illustrating what goes into the pricing of an option. Option prices were no longer wild guesswork. They could now be rationalized. Soon, additional models and alterations to the Black-Scholes model were developed for options on indexes, dividend-paying stocks, bonds, commodities, and other optionable instruments. All the option-pricing models commonly in use today have slightly different means but achieve the same end: the option’stheoretical value. For American-exercise equity options, six inputs are entered into any option-pricing model to generate atheoretical value: stock price, strike price, time until expiration, interest rate, dividends, and volatility.\nTheoretical value—what aconcept! Atrader plugs six numbers into apricing model, and it tells him what the option is worth, right? Well, in practical terms, that’snot exactly how it works. An option is worth what the market bears. Economists call this price discovery. The price of an option is determined by the forces of supply and demand working in afree and open market. Herein lies an important concept for option traders: the difference between price and value.\nPrice can be observed rather easily from any source that offers option quotes (web sites, your broker, quote vendors, and so on). Value is calculated by apricing model. But, in practice, the theoretical value is really not an output at all. It is already known: the market determines it. The trader rectifies price and value by setting the theoretical value to fall between the bid and the offer of the option by adjusting the inputs to the model. Professional traders often refer to the theoretical value as the fair value of the option.\nAt this point, please note the absence of the mathematical formula for the Black-Scholes model (or any other pricing model, for that matter). Although the foundation of trading option greeks is mathema", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00011.html", "doc_id": "82fb802f36575b30d74498f7e8de3c48bfd1c163e04cc86ad41dea8c765fcb67", "chunk_index": 0}
{"text": "model. Professional traders often refer to the theoretical value as the fair value of the option.\nAt this point, please note the absence of the mathematical formula for the Black-Scholes model (or any other pricing model, for that matter). Although the foundation of trading option greeks is mathematical, this book will keep the math to aminimum—which is still quite abit. The focus of this book is on practical applications, not academic theory. It’sabout learning to drive the car, not mastering its engineering.\nThe trader has an equation with six inputs equaling one known output. What good is this equation? An option-pricing model helps atrader understand how market forces affect the value of an option. Five of the six inputs are dynamic; the only constant is the strike price of the option in question. If the price of the option changes, it’sbecause one or more of the five variable inputs has changed. These variables are independent of each other, but they can change in harmony, having either acumulative or net effect on the option’svalue. An option trader needs to be concerned with the relationship of these variables (price, time, volatility, interest). This multidimensional view of asset pricing is unique to option traders.\nDelta\nThe five figures commonly used by option traders are represented by Greek letters: delta, gamma, theta, vega, rho. The figures are referred to as option greeks. Vega, of course, is not an actual letter of the greek alphabet, but in the options vernacular, it is considered one of the greeks.\nThe greeks are aderivation of an option-pricing model, and each Greek letter represents aspecific sensitivity to influences on the option’svalue. To understand concepts represented by these five figures, we’ll start with delta, which is defined in four ways:\n1. The rate of change of an option value relative to achange in the underlying stock price.\n2. The derivative of the graph of an option value in relation to the stock price.\n3. The equivalent of underlying shares represented by an option position.\n4. The estimate of the likelihood of an option expiring in-the-money.\n1\nDefinition 1\n: Delta (Δ) is the rate of change of an option’svalue relative to achange in the price of the underlying security. Atrader who is bullish on aparticular stock may choose to buy acall instead of buying the underlying security. If the price of the stock rises by $1, the trader would expect to profit on the call—but by how much? To answer that question, the trader must consider the delta of the option.\nDelta is stated as apercentage. If an option has a 50 delta, its price will change by 50 percent of the change of the underlying stock price. Delta is generally written as either awhole number, without the percent sign, or as adecimal. So if an option has a 50 percent delta, this will be indicated as 0.50, or 50. For the most part, we’ll use the former convention in our discussion.\nCall values increase when the underlying stock price increases and vice versa. Because calls have this positive correlation with the underlying, they have positive deltas. Here is asimplified example of the effect of delta on an option:\nConsider a $60 stock with acall option that has a 0.50 delta and is trading for 3.00. Considering only the delta, if the stock price increases by $1, the theoretical value of the call will rise by 0.50. That’s 50 percent of the stock price change. The new call value will be 3.50. If the stock price decreases by $1, the 0.50 delta will cause the call to decrease in value by 0.50, from 3.00 to 2.50.\nPuts have anegative correlation to the underlying. That is, put values decrease when the stock price rises and vice versa. Puts, therefore, have negative deltas. Here is asimplified example of the delta effect on a −0.40-delta put:\nAs the stock rises from $60 to $61, the delta of −0.40 causes the put value to go from $2.25 to $1.85. The put decreases by 40 percent of the stock price increase. If the stock price instead declined by $1, the put value would increase by $0.40, to $2.65.\nUnfortunately, real life is abit more complicated than the simplified examples of delta used here. In reality, the value of both the call and the put will likely be higher with the stock at $61 than was shown in these examples. We’ll expand on this concept later when we tackle the topic of gamma.\nDefinition 2\n: Delta can also be described another way.\nExhibit 2.1\nshows the value of acall option with three months to expiration at avariable stock price. As the stock price rises, the call is worth more; as the stock price declines, the call value moves toward zero. Mathematically, for any given point on the graph, the derivative will show the rate of change of the option price.\nThe delta is the first derivative of the graph of the option price relative to the stock price\n.\nEXHIBIT 2.1\nCall value compared with stock price.\nDefinition 3\n: In terms of absolute value (meaning that plus and minus signs are ignored), the delta of an option is be", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00011.html", "doc_id": "82fb802f36575b30d74498f7e8de3c48bfd1c163e04cc86ad41dea8c765fcb67", "chunk_index": 1}
{"text": "te of change of the option price.\nThe delta is the first derivative of the graph of the option price relative to the stock price\n.\nEXHIBIT 2.1\nCall value compared with stock price.\nDefinition 3\n: In terms of absolute value (meaning that plus and minus signs are ignored), the delta of an option is between 1.00 and 0. Its price can change in tandem with the stock, as with a 1.00 delta; or it cannot change at all as the stock moves, as with a 0 delta; or anything in between. By definition, stock has a 1.00 delta—it\nis\nthe underlying security. A $1 rise in the stock yields a $100 profit on around lot of 100 shares. Acall with a 0.60 delta rises by $0.60 with a $1 increase in the stock. The owner of acall representing rights on 100 shares earns $60 for a $1 increase in the underlying. It’sas if the call owner in this example is long 60 shares of the underlying stock.\nDelta is the option’sequivalent of aposition in the underlying shares\n.\nAtrader who buys five 0.43-delta calls has aposition that is effectively long 215 shares—that’s 5 contracts × 0.43 deltas × 100 shares. In option lingo, the trader is long 215 deltas. Likewise, if the trader were short five 0.43-delta calls, the trader would be short 215 deltas.\nThe same principles apply to puts. Being long 10 0.59-delta puts makes the trader short atotal of 590 deltas, aposition that profits or loses like being short 590 shares of the underlying stock. Conversely, if the trader were short 10 0.59-delta puts, the trader would theoretically make $590 if the stock were to rise $1 and lose $590 if the stock fell by $1—just like being long 590 shares.\nDefinition 4\n: The final definition of delta is considered the trader’sdefinition. It’smathematically imprecise but is used nonetheless as ageneral rule of thumb by option traders. Atrader would say the\ndelta is astatistical approximation of the likelihood of the option expiring in-the-money\n. An option with a 0.75 delta would have a 75 percent chance of being in-the-money at expiration under this definition. An option with a 0.20 delta would be thought of having a 20 percent chance of expiring in-the-money.\nDynamic Inputs\nOption deltas are not constants. They are calculated from the dynamic inputs of the pricing model—stock price, time to expiration, volatility, and so on. When these variables change, the changes affect the delta. These changes can be mathematically quantified—they are systematic. Understanding these patterns and other quirks as to how delta behaves can help traders use this tool more effectively. Let’sdiscuss afew observations about the characteristics of delta.\nFirst, call and put deltas are closely related.\nExhibit 2.2\nis apartial option chain of 70-day calls and puts in Rambus Incorporated (RMBS). The stock was trading at $21.30 when this table was created. In\nExhibit 2.2\n, the 20 calls have a 0.66 delta.\nEXHIBIT 2.2\nRMBS Option chain with deltas.\nNotice the deltas of the put-call pairs in this exhibit. As ageneral rule, the absolute value of the call delta plus the absolute value of the put delta add up to close to 1.00. The reason for this has to do with amathematical relationship called put-call parity, which is briefly discussed later in this chapter and described in detail in Chapter 6. But with equity options, the put-call pair doesn’talways add up to exactly 1.00.\nSometimes the difference is simply due to rounding. But sometimes there are other reasons. For example, the 30-strike calls and puts in\nExhibit 2.2\nhave deltas of 0.14 and −0.89, respectively. The absolute values of the deltas add up to 1.03. Because of the possibility of early exercise of American options, the put delta is abit higher than the call delta would imply. When puts have agreater chance of early exercise, they begin to act more like short stock and consequently will have agreater delta. Often, dividend-paying stocks will have higher deltas on some in-the-money calls than the put in the pair would imply. As the ex-dividend date—the date the stock begins trading without the dividend—approaches, an in-the-money call can become more apt to be exercised, because traders will want to own stock to capture the dividend. Here, the call begins to act more like long stock, leading to ahigher delta.\nMoneyness and Delta\nThe next observation is the effect of moneyness on the option’sdelta. Moneyness describes the degree to which the option is in- or out-of-the-money. As ageneral rule, options that are in-the-money (ITM) have deltas greater than 0.50. Options that are out-of-the-money (OTM) have deltas less than 0.50. Finally, options that are at-the-money (ATM) have deltas that are about 0.50. The more in-the-money the option is, the closer to 1.00 the delta is. The more out-of-the-money, the closer the delta is to 0.\nBut ATM options are usually not exactly 0.50. For ATMs, both the call and the put deltas are generally systematically avalue other than 0.50. Typically, the call has ahigher delta than 0.50 and the put has alower absol", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00011.html", "doc_id": "82fb802f36575b30d74498f7e8de3c48bfd1c163e04cc86ad41dea8c765fcb67", "chunk_index": 2}
{"text": "er to 1.00 the delta is. The more out-of-the-money, the closer the delta is to 0.\nBut ATM options are usually not exactly 0.50. For ATMs, both the call and the put deltas are generally systematically avalue other than 0.50. Typically, the call has ahigher delta than 0.50 and the put has alower absolute value than 0.50. Incidentally, the call’stheoretical value is generally greater than the put’swhen the options are right at-the-money as well. One reason for this disparity between exactly at-the-money calls and puts is the interest rate. The more time until expiration, the more effect the interest rate will have, and, therefore, the higher the call’stheoretical and delta will be relative to the put.\nEffect of Time on Delta\nIn aclose contest, the last few minutes of afootball game are often the most exciting—not because the players run faster or knock heads harder but because one strategic element of the game becomes more and more important: time. The team that’sin the lead wants the game clock to run down with no interruption to solidify its position. The team that’slosing uses its precious time-outs strategically. The more playing time left, the less certain defeat is for the losing team.\nAlthough mathematically imprecise, the trader’sdefinition can help us gain insight into how time affects option deltas. The more time left until an option’sexpiration, the less certain it is whether the option will be ITM or OTM at expiration. The deltas of both the ITM and the OTM options reflect that uncertainty. The more time left in the life of the option, the closer the deltas tend to gravitate to 0.50. A 0.50 delta represents the greatest level of uncertainty—acoin toss.\nExhibit 2.3\nshows the deltas of ahypothetical equity call with astrike price of 50 at various stock prices with different times until expiration. All other parameters are held constant.\nEXHIBIT 2.3\nEstimated delta of 50-strike call—impact of time.\nAs shown in\nExhibit 2.3\n, the more time until expiration, the closer ITMs and OTMs move to 0.50. At expiration, of course, the option is either a 100 delta or a 0 delta; it’seither stock or not.\nEffect of Volatility on Delta\nThe level of volatility affects option deltas as well. We’ll discuss volatility in more detail in future chapters, but it’simportant to address it here as it relates to the concept of delta.\nExhibit 2.4\nshows how changing the volatility percentage (explained further in Chapter 3), as opposed to the time to expiration, affects option deltas. In this table, the delta of acall with 91 days until expiration is studied.\nEXHIBIT 2.4\nEstimated delta of 50-strike call—impact of volatility.\nNotice the effect that volatility has on the deltas of this option with the underlying stock at various prices. In this table, at alow volatility with the call deep in- or out-of-the-money, the delta is very large or very small, respectively. At 10 percent volatility with the stock at $58 ashare, the delta is 1.00. At that same volatility level with the stock at $42 ashare, the delta is 0.\nBut at higher volatility levels, the deltas change. With the stock at $58, a 45 percent volatility gives the 50-strike call a 0.79 delta—much smaller than it was at the low volatility level. With the stock at $42, a 45-percent volatility returns a 0.30 delta for the call. Generally speaking, ITM option deltas are smaller given ahigher volatility assumption, and OTM option deltas are bigger with ahigher volatility.\nEffect of Stock Price on Delta\nAn option that is $5 in-the-money on a $20 stock will have ahigher delta than an option that is $5 in-the-money on a $200 stock. Proportionately, the former is more in-the-money. Comparing two options that are in-the-money by the same percentage yields similar results.\nAs the stock price changes because the strike price remains stable, the option’sdelta will change. This phenomenon is measured by the option’sgamma.\nGamma\nThe strike price is the only constant in the pricing model. When the stock price moves relative to this constant, the option in question becomes more in-the-money or out-of-the-money. This means the delta changes. This isolated change is measured by the option’sgamma, sometimes called\ncurvature\n.\nGamma (Γ) is the rate of change of an option’sdelta given achange in the price of the underlying security\n. Gamma is conventionally stated in terms of deltas per dollar move. The simplified examples above under Definition 1 of delta, used to describe the effect of delta, had one important piece of the puzzle missing: gamma. As the stock price moved higher in those examples, the delta would not remain constant. It would change due to the effect of gamma. The following example shows how the delta would change given a 0.04 gamma attributed to the call option.\nThe call in this example starts as a 0.50-delta option. When the stock price increases by $1, the delta increases by the amount of the gamma. In this example, delta increases from 0.50 to 0.54, adding 0.04 deltas. As the s", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00011.html", "doc_id": "82fb802f36575b30d74498f7e8de3c48bfd1c163e04cc86ad41dea8c765fcb67", "chunk_index": 3}
{"text": "how the delta would change given a 0.04 gamma attributed to the call option.\nThe call in this example starts as a 0.50-delta option. When the stock price increases by $1, the delta increases by the amount of the gamma. In this example, delta increases from 0.50 to 0.54, adding 0.04 deltas. As the stock price continues to rise, the delta continues to move higher. At $62, the call’sdelta is 0.58.\nThis increase in delta will affect the value of the call. When the stock price first begins to rise from $60, the option value is increasing at arate of 50 percent—the call’sdelta at that stock price. But by the time the stock is at $61, the option value is increasing at arate of 54 percent of the stock price. To estimate the theoretical value of the call at $61, we must first estimate the average change in the delta between $60 and $61. The average delta between $60 and $61 is roughly 0.52. It’sdifficult to calculate the average delta exactly because gamma is not constant; this is discussed in more detail later in the chapter. Amore realistic example of call values in relation to the stock price would be as follows:\nEach $1 increase in the stock shows an increase in the call value about equal to the average delta value between the two stock prices. If the stock were to decline, the delta would get smaller at adecreasing rate.\nAs the stock price declines from $60 to $59, the option delta decreases from 0.50 to 0.46. There is an average delta of about 0.48 between the two stock prices. At $59 the new theoretical value of the call is 2.52. The gamma continues to affect the option’sdelta and thereby its theoretical value as the stock continues its decline to $58 and beyond.\nPuts work the same way, but because they have anegative delta, when there is apositive stock-price movement the gamma makes the put delta less negative, moving closer to 0. The following example clarifies this.\nAs the stock price rises, this put moves more and more out-of-the-money. Its theoretical value is decreasing by the rate of the changing delta. At $60, the delta is −0.40. As the stock rises to $61, the delta changes to −0.36. The average delta during that move is about −0.38, which is reflected in the change in the value of the put.\nIf the stock price declines and the put moves more toward being in-the-money, the delta becomes more negative—that is, the put acts more like ashort stock position.\nHere, the put value rises by the average delta value between each incremental change in the stock price.\nThese examples illustrate the effect of gamma on an option without discussing the impact on the trader’sposition. When traders buy options, they acquire positive gamma. Since gamma causes options to gain value at afaster rate and lose value at aslower rate, (positive) gamma helps the option buyer. Atrader buying one call or put in these examples would have +0.04 gamma. Buying 10 of these options would give the trader a +0.4 gamma.\nWhen traders sell options, gamma works against them. When options lose value, they move toward zero at aslower rate. When the underlying moves adversely, gamma speeds up losses. Selling options yields anegative gamma position. Atrader selling one of the above calls or puts would have −0.04 gamma per option.\nThe effect of gamma is less significant for small moves in the underlying than it is for bigger moves. On proportionately large moves, the delta can change quite abit, making abig difference in the position’s P&(L). In\nExhibit 2.1\n, the left side of the diagram showed the call price not increasing at all with advances in the stock—a 0 delta. The right side showed the option advancing in price 1-to-1 with the stock—a 1.00 delta. Between the two extremes, the delta changes. From this diagram another definition for gamma can be inferred: gamma is the second derivative of the graph of the option price relative to the stock price. Put another way, gamma is the first derivative of agraph of the delta relative to the stock price.\nExhibit 2.5\nillustrates the delta of acall relative to the stock price.\nEXHIBIT 2.5\nCall delta compared with stock price.\nNot only does the delta change, but it changes at achanging rate. Gamma is not constant. Moneyness, time to expiration, and volatility each have an effect on the gamma of an option.\nDynamic Gamma\nWhen options are far in-the-money or out-of-the-money, they are either 1.00 delta or 0 delta. At the extremes, small changes in the stock price will not cause the delta to change much. When an option is at-the-money, it’sadifferent story. Its delta can change very quickly.\nITM and OTM options have alow gamma.\nATM options have arelatively high gamma.\nExhibit 2.6\nis an example of how moneyness translates into gamma on QQQ calls.\nEXHIBIT 2.6\nGamma of QQQ calls with QQQ at $44.\nWith QQQ at $44, 92 days until expiration, and aconstant volatility input of 19 percent, the 36- and 54-strike calls are far enough in- and out-of-the-money, respectively, that if the Qs move asmall amount in either di", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00011.html", "doc_id": "82fb802f36575b30d74498f7e8de3c48bfd1c163e04cc86ad41dea8c765fcb67", "chunk_index": 4}
{"text": "anslates into gamma on QQQ calls.\nEXHIBIT 2.6\nGamma of QQQ calls with QQQ at $44.\nWith QQQ at $44, 92 days until expiration, and aconstant volatility input of 19 percent, the 36- and 54-strike calls are far enough in- and out-of-the-money, respectively, that if the Qs move asmall amount in either direction from the current price of $44, the movement won’tchange their deltas much at all. The chances of their money status changing between now and expiration would not be significantly different statistically given asmall stock price change. They have the smallest gammas in the table.\nThe highest gammas shown here are around the ATM strike prices. (Note that because of factors not yet discussed, the strike that is exactly at-the-money may not have the highest gamma. The highest gamma is likely to occur at aslightly higher strike price.)\nExhibit 2.7\nshows agraph of the corresponding numbers in\nExhibit 2.6\n.\nEXHIBIT 2.7\nOption gamma.\nAdecrease in the time to expiration solidifies the likelihood of ITMs or OTMs remaining as such. But an ATM option’smoneyness at expiration remains to the very end uncertain. As expiration draws nearer, the gamma decreases for ITMs and OTMs and increases for the ATM strikes.\nExhibit 2.8\nshows the same 92-day QQQ calls plotted against 7-day QQQ calls.\nEXHIBIT 2.8\nGamma as time passes.\nAt seven days until expiration, there is less time for price action in the stock to change the expected moneyness at expiration of ITMs or OTMs. ATM options, however, continue to be in play. Here, the ATM gamma is approaching 0.35. But the strikes below 41 and above 48 have 0 gamma.\nSimilarly-priced securities that tend to experience bigger price swings may have strikes $3 away-from-the-money with seven-day gammas greater than zero. The volatility of the underlying will affect gamma, too.\nExhibit 2.9\nshows the same 19 percent volatility QQQ calls in contrast with agraph of the gamma if the volatility is doubled.\nEXHIBIT 2.9\nGamma as volatility changes.\nRaising the volatility assumption flattens the curve, causing ITM and OTM to have higher gamma while lowering the gamma for ATMs.\nShort-term ATM options with low volatility have the highest gamma. Lower gamma is found in ATMs when volatility is higher and it is lower for ITMs and OTMs and in longer-dated options.\nTheta\nOption prices can be broken down into two parts: intrinsic value and time value. Intrinsic value is easily measurable. It is simply the ITM part of the premium. Time value, or extrinsic value, is what’sleft over—the premium paid over parity for the option. All else held constant, the more time left in the life of the option, the more valuable it is—there is more time for the stock to move. And as the useful life of an option decreases, so does its time value.\nThe decline in the value of an option because of the passage of time is called time decay, or erosion. Incremental measurements of time decay are represented by the Greek letter theta (θ).\nTheta is the rate of change in an option’sprice given aunit change in the time to expiration\n. What exactly is the\nunit\ninvolved here? That depends.\nSome providers of option greeks will display thetas that represent one day’sworth of time decay. Some will show thetas representing seven days of decay. In the case of aone-day theta, the figure may be based on aseven-day week or on aweek counting only trading days. The most common and, arguably, most useful display of this figure is the one-day theta based on the seven-day week. There are, after all, seven days in aweek, each day of which can see an occurrence with the potential to cause arevaluation in the stock price (that is, news can come out on Saturday or Sunday). The one-day theta based on aseven-day week will be used throughout this book.\nTaking the Day Out\nWhen the number of days to expiration used in the pricing model declines from, say, 32 days to 31 days, the price of the option decreases by the amount of the theta, all else held constant. But when is the day “taken out”? It is intuitive to think that after the market closes, the model is changed to reflect the passing of one day’stime. But, in fact, this change is logically anticipated and may be priced in early.\nIn the earlier part of the week, option prices can often be observed getting cheaper relative to the stock price sometime in the middle of the day. This is because traders will commonly take the day out of their model during trading hours after the underlying stabilizes following the morning business. On Fridays and sometimes Thursdays, traders will take all or part of the weekend out. Commonly, by Friday afternoon, traders will be using Monday’sdays to value their options.\nWhen option prices are seen getting cheaper on, say, a Friday, how can one tell whether this is the effect of the market taking the weekend out or achange in some other input, such as volatility? To some degree, it doesn’tmatter. Remember, the model is used to reflect what the market is doing, not the other way a", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00011.html", "doc_id": "82fb802f36575b30d74498f7e8de3c48bfd1c163e04cc86ad41dea8c765fcb67", "chunk_index": 5}
{"text": "ices are seen getting cheaper on, say, a Friday, how can one tell whether this is the effect of the market taking the weekend out or achange in some other input, such as volatility? To some degree, it doesn’tmatter. Remember, the model is used to reflect what the market is doing, not the other way around. In many cases, it’slogical to presume that small devaluations in option prices intraday can be attributed to the routine of the market taking the day out.\nFriend or Foe?\nTheta can be agood thing or abad thing, depending on the position. Theta hurts long option positions; whereas it helps short option positions. Take an 80-strike call with atheoretical value of 3.16 on astock at $82 ashare. The 32-day 80 call has atheta of 0.03. If atrader owned one of these calls, the trader’sposition would theoretically lose 0.03, or $0.03, as the time until expiration change from 32 to 31 days. This trader has anegative theta position. Atrader short one of these calls would have an overnight theoretical profit of $0.03 attributed to theta. This trader would have apositive theta.\nTheta affects put traders as well. Using all the same modeling inputs, the 32-day 80-strike put would have atheta of 0.02. Aput holder would theoretically lose $0.02 aday, and aput writer would theoretically make $0.02. Long options carry with them negative theta; short options carry positive theta.\nAhigher theta for the call than for the put of the same strike price is common when an interest rate greater than zero is used in the pricing model. As will be discussed in greater detail in the section on rho, interest causes the time value of the call to be higher than that of the corresponding put. At expiration, there is no time value left in either option. Because the call begins with more time value, its premium must decline at afaster rate than that of the put. Most modeling software will attribute the disparate rates of decline in value all to theta, whereas some modeling interfaces will make clear the distinction between the effect of time decay and the effect of interest on the put-call pair.\nThe Effect of Moneyness and Stock Price on Theta\nTheta is not aconstant. As variables influencing option values change, theta can change, too. One such variable is the option’smoneyness.\nExhibit 2.10\nshows theoretical values (theos), time values, and thetas for 3-month options on Adobe (ADBE). In this example, Adobe is trading at $31.30 ashare with three months until expiration. The more ITM acall or aput gets, the higher its theoretical value. But when studying an option’stime decay, one needs to be concerned only with the option’stime value, because intrinsic value is not subject to time decay.\nEXHIBIT 2.10\nAdobe theos and thetas (Adobe at $31.30).\nThe ATM options shown here have higher time value than ITM or OTM options. Hence, they have more time premium to lose in the same three-month period. ATM options have the highest rate of decay, which is reflected in higher thetas. As the stock price changes, the theta value will change to reflect its change in moneyness.\nIf this were ahigher-priced stock, say, 10 times the stock price used in this example, with all other inputs held constant, the option values, and therefore the thetas, would be higher. If this were astock trading at $313, the 325-strike call would have atheoretical value of 16.39 and aone-day theta of 0.189, given inputs used otherwise identical to those in the Adobe example.\nThe Effects of Volatility and Time on Theta\nStock price is not the only factor that affects theta values. Volatility and time to expiration come into play here as well. The volatility input to the pricing model has adirect relationship to option values. The higher the volatility, the higher the value of the option. Higher-valued options decay at afaster rate than lower-valued options—they have to; their time values will both be zero at expiration. All else held constant, the higher the volatility assumption, the higher the theta.\nThe days to expiration have adirect relationship to option values as well. As the number of days to expiration decreases, the rate at which an option decays may change, depending on the relationship of the stock price to the strike price. ATM options tend to decay at anonlinear rate—that is, they lose value faster as expiration approaches—whereas the time values of ITM and OTM options decay at asteadier rate.\nConsider ahypothetical stock trading at $70 ashare.\nExhibit 2.11\nshows how the theoretical values of the 75-strike call and the 70-strike call decline with the passage of time, holding all other parameters constant.\nEXHIBIT 2.11\nRate of decay: ATM vs. OTM.\nThe OTM 75-strike call has afairly steady rate of time decay over this 26-week period. The ATM 70-strike call, however, begins to lose its value at an increasing rate as expiration draws nearer. The acceleration of premium erosion continues until the option expires.\nExhibit 2.12\nshows the thetas for this ATM call during the last 10 day", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00011.html", "doc_id": "82fb802f36575b30d74498f7e8de3c48bfd1c163e04cc86ad41dea8c765fcb67", "chunk_index": 6}
{"text": "eady rate of time decay over this 26-week period. The ATM 70-strike call, however, begins to lose its value at an increasing rate as expiration draws nearer. The acceleration of premium erosion continues until the option expires.\nExhibit 2.12\nshows the thetas for this ATM call during the last 10 days before expiration.\nEXHIBIT 2.12\nTheta as expiration approaches.\nDays to Exp\n.\nATM Theta\n10\n0.075\n9\n0.079\n8\n0.084\n7\n0.089\n6\n0.096\n5\n0.106\n4\n0.118\n3\n0.137\n2\n0.171\n1\n0.443\nIncidentally, in this example, when there is one day to expiration, the theoretical value of this call is about 0.44. The final day before expiration ultimately sees the entire time premium erode.\nVega\nOver the past decade or so, computers have revolutionized option trading. Options traded through an online broker are filled faster than you can say, “Oops! Imeant to click on puts.” Now trading is facilitated almost entirely online by professional and retail traders alike. Market and trading information is disseminated worldwide in subseconds, making markets all the more efficient. And the tools now available to the common retail trader are very powerful as well. Many online brokers and other web sites offer high-powered tools like screeners, which allow traders to sift through thousands of options to find those that fit certain parameters.\nUsing ascreener to find ATM calls on same-priced stocks—say, stocks trading at $40 ashare—can yield aresult worth talking about here. One $40 stock can have a 40-strike call trading at around 0.50, while adifferent $40 stock can have a 40 call with the same time to expiration trading at more like 2.00. Why? The model doesn’tknow the name of the company, what industry it’sin, or what its price-to-earnings ratio is. It is amathematical equation with six inputs. If five of the inputs—the stock price, strike price, time to expiration, interest rate, and dividends—are identical for two different options but they’re trading at different prices, the difference must be the sixth variable, which is volatility.\nImplied Volatility (IV) and Vega\nThe volatility component of option values is called implied volatility (IV). (For more on implied volatility and how it relates to vega, see Chapter 3.) IV is apercentage, although in practice the percent sign is often omitted. This is the value entered into apricing model, in conjunction with the other variables, that returns the option’stheoretical value. The higher the volatility input, the higher the theoretical value, holding all other variables constant. The IV level can change and often does—sometimes dramatically. When IV rises or falls, option prices rise and fall in line with it. But by how much?\nThe relationship between changes in IV and changes in an option’svalue is measured by the option’svega.\nVega is the rate of change of an option’stheoretical value relative to achange in implied volatility\n. Specifically, if the IV rises or declines by one percentage point, the theoretical value of the option rises or declines by the amount of the option’svega, respectively. For example, if acall with atheoretical value of 1.82 has avega of 0.06 and IV rises one percentage point from, say, 17 percent to 18 percent, the new theoretical value of the call will be 1.88—it would rise by 0.06, the amount of the vega. If, conversely, the IV declines 1 percentage point, from 17 percent to 16 percent, the call value will drop to 1.76—that is, it would decline by the vega.\nAput with the same expiration month and the same strike on the same underlying will have the same vega value as its corresponding call. In this example, raising or lowering IV by one percentage point would cause the corresponding put value to rise or decline by $0.06, just like the call.\nAn increase in IV and the consequent increase in option value helps the P&(L) of long option positions and hurts short option positions. Buying acall or aput establishes along vega position. For short options, the opposite is true. Rising IV adversely affects P&(L), whereas falling IV helps. Shorting acall or put establishes ashort vega position.\nThe Effect of Moneyness on Vega\nLike the other greeks, vega is asnapshot that is afunction of multiple facets of determinants influencing option value. The stock price’srelationship to the strike price is amajor determining factor of an option’svega. IV affects only the time value portion of an option. Because ATM options have the greatest amount of time value, they will naturally have higher vegas. ITM and OTM options have lower vega values than those of the ATM options.\nExhibit 2.13\nshows an example of 186-day options on AT&T Inc. (T), their time value, and the corresponding vegas.\nEXHIBIT 2.13\nAT&Ttheos and vegas (Tat $30, 186 days to Expry, 20% IV).\nNote that the 30-strike calls and puts have the highest time values. This strike boasts the highest vega value, at 0.085. The lower the time premium, the lower the vega—therefore, the less incremental IV changes affect the option. Since higher-pr", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00011.html", "doc_id": "82fb802f36575b30d74498f7e8de3c48bfd1c163e04cc86ad41dea8c765fcb67", "chunk_index": 7}
{"text": "theos and vegas (Tat $30, 186 days to Expry, 20% IV).\nNote that the 30-strike calls and puts have the highest time values. This strike boasts the highest vega value, at 0.085. The lower the time premium, the lower the vega—therefore, the less incremental IV changes affect the option. Since higher-priced stocks have higher time premium (in absolute terms, not necessarily in percentage terms) they will have higher vega. Incidentally, if this were a $300 stock instead of a $30 stock, the 186-day ATMs would have a 0.850 vega, if all other model inputs remain the same.\nThe Effect of Implied Volatility on Vega\nThe distribution of vega values among the strike prices shown in\nExhibit 2.13\nholds for aspecific IV level. The vegas in\nExhibit 2.13\nwere calculated using a 20 percent IV. If adifferent IV were used in the calculation, the relationship of the vegas to one another might change.\nExhibit 2.14\nshows what the vegas would be at different IV levels.\nEXHIBIT 2.14\nVega and IV.\nNote in\nExhibit 2.14\nthat at all three IV levels, the ATM strike maintains asimilar vega value. But the vegas of the ITM and OTM options can be significantly different. Lower IV inputs tend to cause ITM and OTM vegas to decline. Higher IV inputs tend to cause vegas to increase for ITMs and OTMs.\nThe Effect of Time on Vega\nAs time passes, there is less time premium in the option that can be affected by changes in IV. Consequently, vega gets smaller as expiration approaches.\nExhibit 2.15\nshows the decreasing vega of a 50-strike call on a $50 stock with a 25 percent IV as time to expiration decreases. Notice that as the value of this ATM option decreases at its nonlinear rate of decay, the vega decreases in asimilar fashion.\nEXHIBIT 2.15\nThe effect of time on vega.\nRho\nOne of my early jobs in the options business was clerking on the floor of the Chicago Board of Trade in what was called the bond room. On one of my first days on the job, the trader Iworked for asked me what his position was in acertain strike. Itold him he was long 200 calls and long 300 puts. “I’mlong 500 puts?” he asked. “No,” Icorrected, “you’re long 200 calls and 300 puts.” At this point, he looked at me like Iwas from another planet and said, “That’s 500. Aput is acall; acall is aput.” That lesson was the beginning of my journey into truly understanding options.\nPut-Call Parity\nPut and call values are mathematically bound together by an equation referred to as put-call parity. In its basic form, put-call parity states:\nwhere\nc\n= call value,\nPV(x)\n= present value of the strike price,\np\n= put value, and\ns\n= stock price.\nThe put-call parity assumes that options are not exercised before expiration (that is, that they are European style). This version of the put-call parity is for European options on non-dividend-paying stocks. Put-call parity can be modified to reflect the values of options on stocks that pay dividends. In practice, equity-option traders look at the equation in aslightly different way:\nTraders serious about learning to trade options must know put-call parity backward and forward. Why? First, by algebraically rearranging this equation, it can be inferred that synthetically equivalent positions can be established by simply adding stock to an option. Again, aput is acall; acall is aput.\nand\nFor example, along call is synthetically equal to along stock position plus along put on the same strike, once interest and dividends are figured in. Asynthetic long stock position is created by buying acall and selling aput of the same month and strike. Understanding synthetic relationships is intrinsic to understanding options. Amore comprehensive discussion of synthetic relationships and tactical considerations for creating synthetic positions is offered in Chapter 6.\nPut-call parity also aids in valuing options. If put-call parity shows adifference in the value of the call versus the value of the put with the same strike, there may be an arbitrage opportunity. That translates as “riskless profit.” Buying the call and selling it synthetically (short put and short stock) could allow aprofit to be locked in if the prices are disparate. Arbitrageurs tend to hold synthetic put and call prices pretty close together. Generally, only professional traders can capture these types of profit opportunities, by trading big enough positions to make very small profits (apenny or less per contract sometimes) matter. Retail traders may be able to take advantage of adisparity in put and call values to some extent, however, by buying or selling the synthetic as asubstitute for the actual option if the position can be established at abetter price synthetically.\nAnother reason that aworking knowledge of put-call parity is essential is that it helps attain abetter understanding of how changes in the interest rate affect option values. The greek rho measures this change. Rho is the rate of change in an option’svalue relative to achange in the interest rate.\nAlthough some modeling programs may displ", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00011.html", "doc_id": "82fb802f36575b30d74498f7e8de3c48bfd1c163e04cc86ad41dea8c765fcb67", "chunk_index": 8}
{"text": "f put-call parity is essential is that it helps attain abetter understanding of how changes in the interest rate affect option values. The greek rho measures this change. Rho is the rate of change in an option’svalue relative to achange in the interest rate.\nAlthough some modeling programs may display this number differently, most display arho for the call and arho for the put, both illustrating the sensitivity to aone-percentage-point change in the interest rate. When the interest rate rises by one percentage point, the value of the call increases by the amount of its rho and the put decreases by the amount of its rho. Likewise, when the interest rate decrease by one percentage point, the value of the call decreases by its rho and the put increases by its rho. For example, acall with arho of 0.12 will increase $0.12 in value if the interest rate used in the model is increased by one percentage point. Of course, interest rates usually don’trise or fall one percentage point in one day. More commonly, rates will have incremental changes of 25 basis points. That means acall with a 0.12 rho will theoretically gain $0.03 given an increase of 0.25 percentage points.\nMathematically, this change in option value as aproduct of achange in the interest rate makes sense when looking at the formula for put-call parity.\nand\nBut the change makes sense intuitively, too, when acall is considered as acheaper substitute for owning the stock. For example, compare a $100 stock with athree-month 60-strike call on that same stock. Being so far ITM, there would likely be no time value in the call. If the call can be purchased at parity, which alternative would be asuperior investment, the call for $40 or the stock for $100? Certainly, the call would be. It costs less than half as much as the stock but has the same reward potential; and the $60 not spent on the stock can be invested in an interest-bearing account. This interest advantage adds value to the call. Raising the interest rate increases this value, and lowering it decreases the interest component of the value of the call.\nAsimilar concept holds for puts. Professional traders often get ashort-stock rebate on proceeds from ashort-stock sale. This is simply interest earned on the capital received when the stock is shorted. Is it better to pay interest on the price of aput for aposition that gives short exposure or to receive interest on the credit from shorting the stock? There is an interest disadvantage to owning the put. Therefore, arise in interest rates devalues puts.\nThis interest effect becomes evident when comparing ATM call and put prices. For example, with interest at 5 percent, three-month options on an $80 stock that pays a $0.25 dividend before option expiration might look something like this:\nThe ATM call is higher in theoretical value than the ATM put by $0.75. That amount can be justified using put-call parity:\n(Here, simple interest of $1 is calculated as 80 × 0.05 × [90 / 360] = 1.)\nChanges in market conditions are kept in line by the put-call parity. For example, if the price of the call rises because of an increase in IV, the price of the put will rise in step. If the interest rate rises by aquarter of apercentage point, from 5 percent to 5.25 percent, the interest calculated for three months on the 80-strike will increase from $1 to $1.05, causing the difference between the call and put price to widen. Another variable that affects the amount of interest and therefore option prices is the time until expiration.\nThe Effect of Time on Rho\nThe more time until expiration, the greater the effect interest rate changes will have on options. In the previous example, a 25-basis-point change in the interest rate on the 80-strike based on athree-month period caused achange of 0.05 to the interest component of put-call parity. That is, 80 × 0.0025 × (90/360) = 0.05. If alonger period were used in the example—say, one year—the effect would be more profound; it will be $0.20: 80 × 0.0025 × (360/360) = 0.20. This concept is evident when the rhos of options with different times to expiration are studied.\nExhibit 2.16\nshows the rhos of ATM Procter & Gamble Co. (PG) calls with various expiration months. The 750-day Long-Term Equity AnticiPation Securities (LEAPS) have arho of 0.858. As the number of days until expiration decreases, rho decreases. The 22-day calls have arho of only 0.015. Rho is usually afairly insignificant factor in the value of short-term options, but it can come into play much more with long-term option strategies involving LEAPS.\nEXHIBIT 2.16\nThe effect of time on rho (Procter & Gamble @ $64.34)\nWhy the Numbers Don’t Don’t Always Add Up\nThere will be many times when studying the rho of options in an option chain will reveal seemingly counterintuitive results. To be sure, the numbers don’talways add up to what appears logical. One reason for this is rounding. Another is that traders are more likely to use simple interest in calculating value, whereas t", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00011.html", "doc_id": "82fb802f36575b30d74498f7e8de3c48bfd1c163e04cc86ad41dea8c765fcb67", "chunk_index": 9}
{"text": "imes when studying the rho of options in an option chain will reveal seemingly counterintuitive results. To be sure, the numbers don’talways add up to what appears logical. One reason for this is rounding. Another is that traders are more likely to use simple interest in calculating value, whereas the model uses compound interest. Hard-to-borrow stocks and stocks involved in mergers and acquisitions may have put-call parities that don’twork out right. But another, more common and more significant fly in the ointment is early exercise.\nSince the interest input in put-call parity is afunction of the strike price, it is reasonable to expect that the higher the strike price, the greater the effect of interest on option prices will be. For European options, this is true to alarge extent, in terms of aggregate impact of interest on the call and put pair. Strikes below the price where the stock is trading have ahigher rho associated with the call relative to the put, whereas strikes above the stock price have ahigher rho associated with the put relative to the call. Essentially, the more in-the-money an option is, the higher its rho. But with European options, observing the aggregate of the absolute values of the call and put rhos would show ahigher combined rho the higher the strike.\nWith American options, the put can be exercised early. Atrader will exercise aput before expiration if the alternative—being short stock and receiving ashort stock rebate—is awiser choice based on the price of the put. Professional traders may own stock as ahedge against aput. They may exercise deep ITM puts (1.00-delta puts) to avoid paying interest on capital charges related to the stock. The potential for early exercise is factored into models that price American options. Here, when puts get deeper in-the-money—that is, more apt to be exercised—the rho decreases. When the strike price is very high relative to the stock price—meaning the put is very deep ITM—and there is little or no time value left to the call or the put, the aggregate put-call rho can be zero. Rho is discussed in greater detail in Chapter 7.\nTHE GREEKS DEFINED\nDelta\n(Δ) is:\n1. The rate of change in an option’svalue relative to achange in the underlying asset price.\n2. The derivative of the graph of an option’svalue in relation to the underlying asset price.\n3. The equivalent of underlying asset represented by an option position.\n4. The estimate of the likelihood of an option’sexpiring in-the-money.\nGamma\n(Γ) is the rate of change in an option’sdelta given achange in the price of the underlying asset.\nTheta\n(θ) is the rate of change in an option’svalue given aunit change in the time to expiration.\nVega\nis the rate of change in an option’svalue relative to achange in implied volatility.\nRho\n(ρ) is the rate of change in an option’svalue relative to achange in the interest rate.\nWhere to Find Option Greeks\nThere are many sources from which to obtain greeks. The Internet is an excellent resource. Googling “option greeks” will display links to over four million web pages, many of which have real-time greeks or an option calculator. An option calculator is asimple interface that accepts the input of the six variables to the model and yields atheoretical value and the greeks for asingle option.\nSome web sites devoted to option education, such as\nMarketTaker.com/option_modeling\n, have free calculators that can be used for modeling positions and using the greeks.\nIn practice, many of the option-trading platforms commonly in use have sophisticated analytics that involve greeks. Most options-friendly online brokers provide trading platforms that enable traders to conduct comprehensive manipulations of the greeks. For example, traders can look at the greeks for their positions up or down one, two, or three standard deviations. Or they can see what happens to their position greeks if IV or time changes. With many trading platforms, position greeks are updated in real time with changes in the stock price—an invaluable feature for active traders.\nCaveats with Regard to Online Greeks\nOften, online greeks are one click away, requiring little effort on the part of the trader. Having greeks calculated automatically online is aquick and convenient way to eyeball greeks for an option. But there is one major problem with online greeks: reliability.\nFor active option traders, greeks are essential. There is no point in using these figures if their accuracy cannot be assured. Experienced traders can often spot these inaccuracies aproverbial mile away.\nWhen looking at greeks from an online source that does not require you to enter parameters into amodel (as would be the case with professional option-trading platforms), special attention needs to be paid to the relationship of the option’stheoretical values to the bid and offer. One must be cautious if the theoretical value of the option lies outside the bid-ask spread. This scenario can exist for brief periods of time, but arbitrageurs ten", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00011.html", "doc_id": "82fb802f36575b30d74498f7e8de3c48bfd1c163e04cc86ad41dea8c765fcb67", "chunk_index": 10}
{"text": "tion-trading platforms), special attention needs to be paid to the relationship of the option’stheoretical values to the bid and offer. One must be cautious if the theoretical value of the option lies outside the bid-ask spread. This scenario can exist for brief periods of time, but arbitrageurs tend to prevent this from occurring routinely. If several options in achain all have theoretical values below the bid or above the offer, there is probably aproblem with one or more of the inputs used in the model. Remember, an option-pricing model is just that: amodel. It reflects what is occurring in the market. It doesn’ttell where an option should be trading.\nThe complex changes that occur intraday in the market—taking the day or weekend out, changes in stock price, volatility, and the interest rate—are not always kept current. The user of the model must keep close watch. It’snot reasonable to expect the computer to do the thinking for you. Automatically calculated greeks can be used as astarting point. But before using these figures in the decision-making process, the trader may have to override the parameters that were used in the online calculation to make the theos line up with market prices. Professional traders will ignore online greeks altogether. They will use the greeks that are products of the inputs they entered in their trading software. It comes down to this: if you want something done right, do it yourself.\nThinking Greek\nThe challenge of trading option greeks is to adapt to thinking in terms of delta, gamma, theta, vega, and rho. One should develop afeel for how greeks react to changing market conditions. Greeks need to be monitored as closely as and in some cases more closely than the option’sprice itself. This greek philosophy forms the foundation of option trading for active traders. It offers alogical way to monitor positions and provides amedium in and of itself to trade.\nNotes\n1\n. Please note that definition 4 is not necessarily mathematically accurate. This “trader’sdefinition” is included in the text because many option traders use delta as aquick rule of thumb for estimating probability without regard to the mathematical shortcomings of doing so.\n2\n. Note that the interest input in the equation is the interest, in dollars and cents, on the strike. Technically, this would be calculated as compounded interest, but in practice many traders use simple interest as aquick and convenient way to do the calculation.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00011.html", "doc_id": "82fb802f36575b30d74498f7e8de3c48bfd1c163e04cc86ad41dea8c765fcb67", "chunk_index": 11}
{"text": "CHAPTER 3\nUnderstanding Volatility\nMost option strategies involve trading volatility in one way or another. It’seasy to think of trading in terms of direction. But trading volatility? Volatility is an abstract concept; it’sadifferent animal than the linear trading paradigm used by most conventional market players. As an option trader, it is essential to understand and master volatility.\nMany traders trade without asolid understanding of volatility and its effect on option prices. These traders are often unhappily surprised when volatility moves against them. They mistake the adverse option price movements that result from volatility for getting ripped off by the market makers or some other market voodoo. Or worse, they surrender to the fact that they simply don’tunderstand why sometimes these unexpected price movements occur in options. They accept that that’sjust the way it is.\nPart of what gets in the way of aready understanding of volatility is context. The term\nvolatility\ncan have afew different meanings in the options business. There are three different uses of the word\nvolatility\nthat an option trader must be concerned with: historical volatility, implied volatility, and expected volatility.\nHistorical Volatility\nImagine there are two stocks: Stock Aand Stock B. Both are trading at around $100 ashare. Over the past month, atypical end-of-day net change in the price of Stock Ahas been up or down $5 to $7. During that same period, atypical daily move in Stock Bhas been something more like up or down $1 or $2. Stock Ahas tended to move more than Stock Bas apercentage of its price, without regard to direction. Therefore, Stock Ais more volatile—in the common usage of the word—than Stock B. In the options vernacular, Stock Ahas ahigher historical volatility than Stock B. Historical volatility (HV) is the annualized standard deviation of daily returns. Also called\nrealized volatility, statistical volatility\n, or\nstock volatility\n, HV is ameasure of how volatile the price movement of asecurity has been during acertain period of time. But exactly how much higher is Stock A’s HV than Stock B’s?\nIn order to objectively compare the volatilities of two stocks, historical volatility must be quantified. HV relates this volatility information in an objective numerical form. The volatility of astock is expressed in terms of standard deviation.\nStandard Deviation\nAlthough knowing the mathematical formula behind standard deviation is not entirely necessary, understanding the concept is essential. Standard deviation, sometimes represented by the Greek letter sigma (σ), is amathematical calculation that measures the dispersion of data from amean value. In this case, the mean is the average stock price over acertain period of time. The farther from the mean the dispersion of occurrences (data) was during the period, the greater the standard deviation.\nOccurrences, in this context, are usually the closing prices of the stock. Some utilizers of volatility data may use other inputs (aweighted average of high, low, and closing prices, for example) in calculating standard deviation. Close-to-close price data are the most commonly used.\nThe number of occurrences, afunction of the time period, used in calculating standard deviation may vary. Many online purveyors of this data use the closing prices from the last 30 consecutive trading days to calculate HV. Weekends and holidays are not factored into the equation since there is no trading, and therefore no volatility, when the market isn’topen. After each day, the oldest price is taken out of the calculation and replaced by the most recent closing price. Using ashorter or longer period can yield different results and can be useful in studying astock’svolatility.\nKnowing the number of days used in the calculation is crucial to understanding what the output represents. For example, if the last 5 trading days were extremely volatile, but the 25 days prior to that were comparatively calm, the 5-day standard deviation would be higher than the 30-day standard deviation.\nStandard deviation is stated as apercentage move in the price of the asset. If a $100 stock has astandard deviation of 15 percent, aone-standard-deviation move in the stock would be either $85 or $115—a 15 percent move in either direction. Standard deviation is used for comparison purposes. Astock with astandard deviation of 15 percent has experienced bigger moves—has been more volatile—during the relevant time period than astock with astandard deviation of 6 percent.\nWhen the frequency of occurrences are graphed, the result is known as adistribution curve. There are many different shapes that adistribution curve can take, depending on the nature of the data being observed. In general, option-pricing models assume that stock prices adhere to alognormal distribution.\nThe shape of the distribution curve for stock prices has long been the topic of discussion among traders and academics alike. Regardless of what the true sh", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00012.html", "doc_id": "3a969a4c4121429c38de967f302584d7e4637f8ef6b6a9d996f046570a20e8c8", "chunk_index": 0}
{"text": "pending on the nature of the data being observed. In general, option-pricing models assume that stock prices adhere to alognormal distribution.\nThe shape of the distribution curve for stock prices has long been the topic of discussion among traders and academics alike. Regardless of what the true shape of the curve is, the concept of standard deviation applies just the same. For the purpose of illustrating standard deviation, anormal distribution is used here.\nWhen the graph of data adheres to anormal distribution, the result is asymmetrical bell-shaped curve. Standard deviation can be shown on the bell curve to either side of the mean.\nExhibit 3.1\nrepresents atypical bell curve with standard deviation.\nEXHIBIT 3.1\nStandard deviation.\nLarge moves in asecurity are typically less frequent than small ones. Events that cause big changes in the price of astock, like acompany’sbeing acquired by another or discovering its chief financial officer cooking the books, are not adaily occurrence. Comparatively smaller price fluctuations that reflect less extreme changes in the value of the corporation are more typically seen day to day. Statistically, the most probable outcome for aprice change is found around the midpoint of the curve. What constitutes alarge move or asmall move, however, is unique to each individual security. For example, atwo percent move in an index like the Standard & Poor’s (S&P) 500 may be considered abig one-day move, while atwo percent move in aparticularly active tech stock may be adaily occurrence. Standard deviation offers astatistical explanation of what constitutes atypical move.\nIn\nExhibit 3.1\n, the lines to either side of the mean represent one standard deviation. About 68 percent of all occurrences will take place between up one standard deviation and down one standard deviation. Two- and three-standard-deviation values could be shown on the curve as well. About 95 percent of data occur between up and down two standard deviations and about 99.7 percent between up and down three standard deviations. One standard deviation is the relevant figure in determining historical volatility.\nStandard Deviation and Historical Volatility\nWhen standard deviation is used in the context of historical volatility, it is annualized to state what the one-year volatility would be. Historical volatility is the annualized standard deviation of daily returns. This means that if astock is trading at $100 ashare and its historical volatility is 10 percent, then about 68 percent of the occurrences (closing prices) are expected to fall between $90 and $110 during aone-year period (based on recent past performance).\nSimply put, historical volatility shows how volatile astock has been based on price movements that have occurred in the past. Although option traders may study HV to make informed decisions as to the value of options traded on astock, it is not adirect function of option prices. For this, we must look to implied volatility.\nImplied Volatility\nVolatility is one of the six inputs of an option-pricing model. Some of the other inputs—strike price, stock price, the number of days until expiration, and the current interest rate—are easily observable. Past dividend policy allows an educated guess as to what the dividend input should be. But where can volatility be found?\nAs discussed in Chapter 2, the output of the pricing model—the option’stheoretical value—in practice is not necessarily an output at all. When option traders use the pricing model, they commonly substitute the actual price at which the option is trading for the theoretical value. Avalue in the middle of the bid-ask spread is often used. The pricing model can be considered to be acomplex algebra equation in which any variable can be solved for. If the theoretical value is known—which it is—it along with the five known inputs can be combined to solve for the unknown volatility.\nImplied volatility (IV) is the volatility input in apricing model that, in conjunction with the other inputs, returns the theoretical value of an option matching the market price.\nFor aspecific stock price, agiven implied volatility will yield aunique option value. Take astock trading at $44.22 that has the 60-day 45-strike call at atheoretical value of $1.10 with an 18 percent implied volatility level. If the stock price remains constant, but IV rises to 19 percent, the value of the call will rise by its vega, which in this case is about 0.07. The new value of the call will be $1.17. Raising IV another point, to 20 percent, raises the theoretical value by another $0.07, to $1.24. The question is: What would cause implied volatility to change?\nSupply and Demand: Not Just a Good Idea, It’sthe Law!\nOptions are an excellent vehicle for speculation. However, the existence of the options market is better justified by the primary economic purpose of options: as arisk management tool. Hedgers use options to protect their assets from adverse price movements, and when the percepti", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00012.html", "doc_id": "3a969a4c4121429c38de967f302584d7e4637f8ef6b6a9d996f046570a20e8c8", "chunk_index": 1}
{"text": "Idea, It’sthe Law!\nOptions are an excellent vehicle for speculation. However, the existence of the options market is better justified by the primary economic purpose of options: as arisk management tool. Hedgers use options to protect their assets from adverse price movements, and when the perception of risk increases, so does demand for this protection. In this context, risk means volatility—the potential for larger moves to the upside and downside. The relative prices of options are driven higher by increased demand for protective options when the market anticipates greater volatility. And option prices are driven lower by greater supply—that is, selling of options—when the market expects lower volatility. Like those of all assets, option prices are subject to the law of supply and demand.\nWhen volatility is expected to rise, demand for options is not limited to hedgers. Speculative traders would arguably be more inclined to buy acall than to buy the stock if they are bullish but expect future volatility to be high. Calls require alower cash outlay. If the stock moves adversely, there is less capital at risk, but still similar profit potential.\nWhen volatility is expected to be low, hedging investors are less inclined to pay for protection. They are more likely to sell back the options they may have bought previously to recoup some of the expense. Options are adecaying asset. Investors are more likely to write calls against stagnant stocks to generate income in anticipated low-volatility environments. Speculative traders will implement option-selling strategies, such as short strangles or iron condors, in an attempt to capitalize on stocks they believe won’tmove much. The rising supply of options puts downward pressure on option prices.\nMany traders sum up IV in two words:\nfear\nand\ngreed\n. When option prices rise and fall, not because of changes in the stock price, time to expiration, interest rates, or dividends, but because of pure supply and demand, it is implied volatility that is the varying factor. There are many contributing factors to traders’ willingness to demand or supply options. Anticipation of events such as earnings reports, Federal Reserve announcements, or the release of other news particular to an individual stock can cause anxiety, or fear, in traders and consequently increase demand for options that causes IV to rise. IV can fall when there is complacency in the market or when the anticipated news has been announced and anxiety wanes. “Buy the rumor, sell the news” is often reflected in option implied volatility. When there is little fear of market movement, traders use options to squeeze out more profits—greed.\nArbitrageurs, such as market makers who trade delta neutral—astrategy that will be discussed further in Chapters 12 and 13—must be relentlessly conscious of implied volatility. When immediate directional risk is eliminated from aposition, IV becomes the traded commodity. Arbitrageurs who focus their efforts on trading volatility (colloquially called\nvol traders\n) tend to think about bids and offers in terms of IV. In the mind of avol trader, option prices are translated into volatility levels. Atrader may look at aparticular option and say it is 30 bid at 31 offer. These values do not represent the prices of the options but rather the corresponding implied volatilities. The meaning behind the trader’sremark is that the market is willing to buy implied volatility at 30 percent and sell it at 31 percent. The actual prices of the options themselves are much less relevant to this type of trader.\nShould HV and IV Be the Same?\nMost option positions have exposure to volatility in two ways. First, the profitability of the position is usually somewhat dependent on movement (or lack of movement) of the underlying security. This is exposure to HV. Second, profitability can be affected by changes in supply and demand for the options. This is exposure to IV. In general, along option position benefits when volatility—both historical and implied—increases. Ashort option position benefits when volatility—historical and implied—decreases. That said, buying options is buying volatility and selling options is selling volatility.\nThe Relationship of HV and IV\nIt’sintuitive that there should exist adirect relationship between the HV and IV. Empirically, this is often the case. Supply and demand for options, based on the market’sexpectations for asecurity’svolatility, determines IV.\nIt is easy to see why IV and HV often act in tandem. But, although HV and IV are related, they are not identical. There are times when IV and HV move in opposite directions. This is not so illogical, if one considers the key difference between the two: HV is calculated from past stock price movements; it is what has happened. IV is ultimately derived from the market’sexpectation for future volatility.\nIf astock typically has an HV of 30 percent and nothing is expected to change, it can be reasonable to expect that in th", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00012.html", "doc_id": "3a969a4c4121429c38de967f302584d7e4637f8ef6b6a9d996f046570a20e8c8", "chunk_index": 2}
{"text": "difference between the two: HV is calculated from past stock price movements; it is what has happened. IV is ultimately derived from the market’sexpectation for future volatility.\nIf astock typically has an HV of 30 percent and nothing is expected to change, it can be reasonable to expect that in the future the stock will continue to trade at a 30 percent HV. By that logic, assuming that nothing is expected to change, IV should be fairly close to HV. Market conditions do change, however. These changes are often regular and predictable. Earnings reports are released once aquarter in many stocks, Federal Open Market Committee meetings happen regularly, and dates of other special announcements are often disclosed to the public in advance. Although the outcome of these events cannot be predicted, when they will occur often can be. It is around these widely anticipated events that HV-IV divergences often occur.\nHV-IV Divergence\nAn HV-IV divergence occurs when HV declines and IV rises or vice versa. The classic example is often observed before acompany’squarterly earnings announcement, especially when there is lack of consensus among analysts’ estimates. This scenario often causes HV to remain constant or decline while IV rises. The reason? When there is agreat deal of uncertainty as to what the quarterly earnings will be, investors are reluctant to buy\nor\nsell the stock until the number is released. When this happens, the stock price movement (volatility) consolidates, causing the calculated HV to decline. IV, however, can rise as traders scramble to buy up options—bidding up their prices. When the news is out, the feared (or hoped for) move in the stock takes place (or doesn’t), and HV and IV tend to converge again.\nExpected Volatility\nWhether trading options or stocks, simple or complex strategies, traders must consider volatility. For basic buy-and-hold investors, taking apotential investment’svolatility into account is innate behavior. Do Ibuy conservative (nonvolatile) stocks or more aggressive (volatile) stocks? Taking into account volatility, based not just on agut feeling but on hard numbers, can lead to better, more objective trading decisions.\nExpected Stock Volatility\nOption traders must have an even greater focus on volatility, as it plays amuch bigger role in their profitability—or lack thereof. Because options can create highly leveraged positions, small moves can yield big profits or losses. Option traders must monitor the likelihood of movement in the underlying closely. Estimating what historical volatility (standard deviation) will be in the future can help traders quantify the probability of movement beyond acertain price point. This leads to better decisions about whether to enter atrade, when to adjust aposition, and when to exit.\nThere is no way of knowing for certain what the future holds. But option data provide traders with tools to develop expectations for future stock volatility. IV is sometimes interpreted as the market’sestimate of the future volatility of the underlying security. That makes it aready-made estimation tool, but there are two caveats to bear in mind when using IV to estimate future stock volatility.\nThe first is that the market can be wrong. The market can wrongly price stocks. This mispricing can lead to acorrection (up or down) in the prices of those stocks, which can lead to additional volatility, which may not be priced in to the options. Although there are traders and academics believe that the option market is fairly efficient in pricing volatility, there is aroom for error. There is the possibility that the option market can be wrong.\nAnother caveat is that volatility is an annualized figure—the annualized standard deviation. Unless the IV of a LEAPS option that has exactly one year until expiration is substituted for the expected volatility of the underlying stock over exactly one year, IV is an incongruent estimation for the future stock volatility. In practice, the IV of an option must be adjusted to represent the period of time desired.\nThere is acommon technique for deannualizing IV used by professional traders and retail traders alike.\n1\nThe first step in this process to deannualize IV is to turn it into aone-day figure as opposed to one-year figure. This is accomplished by dividing IV by the square root of the number of trading days in ayear. The number many traders use to approximate the number of trading days per year is 256, because its square root is around number: 16. The formula is\nFor example, a $100 stock that has an at-the-money (ATM) call trading at a 32 percent volatility implies that there is about a 68 percent chance that the underlying stock will be between $68 and $132 in one year’stime—that’s $100 ± ($100 × 0.32). The estimation for the market’sexpectation for the volatility of the stock for one day in terms of standard deviation as apercentage of the price of the underlying is computed as follows:\nIn one day’stime, based on an IV of 32 pe", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00012.html", "doc_id": "3a969a4c4121429c38de967f302584d7e4637f8ef6b6a9d996f046570a20e8c8", "chunk_index": 3}
{"text": "be between $68 and $132 in one year’stime—that’s $100 ± ($100 × 0.32). The estimation for the market’sexpectation for the volatility of the stock for one day in terms of standard deviation as apercentage of the price of the underlying is computed as follows:\nIn one day’stime, based on an IV of 32 percent, there is a 68 percent chance of the stock’sbeing within 2 percent of the stock price—that’sbetween $98 and $102.\nThere may be times when it is helpful for traders to have avolatility estimation for aperiod of time longer than one day—aweek or amonth, for example. This can be accomplished by multiplying the one-day volatility by the square root of the number of trading days in the relevant period. The equation is as follows:\nIf the period in question is one month and there are 22 business days remaining in that month, the same $100 stock with the ATM call trading at a 32 percent implied volatility would have aone-month volatility of 9.38 percent.\nBased on this calculation for one month, it can be estimated that there is a 68 percent chance of the stock’sclosing between $90.62 and $109.38 based on an IV of 32 percent.\nExpected Implied Volatility\nAlthough there is agreat deal of science that can be applied to calculating expected actual volatility, developing expectations for implied volatility is more of an art. This element of an option’sprice provides more risk and more opportunity. There are many traders who make their living distilling direction out of their positions and trading implied volatility. To be successful, atrader must forecast IV.\nConceptually, trading IV is much like trading anything else. Atrader who thinks astock is going to rise will buy the stock. Atrader who thinks IV is going to rise will buy options. Directional stock traders, however, have many more analysis tools available to them than do vol traders. Stock traders have both technical analysis (TA) and fundamental analysis at their disposal.\nTechnical Analysis\nThere are scores, perhaps hundreds, of technical tools for analyzing stocks, but there are not many that are available for analyzing IV. Technical analysis is the study of market data, such as past prices or volume, which is manipulated in such away that it better illustrates market activity. TA studies are usually represented graphically on achart.\nDeveloping TA tools for IV is more of achallenge than it is for stocks. One reason is that there is simply alot more data to manage—for each stock, there may be hundreds of options listed on it. The only practical way of analyzing options from a TA standpoint is to use implied volatility. IV is more useful than raw historical option prices themselves. Information for both IV and HV is available in the form of volatility charts, or vol charts. (Vol charts are discussed in detail in Chapter 14.) Volatility charts are essential for analyzing options because they give more complete information.\nTo get aclear picture of what is going on with the price of an option (the goal of technical analysis for any asset), just observing the option price does not supply enough information for atrader to work with. It’sincomplete. For example, if acall rises in value, why did it rise? What greek contributed to its value increase? Was it delta because the underlying stock rose? Or was it vega because volatility rose? How did time decay factor in? Using avolatility chart in conjunction with aconventional stock chart (and being aware of time decay) tells the whole, complete, story.\nAnother reason historical option prices are not used in TA is the option bid-ask spread. For most stocks, the difference between the bid and the ask is equal to avery small percentage of the stock’sprice. Because options are highly leveraged instruments, their bid-ask width can equal amuch higher percentage of the price.\nIf atrader uses the last trade to graph an option’sprice, it could look as if avery large percentage move has occurred when in fact it has not. For example, if the option trades asmall contract size on the bid (0.80), then on the offer (0.90) it would appear that the option rose 12.5 percent in value. This large percentage move is nothing more than market noise. Using volatility data based off the midpoint-of-the-market theoretical value eliminates such noise.\nFundamental Analysis\nFundamental analysis can have an important role in developing expectations for IV. Fundamental analysis is the study of economic factors that affect the value of an asset in order to determine what it is worth. With stocks, fundamental analysis may include studying income statements, balance sheets, and earnings reports. When the asset being studied is IV, there are fewer hard facts available. This is where the art of analyzing volatility comes into play.\nEssentially, the goal is to understand the psychology of the market in relation to supply and demand for options. Where is the fear? Where is the complacency? When are news events anticipated? How important are they? Ultimately, t", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00012.html", "doc_id": "3a969a4c4121429c38de967f302584d7e4637f8ef6b6a9d996f046570a20e8c8", "chunk_index": 4}
{"text": "lable. This is where the art of analyzing volatility comes into play.\nEssentially, the goal is to understand the psychology of the market in relation to supply and demand for options. Where is the fear? Where is the complacency? When are news events anticipated? How important are they? Ultimately, the question becomes: what is the potential for movement in the underlying? The greater the chance of stock movement, the more likely it is that IV will rise. When unexpected news is announced, IV can rise quickly. The determination of the fundamental relevance of surprise announcements must be made quickly.\nUnfortunately, these questions are subjective in nature. They require the trader to apply intuition and experience on acase-by-case basis. But there are afew observations to be made that can help atrader make better-educated decisions about IV.\nReversion to the Mean\nThe IVs of the options on many stocks and indexes tend to trade in arange unique to those option classes. This is referred to as the mean—or average—volatility level. Some securities will have smaller mean IV ranges than others. The range being observed should be established for aperiod long enough to confirm that it is atypical IV for the security, not just atemporary anomaly. Traders should study IV over the most recent 6-month period. When IV has changed significantly during that period, a 12-month study may be necessary. Deviations from this range, either above or below the established mean range, will occur from time to time. When following abreakout from the established range, it is common for IV to revert back to its normal range. This is commonly called\nreversion to the mean\namong volatility watchers.\nThe challenge is recognizing when things change and when they stay the same. If the fundamentals of the stock change in such away as to give the options market reason to believe the stock will now be more or less volatile on an ongoing basis than it typically has been in the recent past, the IV may not revert to the mean. Instead, anew mean volatility level may be established.\nWhen considering the likelihood of whether IV will revert to recent levels after it has deviated or find anew range, the time horizon and changes in the marketplace must be taken into account. For example, between 1998 and 2003 the mean volatility level of the SPX was around 20 percent to 30 percent. By the latter half of 2006, the mean IV was in the range of 10 percent to 13 percent. The difference was that between 1998 and 2003 was the buildup of “the tech bubble,” as it was called by the financial media. Market volatility ultimately leveled off in 2003.\nIn alater era, between the fall of 2010 and late summer of 2011 SPX implied volatility settled in to trade mostly between 12 and 20 percent. But in August 2011, as the European debt crisis heated up, anew, more volatile range between 24 and 40 percent reigned for some time.\nNo trader can accurately predict future IV any more than one can predict the future price of astock. However, with IV there are often recurring patterns that traders can observe, like the ebb and flow of IV often associated with earnings or other regularly scheduled events. But be aware that the IV’srising before the last 15 earnings reports doesn’tmean it will this time.\nCBOE Volatility Index\n®\nOften traders look to the implied volatility of the market as awhole for guidance on the IV of individual stocks. Traders use the Chicago Board Options Exchange (CBOE) Volatility Index\n®\n, or VIX\n®\n, as an indicator of overall market volatility.\nWhen people talk about the market, they are talking about abroad-based index covering many stocks on many diverse industries. Usually, they are referring to the S&P 500. Just as the IV of astock may offer insight about investors’ feelings about that stock’sfuture volatility, the volatility of options on the S&P 500—SPX options—may tell something about the expected volatility of the market as awhole.\nVIX is an index published by the Chicago Board Options Exchange that measures the IV of ahypothetical 30-day option on the SPX. A 30-day option on the SPX only truly exists once amonth—30 days before expiration. CBOE computes ahypothetical 30-day option by means of aweighted average of the two nearest-term months.\nWhen the S&P 500 rises or falls, it is common to see individual stocks rise and fall in sympathy with the index. Most stocks have some degree of market risk. When there is aperception of higher risk in the market as awhole, there can consequently be aperception of higher risk in individual stocks. The rise or fall of the IV of SPX can translate into the IV of individual stocks rising or falling.\nImplied Volatility and Direction\nWho’safraid of falling stock prices? Logically, declining stocks cause concern for investors in general. There is confirmation of that statement in the options market. Just look at IV. With most stocks and indexes, there is an inverse relationship between IV and the underlying price.\nExhi", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00012.html", "doc_id": "3a969a4c4121429c38de967f302584d7e4637f8ef6b6a9d996f046570a20e8c8", "chunk_index": 5}
{"text": "Direction\nWho’safraid of falling stock prices? Logically, declining stocks cause concern for investors in general. There is confirmation of that statement in the options market. Just look at IV. With most stocks and indexes, there is an inverse relationship between IV and the underlying price.\nExhibit 3.2\nshows the SPX plotted against its 30-day IV, or the VIX.\nEXHIBIT 3.2\nSPX vs. 30-day IV (VIX).\nThe heavier line is the SPX, and the lighter line is the VIX. Note that as the price of SPX rises, the VIX tends to decline and vice versa. When the market declines, the demand for options tends to increase. Investors hedge by buying puts. Traders speculate on momentum by buying puts and speculate on aturnaround by buying calls. When the market moves higher, investors tend to sell their protection back and write covered calls or cash-secured puts. Option speculators initiate option-selling strategies. There is less fear when the market is rallying.\nThis inverse relationship of IV to the price of the underlying is not unique to the SPX; it applies to most individual stocks as well. When astock moves lower, the market usually bids up IV, and when the stock rises, the market tends to offer IV creating downward pressure.\nCalculating Volatility Data\nAccurate data are essential for calculating volatility. Many of the volatility data that are readily available are useful, but unfortunately, some are not. HV is avalue that is easily calculated from publicly accessible past closing prices of astock. It’srather straightforward. Traders can access HV from many sources. Retail traders often have access to HV from their brokerage firm. Trading firms or clearinghouses often provide professional traders with HV data. There are some excellent online resources for HV as well.\nHV is acalculation with little subjectivity—the numbers add up how they add up. IV, however, can be abit more ambiguous. It can be calculated different ways to achieve different desired outcomes; it is user-centric. Most of the time, traders consider the theoretical value to be between the bid and the ask prices. On occasion, however, atrader will calculate IV for the bid, the ask, the last trade price, or, sometimes, another value altogether. There may be avalid reason for any of these different methods for calculating IV. For example, if atrader is long volatility and aspires to reduce his position, calculating the IV for the bid shows him what IV level can be sold to liquidate his position.\nFirms, online data providers, and most options-friendly brokers offer IV data. Past IV data is usually displayed graphically in what is known as avolatility chart or vol chart. Current IV is often displayed along with other data right in the option chain. One note of caution: when the current IV is displayed, however, it should always be scrutinized carefully. Was the bid used in calculating this figure? What about the ask? How long ago was this calculation made? There are many questions that determine the accuracy of acurrent IV, and rarely are there any answers to support the number. Traders should trust only IV data they knowingly generated themselves using apricing model.\nVolatility Skew\nThere are many platforms (software or Web-based) that enable traders to solve for volatility values of multiple options within the same option class. Values of options of the same class are interrelated. Many of the model parameters are shared among the different series within the same class. But IV can be different for different options within the same class. This is referred to as the\nvolatility skew\n. There are two types of volatility skew: term structure of volatility and vertical skew.\nTerm Structure of Volatility\nTerm structure of volatility—also called\nmonthly skew\nor\nhorizontal skew\n—is the relationship among the IVs of options in the same class with the same strike but with different expiration months. IV, again, is often interpreted as the market’sestimate of future volatility. It is reasonable to assume that the market will expect some months to be more volatile than others. Because of this, different expiration cycles can trade at different IVs. For example, if acompany involved in amajor product-liability lawsuit is expecting averdict on the case to be announced in two months, the one-month IV may be low, as the stock is not expected to move much until the suit is resolved. The two-month volatility may be much higher, however, reflecting the expectations of abig move in the stock up or down, depending on the outcome.\nThe term\nstructure of volatility\nalso varies with the normal ebb and flow of volatility within the business cycle. In periods of declining volatility, it is common for the month with the least amount of time until expiration, also known as the front month, to trade at alower volatility than the back months, or months with more time until expiration. Conversely, when volatility is rising, the front month tends to have ahigher IV than the back months.\nExhibi", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00012.html", "doc_id": "3a969a4c4121429c38de967f302584d7e4637f8ef6b6a9d996f046570a20e8c8", "chunk_index": 6}
{"text": "mon for the month with the least amount of time until expiration, also known as the front month, to trade at alower volatility than the back months, or months with more time until expiration. Conversely, when volatility is rising, the front month tends to have ahigher IV than the back months.\nExhibit 3.3\nshows historical option prices and their corresponding IVs for 32.5-strike calls on General Motors (GM) during aperiod of low volatility.\nEXHIBIT 3.3\nGM term structure of volatility.\nIn this example, no major news is expected to be released on GM, and overall market volatility is relatively low. The February 32.5 call has the lowest IV, at 32 percent. Each consecutive month has ahigher IV than the previous month. Agraduated increasing or decreasing IV for each consecutive expiration cycle is typical of the term structure of volatility.\nUnder normal circumstances, the front month is the most sensitive to changes in IV. There are two reasons for this. First, front-month options are typically the most actively traded. There is more buying and selling pressure. Their IV is subject to more activity. Second, vegas are smaller for options with fewer days until expiration. This means that for the same monetary change in an option’svalue, the IV needs to move more for short-term options.\nExhibit 3.4\nshows the same GM options and their corresponding vegas.\nEXHIBIT 3.4\nGM vegas.\nIf the value of the September 32.5 calls increases by $0.10, IV must rise by 1 percentage point. If the February 32.5 calls increase by $0.10, IV must rise 3 percentage points. As expiration approaches, the vega gets even smaller. With seven days until expiration, the vega would be about 0.014. This means IV would have to change about 7 points to change the call value $0.10.\nVertical Skew\nThe second type of skew found in option IV is vertical skew, or strike skew. Vertical skew is the disparity in IV among the strike prices within the same month for an option class. The options on most stocks and indexes experience vertical skew. As ageneral rule, the IV of downside options—calls and puts with strike prices lower than the at-the-money (ATM) strike—trade at higher IVs than the ATM IV. The IV of upside options—calls and puts with strike prices higher than the ATM strike—typically trade at lower IVs than the ATM IV.\nThe downside is often simply referred to as puts and the upside as calls. The rationale for this lingo is that OTM options (puts on the downside and calls on the upside) are usually more actively traded than the ITM options. By put-call parity, aput can be synthetically created from acall, and acall can be synthetically created from aput simply by adding the appropriate long or short stock position.\nExhibit 3.5\nshows the vertical skew for 86-day options on Citigroup Inc. (C) on atypical day, with IVs rounded to the nearest tenth.\nEXHIBIT 3.5\nCitigroup vertical skew.\nNotice the IV of the puts (downside options) is higher than that of the calls (upside options), with the 31 strike’svolatility more than 10 points higher than that of the 38 strike. Also, the difference in IV per unit change in the strike price is higher for the downside options than it is for the upside ones. The difference between the IV of the 31 strike is 2 full points higher than the 32 strike, which is 1.8 points higher than the 33 strike. But the 36 strike’s IV is only 1.1 points higher than the 37 strike, which is also just 1.1 points higher than the 38 strike.\nThis incremental difference in the IV per strike is often referred to as the slope. The puts of most underlyings tend to have agreater slope to their skew than the calls. Many models allow values to be entered for the upside slope and the downside slope that mathematically increase or decrease IVs of each strike incrementally. Some traders believe the slope should be astraight line, while others believe it should be an exponentially sloped line.\nIf the IVs were graphed, the shape of the skew would vary among asset classes. This is sometimes referred to as the volatility smile or sneer, depending on the shape of the IV skew. Although\nExhibit 3.5\nis atypical paradigm for the slope for stock options, bond options and other commodity options would have differently shaped skews. For example, grain options commonly have calls with higher IVs than the put IVs.\nVolatility skew is dependent on supply and demand. Greater demand for downside protection may cause the overall IV to rise, but it can cause the IV of puts to rise more relative to the calls or vice versa. There are many traders who make their living trading volatility skew.\nNote\n1\n. This technique provides only an estimation of future volatility.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00012.html", "doc_id": "3a969a4c4121429c38de967f302584d7e4637f8ef6b6a9d996f046570a20e8c8", "chunk_index": 7}
{"text": "CHAPTER 4\nOption-Specific Risk and Opportunity\nNew endeavors can be intimidating. The first day at anew job or new school is achallenge. Option trading is no different. When traders first venture into the world of options, they tend to start with what they know—trading direction. Buying stocks is at the heart of the comfort zone for many traders. Buying acall as asubstitute for buying astock is alogical progression. And for the most part, call buying is apretty straightforward way to take abullish position in astock. But it’snot\njust\nabullish position. The greeks come into play with the long call, providing both risk and opportunity.\nLong ATM Call\nKim is atrader who is bullish on the Walt Disney Company (DIS) over the short term. The time horizon of her forecast is three weeks. Instead of buying 100 shares of Disney at $35.10 per share, Kim decides to buy one Disney March 35 call at $1.10. In this example, March options have 44 days until expiration. How can Kim profit from this position? How can she lose?\nExhibit 4.1\nshows the profit and loss (P&(L)) for the call at different time periods. The top line is when the trade is executed; the middle, dotted line is after three weeks have passed; and the bottom, darker line is at expiration. Kim wants Disney to rise in price, which is evident by looking at the graph for any of the three time horizons. She would anticipate aloss if the stock price declines. These expectations are related to the position’sdelta, but that is not the only risk exposure Kim has. As indicated by the three different lines in\nExhibit 4.1\n, the call loses value over time. This is called\ntheta risk\n. She has other risk exposure as well.\nExhibit 4.2\nlists the greeks for the DIS March 35 call.\nEXHIBIT 4.1\nP&(L) of Disney 35 call.\nEXHIBIT 4.2\nGreeks for 35 Disney call.\nDelta\n0.57\nGamma\n0.166\nTheta\n−0.013\nVega\n0.048\nRho\n0.023\nKim’simmediate directional exposure is quantified by the delta, which is 0.57. Delta is immediate directional exposure because it’ssubject to change by the amount of the gamma. The positive gamma of this position helps Kim by increasing the delta as Disney rises and decreasing it as it falls. Kim, however, has time working against her—theta. At this point, she theoretically loses $0.013 per day. Since her call is close to being at-the-money, she would anticipate her theta becoming more negative as expiration approaches if Disney’sshare price remains unchanged. She also has positive vega exposure. Aone-percentage-point increase in implied volatility (IV) earns Kim just under $0.05. Aone-point decrease costs her about $0.05. With so few days until expiration, the 35-strike call has very little rho exposure. Afull one-percentage-point change in the interest rate changes her call’svalue by only $0.023.\nDelta\nSome of Kim’srisks warrant more concern than others. With this position, delta is of the greatest concern, followed by theta. Kim expects the call to rise in value and accepts the risk of decline. Delta exposure was her main rationale for establishing the position. She expects to hold it for about three weeks. Kim is willing to accept the trade-off of delta exposure for theta, which will cost her three weeks of erosion of option premium. If the anticipated delta move happens sooner than expected, Kim will have less decay.\nExhibit 4.3\nshows the value of her 35 call at various stock prices over time. The left column is the price of Disney. The top row is the number of days until expiration.\nEXHIBIT 4.3\nDisney 35 call price–time matrix–value.\nThe effect of delta is evident as the stock rises or falls. When the position is established (44 days until expiration), the change in the option price if the stock were to move from $35 to $36 is 0.62 (1.66 − 1.04). Between stock prices of $36 and $37, the option gains 0.78 (2.44 −1.66). If the stock were to decline in value from $35 to $34, the option loses 0.47 (1.04 − 0.57). The option gains value at afaster rate as the stock rises and loses value at aslower rate as the stock falls. This is the effect of gamma.\nGamma\nWith this type of position, gamma is an important but secondary consideration. Gamma is most helpful to Kim in developing expectations of what the delta will be as the stock price rises or falls.\nExhibit 4.4\nshows the delta at various stock prices over time.\nEXHIBIT 4.4\nDisney call price–time matrix–delta.\nKim pays attention to gamma only to gauge her delta. Why is this important to her? In this trade, Kim is focused on direction. Knowing how much her call will rise or fall in step with the stock is her main concern. Notice that her delta tends to get bigger as the stock rises and smaller as the stock falls. As time passes, the delta gravitates toward 1.00 or 0, depending on whether the call is in-the-money (ITM) or out-of-the-money (OTM).\nTheta\nOption buying is averitable race against the clock. With each passing day, the option loses theoretical value. Refer back to\nExhibit 4.3\n. When three weeks pass and the time to", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00013.html", "doc_id": "95d38556469cfb0e19300dd032f406bca02eac0e73f64ebddaed2d1534f5b4f5", "chunk_index": 0}
{"text": "he delta gravitates toward 1.00 or 0, depending on whether the call is in-the-money (ITM) or out-of-the-money (OTM).\nTheta\nOption buying is averitable race against the clock. With each passing day, the option loses theoretical value. Refer back to\nExhibit 4.3\n. When three weeks pass and the time to expiration decreases from 44 days to 23, what happens to the call value? If the stock price stays around its original level, theta will be responsible for aloss of about 30 percent of the premium. If Disney is at $35 with 23 days to expiration, the call will be worth $0.73. With abig enough move in either direction, however, theta matters much less.\nWith 23 days to expiration and Disney at $39, there is only 0.12 of time value—the premium paid over parity for the option. At that point, it is almost all delta exposure. Similarly, if the Disney stock price falls after three weeks to $33, the call will have only 0.10 of time value. Time decay is the least of Kim’sconcerns if the stock makes abig move.\nVega\nAfter delta and theta, vega is the next most influential contributor to Kim’sprofit or peril. With Disney at $35.10, the 1.10 premium for the 35-strike call represents $1 of time value—all of which is vulnerable to changes in IV. The option’s 1.10 value returns an IV of about 19 percent, given the following inputs:\nStock: $35.10\nStrike: 35\nDays to expiration: 44\nInterest: 5.25 percent\nNo dividend paid during this period\nConsequently, the vega is 0.048. What does the 0.048 vega tell Kim? Given the preceding inputs, for each point the IV rises or falls, the option’svalue gains or loses about $0.05.\nSome of the inputs, however, will change. Kim anticipates that Disney will rise in price. She may be right or wrong. Either way, it is unlikely that the stock will remain exactly at $35.10 to option expiration. The only certainty is that time will pass.\nBoth price and time will change Kim’svega exposure.\nExhibit 4.5\nshows the changing vega of the 35 call as time and the underlying price change.\nEXHIBIT 4.5\nDisney 35 call price–time matrix–vega.\nWhen comparing\nExhibit 4.5\nto\nExhibit 4.3\n, it’seasy to see that as the time value of the option declines, so does Kim’sexposure to vega. As time passes, vega gets smaller. And as the call becomes more in- or out-of-the-money, vega gets smaller. Since she plans to hold the position for around three weeks, she is not concerned about small fluctuations in IV in the interim.\nIf indeed the rise in price that Kim anticipates comes to pass, vega becomes even less of aconcern. With 23 days to expiration and DIS at $37, the call value is 2.21. The vega is $0.018. If IV decreases as the stock price rises—acommon occurrence—the adverse effect of vega will be minimal. Even if IV declines by 5 points, to ahistorically low IV for DIS, the call loses less than $0.10. That’sless than 5 percent of the new value of the option.\nIf dividend policy changes or the interest rate changes, the value of Kim’scall will be affected as well. Dividends are often fairly predictable. However, alarge unexpected dividend payment can have asignificant adverse impact on the value of the call. For example, if asurprise $3 dividend were announced, owning the stock would become greatly preferable to owning the call. This preference would be reflected in the call premium. This is ascenario that an experienced trader like Kim will realize is apossibility, although not aprobability. Although she knows it can happen, she will not plan for such an event unless she believes it is likely to happen. Possible reasons for such abelief could be rumors or the company’shistorically paying an irregular dividend.\nRho\nFor all intents and purposes, rho is of no concern to Kim. In recent years, interest rate changes have not been amajor issue for option traders. In the Alan Greenspan years of Federal Reserve leadership, changes in the interest rate were usually announced at the regularly scheduled Federal Open Market Committee (FOMC) meetings, with but afew exceptions. Ben Bernanke, likewise, changed interest rates fairly predictably, when he made any rate changes at all. In these more stable periods, if there is no FOMC meeting scheduled during the life of the call, it’sunlikely that rates will change. Even if they do, the rho with 44 days to expiration is only 0.023. This means that if rates change by awhole percentage point—which is four times the most common incremental change—the call value will change by alittle more than $0.02. In this case, this is an acceptable risk. With 23 days to expiration, the ATM 35 call has arho of only 0.011.\nTweaking Greeks\nWith this position, some risks are of greater concern than others. Kim may want more exposure to some greeks and less to others. What if she is concerned that her forecasted price increase will take longer than three weeks? She may want less exposure to theta. What if she is particularly concerned about adecline in IV? She may want to decrease her vega. Conversely, she may believe I", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00013.html", "doc_id": "95d38556469cfb0e19300dd032f406bca02eac0e73f64ebddaed2d1534f5b4f5", "chunk_index": 1}
{"text": "exposure to some greeks and less to others. What if she is concerned that her forecasted price increase will take longer than three weeks? She may want less exposure to theta. What if she is particularly concerned about adecline in IV? She may want to decrease her vega. Conversely, she may believe IV will rise and therefore want to increase her vega.\nKim has many ways at her disposal to customize her greeks. All of her alternatives come with trade-offs. She can buy more calls, increasing her greek positions in exact proportion. She can buy or sell stock or options against her call, creating aspread. The simplest way to alter her exposure to option greeks is to choose adifferent call to buy. Instead of buying the ATM call, Kim can buy acall with adifferent relationship to the current stock price.\nLong OTM Call\nKim can reduce her exposure to theta and vega by buying an OTM call. The trade-off here is that she also reduces her immediate delta exposure. Depending on how much Kim believes Disney will rally, this may or may not be aviable trade-off. Imagine that instead of buying one Disney March 35 call, Kim buys one Disney March 37.50 call, for 0.20.\nThere are afew observations to be made about this alternative position. First, the net premium, and therefore overall risk, is much lower, 0.20 instead of 1.10. From an expiration standpoint, the breakeven at expiration is $37.70 (the strike price plus the call premium). Since Kim plans on exiting the position after about three weeks, the exact break-even point at the expiration of the contract is irrelevant. But the concept is the same: the stock needs to rise significantly.\nExhibit 4.6\nshows how Kim’sconcerns translate into greeks.\nEXHIBIT 4.6\nGreeks for Disney 35 and 37.50 calls.\n35 Call\n37.50 Call\nDelta\n0.57\n0.185\nGamma\n0.166\n0.119\nTheta\n−0.013\n−0.007\nVega\n0.048\n0.032\nRho\n0.023\n0.007\nThis table compares the ATM call with the OTM call. Kim can reduce her theta to half that of the ATM call position by purchasing an OTM. This is certainly afavorable difference. Her vega is lower with the 37.50 call, too. This may or may not be afavorable difference. That depends on Kim’sopinion of IV.\nOn the surface, the disparity in delta appears to be ahighly unfavorable trade-off. The delta of the 37.50 call is less than one third of the delta of the 35 call, and the whole motive for entering into this trade is to trade direction! Although this strategy is very delta oriented, its core is more focused on gamma and theta.\nThe gamma of the 37.50 call is about 72 percent that of the 35 call. But the theta of the 37.50 call is about half that of the 35 call. Kim is improving her gamma/theta relationship by buying the OTM, but with the call being so far out-of-the-money and so inexpensive, the theta needs to be taken with agrain of salt. It is ultimately gamma that will make or break this delta play.\nThe price of the option is 0.20—arather low premium. In order for the call to gain in value, delta has to go to work with help from gamma. At this point, the delta is small, only 0.185. If Kim’sforecast is correct and there is abig move upward, gamma will cause the delta to increase, and therefore also the premium to increase exponentially. The call’ssensitivity to gamma, however, is dynamic.\nExhibit 4.7\nshows how the gamma of the 37.50 call changes as the stock price moves over time. At any point in time, gamma is highest when the call is ATM. However, so is theta. Kim wants to reap as much benefit from gamma as possible while minimizing her exposure to theta. Ideally, she wants Disney to rally through the strike price—through the high gamma and back to the low theta. After three weeks pass, with 23 days until expiration, if Disney is at $37 ashare, the gamma almost doubles, to 0.237. When the call is ATM, the delta increases at its fastest rate. As Disney rises above the strike, the gamma figures in the table begin to decline.\nEXHIBIT 4.7\nDisney 37.50 call price–time matrix–gamma.\nGamma helps as the stock price declines, too.\nExhibit 4.8\nshows the effect of time and gamma on the delta of the 37.50 call.\nEXHIBIT 4.8\nDisney 37.50 call price–time matrix–delta.\nThe effect of gamma is readily observable, as the delta at any point in time is always higher at higher stock prices and lower at lower stock prices. Kim benefits greatly when the delta grows from its initial level of 0.185 to above 0.50—above the point of being at-the-money. If the stock moves lower, gamma helps take away the pain of the price decline by decreasing the delta.\nWhile delta, gamma, and theta occupy Kim’sthoughts, it is ultimately dollars and cents that matter. She needs to translate her study of the greeks into cold, hard cash.\nExhibit 4.9\nshows the theoretical values of the 37.50 call.\nEXHIBIT 4.9\nDisney 37.50 call price–time matrix–value.\nThe sooner the price rise occurs, the better. It means less time for theta to eat away profits. If Kim must hold the position for the entire three weeks, she needs agood pop in th", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00013.html", "doc_id": "95d38556469cfb0e19300dd032f406bca02eac0e73f64ebddaed2d1534f5b4f5", "chunk_index": 2}
{"text": "cash.\nExhibit 4.9\nshows the theoretical values of the 37.50 call.\nEXHIBIT 4.9\nDisney 37.50 call price–time matrix–value.\nThe sooner the price rise occurs, the better. It means less time for theta to eat away profits. If Kim must hold the position for the entire three weeks, she needs agood pop in the stock to make it worth her while. At a $37 share price, the call is worth about 0.50, assuming all other market influences remain constant. That’sabout a 150 percent profit. At $38,\nExhibit 4.9\nreveals the call value to be 1.04. That’sa 420 percent profit.\nOn one hand, it’shard for atrader like Kim not to get excited about the prospect of making 420 percent on an 8 percent move in astock. On the other hand, Kim has to put things in perspective. When the position is established, the call has a 0.185 delta. By the trader’sdefinition of delta, that means the call is estimated to have about an 18.5 percent chance of expiring in-the-money. More than four out of five times, this position will be trading below the strike at expiration.\nAlthough Kim is not likely to hold the position until expiration, this observation tells her something: she’sstarting in the hole. She is more likely to lose than to win. She needs to be compensated well for her risk on the winners to make up for the more prevalent losers.\nBuying OTM calls can be considered more speculative than buying ITM or ATM calls. Unlike what the at-expiration diagrams would lead one to believe, OTM calls are not simply about direction. There’sabit more to it. They are really about gamma, time, and the magnitude of the stock’smove (volatility). Long OTM calls require abig move in the right direction for gamma to do its job.\nLong ITM Call\nKim also has the alternative to buy an ITM call. Instead of the 35 or 37.50 call, she can buy the 32.50. The 32.50 call shares some of the advantages the 37.50 call has over the 35 call, but its overall greek characteristics make it avery different trade from the two previous alternatives.\nExhibit 4.10\nshows acomparison of the greeks of the three different calls.\nEXHIBIT 4.10\nGreeks for Disney 32.50, 35, and 37.50 calls.\nLike the 37.50 call, the 32.50 has alower gamma, theta, and vega than the ATM 35-strike call. Because the call is ITM, it has ahigher delta: 0.862. In this example, Kim can buy the 32.50 call for 3. That’s 0.40 over parity (3 − [35.10 − 32.50] = 0.40). There is not much time value, but more than the 37.50 call has. Thus, theta is of some concern. Ultimately, the ITMs have 0.40 of time value to lose compared with the 0.20 of the OTM calls. Vega is also of some concern, but not as much as in the other alternatives because the vega of the 32.50 is lower than the 35s or the 37.50s. Gamma doesn’thelp much as the stock rallies—it will get smaller as the stock price rises. Gamma will, however, slow losses somewhat if the stock declines by decreasing delta at an increasing rate.\nIn this case, the greek of greatest consequence is delta—it is amore purely directional play than the other alternatives discussed.\nExhibit 4.11\nshows the matrix of the delta of the 32.50 call.\nEXHIBIT 4.11\nDisney 32.50 call price–time matrix–delta.\nBecause the call starts in-the-money and has arelatively low gamma, the delta remains high even if Disney declines significantly. Gamma doesn’treally kick in until the stock retreats enough to bring the call closer to being at-the-money. At that point, the position will have suffered abig loss, and the higher gamma is of little comfort.\nKim’smotivation for selecting the ITM call above the ATM and OTM calls would be increased delta exposure. The 0.86 delta makes direction the most important concern right out of the gate.\nExhibit 4.12\nshows the theoretical values of the 32.50 call.\nEXHIBIT 4.12\nDisney 32.50 call price–time matrix–value.\nSmall directional moves contribute to significant leveraged gains or losses. From share price $35 to $36, the call gains 0.90—from 2.91 to 3.81—about a 30 percent gain. However, from $35 to $34, the call loses 0.80, or 27 percent. With only 0.40 of time value, the nondirectional greeks (theta, gamma, and vega) are asecondary consideration.\nIf this were adeeper ITM call, the delta would start out even higher, closer to 1.00, and the other relevant greeks would be closer to zero. The deeper ITM acall, the more it acts like the stock and the less its option characteristics (greeks) come into play.\nLong ATM Put\nThe beauty of the free market is that two people can study all the available information on the same stock and come up with completely different outlooks. First of all, this provides for entertaining television on the business-news channels when the network juxtaposes an outspoken bullish analyst with an equally unreserved bearish analyst. But differing opinions also make for arobust marketplace. Differing opinions are the oil that greases the machine that is price discovery. From amarket standpoint, it’swhat makes the world go round.\nIt is possible that there is anoth", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00013.html", "doc_id": "95d38556469cfb0e19300dd032f406bca02eac0e73f64ebddaed2d1534f5b4f5", "chunk_index": 3}
{"text": "spoken bullish analyst with an equally unreserved bearish analyst. But differing opinions also make for arobust marketplace. Differing opinions are the oil that greases the machine that is price discovery. From amarket standpoint, it’swhat makes the world go round.\nIt is possible that there is another trader, Mick, in the market studying Disney, who arrives at the conclusion that the stock is overpriced. Mick believes the stock will decline in price over the next three weeks. He decides to buy one Disney March 35 put at 0.80. In this example, March has 44 days to expiration.\nMick initiates this long put position to gain downside exposure, but along with his bearish position comes option-specific risk and opportunity. Mick is buying the same month and strike option as Kim did in the first example of this chapter: the March 35 strike. Despite the different directional bias, Mick’sposition and Kim’sposition share many similarities.\nExhibit 4.13\noffers acomparison of the greeks of the Disney March 35 call and the Disney March 35 put.\nEXHIBIT 4.13\nGreeks for Disney 35 call and 35 put.\nCall\nPut\nDelta\n0.57\n−0.444\nGamma\n0.166\n0.174\nTheta\n−0.013\n−0.009\nVega\n0.048\n0.048\nRho\n0.023\n−0.015\nThe first comparison to note is the contrasting deltas. The put delta is negative, in contrast to the call delta. The absolute value of the put delta is close to 1.00 minus the call delta. The put is just slightly OTM, so its delta is just under 0.50, while that of the call is just over 0.50. The disparate, yet related deltas represent the main difference between these two trades.\nThe difference between the gamma of the 35 put and that of the corresponding call is fairly negligible: 0.174 versus 0.166, respectively. The gamma of this ATM put will enter into the equation in much the same way as the gamma of the ATM call. The put’snegative delta will become more negative as the stock declines, drawing closer to −1.00. It will get less negative as the stock price rises, drawing closer to zero. Gamma is important here, because it helps the delta. Delta, however, still remains the most important greek.\nExhibit 4.14\nillustrates how the 35 put delta changes as time and price change.\nEXHIBIT 4.14\nDisney 35 put price–time matrix–delta.\nSince this put is ATM, it starts out with abig enough delta to offer the directional exposure Mick desires. The delta can change, but gamma ensures that it always changes in Mick’sfavor.\nExhibit 4.15\nshows how the value of the 35 put changes with the stock price.\nEXHIBIT 4.15\nDisney 35 put price–time matrix–value.\nOver time, adecline of only 10 percent in the stock yields high percentage returns. This is due to the leveraged directional nature of this trade—delta.\nWhile the other greeks are not of primary concern, they must be monitored. At the onset, the 0.80 premium is all time value and, therefore subject to the influences of time decay and volatility. This is where trading greeks comes into play.\nConventional trading wisdom says, “Cut your losses early, and let your profits run.” When trading astock, that advice is intellectually easy to understand, although psychologically difficult to follow. Buyers of options, especially ATM options, must follow this advice from the standpoint of theta. Options are decaying assets. The time premium will be zero at expiration. ATMs decay at an increasing nonlinear rate. Exiting along position before getting too close to expiration can cut losses caused by an increasing theta. When to cut those losses, however, will differ from trade to trade, situation to situation, and person to person.\nWhen buying options, accepting some loss of premium due to time decay should be part of the trader’splan. It comes with the territory. In this example, Mick is willing to accept about three weeks of erosion. Mick needs to think about what his put will be worth, not just if the underlying rises or falls but also if it doesn’tmove at all. At the time the position is established, the theta is 0.009, just under apenny. If Disney share price is unchanged when three weeks pass, his theta will be higher.\nExhibit 4.16\nshows how thetas and theoretical values change over time if DIS stock remains at $35.10.\nEXHIBIT 4.16\nDisney 35 put—thetas and theoretical values.\nMick needs to be concerned not only about what the theta is now but what it will be when he plans on exiting the position. His plan is to exit the trade in about three weeks, at which point the put theta will be −0.013. If he amortizes his theta over this three-week period, he theoretically loses an average of about 0.01 aday during this time if nothing else changes. The average daily theta is calculated here by subtracting the value of the put at 23 days to expiration from its value when the trade was established to find the loss of premium attributed to time decay, then dividing by the number of days until expiration.\nSince the theta doesn’tchange much over the first three weeks, Mick can eyeball the theta rather easily. As expiration ap", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00013.html", "doc_id": "95d38556469cfb0e19300dd032f406bca02eac0e73f64ebddaed2d1534f5b4f5", "chunk_index": 4}
{"text": "at 23 days to expiration from its value when the trade was established to find the loss of premium attributed to time decay, then dividing by the number of days until expiration.\nSince the theta doesn’tchange much over the first three weeks, Mick can eyeball the theta rather easily. As expiration approaches and theta begins to grow more quickly, he’ll need to do the math.\nAt nine days to expiration, the theoretical value of Mick’sput is about 0.35, assuming all other variables are held constant. By that time, he will have lost 0.45 (0.80 − 0.35) due to erosion over the 35-day period he held the position if the stock hasn’tmoved. Mick’saverage daily theta during that period is about 0.0129 (0.45 ÷ 35). The more time he holds the trade, the greater aconcern is theta. Mick must weigh his assessment of the likelihood of the option’sgaining value from delta against the risk of erosion. If he holds the trade for 35 days, he must make 0.0129 on average per day from delta to offset theta losses. If the forecast is not realized within the expected time frame or if the forecast changes, Mick needs to act fast to curtail average daily theta losses.\nFinding the Right Risk\nMick could lower the theta of his position by selecting aput with agreater number of days to expiration. This alternative has its own set of trade-offs: lower gamma and higher vega than the 44-day put. He could also select an ITM put or an OTM put. Like Kim’scall alternatives, the OTM put would have less exposure to time decay, lower vega, lower gamma, and alower delta. It would have alower premium, too. It would require abigger price decline than the ATM put and would be more speculative.\nThe ITM put would also have lower theta, vega, and gamma, but it would have ahigher delta. It would take on more of the functionality of ashort stock position in much the same way that Kim’s ITM call alternative did for along stock position. In its very essence, however, an option trade, ITM or otherwise, is still fundamentally different than astock trade.\nStock has a 1.00 delta. The delta of astock never changes, so it has zero gamma. Stock is not subject to time decay and has no volatility component to its pricing. Even though ITM options have deltas that approach 1.00 and other greeks that are relatively low, they have two important differences from an equity. The first is that the greeks of options are dynamic. The second is the built-in leverage feature of options.\nThe relationship of an option’sstrike price to the stock price can change constantly. Options that are ITM now may be OTM tomorrow and vice versa. Greeks that are not in play at the moment may be later. Even if there is no time value in the option now because it is so far away-from-the-money, there is the potential for time premium to become acomponent of the option’sprice if the stock moves closer to the strike price. Gamma, theta, and vega always have the potential to come into play.\nSince options are leveraged by nature, small moves in the stock can provide big profits or big losses. Options can also curtail big losses if used for hedging. Long option positions can reap triple-digit percentage gains quickly with afavorable move in the underlying. Even though 100 percent of the premium can be lost just as easily, one option contract will have far less nominal exposure than asimilar position in the stock.\nIt’s All About Volatility\nWhat are Kim and Mick really trading? Volatility. The motivation for buying an option as opposed to buying or shorting the stock is volatility. To some degree, these options have exposure to both flavors of volatility—implied volatility and historical volatility (HV). The positions in each of the examples have positive vega. Their values are influenced, in part, by IV. Over time, IV begins to lose its significance if the option is no longer close to being at-the-money.\nThe main objective of each of these trades is to profit from the volatility of the stock’sprice movement, called future stock volatility or future realized volatility. The strategies discussed in this chapter are contingent on volatility being one directional. The bigger the move in the trader’sforecasted direction the better. Volatility in the form of an adverse directional move results in adecline in premium. The gamma in these long option positions makes volatility in the right direction more beneficial and volatility in the wrong direction less costly.\nThis phenomenon is hardly unique to the long call and the long put. Although some basic strategies, such as the ones studied in this chapter, depend on aparticular direction, many don’t. Except for interest rate strategies and perhaps some arbitrage strategies, all option trades are volatility trades in one way or another. In general, option strategies can be divided into two groups: volatility-buying strategies and volatility-selling strategies. The following is abreakdown of common option strategies into categories of volatility-buying strategies and vol", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00013.html", "doc_id": "95d38556469cfb0e19300dd032f406bca02eac0e73f64ebddaed2d1534f5b4f5", "chunk_index": 5}
{"text": "all option trades are volatility trades in one way or another. In general, option strategies can be divided into two groups: volatility-buying strategies and volatility-selling strategies. The following is abreakdown of common option strategies into categories of volatility-buying strategies and volatility-selling strategies:\nVolatility-Selling Strategies\nVolatility-Buying Strategies\nShort Call, Short Put, Covered Call, Covered Put, Bull Call Spread, Bear Call Spread, Bull Put Spread, Bear Put Spread, Short Straddle, Short Strangle, Guts, Ratio Call Spread, Calendar, Butterfly, Iron Butterfly, Broken-Wing Butterfly, Condor, Iron Condor, Diagonals, Double Diagonals, Risk Reversals/Collars.\nLong Call, Long Put, Bull Call Spread, Bear Call Spread, Bull Put Spread, Bear Put Spread, Long Straddle, Long Strangle, Guts, Back Spread, Calendar, Butterfly, Iron Butterfly, Broken-Wing Butterfly, Condor, Iron Condor, Diagonals, Double Diagonals, Risk Reversals/Collars.\nLong option strategies appear in the volatility-buying group because they have positive gamma and positive vega. Short option strategies appear in the volatility-selling group because of negative gamma and vega. There are some strategies that appear in both groups—for example, the butterfly/condor family, which is typically associated with income generation. These particular volatility strategies are commonly instituted as volatility-selling strategies. However, depending on whether the position is bought or sold and where the stock price is in relation to the strike prices, the position could fall into either group. Some strategies, like the vertical spread family—bull and bear call and put spreads—and risk reversal/collar spreads naturally fall into either category, depending on where the stock is in relation to the strikes. The calendar spread family is unique in that it can have characteristics of each group at the same time.\nDirection Neutral, Direction Biased, and Direction Indifferent\nAs typically traded, volatility-selling option strategies are direction neutral. This means that the position has the greatest results if the underlying price remains in arange—that is, neutral. Although some option-selling strategies—for example, anaked put—may have apositive or negative delta in the short term, profit potential is decidedly limited. This means that if traders are expecting abig move, they are typically better off with option-buying strategies.\nOption-buying strategies can be either direction biased or direction indifferent. Direction-biased strategies have been shown throughout this chapter. They are delta trades. Direction-indifferent strategies are those that benefit from increased volatility in the underlying but where the direction of the move is irrelevant to the profitability of the trade. Movement in either direction creates awinner.\nAre You a Buyer or a Seller?\nThe question is: which is better, selling volatility or buying volatility? Ihave attended option seminars with instructors (many of whom Iregard with great respect) teaching that volatility-selling strategies, or income-generating strategies, are superior to buying options. Ialso know option gurus that tout the superiority of buying options. The answer to the question of which is better is simple: it’sall amatter of personal preference.\nWhen Ibegan trading on the floor of Chicago Board Options Exchange (CBOE) in the 1990s, Iquickly became aware of adichotomy among my market-making peers. Those making markets on the floor of the exchange at that time were divided into two groups: teenie buyers and teenie sellers.\nTeenie Buyers\nBefore options traded in decimals (dollars and cents) like they do today, the lowest price increment in which an option could be traded was one sixteenth of adollar—ateenie\n. Teenie buyers were market makers who would buy back OTM options at one sixteenth to eliminate short positions. They would sometimes even initiate long OTM option positions at ateenie, too. The focus of the teenie-buyer school of thought was the fact that long options have unlimited reward, while short options have unlimited risk. An option purchased so far OTM that it was offered at one sixteenth is unlikely to end up profitable, but it’san inexpensive lottery ticket. At worst, the trader can only lose ateenie. Teenie buyers felt being short OTM options that could be closed by paying asixteenth was an unreasonable risk.\nTeenie Sellers\nTeenie sellers, however, focused on the fact that options offered at one sixteenth were far enough OTM that they were very likely to expire worthless. This appears to be free money, unless the unexpected occurs, in which case potential losses can be unlimited. Teenie sellers would routinely save themselves $6.25 (one sixteenth of adollar per contract representing 100 shares) by selling their long OTMs at ateenie to close the position. They sometimes would even initiate short OTM contracts at one sixteenth.\nThese long-option or short-option biases hold for othe", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00013.html", "doc_id": "95d38556469cfb0e19300dd032f406bca02eac0e73f64ebddaed2d1534f5b4f5", "chunk_index": 6}
{"text": "e sellers would routinely save themselves $6.25 (one sixteenth of adollar per contract representing 100 shares) by selling their long OTMs at ateenie to close the position. They sometimes would even initiate short OTM contracts at one sixteenth.\nThese long-option or short-option biases hold for other types of strategies as well. Volatility-selling positions, such as the iron condor, can be constructed to have limited risk. The paradigm for these strategies is they tend to produce winners more often than not. But when the position loses, the trader loses more than he would stand to profit if the trade worked out favorably.\nHerein lies the issue of preference. Long-option traders would rather trade Babe Ruth–style. For years, Babe Ruth was the record holder for the most home runs. At the same time, he was also the record holder for the most strikeouts. The born fighters that are option buyers accept the fact that they will have more strikeouts, possibly many more strikeouts, than winning trades. But the strategy dictates that the profit on one winner more than makes up for the string of small losers.\nShort-option traders, conversely, like to have everything cool and copacetic. They like the warm and fuzzy feeling they get from the fact that month after month they tend to generate winners. The occasional loser that nullifies afew months of profits is all part of the game.\nOptions and the Fair Game\nThere may be astatistical advantage to buying stock as opposed to shorting stock, because the market has historically had apositive annualized return over the long run. Astatistical advantage to being either an option buyer or an option seller, however, should not exist in the long run, because the option market prices IV. Assuming an overall efficient market for pricing volatility into options, there should be no statistical advantage to systematically buying or selling options.\n1\nConsider agame consisting of one six-sided die. Each time aone, two, or three is rolled, the house pays the player $1. Each time afour, five, or six is rolled, the house pays zero. What is the most aplayer would be willing to pay to play this game? If the player paid nothing, the house would be at atremendous disadvantage, paying $1 50 percent of the time and nothing the other 50 percent of the time. This would not be afair game from the house’sperspective, as it would collect no money. If the player paid $1, the player would get his dollar back when one, two, or three came up. Otherwise, he would lose his dollar. This is not afair game from the player’sperspective.\nThe chances of winning this game are 3 out of 6, or 50–50. If this game were played thousands of times, one would expect to receive $1 half the time and receive nothing the other half of the time. The average return per roll one would expect to receive would be $0.50, that’s ($1 × 50 percent + $0 × 50 percent). This becomes afair game with an entrance fee of $0.50.\nNow imagine asimilar game in which asix-sided die is rolled. This time if aone is rolled, the house pays $1. If any other number is rolled, the house pays nothing. What is afair price to play this game? The same logic and the same math apply. There is apercent chance of aone coming up and the player receiving $1. And there is apercent chance of each of the other five numbers being rolled and the player receiving nothing. Mathematically, this translates to:\npercent\npercent). Fair value for achance to play this game is about $0.1667 per roll.\nThe fair game concept applies to option prices as well. The price of the game, or in this case the price of the option, is determined by the market in the form of IV. The odds are based on the market’sexpectations of future volatility. If buying options offered asuperior payout based on the odds of success, the market would put upward pressure on prices until this arbitrage opportunity ceased to exist. It’sthe same for selling volatility. If selling were afundamentally better strategy, the market would depress option prices until selling options no longer produced away to beat the odds. The options market will always equalize imbalances.\nNote\n1\n. This is not to say that unique individual opportunities do not exist for overpriced or underpriced options, only that options are not overpriced or underpriced in general. Thus, neither an option-selling nor option-buying methodology should provide an advantage.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00013.html", "doc_id": "95d38556469cfb0e19300dd032f406bca02eac0e73f64ebddaed2d1534f5b4f5", "chunk_index": 7}
{"text": "CHAPTER 5\nAn Introduction to Volatility-Selling Strategies\nAlong with death and taxes, there is one other fact of life we can all count on: the time value of all options ultimately going to zero. What an alluring concept! In abusiness where expected profits can be thwarted by an unexpected turn of events, this is one certainty traders can count on. Like all certainties in the financial world, there is away to profit from this fact, but it’snot as easy as it sounds. Alas, the potential for profit only exists when there is risk of loss.\nIn order to profit from eroding option premiums, traders must implement option-selling strategies, also known as volatility-selling strategies. These strategies have their own set of inherent risks. Selling volatility means having negative vega—the risk of implied volatility rising. It also means having negative gamma—the risk of the underlying being too volatile. This is the nature of selling volatility. The option-selling trader does not want the underlying stock to move—that is, the trader wants the stock to be less volatile. That is the risk.\nProfit Potential\nProfit for the volatility seller is realized in aroundabout sort of way. The reward for low volatility is achieved through time decay. These strategies have positive theta. Just as the volatility-buying strategies covered in Chapter 4 had time working against them, volatility-selling strategies have time working in their favor. The trader is effectively paid to assume the risk of movement.\nGamma-Theta Relationship\nThere exists atrade-off between gamma and theta. Long options have positive gamma and negative theta. Short options have negative gamma and positive theta. Positions with greater gamma, whether positive or negative, tend to have greater theta values, negative or positive. Likewise, lower absolute values for gamma tend to go hand in hand with lower absolute values for theta. The gamma-theta relationship is the most important consideration with many types of strategies. Gamma-theta is often the measurement with the greatest influence on the bottom line.\nGreeks and Income Generation\nWith volatility-selling strategies (sometimes called income-generating strategies), greeks are often overlooked. Traders simply dismiss greeks as unimportant to this kind of trade. There is some logic behind this reasoning. Time decay provides the profit opportunity. In order to let all of time premium erode, the position must be held until expiration. Interim changes in implied volatility are irrelevant if the position is held to term. The gamma-theta loses some significance if the position is held until expiration, too. The position has either passed the break-even point on the at-expiration diagram, or it has not. Incremental daily time decay–related gains are not the ultimate goal. The trader is looking for all the time premium, not portions of it.\nSo why do greeks matter to volatility sellers? Greeks allow traders to be flexible. Consider short-term-momentum stock traders. The traders buy astock because they believe it will rise over the next month. After one week, if unexpected bearish news is announced causing the stock to break through its support lines, the traders have adecision to make. Short-term speculative traders very often choose to cut their losses and exit the position early rather than risk alarger loss hoping for arecovery.\nVolatility-selling option traders are often faced with the same dilemma. If the underlying stays in line with the traders’ forecast, there is little to worry about. But if the environment changes, the traders have to react. Knowing the greeks for aposition can help traders make better decisions if they plan to close the position before expiration.\nNaked Call\nAnaked call is when atrader shorts acall without having stock or other options to cover or protect it. Since the call is uncovered, it is one of the riskier trades atrader can make. Recall the at-expiration diagram for the naked call from Chapter 1,\nExhibit 1.3\n: Naked TGT Call. Theoretically, there is limited reward and unlimited risk. Yet there are times when experienced traders will justify making such atrade. When astock has been trading in arange and is expected to continue doing so, traders may wait until it is near the top of the channel, where there is resistance, and then short acall.\nFor example, atrader, Brendan, has been studying achart of Johnson & Johnson (JNJ). Brendan notices that for afew months the stock has trading been in achannel between $60 and $65. As he observes Johnson & Johnson beginning to approach the resistance level of $65 again, he considers selling acall to speculate on the stock not rising above $65. Before selling the call, Brendan consults other technical analysis tools, like ADX/DMI, to confirm that there is no trend present. ADX/DMI is used by some traders as afilter to determine the strength of atrend and whether the stock is overbought or oversold. In this case, the indicator shows no strong trend pre", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00014.html", "doc_id": "01107f315fc580e07ea295f188e733f66cee602679430263d82534b04aa781d8", "chunk_index": 0}
{"text": "ng the call, Brendan consults other technical analysis tools, like ADX/DMI, to confirm that there is no trend present. ADX/DMI is used by some traders as afilter to determine the strength of atrend and whether the stock is overbought or oversold. In this case, the indicator shows no strong trend present. Brendan then performs due diligence. He studies the news. He looks for anything specific that could cause the stock to rally. Is the stock atakeover target? Brendan finds nothing. He then does earnings research to find out when they will be announced, which is not for almost two more months.\nNext, Brendan pulls up an option chain on his computer. He finds that with the stock trading around $64 per share, the market for the November 65 call (expiring in four weeks) is 0.66 bid at 0.68 offer. Brendan considers when Johnson & Johnson’searnings report falls. Although recent earnings have seldom been amajor concern for Johnson & Johnson, he certainly wants to sell an option expiring before the next earnings report. The November fits the mold. Brendan sells ten of the November 65 calls at the bid price of 0.66.\nBrendan has arather straightforward goal. He hopes to see Johnson & Johnson shares remain below $65 between now and expiration. If he is right, he stands to make $660. If he is wrong?\nExhibit 5.1\nshows how Brendan’scalls hold up if they are held until expiration.\nEXHIBIT 5.1\nNaked Johnson & Johnson call at expiration.\nConsidering the risk/reward of this trade, Brendan is rightfully concerned about abig upward move. If the stock begins to rally, he must be prepared to act fast. Brendan must have an idea in advance of what his pain threshold is. In other words, at what price will he buy back his calls and take aloss if Johnson & Johnson moves adversely?\nHe decides he will buy all 10 of his calls back at 1.10 per contract if the trade goes against him. (1.10 is an arbitrary price used for illustrative purposes. The actual price will vary, based on the situation and the risk tolerance of the trader. More on when to take profits and losses is discussed in future chapters.) He may choose to enter agood-till-canceled (GTC) stop-loss order to buy back his calls. Or he may choose to monitor the stock and enter the order when he sees the calls offered at 1.10—amental stop order. What Brendan needs to know is: How far can the stock price advance before the calls are at 1.10?\nBrendan needs to examine the greeks of this trade to help answer this question.\nExhibit 5.2\nshows the hypothetical greeks for the position in this example.\nEXHIBIT 5.2\nGreeks for short Johnson & Johnson 65 call (per contract).\nDelta\n−0.34\nGamma\n−0.15\nTheta\n0.02\nVega\n−0.07\nThe short call has anegative delta. It also has negative gamma and vega, but it has positive time decay (theta). As Johnson & Johnson ticks higher, the delta increases the nominal value of the call. Although this is not adirectional trade per se, delta is acrucial element. It will have abig impact on Brendan’sexpectations as to how high the stock can rise before he must take his loss.\nFirst, Brendan considers how much the option price can move before he covers. The market now is 0.66 bid at 0.68 offer. To buy back his calls at 1.10, they must be offered at 1.10. The difference between the offer now and the offer price at which Brendan will cover is 0.42 (that’s 1.10 − 0.68). Brendan can use delta to convert the change in the ask prices into astock price change. To do so, Brendan divides the change in the option price by the delta.\nThe −0.34 delta indicates that if JNJ rises $1.24, the calls should be offered at 1.10.\nBrendan takes note that the bid-ask spreads are typically 0.01 to 0.03 wide in near-term Johnson & Johnson options trading under 1.00. This is not necessarily the case in other option classes. Less liquid names have wider spreads. If the spreads were wider, Brendan would have more slippage. Slippage is the difference between the assumed trade price and the actual price of the fill as aproduct of the bid-ask spread. It’sthe difference between theory and reality. If the bid-ask spread had atypical width of, say, 0.70, the market would be something more like 0.40 bid at 1.10 offer. In this case, if the stock moved even afew cents higher, Brendan could not buy his calls back at his targeted exit price of 1.10. The tighter markets provide lower transaction costs in the form of lower slippage. Therefore, there is more leeway if the stock moves adversely when there are tighter bid-ask option spreads.\nBut just looking at delta only tells apart of the story. In reality, the delta does not remain constant during the price rise in Johnson & Johnson but instead becomes more negative. Initially, the delta is −0.34 and the gamma is −0.15. After arise in the stock price, the delta will be more negative by the amount of the gamma. To account for the entire effect of direction, Brendan needs to take both delta and gamma into account. He needs to estimate the average delta based on g", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00014.html", "doc_id": "01107f315fc580e07ea295f188e733f66cee602679430263d82534b04aa781d8", "chunk_index": 1}
{"text": "Initially, the delta is −0.34 and the gamma is −0.15. After arise in the stock price, the delta will be more negative by the amount of the gamma. To account for the entire effect of direction, Brendan needs to take both delta and gamma into account. He needs to estimate the average delta based on gamma during the stock price move. The formula for the change in stock price is\nTaking into account the effect of gamma as well as delta, Johnson & Johnson needs to rise only $1.01, in order for Brendan’scalls to be offered at his stop-loss price of 1.10.\nWhile having apredefined price point to cover in the event the underlying rises is important, sometimes traders need to think on their feet. If material news is announced that changes the fundamental outlook for the stock, Brendan will have to adjust his plan. If the news leads Brendan to become bullish on the stock, he should exit the trade at once, taking asmall loss now instead of the bigger loss he would expect later. If the trader is uncertain as to whether to hold or close the position, the Would I Do It Now? rule is auseful rule of thumb.\nWould I Do It Now? Rule\nTo follow this rule, ask yourself, “If Idid not already have this position, would Ido it now? Would Iestablish the position at the current market prices, given the current market scenario?” If the answer is no, then the solution is simple: Exit the trade.\nFor example, if after one week material news is released and Johnson & Johnson is trading higher, at $64.50 per share, and the November 65 call is trading at 0.75, Brendan must ask himself, based on the price of the stock and all known information, “If Iwere not already short the calls, would Ishort them now at the current price of 0.75, with the stock trading at $64.50?”\nBrendan’sopinion of the stock is paramount in this decision. If, for example, based on the news that was announced he is now bullish, he would likely not want to sell the calls at 0.75—he only gets $0.09 more in option premium and the stock is 0.50 closer to the strike. If, however, he is not bullish, there is more to consider.\nTheta can be of great use in decision making in this situation. As the number of days until expiration decreases and the stock approaches $65 (making the option more at-the-money), Brendan’stheta grows more positive.\nExhibit 5.3\nshows the theta of this trade as the underlying rises over time.\nEXHIBIT 5.3\nTheta of Johnson & Johnson.\nWhen the position is first established, positive theta comforts Brendan by showing that with each passing day he gets alittle closer to his goal—to have the 65 calls expire out-of-the-money (OTM) and reap aprofit of the entire 66-cent premium. Theta becomes truly useful if the position begins to move against him. As Johnson & Johnson rises, the trade gets more precarious. His negative delta increases. His negative gamma increases. His goal becomes more out of reach. In conjunction with delta and gamma, theta helps Brendan decide whether the risk is worth the reward.\nIn the new scenario, with the stock at $64.50, Brendan would collect $18 aday (1.80 × 10 contracts). Is the risk of loss in the short run worth earning $18 aday? With Johnson & Johnson at $64.50, would Brendan now short 10 calls at 0.75 to collect $18 aday, knowing that each day may bring acontinued move higher in the stock? The answer to this question depends on Brendan’sassessment of the risk of the underlying continuing its ascent. As time passes, if the stock remains closer to the strike, the daily theta rises, providing more reward. Brendan must consider that as theta—the reward—rises, so does gamma: arisk factor.\nAsmall but noteworthy risk is that implied volatility could rise. The negative vega of this position would, then, adversely affect the profitability of this trade. It will make Brendan’s 1.10 cover-point approach faster because it makes the option more expensive. Vega is likely to be of less consequence because it would ultimately take the stock’srising though the strike price for the trade to be aloser at expiration.\nShort Naked Puts\nAnother trader, Stacie, has also been studying Johnson & Johnson. Stacie believes Johnson & Johnson is on its way to test the $65 resistance level yet again. She believes it may even break through $65 this time, based on strong fundamentals. Stacie decides to sell naked puts. Anaked put is ashort put that is not sold in conjunction with stock or another option.\nWith the stock around $64, the market for the November 65 put is 1.75 bid at 1.80. Stacie likes the fact that the 65 puts are slightly in-the-money (ITM) and thus have ahigher delta. If her price rise comes sooner than expected, the high delta may allow her to take aprofit early. Stacie sells 10 puts at 1.75.\nIn the best-case scenario, Stacie retains the entire 1.75. For that to happen, she will need to hold this position until expiration and the stock will have to rise to be trading above the 65 strike. Logically, Stacie will want to do an at-expiration analysis.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00014.html", "doc_id": "01107f315fc580e07ea295f188e733f66cee602679430263d82534b04aa781d8", "chunk_index": 2}
{"text": "it early. Stacie sells 10 puts at 1.75.\nIn the best-case scenario, Stacie retains the entire 1.75. For that to happen, she will need to hold this position until expiration and the stock will have to rise to be trading above the 65 strike. Logically, Stacie will want to do an at-expiration analysis.\nExhibit 5.4\nshows Stacie’snaked put trade if she holds it until expiration.\nEXHIBIT 5.4\nNaked Johnson & Johnson put at expiration.\nWhile harvesting the entire premium as aprofit sounds attractive, if Stacie can take the bulk of her profit early, she’ll be happy to close the position and eliminate her risk—nobody ever went broke taking aprofit. Furthermore, she realizes that her outlook may be wrong: Johnson & Johnson may decline. She may have to close the position early—maybe for aprofit, maybe for aloss. Stacie also needs to study her greeks.\nExhibit 5.5\nshows the greeks for this trade.\nEXHIBIT 5.5\nGreeks for short Johnson & Johnson 65 put (per contract).\nDelta\n0.65\nGamma\n−0.15\nTheta\n0.02\nVega\n−0.07\nThe first item to note is the delta. This position has adirectional bias. This bias can work for or against her. With apositive 0.65 delta per contract, this position has adirectional sensitivity equivalent to being long around 650 shares of the stock. That’sthe delta × 100 shares × 10 contracts.\nStacie’strade is not just abullish version of Brendan’s. Partly because of the size of the delta, it’sdifferent—specific directional bias aside. First, she will handle her trade differently if it is profitable.\nFor example, if over the next week or so Johnson & Johnson rises $1, positive delta and negative gamma will have anet favorable effect on Stacie’sprofitability. Theta is small in comparison and won’thave too much of an effect. Delta/gamma will account for adecrease in the put’stheoretical value of about $0.73. That’sthe estimated average delta times the stock move, or [0.65 + (–0.15/2)] × 1.00.\nStacie’sactual profit would likely be less than 0.73 because of the bid-ask spread. Stacie must account for the fact that the bid-ask is 0.05 wide (1.75–1.80). Because Stacie would buy to close this position, she should consider the 0.73 price change relative to the 1.80 offer, not the 1.75 trade price—that is, she factors in anickel of slippage. Thus, she calculates, that the puts will be offered at 1.07 (that’s 1.80 − 0.73) when the stock is at $65. That is again of $0.68.\nIn this scenario, Stacie should consider the Would I Do It Now? rule to guide her decision as to whether to take her profit early or hold the position until expiration. Is she happy being short ten 65 puts at 1.07 with Johnson & Johnson at $65? The premium is lower now. The anticipated move has already occurred, and she still has 28 days left in the option that could allow for the move to reverse itself. If she didn’thave the trade on now, would she sell ten 65 puts at 1.07 with Johnson & Johnson at $65? Based on her original intention, unless she believes strongly now that abreakout through $65 with follow-through momentum is about to take place, she will likely take the money and run.\nStacie also must handle this trade differently from Brendan in the event that the trade is aloser. Her trade has ahigher delta. An adverse move in the underlying would affect Stacie’strade more than it would Brendan’s. If Johnson & Johnson declines, she must be conscious in advance of where she will cover.\nStacie considers both how much she is willing to lose and what potential stock-price action will cause her to change her forecast. She consults astock chart of Johnson & Johnson. In this example, we’ll assume there is some resistance developing around $64 in the short term. If this resistance level holds, the trade becomes less attractive. The at-expiration breakeven is $63.25, so the trade can still be awinner if Johnson & Johnson retreats. But Stacie is looking for the stock to approach $65. She will no longer like the risk/reward of this trade if it looks like that price rise won’toccur. She makes the decision that if Johnson & Johnson bounces off the $64 level over the next couple weeks, she will exit the position for fear that her outlook is wrong. If Johnson & Johnson drifts above $64, however, she will ride the trade out.\nIn this example, Stacie is willing to lose 1.00 per contract. Without taking into account theta or vega, that 1.00 loss in the option should occur at astock price of about $63.28. Theta is somewhat relevant here. It helps Stacie’spotential for profit as time passes. As time passes and as the stock rises, so will theta, helping her even more. If the stock moves lower (against her) theta helps ease the pain somewhat, but the further in-the-money the put, the lower the theta.\nVega can be important here for two reasons: first, because of how implied volatility tends to change with market direction, and second, because it can be read as an indication of the market’sexpectations.\nThe Double Whammy\nWith the stock around $64, there is anegative vega of abo", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00014.html", "doc_id": "01107f315fc580e07ea295f188e733f66cee602679430263d82534b04aa781d8", "chunk_index": 3}
{"text": "he lower the theta.\nVega can be important here for two reasons: first, because of how implied volatility tends to change with market direction, and second, because it can be read as an indication of the market’sexpectations.\nThe Double Whammy\nWith the stock around $64, there is anegative vega of about seven cents. As the stock moves lower, away from the strike, the vega gets abit smaller. However, the market conditions that would lead to adecline in the price of Johnson & Johnson would likely cause implied volatility (IV) to rise. If the stock drops, Stacie would have two things working against her—delta and vega—adouble whammy. Stacie needs to watch her vega.\nExhibit 5.6\nshows the vega of Stacie’sput as it changes with time and direction.\nEXHIBIT 5.6\nJohnson & Johnson 65 put vega.\nIf after one week passes Johnson & Johnson gaps lower to, say, $63.00 ashare, the vega will be 0.043 per contract. If IV subsequently rises 5 points as aresult of the stock falling, vega will make Stacie’sputs theoretically worth 21.5 cents more per contract. She will lose $215 on vega (that’s 0.043 vega × 5 volatility points × 10 contracts) plus the adverse delta/gamma move.\nAgap opening will cause her to miss the opportunity to stop herself out at her target price entirely. Even if the stock drifts lower, her targeted stop-loss price will likely come sooner than expected, as the option price will likely increase both by delta/gamma and vega resulting from rising volatility. This can cause her to have to cover sooner, which leaves less room for error. With this trade, increases in IV due to market direction can make it feel as if the delta is greater than it actually is as the market declines. Conversely, IV softening makes it feel as if the delta is smaller than it is as the market rises.\nThe second reason IV has importance for this trade (as for most other strategies) is that it can give some indication of how much the market thinks the stock can move. If IV is higher than normal, the market perceives there to be more risk than usual of future volatility. The question remains: Is the higher premium worth the risk?\nThe answer to this question is subjective. Part of the answer is based on Stacie’sassessment of future volatility. Is the market right? The other part is based on Stacie’srisk tolerance. Is she willing to endure the greater price swings associated with the potentially higher volatility? This can mean getting whipsawed, which is exiting aposition after reaching astop-loss point only to see the market reverse itself. The would-be profitable trade is closed for aloss. Higher volatility can also mean ahigher likelihood of getting assigned and acquiring an unwanted long stock position.\nCash-Secured Puts\nThere are some situations where higher implied volatility may be abeneficial trade-off. What if Stacie’smotivation for shorting puts was different? What if she would like to own the stock, just not at the current market price? Stacie can sell ten 65 puts at 1.75 and deposit $63,250 in her trading account to secure the purchase of 1,000 shares of Johnson & Johnson if she gets assigned. The $63,250 is the $65 per share she will pay for the stock if she gets assigned, minus the 1.75 premium she received for the put × $100 × 10 contracts. Because the cash required to potentially purchase the stock is secured by cash sitting ready in the account, this is called acash-secured put.\nHer effective purchase price if assigned is $63.25—the same as her breakeven at expiration. The idea with this trade is that if Johnson & Johnson is anywhere under $65 per share at expiration, she will buy the stock effectively at $63.25. If assigned, the time premium of the put allows her to buy the stock at adiscount compared with where it is priced when the trade is established, $64. The higher the time premium—or the higher the implied volatility—the bigger the discount.\nThis discount, however, is contingent on the stock not moving too much. If it is above $65 at expiration she won’tget assigned and therefore can only profit amaximum of 1.75 per contract. If the stock is below $63.25 at expiration, the time premium no longer represents adiscount, in fact, the trade becomes aloser. In away, Stacie is still selling volatility.\nCovered Call\nThe problem with selling anaked call is that it has unlimited exposure to upside risk. Because of this, many traders simply avoid trading naked calls. Amore common, and some would argue safer, method of selling calls is to sell them covered.\nAcovered call is when calls are sold and stock is purchased on ashare-for-share basis to cover the unlimited upside risk of the call. For each call that is sold, 100 shares of the underlying security are bought. Because of the addition of stock to this strategy, covered calls are traded with adifferent motivation than naked calls.\nThere are clearly many similarities between these two strategies. The main goal for both is to harvest the premium of the call. The theta for the cal", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00014.html", "doc_id": "01107f315fc580e07ea295f188e733f66cee602679430263d82534b04aa781d8", "chunk_index": 4}
{"text": "derlying security are bought. Because of the addition of stock to this strategy, covered calls are traded with adifferent motivation than naked calls.\nThere are clearly many similarities between these two strategies. The main goal for both is to harvest the premium of the call. The theta for the call is the same with or without the stock component. The gamma and vega for the two strategies are the same as well. The only difference is the stock. When stock is added to an option position, the net delta of the position is the only thing affected. Stock has adelta of one, and all its other greeks are zero.\nThe pivotal point for both positions is the strike price. That’sthe point the trader wants the stock to be above or below at expiration. With the naked call, the maximum payout is reaped if the stock is below the strike at expiration, and there is unlimited risk above the strike. With the covered call, the maximum payout is reaped if the stock is above the strike at expiration. If the stock is below the strike at expiration, the risk is substantial—the stock can potentially go to zero.\nPutting It on\nThere are afew important considerations with the covered call, both when putting on, or entering, the position and when taking off, or exiting, the trade. The risk/reward implications of implied volatility are important in the trade-planning process. Do Iwant to get paid more to assume more potential risk? More speculative traders like the higher premiums. More conservative (investment-oriented) covered-call sellers like the low implied risk of low-IV calls. Ultimately, amain focus of acovered call is the option premium. How fast can it go to zero without the movement hurting me? To determine this, the trader must study both theta and delta.\nThe first step in the process is determining which month and strike call to sell. In this example, Harley-Davidson Motor Company (HOG) is trading at about $69 per share. Atrader, Bill, is neutral to slightly bullish on Harley-Davidson over the next three months.\nExhibit 5.7\nshows aselection of available call options for Harley-Davidson with corresponding deltas and thetas.\nEXHIBIT 5.7\nHarley-Davidson calls.\nIn this example, the May 70 calls have 85 days until expiration and are 2.80 bid. If Harley-Davidson remained at $69 until May expiration, the 2.80 premium would represent a 4 percent profit over this 85-day period (2.80 ÷ 69). That’san annualized return of about 17 percent ([0.04 / 85)] × 365).\nBill considers his alternatives. He can sell the April (57-day) 70 calls at 2.20 or the March (22-day) 70 calls at 0.85. Since there is adifferent number of days until expiration, Bill needs to compare the trades on an apples-to-apples basis. For this, he will look at theta and implied volatility.\nPresumably, the March call has atheta advantage over the longer-term choices. The March 70 has atheta of 0.032, while the April 70’stheta is 0.026 and the May 70’sis 0.022. Based on his assessment of theta, Bill would have the inclination to sell the March. If he wants exposure for 90 days, when the March 70 call expires, he can roll into the April 70 call and then the May 70 call (more on this in subsequent chapters). This way Bill can continue to capitalize on the nonlinear rate of decay through May.\nNext, Bill studies the IV term structure for the Harley-Davidson ATMs and finds the March has about a 19.2 percent IV, the April has a 23.3 percent IV, and the May has a 23 percent IV. March is the cheapest option by IV standards. This is not necessarily afavorable quality for ashort candidate. Bill must weigh his assessment of all relevant information and then decide which trade is best. With this type of astrategy, the benefits of the higher theta can outweigh the disadvantages of selling the lower IV. In this case, Bill may actually like selling the lower IV. He may infer that the market believes Harley-Davidson will be less volatile during this period.\nSo far, Bill has been focusing his efforts on the 70 strike calls. If he trades the March 70 covered call, he will have anet delta of 0.588 per contract. That’sthe negative 0.412 delta from shorting the call plus the 1.00 delta of the stock. His indifference point if the trade is held until expiration is $70.85. The indifference point is the point at which Bill would be indifferent as to whether he held only the stock or the covered call. This is figured by adding the strike price of $70 to the 0.85 premium. This is the effective sale price of the stock if the call is assigned. If Bill wants more potential for upside profit, he could sell ahigher strike. He would have to sell the April or May 75, since the March 75s are azero bid. This would give him ahigher indifference point, and the upside profits would materialize quickly if HOG moved higher, since the covered-call deltas would be higher with the 75 calls. The April 75 covered-call net delta is 0.796 per contract (the stock delta of 1.00 minus the 0.204 delta of the call). The May 75 c", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00014.html", "doc_id": "01107f315fc580e07ea295f188e733f66cee602679430263d82534b04aa781d8", "chunk_index": 5}
{"text": "e him ahigher indifference point, and the upside profits would materialize quickly if HOG moved higher, since the covered-call deltas would be higher with the 75 calls. The April 75 covered-call net delta is 0.796 per contract (the stock delta of 1.00 minus the 0.204 delta of the call). The May 75 covered-call delta is 0.751.\nBut Bill is neutral to only slightly bullish. In this case, he’drather have the higher premium—high theta is more desirable than high delta in this situation. Bill buys 1,000 shares of Harley-Davidson at $69 and sells 10 Harley-Davidson March 70 calls at 0.85.\nBill also needs to plan his exit. To exit, he must study two things: an at-expiration diagram and his greeks.\nExhibit 5.8\nshows the P&(L) at expiration of the Harley-Davidson March 70 covered call.\nExhibit 5.9\nshows the greeks.\nEXHIBIT 5.8\nHarley-Davidson covered call.\nEXHIBIT 5.9\nGreeks for Harley-Davidson covered call (per contract).\nDelta\n0.591\nGamma\n−0.121\nTheta\n0.032\nVega\n−0.066\nTaking It Off\nIf the trade works out perfectly for Bill, 22 days from now Harley-Davidson will be trading right at $70. He’dprofit on both delta and theta. If the trade isn’texactly perfect, but still good, Harley-Davidson will be anywhere above $68.15 in 22 days. It’sthe prospect that the trade may not be so good at March expiration that occupies Bill’sthoughts, but atrader has to hope for the best and plan for the worst.\nIf it starts to trend, Bill needs to react. The consequences to the stock’strending to the upside are not quite so dire, although he might be somewhat frustrated with any lost opportunity above the indifference point. It’sthe downside risk that Bill will more vehemently guard against.\nFirst, the same IV/vega considerations exist as they did in the previous examples. In the event the trade is closed early, IV/vega may help or hinder profitability. Arise in implied volatility will likely accompany adecline in the stock price. This can bring Bill to his stop-loss sooner. Delta versus theta however, is the major consideration. He will plan his exit price in advance and cover when the planned exit price is reached.\nThere are more moving parts with the covered call than anaked option. If Bill wants to close the position early, he can leg out, meaning close only one leg of the trade (the call or the stock) at atime. If he legs out of the trade, he’slikely to close the call first. The motivation for exiting atrade early is to reduce risk. Anaked call is hardly less risky than acovered call.\nAnother tactic Bill can use, and in this case will plan to use, is rolling the call. When the March 70s expire, if Harley-Davidson is still in the same range and his outlook is still the same, he will sell April calls to continue the position. After the April options expire, he’ll plan to sell the Mays.\nWith this in mind, Bill may consider rolling into the Aprils before March expiration. If it is close to expiration and Harley-Davidson is trading lower, theta and delta will both have devalued the calls. At the point when options are close to expiration and far enough OTM to be offered close to zero, say 0.05, the greeks and the pricing model become irrelevant. Bill must consider in absolute terms if it is worth waiting until expiration to make 0.05. If there is alot of time until expiration, the answer is likely to be no. This is when Bill will be apt to roll into the Aprils. He’ll buy the March 70s for anickel, adime, or maybe 0.15 and at the same time sell the Aprils at the bid. This assumes he wants to continue to carry the position. If the roll is entered as asingle order, it is called acalendar spread or atime spread.\nCovered Put\nThe last position in the family of basic volatility-selling strategies is the covered put, sometimes referred to as selling puts and stock. In acovered put, atrader sells both puts and stock on aone-to-one basis. The term\ncovered put\nis abit of amisnomer, as the strategy changes from limited risk to unlimited risk when short stock is added to the short put. Anaked put can produce only losses until the stock goes to zero—still asubstantial loss. Adding short stock means that above the strike gains on the put are limited, while losses on the stock are unlimited. The covered put functions very much like anaked call. In fact, they are synthetically equal. This concept will be addressed further in the next chapter.\nLet’slooks at another trader, Libby. Libby is an active trader who trades several positions at once. Libby believes the overall market is in arange and will continue as such over the next few weeks. She currently holds ashort stock position of 1,000 shares in Harley-Davidson. She is becoming more neutral on the stock and would consider buying in her short if the market dipped. She may consider entering into acovered-put position. There is one caveat: Libby is leaving for acruise in two weeks and does not want to carry any positions while she is away. She decides she will sell the covered put and actively manage the t", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00014.html", "doc_id": "01107f315fc580e07ea295f188e733f66cee602679430263d82534b04aa781d8", "chunk_index": 6}
{"text": "ould consider buying in her short if the market dipped. She may consider entering into acovered-put position. There is one caveat: Libby is leaving for acruise in two weeks and does not want to carry any positions while she is away. She decides she will sell the covered put and actively manage the trade until her vacation. Libby will sell 10 Harley-Davidson March (22-day) 70 puts at 1.85 against her short 1,000 shares of Harley-Davidson, which is trading at $69 per share.\nShe knows that her maximum profit if the stock declines and assignment occurs will be $850. That’s 0.85 × $100 × 10 contracts. Win or lose, she will close the position in two weeks when there are only eight days until expiration. To trade this covered put she needs to watch her greeks.\nExhibit 5.10\nshows the greeks for the Harley-Davidson 70-strike covered put.\nEXHIBIT 5.10\nGreeks for Harley-Davidson covered put (per contract).\nDelta\n−0.419\nGamma\n−0.106\nTheta\n0.031\nVega\n−0.066\nLibby is really focusing on theta. It is currently about $0.03 per day but will increase if the put stays close-to-the-money. In two weeks, the time premium will have decayed significantly. Amove downward will help, too, as the −0.419 delta indicates.\nExhibit 5.11\ndisplays an array of theoretical values of the put at eight days until expiration as the stock price changes.\nEXHIBIT 5.11\nHOG 70 put values at 8 days to expiry.\nAs long as Harley-Davidson stays below the strike price, Libby can look at her put from apremium-over-parity standpoint. Below the strike, the intrinsic value of the put doesn’tmatter too much, because losses on intrinsic value are offset by gains on the stock. For Libby, all that really matters is the time value. She sold the puts at 0.85 over parity. If Harley-Davidson is trading at $68 with eight days to go, she can buy her puts back for 0.12 over parity. That’sa 73-cent profit, or $730 on her 10 contracts. This doesn’taccount for any changes in the time value that may occur as aresult of vega, but vega will be small with Harley-Davidson at $68 and eight days to go. At this point, she would likely close down the whole position—buying the puts and buying the stock—to take aprofit on aposition that worked out just about exactly as planned.\nHer risk, though, is to the upside. Abig rally in the stock can cause big losses. From atheoretical standpoint, losses are potentially unlimited with this type of trade. If the stock is above the strike, she needs to have amental stop order in mind and execute the closing order with discipline.\nCurious Similarities\nThese basic volatility-selling strategies are fairly simple in nature. If the trader believes astock will not rise above acertain price, the most straightforward way to trade the forecast is to sell acall. Likewise, if the trader believes the stock will not go below acertain price he can sell aput. The covered call and covered put are also ways to generate income on long or short stock positions that have these same price thresholds. In fact, the covered call and covered put have some curious similarities to the naked put and naked call. The similarities between the two pairs of positions are no coincidence. The following chapter sheds light on these similarities.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00014.html", "doc_id": "01107f315fc580e07ea295f188e733f66cee602679430263d82534b04aa781d8", "chunk_index": 7}
{"text": "CHAPTER 6\nPut-Call Parity and Synthetics\nIn order to understand more complex spread strategies involving two or more options, it is essential to understand the arbitrage relationship of the put-call pair. Puts and calls of the same month and strike on the same underlying have prices that are defined in amathematical relationship. They also have distinctly related vegas, gammas, thetas, and deltas. This chapter will show how the metrics of these options are interrelated. It will also explore synthetics and the idea that by adding stock to aposition, atrader may trade with indifference either acall or aput to the same effect.\nPut-Call Parity Essentials\nBefore the creation of the Black-Scholes model, option pricing was hardly an exact science. Traders had only afew mathematical tools available to compare the relative prices of options. One such tool, put-call parity, stems from the fact that puts and calls on the same class sharing the same month and strike can have the same functionality when stock is introduced.\nFor example, traders wanting to own astock with limited risk can buy amarried put: long stock and along put on ashare-for-share basis. The traders have infinite profit potential, and the risk of the position is limited below the strike price of the option. Conceptually, long calls have the same risk/reward profile—unlimited profit potential and limited risk below the strike.\nExhibit 6.1\nis an overview of the at-expiration diagrams of amarried put and along call.\nEXHIBIT 6.1\nLong call vs. long stock + long put (married put).\nMarried puts and long calls sharing the same month and strike on the same security have at-expiration diagrams with the same shape. They have the same volatility value and should trade around the same implied volatility (IV). Strategically, these two positions provide the same service to atrader, but depending on margin requirements, the married put may require more capital to establish, because the trader must buy not just the option but also the stock.\nThe stock component of the married put could be purchased on margin. Buying stock on margin is borrowing capital to finance astock purchase. This means the trader has to pay interest on these borrowed funds. Even if the stock is purchased without borrowing, there is opportunity cost associated with the cash used to pay for the stock. The capital is tied up. If the trader wants to use funds to buy another asset, he will have to borrow money, which will incur an interest obligation. Furthermore, if the trader doesn’tinvest capital in the stock, the capital will rest in an interest-bearing account. The trader forgoes that interest when he buys astock. However the trader finances the purchase, there is an interest cost associated with the transaction.\nBoth of these positions, the long call and the married put, give atrader exposure to stock price advances above the strike price. The important difference between the two trades is the value of the stock below the strike price—the part of the trade that is not at risk in either the long call or the married put. On this portion of the invested capital, the trader pays interest with the married put (whether actually or in the form of opportunity cost). This interest component is apricing consideration that adds cost to the married put and not the long call.\nSo if the married put is amore expensive endeavor than the long call because of the interest paid on the investment portion that is below the strike, why would anyone buy amarried put? Wouldn’ttraders instead buy the less expensive—less capital intensive—long call? Given the additional interest expense, they would rather buy the call. This relates to the concept of arbitrage. Given two effectively identical choices, rational traders will choose to buy the less expensive alternative. The market as awhole would buy the calls, creating demand which would cause upward price pressure on the call. The price of the call would rise until its interest advantage over the married put was gone. In arobust market with many savvy traders, arbitrage opportunities don’texist for very long.\nIt is possible to mathematically state the equilibrium point toward which the market forces the prices of call and put options by use of the put-call parity. As shown in Chapter 2, the put-call parity states\nwhere cis the call premium, PV(x) is the present value of the strike price, pis the put premium and sis the stock price.\nAnother, less academic and more trader-friendly way of stating this equation is\nwhere Interest is calculated as\nInterest = Strike × Interest Rate ×(Days to Expiration/365)\n1\nThe two versions of the put-call parity stated here hold true for European options on non-dividend-paying stocks.\nDividends\nAnother difference between call and married-put values is dividends. Acall option does not extend to its owner the right to receive adividend payment. Traders, however, who are long aput and long stock are entitled to adividend if it is the corporation", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00015.html", "doc_id": "b6d98d5f72460719733d66baa53c19511ba7b39b95f21fbea8ab5fb5029e19d5", "chunk_index": 0}
{"text": "ptions on non-dividend-paying stocks.\nDividends\nAnother difference between call and married-put values is dividends. Acall option does not extend to its owner the right to receive adividend payment. Traders, however, who are long aput and long stock are entitled to adividend if it is the corporation’spolicy to distribute dividends to its shareholders.\nAn adjustment must be made to the put-call parity to account for the possibility of adividend payment. The equation must be adjusted to account for the absence of dividends paid to call holders. For adividend-paying stock, the put-call parity states\nThe interest advantage and dividend disadvantage of owning acall is removed from the market by arbitrageurs. Ultimately, that is what is expressed in the put-call parity. It’saway to measure the point at which the arbitrage opportunity ceases to exist. When interest and dividends are factored in, along call is an equal position to along put paired with long stock. In options nomenclature, along put with long stock is asynthetic long call. Algebraically rearranging the above equation:\nThe interest and dividend variables in this equation are often referred to as the basis. From this equation, other synthetic relationships can be algebraically derived, like the synthetic long put.\nAsynthetic long put is created by buying acall and selling (short) stock. The at-expiration diagrams in\nExhibit 6.2\nshow identical payouts for these two trades.\nEXHIBIT 6.2\nLong put vs. long call + short stock.\nThe concept of synthetics can become more approachable when studied from the perspective of delta as well. Take the 50-strike put and call listed on a $50 stock. Ageneral rule of thumb in the put-call pair is that the call delta plus the put delta equals 1.00 when the signs are ignored. If the 50 put in this example has a −0.45 delta, the 50 call will have a 0.55 delta. By combining the long call (0.55 delta) with short stock (–1.00 delta), we get asynthetic long put with a −0.45 delta, just like the actual put. The directional risk is the same for the synthetic put and the actual put.\nAsynthetic short put can be created by selling acall of the same month and strike and buying stock on ashare-for-share basis (i.e., acovered call). This is indicated mathematically by multiplying both sides of the put-call parity equation by −1:\nThe at-expiration diagrams, shown in\nExhibit 6.3\n, are again conceptually the same.\nEXHIBIT 6.3\nShort put vs. short call + long stock.\nAshort (negative) put is equal to ashort (negative) call plus long stock, after the basis adjustment. Consider that if the put is sold instead of buying stock and selling acall, the interest that would otherwise be paid on the cost of the stock up to the strike price is asavings to the put seller. To balance the equation, the interest benefit of the short put must be added to the call side (or subtracted from the put side). It is the same with dividends. The dividend benefit of owning the stock must be subtracted from the call side to make it equal to the short put side (or added to the put side to make it equal the call side).\nThe same delta concept applies here. The short 50-strike put in our example would have a 0.45 delta. The short call would have a −0.55 delta. Buying one hundred shares along with selling the call gives the synthetic short put anet delta of 0.45 (–0.55 + 1.00).\nSimilarly, asynthetic short call can be created by selling aput and selling (short) one hundred shares of stock.\nExhibit 6.4\nshows aconceptual overview of these two positions at expiration.\nEXHIBIT 6.4\nShort call vs. short put + short stock.\nPut-call parity can be manipulated as shown here to illustrate the composition of the synthetic short call.\nMost professional traders earn ashort stock rebate on the proceeds they receive when they short stock—an advantage to the short-put–short-stock side of the equation. Additionally, short-stock sellers must pay dividends on the shares they are short—aliability to the married-put seller. To make all things equal, one subtracts interest and adds dividends to the put side of the equation.\nComparing Synthetic Calls and Puts\nThe common thread among the synthetic positions explained above is that, for aput-call pair, long options have synthetic equivalents involving long options, and short options have synthetic equivalents involving short options. After accounting for the basis, the four basic synthetic option positions are:\nBecause acall or put position is interchangeable with its synthetic position, an efficient market will ensure that the implied volatility is closely related for both. For example, if along call has an IV of 25 percent, the corresponding put should have an IV of about 25 percent, because the long put can easily be converted to asynthetic long call and vice versa. The greeks will be similar for synthetically identical positions, too. The long options and their synthetic equivalents will have positive gamma and vega with negative theta. The short", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00015.html", "doc_id": "b6d98d5f72460719733d66baa53c19511ba7b39b95f21fbea8ab5fb5029e19d5", "chunk_index": 1}
{"text": "ave an IV of about 25 percent, because the long put can easily be converted to asynthetic long call and vice versa. The greeks will be similar for synthetically identical positions, too. The long options and their synthetic equivalents will have positive gamma and vega with negative theta. The short options and their synthetics will have negative gamma and vega with positive theta.\nAmerican-Exercise Options\nPut-call parity was designed for European-style options. The early exercise possibility of American-style options gums up the works abit. Because acall (put) and asynthetic call (put) are functionally the same, it is logical to assume that the implied volatility and the greeks for both will be exactly the same. This is not necessarily true with American-style options. However, put-call parity may still be useful with American options when the limitations of the equation are understood. With at-the-money American-exercise options, the differences in the greeks for aput-call pair are subtle.\nExhibit 6.5\nis acomparison of the greeks for the 50-strike call and the 50-strike put with the underlying at $50 and 66 days until expiration.\nEXHIBIT 6.5\nGreeks for a 50-strike put-call pair on a $50 stock.\nCall\nPut\nDelta\n0.554\n0.457\nGamma\n0.075\n0.078\nTheta\n0.020\n0.013\nVega\n0.084\n0.084\nThe examples used earlier in this chapter in describing the deltas of synthetics were predicated on the rule of thumb that the absolute values of call and put deltas add up to 1.00. To be abit more realistic, consider that because of American exercise, the absolute delta values of put-call pairs don’talways add up to 1.00. In fact,\nExhibit 6.5\nshows that the call has closer to a 0.554 delta. The put struck at the same price then has a 0.457 delta. By selling 100 shares against the long call, we can create acombined-position delta (call delta plus stock delta) that is very close to the put’sdelta. The delta of this synthetic put is −0.446 (0.554 − 1.00). The delta of aput will always be similar to the delta of its corresponding synthetic put. This is also true with call–synthetic-call deltas. This relationship mathematically is\nThis holds true whether the options are in-, at-, or out-of-the-money. For example, with astock at $54, the 50-put would have a −0.205 delta and the call would have a 0.799 delta. Selling 100 shares against the call to create the synthetic put yields anet delta of −0.201.\nIf long or short stock is added to acall or put to create asynthetic, delta will be the only greek affected. With that in mind, note the other greeks displayed in\nExhibit 6.5\n—especially theta. Proportionally, the biggest difference in the table is in theta. The disparity is due in part to interest. When the effects of the interest component outweigh the effects of the dividend, the time value of the call can be higher than the time value of the put. Because the call must lose more premium than the put by expiration, the theta of the call must be higher than the theta of the put.\nAmerican exercise can also cause the option prices in put-call parity to not add up. Deep in-the-money (ITM) puts can trade at parity while the corresponding call still has time value. The put-call equation can be unbalanced. The same applies to calls on dividend-paying stocks as the dividend date approaches. When the date is imminent, calls can trade close to parity while the puts still have time value. The role of dividends will be discussed further in Chapter 8.\nSynthetic Stock\nNot only can synthetic calls and puts be derived by manipulation of put-call parity, but synthetic positions for the other security in the equation—stock—can be derived, as well. By isolating stock on one side of the equation, the formula becomes\nAfter accounting for interest and dividends, buying acall and selling aput of the same strike and time to expiration creates the equivalent of along stock position. This is called asynthetic stock position, or acombo. After accounting for the basis, the equation looks conceptually like this:\nThis is easy to appreciate when put-call parity is written out as it is here. It begins to make even more sense when considering at-expiration diagrams and the greeks.\nExhibit 6.6\nillustrates along stock position compared with along call combined with ashort put position.\nEXHIBIT 6.6\nLong stock vs. long call + short put.\nAquick glance at these two strategies demonstrates that they are the same, but think about why. Consider the synthetic stock position if both options are held until expiration. The long call gives the trader the right to buy the stock at the strike price. The short put gives the trader the obligation to buy the stock at the same strike price. It doesn’tmatter what the strike price is. As long as the strike is the same for the call and the put, the trader will have along position in the underlying at the shared strike at expiration when exercise or assignment occurs.\nThe options in this example are 50-strike options. At expiration, the trader can ex", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00015.html", "doc_id": "b6d98d5f72460719733d66baa53c19511ba7b39b95f21fbea8ab5fb5029e19d5", "chunk_index": 2}
{"text": "atter what the strike price is. As long as the strike is the same for the call and the put, the trader will have along position in the underlying at the shared strike at expiration when exercise or assignment occurs.\nThe options in this example are 50-strike options. At expiration, the trader can exercise the call to buy the underlying at $50 if the stock is above the strike. If the underlying is below the strike at expiration, he’ll get assigned on the put and buy the stock at $50. If the stock is bought, whether by exercise or assignment, the\neffective price\nof the potential stock purchase, however, is not necessarily $50.\nFor example, if the trader bought one 50-strike call at 3.50 and sold one 50-strike put at 1.50, he will effectively purchase the underlying at $52 upon exercise or assignment. Why? The trader paid anet of $2 to get along position in the stock synthetically (3.50 of call premium debited minus 1.50 of put premium credited). Whether the call or the put is ITM, the effective purchase price of the stock will always be the strike price plus or minus the cost of establishing the synthetic, in this case, $52.\nThe question that begs to be asked is: would the trader rather buy the stock or pay $2 to have the same market exposure as long stock? Arbitrageurs in the market (with the help of the put-call parity) ensure that neither position—long stock or synthetic long stock—is better than the other.\nFor example, assume astock is trading at $51.54. With 71 days until expiration, 26.35 IV, a 5 percent interest rate, and no dividends, the 50-strike call is theoretically worth 3.50, and the 50-strike put is theoretically worth 1.50.\nExhibit 6.7\ncharts the synthetic stock versus the actual stock when there are 71 days until expiration.\nEXHIBIT 6.7\nLong stock and synthetic long stock with 71 days to expiration.\nLooking at this exhibit, it appears that being long the actual stock outperforms being long the stock synthetically. If the stock is purchased at $51.54, it need only rise apenny higher to profit (in the theoretical world where traders do not pay commissions on transactions). If the synthetic is purchased for $2, the stock needs to rise $0.46 to break even—an apparent disadvantage. This figure, however, does not include interest.\nThe synthetic stock offers the same risk/reward as actually being long the stock. There is abenefit, from the perspective of interest, to paying only $2 for this exposure rather than $51.54. The interest benefit here is about $0.486. We can find this number by calculating the interest as we did earlier in the chapter. Interest, again, is computed as the strike price times the interest rate times the number of days to expiration divided by the number of days in ayear. The formula is as follows:\nInputting the numbers from this example:\nThe $0.486 of interest is about equal to the $0.46 disparity between the diagrams of the stock and the synthetic stock with 71 days until expiration. The difference is due mainly to rounding and the early-exercise potential of the American put. In mathematical terms\nThe synthetic long stock is approximately equal to the long stock position when considering the effect of interest. The two lines in\nExhibit 6.7\n—representing stock and synthetic stock—would converge with each passing day as the calculated interest decreases.\nThis equation works as well for asynthetic short stock position; reversing the signs reveals the synthetic for short stock.\nOr, in this case,\nShorting stock at $51.54 is about equal to selling the 50 call and buying the 50 put for a $2 credit based on the interest of 0.486 computed on the 50 strike. Again, the $0.016 disparity between the calculated interest and the actual difference between the synthetic value and the stock price is afunction of rounding and early exercise. More on this in the “Conversions and Reversals” section.\nSynthetic Stock Strategies\nUltimately, when we roll up our sleeves and get down to the nitty-gritty, options trading is less about having another alternative for trading the direction of the underlying than it is about trading the greeks. Different strategies allow traders to exploit different facets of option pricing. Some strategies allow traders to trade volatility. Some focus mainly on theta. Many of the strategies discussed in this section present ways for atrader to distill risk down mostly to interest rate exposure.\nConversions and Reversals\nWhen calls and puts are combined to create synthetic stock, the main differences are the interest rate and dividends. This is important because the risks associated with interest and dividends can be isolated, and ultimately traded, when synthetic stock is combined with the underlying. There are two ways to combine synthetic stock with its underlying security: aconversion and areversal.\nConversion\nAconversion is athree-legged position in which atrader is long stock, short acall, and long aput. The options share the same month and strike price. By most met", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00015.html", "doc_id": "b6d98d5f72460719733d66baa53c19511ba7b39b95f21fbea8ab5fb5029e19d5", "chunk_index": 3}
{"text": "ined with the underlying. There are two ways to combine synthetic stock with its underlying security: aconversion and areversal.\nConversion\nAconversion is athree-legged position in which atrader is long stock, short acall, and long aput. The options share the same month and strike price. By most metrics, this is avery flat position. Atrader with aconversion is long the stock and, at the same time, synthetically short the same stock. Consider this from the perspective of delta. In aconversion, the trader is long 1.00 deltas (the long stock) and short very close to 1.00 deltas (the synthetic short stock). Conversions have net flat deltas.\nThe following is asimple example of atypical conversion and the corresponding deltas of each component.\nShort one 35-strike call:\n−0.63 delta\nLong one 35-strike put:\n−0.37 delta\nLong 100 shares:\n1.00 delta\n0.00 delta\nThe short call contributes anegative delta to the position, in this case, −0.63. The long put also contributes anegative delta, −0.37. The combined delta of the synthetic stock is −1.00 in this example, which is like being short 100 shares of stock. When the third leg of the spread is added, the long 100 shares, it counterbalances the synthetic. The total delta for the conversion is zero.\nMost of the conversion’sother greeks are pretty flat as well. Gamma, theta, and vega are similar for the call and the put in the conversion, because they have the same expiration month and strike price. Because the trader is selling one option and buying another—acall and aput, respectively—with the same month and strike, the greeks come very close to offsetting each other. For all intents and purposes, the trader is out of the primary risks of the position as measured by greeks when aposition is converted. Let’slook at amore detailed example.\nAtrader executes the following trade (for the purposes of this example, we assume the stock pays no dividend and the trade is executed at fair value):\nSell one 71-day 50 call at 3.50\nBuy one 71-day 50 put at 1.50\nBuy 100 shares at $51.54\nThe trader buys the stock at $51.54 and synthetically sells the stock at $52. The synthetic price is computed as −3.50 + 1.50 − 50. Therefore, the stock is sold synthetically at $0.46 over the actual stock price.\nExhibit 6.8\nshows the analytics for the conversion.\nEXHIBIT 6.8\nConversion greeks.\nThis position has very subtle sensitivity to the greeks. The net delta for the spread has avery slightly negative bias. The bias is so small it is negligible to most traders, except professionals trading very large positions.\nWhy does this negative delta bias exist? Mathematically, the synthetic’sdelta can be higher with American options than with their European counterparts because of the possibility of early exercise of the put. This anomaly becomes more tangible when we consider the unique directional risk associated with this trade.\nIn this example, the stock is synthetically sold at $0.46 over the price at which the stock is bought. If the stock declines significantly in value before expiration, the put will, at some point, trade at parity while the call loses all its time value. In this scenario, the value of the synthetic stock will be short at effectively the same price as the actual stock price. For example, if the stock declines to $35 per share then the numbers are as follows:\nor\nWith American options, aput this far in-the-money with less than 71 days until expiry will be all intrinsic value. Interest, in this case, will not factor into the put’svalue, because the put can be exercised. By exercising the put, both the long stock leg and the long put leg can be closed for even money, leaving only the theoretically worthless call. The stock-synthetic spread is sold at 0.46 and essentially bought at zero when the put is exercised. If the put is exercised before expiration, the profit potential is 0.46 minus the interest calculated between the trade date and the day the put is exercised. If, however, the conversion is held until expiration, the $0.46 is negated by the $0.486 of interest incurred from holding long stock over the entire 71-day period, hence the trader’sdesire to see the stock decline before expiration, and thus the negative bias toward delta.\nThis is, incidentally, why the synthetic price (0.46 over the stock price) does not exactly equal the calculated value of the interest (0.486). The trader can exercise the put early if the stock declines and capitalize on the disparity between the interest calculated when the conversion was traded and the actual interest calculation given the shorter time frame. The model values the synthetic at alittle less than the interest value would indicate—in this case $0.46 instead of $0.486.\nThe gamma of this trade is fairly negligible. The theta is slightly positive. Rho is the figure that deserves the most attention. Rho is the change in an option’sprice given achange in the interest rate.\nThe −0.090 rho of the conversion indicates that if the interest rate rise", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00015.html", "doc_id": "b6d98d5f72460719733d66baa53c19511ba7b39b95f21fbea8ab5fb5029e19d5", "chunk_index": 4}
{"text": ".46 instead of $0.486.\nThe gamma of this trade is fairly negligible. The theta is slightly positive. Rho is the figure that deserves the most attention. Rho is the change in an option’sprice given achange in the interest rate.\nThe −0.090 rho of the conversion indicates that if the interest rate rises one percentage point, the position as awhole loses $0.09. Why? The financing of the position gets more expensive as the interest rate rises. The trader would have to pay more in interest to carry the long stock. In this example, if interest rises by one percentage point, the synthetic stock, which had an effective short price of $0.46 over the price of the long stock before the interest rate increase, will be $0.55 over the price of the long stock afterward. If, however, the interest rate declines by one percentage point, the trader profits $0.09, as the synthetic is repriced by the market to $0.37 over the stock price. The lower the interest rate, the less expensive it is to finance the long stock. This is proven mathematically by put-call parity. Negative rho indicates abearish position on the interest rate; the trader wants it to go lower. Positive rho is abullish interest rate position.\nBut aone-percentage-point change in the interest rate in one day is abig and uncommon change. The question is: is rho relevant? That depends on the type of position and the type of trader. A 0.090 rho would lead to a 0.0225 profit-and-loss (P&(L)) change per one lot conversion on a 25-basis-point, or quarter percent, change. That’sjust $2.25 per spread. This incremental profit or loss, however, can be relevant to professional traders like market makers. They trade very large positions with the aspiration of making small incremental profits on each trade. Amarket maker with a 5,000-lot conversion would stand to make or lose $11,250, given aquarter-percentage-point change in interest rate and a 0.090 rho.\nThe Mind of a Market Maker\nMarket makers are among the only traders who can trade conversions and reversals profitably, because of the size of their trades and the fact that they can buy the bid and sell the offer. Market makers often attempt to leg into and out of conversions (and reversals). Given the conversion in this example, amarket maker may set out to sell calls and in turn buy stock to hedge the call’sdelta risk (this will be covered in Chapters 12 and 17), then buy puts and the rest of the stock to create abalanced conversion: one call to one put to one hundred shares. The trader may try to put on the conversion in the previous example for atotal of $0.50 over the price of the long stock instead of the $0.46 it’sworth. He would then try to leg out of the trade for less, say $0.45 over the stock, with the goal of locking in a $0.05 profit per spread on the whole trade.\nReversal\nAreversal, or reverse conversion, is simply the opposite of the conversion: buy call, sell put, and sell (short) stock. Areversal can be executed to close aconversion, or it can be an opening transaction. Using the same stock and options as in the previous example, atrader could establish areversal as follows:\nBuy one 71-day 50 call at 3.50\nSell one 71-day 50 put at 1.50\nSell 100 shares at 51.54\nThe trader establishes ashort position in the stock at $51.54 and along synthetic stock position effectively at $52.00. He buys the stock synthetically at $0.46 over the stock price, again assuming the trade can be executed at fair value. With the reversal, the trader has abullish position on interest rates, which is indicated by apositive rho.\nIn this example, the rho for this position is 0.090. If interest rates rise one percentage point, the synthetic stock (which the trader is long) gains nine cents in value relative to the stock. The short stock rebate on the short stock leg earns more interest at ahigher interest rate. If rates fall one percentage point, the synthetic long stock loses $0.09. The trader earns less interest being short stock given alower interest rate.\nWith the reversal, the fact that the put can be exercised early is arisk. Since the trader is short the put and short stock, he hopes not to get assigned. If he does, he misses out on the interest he planned on collecting when he put on the reversal for $0.46 over.\nPin Risk\nConversions and reversals are relatively low-risk trades. Rho and early exercise are relevant to market makers and other arbitrageurs, but they are among the lowest-risk positions they are likely to trade. There is one indirect risk of conversions and reversals that can be of great concern to market makers around expiration: pin risk. Pin risk is the risk of not knowing for certain whether an option will be assigned. To understand this concept, let’srevisit the mind of amarket maker.\nRecall that market makers have two primary functions:\n1. Buy the bid or sell the offer.\n2. Manage risk.\nWhen institutional or retail traders send option orders to an exchange (through abroker), market makers are usually the ones with", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00015.html", "doc_id": "b6d98d5f72460719733d66baa53c19511ba7b39b95f21fbea8ab5fb5029e19d5", "chunk_index": 5}
{"text": "understand this concept, let’srevisit the mind of amarket maker.\nRecall that market makers have two primary functions:\n1. Buy the bid or sell the offer.\n2. Manage risk.\nWhen institutional or retail traders send option orders to an exchange (through abroker), market makers are usually the ones with whom they trade. Customers sell the bid; the market makers buy the bid. Customers buy the offer; the market makers sell the offer. The first and arguably easier function of market makers is accomplished whenever amarketable order is sent to the exchange.\nManaging risk can get abit hairy. For example, once the market makers buy April 40 calls, their first instinct is to hedge by selling stock to become delta neutral. Market makers are almost always delta neutral, which mitigates the direction risk. The next step is to mitigate theta, gamma, and vega risk by selling options. The ideal options to sell are the same calls that were bought—that is, get out of the trade. The next best thing is to sell the April 40 puts and sell more stock. In this case, the market makers have established areversal and thereby have very little risk. If they can lock in the reversal for asmall profit, they have done their job.\nWhat happens if the market makers still have the reversal in inventory at expiration? If the stock is above the strike price—40, in this case—the puts expire, the market makers exercise the calls, and the short stock is consequently eliminated. The market makers are left with no position, which is good. They’re delta neutral. If the stock is below 40, the calls expire, the puts get assigned, and the short stock is consequently eliminated. Again, no position. But what if the stock is exactly at $40? Should the calls be exercised? Will the puts get assigned? If the puts are assigned, the traders are left with no short stock and should let the calls expire without exercising so as not to have along delta position after expiration. If the puts are not assigned, they should exercise the calls to get delta flat. It’salso possible that only some of the puts will be assigned.\nBecause they don’tknow how many, if any, of the puts will be assigned, the market makers have pin risk. To avoid pin risk, market makers try to eliminate their position if they have conversions or reversals close to expiration.\nBoxes and Jelly Rolls\nThere are two other uses of synthetic stock positions that form conventional strategies: boxes and rolls.\nBoxes\nWhen long synthetic stock is combined with short synthetic stock on the same underlying within the same expiration cycle but with adifferent strike price, the resulting position is known as abox. With abox, atrader is synthetically both long and short the stock. The two positions, for all intents and purposes, offset each other directionally. The risk of stock-price movement is almost entirely avoided. Astudy of the greeks shows that the delta is close to zero. Gamma, theta, vega, and rho are also negligible. Here’san example of a 60–70 box for April options:\nShort 1 April 60 call\nLong 1 April 60 put\nLong 1 April 70 call\nShort 1 April 70 put\nIn this example, the trader is synthetically short the 60-strike and, at the same time, synthetically long the 70-strike.\nExhibit 6.9\nshows the greeks.\nEXHIBIT 6.9\nBox greeks.\nAside from the risks associated with early exercise implications, this position is just about totally flat. The near-1.00 delta on the long synthetic stock struck at 60 is offset by the near-negative-1.00 delta of the short synthetic struck at 70. The tiny gammas and thetas of both combos are brought closer to zero when they are spread against each another. Vega is zero. And the bullish interest rate sensitivity of the long combo is nearly all offset by the bearish interest sensitivity of the short combo. The stock can move, time can pass, volatility and interest can change, and there will be very little effect on the trader’s P&(L). The question is: Why would someone trade abox?\nMarket makers accumulate positions in the process of buying bids and selling offers. But they want to eliminate risk. Ideally, they try to be\nflat the strike\n—meaning have an equal number of calls and puts at each strike price, whether through aconversion or areversal. Often, they have aconversion at one strike and areversal at another. The stock positions for these cancel each other out and the trader is left with only the four option legs—that is, abox. They can eliminate pin risk on both strikes by trading the box as asingle trade to close all four legs. Another reason for trading abox has to do with capital.\nBorrowing and Lending Money\nThe first thing to consider is how this spread is priced. Let’slook at another example of abox, the October 50–60 box.\nLong 1 October 60 call\nShort 1 October 60 put\nShort 1 October 70 call\nLong 1 October 70 put\nAtrader with this position is synthetically long the stock at $60 and short the stock at $70. That sounds like $10 in the bank. The question is: How much would atrader", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00015.html", "doc_id": "b6d98d5f72460719733d66baa53c19511ba7b39b95f21fbea8ab5fb5029e19d5", "chunk_index": 6}
{"text": "example of abox, the October 50–60 box.\nLong 1 October 60 call\nShort 1 October 60 put\nShort 1 October 70 call\nLong 1 October 70 put\nAtrader with this position is synthetically long the stock at $60 and short the stock at $70. That sounds like $10 in the bank. The question is: How much would atrader be willing to pay for the right to $10? And for how much would someone be willing to sell it? At face value, the obvious answer is that the equilibrium point is at $10, but there is one variable that must be factored in: time.\nIn this example, assume that the October call has 90 days until expiration and the interest rate is 6 percent. Arational trader would not pay $10 today for the right to have $10 90 days from now. That would effectively be like loaning the $10 for 90 days and not receiving interest—Alosing proposition! The trader on the other side of this box would be happy to enter into the spread for $10. He would have interest-free use of $10 for 90 days. That’sfree money! Certainly, there is interest associated with the cost of carrying the $10. In this case, the interest would be $0.15.\nThis $0.15 is discounted from the price of the $10 box. In fact, the combined net value of the options composing the box should be about 9.85—with differences due mainly to rounding and the early exercise possibility for American options.\nAtrader buying this box—that is, buying the more ITM call and more ITM put—would expect to pay $0.15 below the difference between the strike prices. Fair value for this trade is $9.85. The seller of this box—the trader selling the meatier options and buying the cheaper ones—would concede up to $0.15 on the credit.\nJelly Rolls\nAjelly roll, or simply aroll, is also aspread with four legs and acombination of two synthetic stock trades. In abox, the difference between the synthetics is the strike price; in aroll, it’sthe contract month. Here’san example:\nLong 1 April 50 call\nShort 1 April 50 put\nShort 1 May 50 call\nLong 1 May 50 put\nThe options in this spread all share the same strike price, but they involve two different months—April and May. In this example, the trader is long synthetic stock in April and short synthetic stock in May. Like the conversion, reversal, and box, this is amostly flat position. Delta, gamma, theta, vega, and even rho have only small effects on ajelly roll, but like the others, this spread serves apurpose.\nAtrader with aconversion or reversal can roll the option legs of the position into amonth with alater expiration. For example, atrader with an April 50 conversion in his inventory (short the 50 call, long the 50 put, long stock) can avoid pin risk as April expiration approaches by trading the roll from the above example. The long April 50 call and short April 50 put cancel out the current option portion of the conversion leaving only the stock. Selling the May 50 calls and buying the May 50 puts reestablishes the conversion amonth farther out.\nAnother reason for trading aroll has to do with interest. The roll in this example has positive exposure to rho in April and negative exposure to rho in May. Based on atrader’sexpectations of future changes in interest rates, aposition can be constructed to exploit opportunities in interest.\nTheoretical Value and the Interest Rate\nThe main focus of the positions discussed in this chapter is fluctuations in the interest rate. But which interest rate? That of 30-year bonds? That of 10- or 5-year notes? Overnight rates? The federal funds rate? In the theoretical world, the answer to this question is not really that important. Professors simply point to the riskless rate and continue with their lessons. But when putting strategies like these into practice, choosing the right rate makes abig difference. To answer the question of which interest rate, we must consider exactly what the rates represent from the standpoint of an economist. Therefore, we must understand how an economist makes arguments—by making assumptions.\nTake the story of the priest, the physicist, and the economist stranded on adesert island with nothing to eat except acan of beans. The problem is, the can is sealed. In order to survive, they must figure out how to open the can. The priest decides he will pray for the can to be opened by means of amiracle. He prays for hours, but, alas, the can remains sealed tight. The physicist devises acomplex system of wheels and pulleys to pop the top off the can. This crude machine unfortunately fails as well. After watching the lack of success of his fellow strandees, the economist announces that he has the solution: “Assume we have acan opener.”\nIn the spirit of economists’ logic, let’simagine for amoment atheoretical economic microcosm in which atrader has two trading accounts at the same firm. The assumptions here are that atrader can borrow 100 percent of astock’svalue to finance the purchase of the security and that there are no legal, moral, or other limitations on trading. In one account the trader is long 100 sha", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00015.html", "doc_id": "b6d98d5f72460719733d66baa53c19511ba7b39b95f21fbea8ab5fb5029e19d5", "chunk_index": 7}
{"text": "c microcosm in which atrader has two trading accounts at the same firm. The assumptions here are that atrader can borrow 100 percent of astock’svalue to finance the purchase of the security and that there are no legal, moral, or other limitations on trading. In one account the trader is long 100 shares, fully leveraged. In the other, the trader is short 100 shares of the same stock, in which case the trader earns ashort-stock rebate.\nIn the long run, what is the net result of this trade? Most likely, this trade is alosing proposition for the trader, because the interest rate at which the trader borrows capital is likely to be higher than the interest rate earned on the short-stock proceeds. In this example, interest is the main consideration.\nBut interest matters in the real world, too. Professional traders earn interest on proceeds from short stock and pay interest on funds borrowed. Interest rates may vary slightly from firm to firm and trader to trader. Interest rates are personal. The interest rate atrader should use when pricing options is specific to his or her situation.\nAtrader with no position in aparticular stock who is interested in trading aconversion should consider that he will be buying the stock. This implies borrowing funds to open the long stock position. The trader should price his options according to the rate he will pay to borrow funds. Conversely, atrader trading areversal should consider the fact that he is shorting the stock and will receive interest at the rate of the short-stock rebate. This trader should price his options at the short-stock rate.\nA Call Is a Put\nThe idea that “aput is acall, acall is aput” is an important one, indeed. It lays the foundation for more advanced spreading strategies. The concepts in this chapter in one way or another enter into every spread strategy that will be discussed in this book from here on out.\nNote\n1\n. Note, for simplicity, simple interest is used in the computation.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00015.html", "doc_id": "b6d98d5f72460719733d66baa53c19511ba7b39b95f21fbea8ab5fb5029e19d5", "chunk_index": 8}
{"text": "CHAPTER 7\nRho\nInterest is one of the six inputs of an option-pricing model for American options. Although interest rates can remain constant for long periods, when interest rates do change, call and put values can be positively or negatively affected. Some options are more sensitive to changes in the interest rate than others. To the unaware trader, interest-rate changes can lead to unexpected profits or losses. But interest rates don’thave to be awild-card risk. They’re one that experienced traders watch closely to avoid unnecessary risk and increase profitability. To monitor the effect of changes in the interest rate, it is important to understand the quiet greek—rho.\nRho and Interest Rates\nRho is ameasurement of the sensitivity of an option’svalue to achange in the interest rate. To understand how and why the interest rate is important to the value of an option, recall the formula for put-call parity stated in Chapter 6.\nCall + Strike − Interest = Put + Stock\n1\nFrom this formula, it’sclear that as the interest rate rises, put prices must fall and call prices must rise to keep put-call parity balanced. With alittle algebra, the equation can be restated to better illustrate this concept:\nand\nIf interest rates fall,\nand\nRho helps quantify this relationship. Calls have positive rho, and puts have negative rho. For example, acall with arho of +0.08 will gain $0.08 with each one-percentage-point rise in interest rates and fall $0.08 with each one-percentage-point fall in interest rates. Aput with arho of −0.08 will lose $0.08 with each one-point rise and gain $0.08 in value with aone-point fall.\nThe effect of changes in the interest variable of put-call parity on call and put values is contingent on three factors: the strike price, the interest rate, and the number of days until expiration.\nInterest = Strike×Interest Rate×(Days to Expiration/365)\n2\nInterest, for our purposes, is afunction of the strike price. The higher the strike price, the greater the interest and, consequently the more changes in the interest rate will affect the option. The higher the interest rate is, the higher the interest variable will be. Likewise, the more time to expiration, the greater the effect of interest. Rho measures an option’ssensitivity to the end results of these three influences.\nTo understand how changes in interest affect option prices, consider atypical at-the-money (ATM) conversion on anon-dividend-paying stock.\nShort 1 May 50 call at 1.92\nLong 1 May 50 put at 1.63\nLong 100 shares at $50\nWith 43 days until expiration at a 5 percent interest rate, the interest on the 50 strike will be about $0.29. Put-call parity ensures that this $0.29 shows up in option prices. After rearranging the equation, we get\nIn this example, both options are exactly ATM. There is no intrinsic value. Therefore, the difference between the extrinsic values of the call and the put must equal interest. If one option were in-the-money (ITM), the intrinsic value on the left side of the equation would be offset by the Stock − Strike on the right side. Still, it would be the difference in the time value of the call and put that equals the interest variable.\nThis is shown by the fact that the synthetic stock portion of the conversion is short at $50.29 (call − put + strike). This is $0.29 above the stock price. The synthetic stock equals the Stock + Interest, or\nCertainly, if the interest rate were higher, the interest on the synthetic stock would be ahigher number. At a 6 percent interest rate, the effective short price of the synthetic stock would be about $50.35. The call would be valued at about 1.95, and the put would be 1.60—anet of $0.35.\nAone-percentage-point rise in the interest rate causes the synthetic stock position to be revalued by $0.06—a $0.03 gain in the call value and a $0.03 decline in the put. Therefore, by definition, the call has a +0.03 rho and the put has a −0.03 rho.\nRho and Time\nThe time component of interest has abig impact on the magnitude of an option’srho, because the greater the number of days until expiration, the greater the interest. Long-term options will be more sensitive to changes in the interest rate and, therefore, have ahigher rho.\nTake astock trading at about $120 per share. The July, October, and January ATM calls have the following rhos with the interest rate at 5.5 percent.\nOption\nRho\nJuly (38-day) 120 calls\n+0.068\nOctober (130-day) 120 calls\n+0.226\nJanuary (221-day) 120 calls\n+0.385\nIf interest rates rise 25 basis points, or aquarter of apercentage point, the July calls with only 38 days until expiration will gain very little: only $0.017 (0.068 × 0.25). The October 120 calls with 130 days until expiration gain more: $0.057 (0.226 × 0.25). The January calls that have 221 days until they expire make $0.096 theoretically (0.385 × 0.25). If all else is held constant, the more time to expiration, the higher the option’srho, and therefore, the more interest will affect the option’svalue.\nConsidering Rho When Pla", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00016.html", "doc_id": "c99e77ba4cb6d76386ddc94ffb4945d27044415a40fd7e7fbb92678dd0cc1607", "chunk_index": 0}
{"text": "ore: $0.057 (0.226 × 0.25). The January calls that have 221 days until they expire make $0.096 theoretically (0.385 × 0.25). If all else is held constant, the more time to expiration, the higher the option’srho, and therefore, the more interest will affect the option’svalue.\nConsidering Rho When Planning Trades\nJust having an opinion on astock is only half the battle in options trading. Choosing the best way to trade aforecast can make all the difference to the success of atrade. Options give traders choices. And one of the choices atrader has is the month in which to trade. When trading LEAPS—Long-Term Equity AnticiPation Securities—delta, gamma, theta, and vega are important, as always, but rho is also avaluable part of the strategy.\nLEAPS\nOptions buyers have time working against them. With each passing day, theta erodes the value of their assets. Buying along-term option, or a LEAPS, helps combat erosion because long-term options can decay at aslower rate. In environments where there is interest rate uncertainty, however, LEAPS traders have to think about more than the rate of decay.\nConsider two traders: Jason and Susanne. Both are bullish on XYZ Corp. (XYZ), which is trading at $59.95 per share. Jason decides to buy a May 60 call at 1.60, and Susanne buys a LEAPS 60 call at 7.60. In this example, May options have 44 days until expiration, and the LEAPS have 639 days.\nBoth of these trades are bullish, but the traders most likely had slightly different ideas about time, volatility, and interest rates when they decided which option to buy.\nExhibit 7.1\ncompares XYZ short-term at-the-money calls with XYZ LEAPS ATM calls.\nEXHIBIT 7.1\nXYZ short-term call vs. LEAPS call.\nTo begin with, it appears that Susanne was allowing quite abit of time for her forecast to be realized—almost two years. Jason, however, was looking for short-term price appreciation. Concerns about time decay may have been amotivation for Susanne to choose along-term option—her theta of 0.01 is half Jason’s, which is 0.02. With only 44 days until expiration, the theta of Jason’s May call will begin to rise sharply as expiration draws near.\nBut the trade-off of lower time decay is lower gamma. At the current stock price, Susanne has ahigher delta. If the XYZ stock price rises $2, the gamma of the May call will cause Jason’sdelta to creep higher than Susanne’s. At $62, the delta for the May 60s would be about 0.78, whereas the LEAPS 60 call delta is about 0.77. This disparity continues as XYZ moves higher.\nPerhaps Susanne had implied volatility (IV) on her mind as well as time decay. These long-term ATM LEAPS options have vegas more than three times the corresponding May’s. If IV for both the May and the LEAPS is at ayearly low, LEAPS might be abetter buy. Aone- or two-point rise in volatility if IV reverts to its normal level will benefit the LEAPS call much more than the May.\nTheta, delta, gamma, and vega are typical considerations with most trades. Because this option is long term, in addition to these typical considerations, Susanne needs to take agood hard look at rho. The LEAPS rho is significantly higher than that of its short-term counterpart. Aone-percentage-point change in the interest rate will change Susanne’s P&(L) by $0.64—that’sabout 8.5 percent of the value of her option—and she has nearly two years of exposure to interest rate fluctuations. Certainly, when the Federal Reserve Board has great concerns about growth or inflation, rates can rise or fall by more than one percentage point in one year’stime.\nIt is important to understand that, like the other greeks, rho is asnapshot at aparticular price, volatility level, interest rate, and moment in time. If interest rates were to fall by one percentage point today, it would cause Susanne’scall to decline in value by $0.64. If that rate drop occurred over the life of the option, it would have amuch smaller effect. Why? Rate changes closer to expiration have less of an effect on option values.\nAssume that on the trade date, when the LEAPS has 639 days until expiration, interest rates fall by 25 basis points. The effect will be adecline in the value of the call of 0.16—one-fourth of the 0.638 rho. If the next rate cut occurs six months later, the rho of the LEAPS will be smaller, because it will have less time until expiration. In this case, after six months, the rho will be only 0.46. Another 25-basis-point drop will hurt the call by $0.115. After another six months, the option will have a 0.26 rho. Another quarter-point cut costs Susanne only $0.065. Any subsequent rate cuts in ensuing months will have almost no effect on the now short-term option value.\nPricing in Interest Rate Moves\nIn the same way that volatility can get priced in to an option’svalue, so can the interest rate. When interest rates are expected to rise or fall, those expectations can be reflected in the prices of options. Say current interest rates are at 8 percent, but the Fed has announced that the economy is grow", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00016.html", "doc_id": "c99e77ba4cb6d76386ddc94ffb4945d27044415a40fd7e7fbb92678dd0cc1607", "chunk_index": 1}
{"text": "he same way that volatility can get priced in to an option’svalue, so can the interest rate. When interest rates are expected to rise or fall, those expectations can be reflected in the prices of options. Say current interest rates are at 8 percent, but the Fed has announced that the economy is growing at too fast of apace and that it may raise interest rates at the next Federal Open Market Committee meeting. Analysts expect more rate hikes to follow. The options with expiration dates falling after the date of the expected rate hikes will have higher interest rates priced in. In this situation, the higher interest rates in the longer-dated options will be evident when entering parameters into the model.\nTake options on Already Been Chewed Bubblegum Corp. (ABC). Atrader, Kyle, enters parameters into the model for ABC options and notices that the prices don’tline up. To get the theoretical values of the ATM calls for all the expiration months to sit in the middle of the actual market values, Kyle may have to tinker with the interest rate inputs.\nAssume the following markets for the ATM 70-strike calls in ABC options:\nCalls\nPuts\nAug 70 calls\n1.75–1.85\n1.30–1.40\nSep 70 calls\n2.65–2.75\n1.75–1.85\nDec 70 calls\n4.70–4.90\n2.35–2.45\nMar 70 calls\n6.50–6.70\n2.65–2.75\nABC is at $70 ashare, has a 20 percent IV in all months, and pays no dividend. August expiration is one month away.\nEntering the known inputs for strike price, stock price, time to expiration, volatility, and dividend and using an 8 percent interest rate yields the following theoretical values for ABC options:\nThe theoretical values, in bold type, are those that don’tline up in the middle of the call and put markets. These values are wrong. The call theoretical values are too low, and the put theoretical values are too high. They are the product of an interest rate that is too low being applied to the model. To generate values that are indicative of market prices, Kyle must change the interest input to the pricing model to reflect the market’sexpectations of future interest rate changes.\nUsing new values for the interest rate yields the following new values:\nAfter recalculating, the theoretical values line up in the middle of the call and put markets. Using higher interest rates for the longer expirations raises the call values and lowers the put values for these months. These interest rates were inferred from, or backed out of, the option-market prices by use of the option-pricing model. In practice, it may take some trial and error to find the correct interest values to use.\nIn times of interest rate uncertainty, rho can be an important factor in determining which strategy to select. When rates are generally expected to continue to rise or fall over time, they are normally priced in to the options, as shown in the previous example. When there is no consensus among analysts and traders, the rates that are priced in may change as economic data are made available. This can cause arevision of option values. In long-term options that have higher rhos, this is abona fide risk. Short-term options are asafer play in this environment. But as all traders know, risk also implies opportunity.\nTrading Rho\nWhile it’spossible to trade rho, most traders forgo this niche for more dynamic strategies with greater profitability. The effects of rho are often overshadowed by the more profound effects of the other greeks. The opportunity to profit from rho is outweighed by other risks. For most traders, rho is hardly ever even looked at.\nBecause LEAPS have higher rho values than corresponding short-term options, it makes sense that these instruments would be appropriate for interest-rate plays. But even with LEAPS, rho exposure usually pales in comparison with that of delta, theta, and vega.\nIt is not uncommon for the rho of along-term option to be 5 to 8 percent of the option’svalue. For example,\nExhibit 7.2\nshows atwo-year LEAPS on a $70 stock with the following pricing-model inputs and outputs:\nEXHIBIT 7.2\nLong 70-strike LEAPS call.\nThe rho is +0.793, or about 5.8 percent of the call value. That means a 25-basis-point rise in rates contributes to only a 20-cent profit on the call. That’sonly about 1.5 percent of the call’svalue. On one hand, 1.5 percent is not avery big profit on atrade. On the other hand, if there are more rate rises at following Fed meetings, the trader can expect further gains on rho.\nEven if the trader is compelled to wait until the next Fed meeting to make another $0.20—or less, as rho will get smaller as time passes—from asecond 25-basis-point rate increase, other influences will diminish rho’ssignificance. If over the six-week period between Fed meetings, the underlying declines by just $0.60, the $0.40 that the trader hoped to make on rho is wiped out by delta loss. With the share price $0.60 lower, the 0.760 delta costs the trade about $0.46. Furthermore, the passing of six weeks (42 days) will lead to aloss of about $0.55 from time decay because o", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00016.html", "doc_id": "c99e77ba4cb6d76386ddc94ffb4945d27044415a40fd7e7fbb92678dd0cc1607", "chunk_index": 2}
{"text": "the underlying declines by just $0.60, the $0.40 that the trader hoped to make on rho is wiped out by delta loss. With the share price $0.60 lower, the 0.760 delta costs the trade about $0.46. Furthermore, the passing of six weeks (42 days) will lead to aloss of about $0.55 from time decay because of the −0.013 theta. There is also the risk from the fat vegas associated with LEAPS. A 1.5 percent drop in implied volatility completely negates any hopes of rho profits.\nAside from the possibility that delta, theta, and vega may get in the way of profits, the bid-ask spread with these long-term options tends to be wider than with their short-term counterparts. If the bid-ask spread is more than $0.40 wide, which is often the case with LEAPS, rho profits are canceled out by this cost of doing business. Buying the offer and selling the bid negative scalps away potential profits.\nWith LEAPS, rho is always aconcern. It will contribute to prosperity or peril and needs to be part of the trade plan from forecast to implementation. Buying or selling a LEAPS call or put, however, is not apractical way to speculate on interest rates.\nTo take aposition on interest rates in the options market, risk needs to be distilled down to rho. The other greeks need to be spread off. This is accomplished only through the conversions, reversals, and jelly rolls described in Chapter 6. However, the bid-ask can still be ahurdle to trading these strategies for non–market makers. Generally, rho is agreek that for most traders is important to understand but not practical to trade.\nNotes\n1\n. Please note, for simplification, dividends are not included.\n2\n. Note, for simplicity, simple interest is used in the calculation.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00016.html", "doc_id": "c99e77ba4cb6d76386ddc94ffb4945d27044415a40fd7e7fbb92678dd0cc1607", "chunk_index": 3}
{"text": "CHAPTER 8\nDividends and Option Pricing\nMuch of this book studies how to break down and trade certain components of option prices. This chapter examines the role of dividends in the pricing structure. There is no greek symbol that measures an option’ssensitivity to changes in the dividend. And in most cases, dividends are not “traded” by means of options in the same way that volatility, interest, and other option price influences are. Dividends do, though, affect option prices, and therefore atrader’s P&(L), so they deserve attention.\nThere are some instances where dividends provide ample opportunity to the option trader, and there some instances where achange in dividend policy can have desirable, or undesirable, effects on the bottom line. Despite the fact that dividends do not technically involve greeks, they need to be monitored in much the same way as do delta, gamma, theta, vega, and rho.\nDividend Basics\nLet’sstart at the beginning. When acompany decides to pay adividend, there are four important dates the trader must be aware of:\n1. Declaration date\n2. Ex-dividend date\n3. Record date\n4. Payable date\nThe first date chronologically is the declaration date. This date is when the company formally declares the dividend. It’swhen the company lets its shareholders know when and in what amount it will pay the dividend. Active traders, however, may buy and sell the same stock over and over again. How does the corporation know exactly who collects the dividend when it is opening up its coffers?\nDividends are paid to shareholders of record who are on the company’sbooks as owning the stock at the opening of business on another important date: the record date. Anyone long the stock at this moment is entitled to the dividend. Anyone with ashort stock position on the opening bell on the record date is required to make payment in the amount of the dividend. Because the process of stock settlement takes time, the important date is actually not the record date. For all intents and purposes, the key date is two days before the record date. This is called the ex-dividend date, or the ex-date.\nTraders who have earned adividend by holding astock in their account on the morning of the ex-date have one more important date they need to know—the date they get paid. The date that the dividend is actually paid is called the payable date. The payable date can be afew weeks after the ex-date.\nLet’swalk through an example. ABC Corporation announces on March 21 (the declaration date) that it will pay a 25-cent dividend to shareholders of record on April 3 (the record date), payable on April 23 (the payable date). This means market participants wishing to receive the dividend must own the stock on the open on April 1 (the ex-date). In practice, they must buy the stock before the closing bell rings on March 31 in order to have it for the open the next day.\nThis presents apotential quandary. If atrader only needs to have the stock on the open on the ex-date, why not buy the stock just before the close on the day before the ex-date, in this case March 31, and sell it the next morning after the open? Could this be an opportunity for riskless profit?\nUnfortunately, no. There are acouple of problems with that strategy. First, as far as the riskless part is concerned, stock prices can and often do change overnight. Yesterday’sclose and today’sopen can sometimes be significantly different. When they are, it is referred to as agap open. Whenever astock is held (long or short), there is risk. The second problem with this strategy to earn riskless profit is with the profit part. On the ex-date, the opening stock price reflects the dividend. Say ABC is trading at $50 at the close on March 31. If the market for the stock opens unchanged the next morning—that is, azero net change on the day on—ABC will be trading at $49.75 ($50 minus the $0.25 dividend). Alas, the quest for riskless profit continues.\nDividends and Option Pricing\nThe preceding discussion demonstrated how dividends affect stock traders. There’sone problem: we’re option traders! Option holders or writers do not receive or pay dividends, but that doesn’tmean dividends aren’trelevant to the pricing of these securities. Observe the behavior of aconversion or areversal before and after an ex-dividend date. Assuming the stock opens unchanged on the ex-date, the relationship of the price of the synthetic stock to the actual stock price will change. Let’slook at an example to explore why.\nAt the close on the day before the ex-date of astock paying a $0.25 dividend, atrader has an at-the-money (ATM) conversion. The stock is trading right at $50 per share. The 50 puts are worth 2.34, and the 50 calls are worth 2.48. Before the ex-date, the trader is\nLong 100 shares at $50\nLong one 50 put at 2.34\nShort one 50 call at 2.48\nHere, the trader is long the stock at $50 and short stock synthetically at $50.14—50 + (2.48 − 2.34). The trader is synthetically short $0.14 over the price at which he is lo", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00017.html", "doc_id": "dbb7773212ad1097334fd3df03b6a5b6d81704db0e84aad0d35e0cb71709bf00", "chunk_index": 0}
{"text": "ls are worth 2.48. Before the ex-date, the trader is\nLong 100 shares at $50\nLong one 50 put at 2.34\nShort one 50 call at 2.48\nHere, the trader is long the stock at $50 and short stock synthetically at $50.14—50 + (2.48 − 2.34). The trader is synthetically short $0.14 over the price at which he is long the stock.\nAssume that the next morning the stock opens unchanged. Since this is the ex-date, that means the stock opens at $49.75—$0.25 lower than the previous day’sclose. The theoretical values of the options will change very little. The options will be something like 2.32 for the put and 2.46 for the call.\nAfter the ex-date, the trader is\nLong 100 shares at $49.75\nLong one 50 put at 2.32\nShort one 50 call at 2.46\nEach option is two cents lower. Why? The change in the option prices is due to theta. In this case, it’s $0.02 for each option. The synthetic stock is still short from an effective price of $50.14. With the stock at $49.75, the synthetic short price is now $0.39 over the stock. Incidentally, $0.39 is $0.25 more than the $0.14 difference before the ex-date.\nDid the trader who held the conversion overnight from before the ex-date to after it make or lose money? Neither. Before the ex-date, he had an asset worth $50 per share (the stock) and he shorted the asset synthetically at $50.14. After the ex-date, he still has assets totaling $50 per share—the stock at $49.75 plus the 0.25 dividend—and he is still synthetically short the stock at $50.14. Before the ex-date, the $0.14 difference between the synthetic and the stock is interest minus the dividend. After the ex-date, the $0.39 difference is all interest.\nDividends and Early Exercise\nAs the ex-date approaches, in-the-money (ITM) calls on equity options can often be found trading at parity, regardless of the dividend amount and regardless of how far off expiration is. This seems counterintuitive. What about interest? What about dividends? Normally, these come into play in option valuation.\nBut option models designed for American options take the possibility of early exercise into account. It is possible to exercise American-style calls and exchange them for the underlying stock. This would give traders, now stockholders, the right to the dividend—aright for which they would not be eligible as call holders. Because of the impending dividend, the call becomes an exercise just before the ex-date. For this reason, the call can trade for parity before the ex-date.\nLet’slook at an example of areversal on a $70 stock that pays a $0.40 dividend. The options in this reversal have 24 days until expiration, which makes the interest on the 60 strike roughly $0.20, given a 5 percent interest rate. The day before the ex-date, atrader has the following position at the stated prices:\nShort 100 shares at $70\nLong one 60 call at 10.00\nShort one 60 put at 0.05\nTo understand how American calls work just before the ex-date, it is helpful first to consider what happens if the trader holds the position until the ex-date. Making the assumption that the stock is unchanged on the ex-dividend date, it will open at $69.60, lower by the amount of the dividend—in this case, $0.40. The put, being so far out-of-the-money (OTM) as to have anegligible delta, will remain unchanged. But what about the call? With no dividend left in the stock, the put call-parity states\nIn this case,\nBefore the ex-date, the model valued the call at parity. Now it values the same call at $0.25 over parity (9.85 − [69.60 − 60]). Another way to look at this is that the time value of the call is now made up of the interest plus the put premium. Either way, that’sagain of $0.25 on the call. That sounds good, but because the trader is short stock, if he hasn’texercised, he will owe the $0.40 dividend—anet loss of $0.15. The new position will be\nShort 100 shares at $69.60\nOwe $0.40 dividend\nLong one 60 call at 9.85\nShort one 60 put at 0.05\nAt the end of the trading day before the ex-date, this trader must exercise the call to capture the dividend. By doing so, he closes two legs of the trade—the call and the stock. The $10 call premium is forfeited, the stock that is short at $70 is bought at $60 (from the call exercise) for a $10 profit. The transaction leads to neither aprofit nor aloss. The purpose of exercising is to avoid the $0.15 loss ($0.25 gain in call time value minus the $0.40 loss in dividends owed).\nThe other way the trader could achieve the same ends is to sell the long call and buy in the short stock. This is tactically undesirable because the trader may have to sell the bid in the call and buy the offer in the stock. Furthermore, when legging atrade in this manner, there is the risk of slippage. If the call is sold first, the stock can move before the trader has achance to buy it at the necessary price. It is generally better and less risky to exercise the call rather than leg out of the trade.\nIn this transaction, the trader begins with afairly flat position (short stock/long synthetic stock)", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00017.html", "doc_id": "dbb7773212ad1097334fd3df03b6a5b6d81704db0e84aad0d35e0cb71709bf00", "chunk_index": 1}
{"text": "the call is sold first, the stock can move before the trader has achance to buy it at the necessary price. It is generally better and less risky to exercise the call rather than leg out of the trade.\nIn this transaction, the trader begins with afairly flat position (short stock/long synthetic stock) and ends with ashort put that is significantly out-of-the-money. For all intents and purposes, exercising the call in this trade is like synthetically selling the put. But at what price? In this case, it’s $0.15. This again is the cost benefit of saving $0.40 by avoiding the dividend obligation versus the $0.25 gain in call time value. Exercising the call is effectively like selling the put at 0.15 in this example. If the dividend is lower or the interest is higher, it may not be worth it to the trader to exercise the call to capture the dividend. How do traders know if their calls should be exercised?\nThe traders must do the math before each ex-dividend date in option classes they trade. The traders have to determine if the benefit from exercising—or the price at which the synthetic put is essentially being sold—is more or less than the price at which they can sell the put. The math used here is adopted from put-call parity:\nThis shows the case where the traders can effectively synthetically sell the put (by exercising) for more than the current put value. Tactically, it’sappropriate to use the bid price for the put in this calculation since that is the price at which the put can be sold.\nIn this case, the traders would be inclined to not exercise. It would be theoretically more beneficial to sell the put if the trader is so inclined.\nHere, the traders, from avaluation perspective, are indifferent as to whether or not to exercise. The question then is simply: do they want to sell the put at this price?\nProfessionals and big retail traders who are long (ITM) calls—whether as part of areversal, part of another type of spread, or because they are long the calls outright—must do this math the day before each ex-dividend date to maximize profits and minimize losses. Not exercising, or forgetting to exercise, can be acostly mistake. Traders who are short ITM dividend-paying calls, however, can reap the benefits of those sleeping on the job. It works both ways.\nTraders who are long stock and short calls at parity before the ex-date may stand to benefit if some of the calls do not get assigned. Any shares of long stock remaining on the ex-date will result in the traders receiving dividends. If the dividends that will be received are greater in value than the interest that will subsequently be paid on the long stock, the traders may stand reap an arbitrage profit because of long call holders’ forgetting to exercise.\nDividend Plays\nThe day before an ex-dividend date in astock, option volume can be unusually high. Tens of thousands of contracts sometimes trade in names that usually have average daily volumes of only acouple thousand. This spike in volume often has nothing to do with the market’sopinion on direction after the dividend. The heavy trading has to do with the revaluation of the relationship of exercisable options to the underlying expected to occur on the ex-dividend date.\nTraders that are long ITM calls and short ITM calls at another strike just before an ex-dividend date have apotential liability and apotential benefit. The potential liability is that they can forget to exercise. This is aliability over which the traders have complete control. The potential benefit is that some of the short calls may not get assigned. If traders on the other side of the short calls (the longs) forget to exercise, the traders that are short the call make out by not having to pay the dividend on short stock.\nProfessionals and big retail traders who have very low transaction costs will sometimes trade ITM call spreads during the afternoon before an ex-dividend date. This consists of buying one call and selling another call with adifferent strike price. Both calls in the dividend-play strategy are ITM and have corresponding puts with little or no value (to be sure, the put value is less than the dividend minus the interest). The traders trade the spreads, fairly indifferent as to whether they buy or sell the spreads, in hope of skating—or not getting assigned—on some of their short calls. The more they don’tget assigned the better.\nThis usually occurs in options that have high open interest, meaning there are alot of outstanding contracts already. The more contracts in existence, the better the possibility of someone forgetting to exercise. The greatest volume also tends to occur in the front month.\nStrange Deltas\nBecause American calls become an exercise possibility when the ex-date is imminent, the deltas can sometimes look odd. When the calls are trading at parity, they have a 1.00 delta. They are asubstitute for the stock. They, in fact, will be stock if and when they are exercised just before the ex-date. But if the puts st", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00017.html", "doc_id": "dbb7773212ad1097334fd3df03b6a5b6d81704db0e84aad0d35e0cb71709bf00", "chunk_index": 2}
{"text": "ls become an exercise possibility when the ex-date is imminent, the deltas can sometimes look odd. When the calls are trading at parity, they have a 1.00 delta. They are asubstitute for the stock. They, in fact, will be stock if and when they are exercised just before the ex-date. But if the puts still have some residual time value, they may also have asmall delta, of 0.05 or perhaps more.\nIn this unique scenario, the delta of the synthetic can be greater than +1.00 or less than −1.00. It is not uncommon to see the absolute values of the call and put deltas add up to 1.07 or 1.08. When the dividend comes out of the options model on the ex-date, synthetics go back to normal. The delta of the synthetic again approaches 1.00. Because of the out-of-whack deltas, delta-neutral traders need to take extra caution in their analytics when ex-dates are near. Alittle common sense should override what the computer spits out.\nInputting Dividend Data into the Pricing Model\nOften dividend payments are regular and predictable. With many companies, the dividend remains constant quarter after quarter. Some corporations have atrack record of incrementally increasing their dividends every year. Some companies pay dividends in avery irregular fashion, by paying special dividends that are often announced as asurprise to investors. In atruly capitalist society, there are no restrictions and no rules on when, whether, or how corporations pay dividends to their shareholders. Unpredictability of dividends, though, can create problems in options valuation.\nWhen acompany has aconstant, reasonably predictable dividend, there is not alot of guesswork. Take Exelon Corp. (EXC). From November 2008 to the time of this writing, Exelon has paid aregular quarterly dividend of $0.525. During that period, atrader has needed simply to enter 0.525 into the pricing calculator for all expected future dividends to generate the theoretical value. Based on recent past performance, the trader could feel confident that the computed analytics were reasonably accurate. If the trader believed the company would continue its current dividend policy, there would be little options-related dividend risk—unless things changed.\nWhen there is uncertainty about when future dividends will be paid in what amounts, the level of dividend-related risk begins to increase. The more uncertainty, the more risk. Let’sexamine an interesting case study: General Electric (GE).\nFor along time, GE was acompany that has had ahistory of increasing its dividends at fairly regular intervals. In fact, there was more than a 30-year stretch in which GE increased its dividend every year. During most of the first decade of the 2000s, increases in GE’sdividend payments were around one to six cents and tended to occur toward the end of December, after December expiration. The dividends were paid four times per year but not exactly quarterly. For several years, the ex-dates were in February, June, September, and December. Option traders trading GE options had apretty easy time estimating their future dividend streams, and consequently evaded valuation problems that could result from using wrong dividend data. Traders would simply adjust the dividend data in the model to match their expectations for predictably increasing future dividends in order to achieve an accurate theoretical value. Let’slook back at GE to see how atrader might have done this.\nThe following shows dividend-history data for GE.\nEx-Date\nDividend\n*\n12/27/02\n$0.19\n02/26/03\n$0.19\n06/26/03\n$0.19\n09/25/03\n$0.19\n12/29/03\n$0.20\n02/26/04\n$0.20\n06/24/04\n$0.20\n09/23/04\n$0.20\n12/22/04\n$0.22\n02/24/05\n$0.22\n06/23/05\n$0.22\n09/22/05\n$0.22\n12/22/05\n$0.25\n02/23/06\n$0.25\n06/22/06\n$0.25\n09/21/06\n$0.25\n12/21/06\n$0.28\n02/22/07\n$0.28\n06/21/07\n$0.28\n*\nThese data are taken from the following Web page on GE’sweb site:\nwww.ge.com/investors/stock_info/dividend_history.html\n.\nAt the end of 2006, GE raised its dividend from $0.25 to $0.28. Atrader trading GE options at the beginning of 2007 would have logically anticipated the next increase to occur again in the following December unless there was reason to believe otherwise. Options expiring before this anticipated next dividend increase would have the $0.28 dividend priced into their values. Options expiring after December 2007 would have ahigher dividend priced into them—possibly an additional three cents to 0.31 (which indeed it was). Calls would be adversely affected by this increase, and puts would be favorably affected. Atypical trader would have anticipated those changes. The dividend data atrader pricing GE options would have entered into the model in January 2007 would have looked something like this.\nEx-Date\nDividend\n*\n02/22/07\n$0.28\n06/21/07\n$0.28\n09/20/07\n$0.28\n12/20/07\n$0.31\n02/21/08\n$0.31\n06/19/08\n$0.31\n09/18/08\n$0.31\n*\nThese data are taken from the following Web page on GE’sweb site:\nwww.ge.com/investors/stock_info/dividend_history.html\n.\nThe trader would have entered the anticipated fu", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00017.html", "doc_id": "dbb7773212ad1097334fd3df03b6a5b6d81704db0e84aad0d35e0cb71709bf00", "chunk_index": 3}
{"text": "is.\nEx-Date\nDividend\n*\n02/22/07\n$0.28\n06/21/07\n$0.28\n09/20/07\n$0.28\n12/20/07\n$0.31\n02/21/08\n$0.31\n06/19/08\n$0.31\n09/18/08\n$0.31\n*\nThese data are taken from the following Web page on GE’sweb site:\nwww.ge.com/investors/stock_info/dividend_history.html\n.\nThe trader would have entered the anticipated future dividend amount in conjunction with the anticipated ex-dividend date. This trader projection goes out to February 2008, which would aid in valuing options expiring in 2007 as well as the 2008 LEAPS. Because the declaration dates had yet to occur, one could not know with certainty when the dividends would be announced or in what amount. Certainly, there would be some estimation involved for both the dates and the amount. But traders would probably get it pretty close—close enough.\nThen, something particularly interesting happened. Instead of raising the dividend going into December 2008 as would be anormal pattern, GE kept it the same. As shown, the 12/24/08 ex-dated dividend remained $0.31.\nEx-Date\nDividend\n*\n02/22/07\n$0.28\n06/21/07\n$0.28\n09/20/07\n$0.28\n12/20/07\n$0.31\n02/21/08\n$0.31\n06/19/08\n$0.31\n09/18/08\n$0.31\n12/24/08\n$0.31\n*\nThese data are taken from the following Web page on GE’sweb site:\nwww.ge.com/investors/stock_info/dividend_history.html\n.\nThe dividend stayed at $0.31 until the June 2009 dividend, which held another jolt for traders pricing options. Around this time, GE’sstock price had taken abeating. It fell from around $42 ashare in the fall of 2007 ultimately to about $6 in March 2009. GE had its first dividend cut in more than three decades. The dividend with the ex-date of 06/18/09 was $0.10.\n12/24/08\n$0.31\n02/19/09\n$0.31\n06/18/09\n$0.10\n09/17/09\n$0.10\n12/23/09\n$0.10\n02/25/10\n$0.10\n06/17/10\n$0.10\n09/16/10\n$0.12\n12/22/10\n$0.14\n02/24/11\n$0.14\n06/16/11\n$0.15\n09/15/11\n$0.15\nThough the company gave warnings in advance, the drastic dividend change had asignificant impact on option prices. Call prices were helped by the dividend cut (or anticipated dividend cut) and put prices were hurt.\nThe break in the pattern didn’tstop there. The dividend policy remained $0.10 for five quarters until it rose to $0.12 in September 2010, then to $0.14 in December 2010, then to $0.15 in June 2011. These irregular changes in the historically predictable dividend policy made it tougher for traders to attain accurate valuations. If the incremental changes were bigger, the problem would have been even greater.\nGood and Bad Dates with Models\nUsing an incorrect date for the ex-date in option pricing can lead to unfavorable results. If the ex-dividend date is not known because it has yet to be declared, it must be estimated and adjusted as need be after it is formally announced. Traders note past dividend history and estimate the expected dividend stream accordingly. Once the dividend is declared, the ex-date is known and can be entered properly into the pricing model. Not executing due diligence to find correct known ex-dates can lead to trouble. Using abad date in the model can yield dubious theoretical values that can be misleading or worse—especially around the expiration.\nSay acall is trading at 2.30 the day before the ex-date of a $0.25 dividend, which happens to be thirty days before expiration. The next day, of course, the stock may have moved higher or lower. Assume for illustrative purposes, to compare apples to apples as it were, that the stock is trading at the same price—in this case, $76.\nIf the trader is using the correct date in the model, the option value will adjust to take into account the effect of the dividend expiring, or reaching its ex-date, when the number of days to expiration left changes from 30 to 29. The call trading postdividend will be worth more relative to the same stock price. If the dividend date the trader is using in the model is wrong, say one day later than it should be, the dividend will still be an input of the theoretical value. The calculated value will be too low. It will be wrong.\nExhibit 8.1\ncompares the values of a 30-day call on the ex-date given the right and the wrong dividend.\nEXHIBIT 8.1\nComparison of 30-day call values\nAt the same stock price of $76 per share, the call is worth $0.13 more after the dividend is taken out of the valuation. Barring any changes in implied volatility (IV) or the interest rate, the market prices of the options should reflect this change. Atrader using an ex-date in the model that is farther in the future than the actual ex-date will still have the dividend as part of the generated theoretical value. With the ex-date just one day later, the call would be worth 2.27. The difference in option value is due to the effect of theta—in this case, $0.03.\nWith abad date, the value of 2.27 would likely be significantly below market price, causing the market value of the option to look more expensive than it actually is. If the trader did not know the date was wrong, he would need to raise IV to make the theoretical value match the market. This option has", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00017.html", "doc_id": "dbb7773212ad1097334fd3df03b6a5b6d81704db0e84aad0d35e0cb71709bf00", "chunk_index": 4}
{"text": "h abad date, the value of 2.27 would likely be significantly below market price, causing the market value of the option to look more expensive than it actually is. If the trader did not know the date was wrong, he would need to raise IV to make the theoretical value match the market. This option has avega of 0.08, which translates into adifference of about two IV points for the theoretical values 2.43 and 2.27. The trader would perceive the call to be trading at an IV two points higher than the market indicates.\nDividend Size\nIt’snot just the date but also the size of the dividend that matters. When companies change the amount of the dividend, options prices follow in step. In 2004, when Microsoft (MSFT) paid aspecial dividend of $3 per share, there were unexpected winners and losers in the Microsoft options. Traders who were long calls or short puts were adversely affected by this change in dividend policy. Traders with short calls or long puts benefited. With long-term options, even less anomalous changes in the size of the dividend can have dramatic effects on options values.\nLet’sstudy an example of how an unexpected rise in the quarterly dividend of astock affects along call position. Extremely Yellow Zebra Corp. (XYZ) has been paying aquarterly dividend of $0.10. After asteady rise in stock price to $61 per share, XYZ declares adividend payment of $0.50. It is expected that the company will continue to pay $0.50 per quarter. Atrader, James, owns the 528-day 60-strike calls, which were trading at 9.80 before the dividend increase was announced.\nExhibit 8.2\ncompares the values of the long-term call using a $0.10 quarterly dividend and using a $0.50 quarterly dividend.\nEXHIBIT 8.2\nEffect of change in quarterly dividend on call value.\nThis $0.40 dividend increase will have abig effect on James’scalls. With 528 days until expiration, there will be six dividends involved. Because James is long the calls, he loses 1.52 per option. If, however, he were short the calls, 1.52 would be his profit on each option.\nPut traders are affected as well. Another trader, Marty, is long the 60-strike XYZ puts. Before the dividend announcement, Marty was running his values with a $0.10 dividend, giving his puts avalue of 5.42.\nExhibit 8.3\ncompares the values of the puts with a $0.10 quarterly dividend and with a $0.50 quarterly dividend.\nEXHIBIT 8.3\nEffect of change in quarterly dividend on put value.\nWhen the dividend increase is announced, Marty will benefit. His puts will rise because of the higher dividend by $0.66 (all other parameters held constant). His long-term puts with six quarters of future expected dividends will benefit more than short-term XYZ puts of the same strike would. Of course, if he were short the puts, he would lose this amount.\nThe dividend inputs to apricing model are best guesses until the dates and amounts are announced by the company. How does one find dividend information? Regularly monitoring the news and press releases on the companies one trades is agood way to stay up to date on dividend information, as well as other company news. Dividend announcements are widely disseminated by the major news services. Most companies also have an investor-relations phone number and section on their web sites where dividend information can be found.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00017.html", "doc_id": "dbb7773212ad1097334fd3df03b6a5b6d81704db0e84aad0d35e0cb71709bf00", "chunk_index": 5}
{"text": "CHAPTER 9\nVertical Spreads\nRisk—it is the focal point around which all trading revolves. It may seem as if profit should be occupying this seat, as most important to trading options, but without risk, there would be no profit! As traders, we must always look for ways to mitigate, eliminate, preempt, and simply avoid as much risk as possible in our pursuit of success without diluting opportunity. Risk must be controlled. Trading vertical spreads takes us one step further in this quest.\nThe basic strategies discussed in Chapters 4 and 5 have strengths when compared with pure linear trading in the equity markets. But they have weaknesses, too. Consider the covered call, one of the most popular option strategies.\nAcovered call is best used as an augmentation to an investment plan. It can be used to generate income on an investment holding, as an entrance strategy into astock, or as an exit strategy out of astock. But from atrading perspective, one can often find better ways to trade such aforecast.\nIf the forecast on astock is neutral to moderately bullish, accepting the risk of stock ownership is often unwise. There is always the chance that the stock could collapse. In many cases, this is an unreasonable risk to assume.\nTo some extent, we can make the same case for the long call, short put, naked call, and the like. In certain scenarios, each of these basic strategies is accompanied with unwanted risks that serve no beneficial purpose to the trader but can potentially cause harm. In many situations, avertical spread is abetter alternative to these basic spreads. Vertical spreads allow atrader to limit potential directional risk, limit theta and vega risk, free up margin, and generally manage capital more efficiently.\nVertical Spreads\nVertical spreads involve buying one option and selling another. Both are on the same underlying and expire the same month, and both are either calls or puts. The difference is in the strike prices of the two options. One is higher than the other, hence the name\nvertical spread\n. There are four vertical spreads: bull call spread, bear call spread, bear put spread, and bull put spread. These four spreads can be sliced and diced into categories anumber of ways: call spreads and put spreads, bull spreads and bear spreads, debit spreads and credit spreads. There is overlap among the four verticals in how and when they are used. The end of this chapter will discuss how the spreads are interrelated.\nBull Call Spread\nAbull call spread is along call combined with ashort call that has ahigher strike price. Both calls are on the same underlying and share the same expiration month. Because the purchased call has alower strike price, it costs more than the call being sold. Establishing the trade results in adebit to the trader’saccount. Because of this debit, it’scalled adebit spread.\nBelow is an example of abull call spread on Apple Inc. (AAPL):\nIn this example, Apple is trading around $391. With 40 days until February expiration, the trader buys the 395–405 call spread for anet debit of $4.40, or $440 in actual cash. Or one could simply say the trader paid $4.40 for the 395–405 call.\nConsider the possible outcomes if the spread is held until expiration.\nExhibit 9.1\nshows an at-expiration diagram of the bull call spread.\nEXHIBIT 9.1\nAAPL bull call spread.\nBefore discussing the greeks, consider the bull call spread from an at-expiration perspective. Unlike the long call, which has two possible outcomes at expiration—above or below the strike—this spread has three possibilities: below both strikes, between the strikes, or above both strikes.\nIn this example, if Apple is below $395 at expiration, both calls expire worthless. The rights and obligations of the options are gone, as is the cash spent on the trade. In this case, the entire debit of $4.40 is lost.\nIf Apple is between the strikes at expiration, the 405-strike call expires worthless. The trader is long stock at an effective price of $399.40. This is the $395-strike price at which the stock would be purchased if the call is exercised, plus the $4.40 premium spent on the spread. The break-even price of the trade is $399.40. If Apple is above $399.40 at expiration, the trade is profitable; below $399.40, it is aloser. The aptly named bull call spread requires the stock to rise to reach its profit potential. But unlike an outright long call, profits are capped with the spread.\nIf Apple is above $405 at expiration, both calls are in-the-money (ITM). If the 395-strike calls are exercised, the trader buys 100 shares of Apple at $395 and these shares, in turn, would be sold at $405 when the 405-strike calls are assigned, for a $10 gain per share. Subtract from that $10 the $4.40 debit spent on the trade and the net profit is $5.60 per share.\nThere are some other differences between the 395–405 call spread and the outright purchase of the 395 call. The absolute risk is lower. To buy the 395-strike call costs 14.60, versus 4.40 for the spread—ab", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00019.html", "doc_id": "4b5634962ddf443342b894eb3f86c91f85007c1ded200d6241ae9f6ba27a7874", "chunk_index": 0}
{"text": "btract from that $10 the $4.40 debit spent on the trade and the net profit is $5.60 per share.\nThere are some other differences between the 395–405 call spread and the outright purchase of the 395 call. The absolute risk is lower. To buy the 395-strike call costs 14.60, versus 4.40 for the spread—abig difference. Because the debit is lower, the margin for the spread is lower at most option-friendly brokers, as well.\nIf we dig alittle deeper, we find some other differences between the bull call spread and the outright call. Long options are haunted by the specter of time. Because the spread involves both along and ashort option, the time-decay risk is lower than that associated with owning an option outright. Implied volatility (IV) risk is lower, too.\nExhibit 9.2\ncompares the greeks of the long 395 call with those of the 395–405 call spread.\nEXHIBIT 9.2\nApple call versus bull call spread (Apple @ $391).\n395 Call\n395–405 Call\nDelta\n0.484\n0.100\nGamma\n0.0097\n0.0001\nTheta\n−0.208\n−0.014\nVega\n0.513\n0.020\nThe positive deltas indicate that both positions are bullish, but the outright call has ahigher delta. Some of the 395 call’sdirectional sensitivity is lost when the 405 call is sold to make aspread. The negative delta of the 405 call somewhat offsets the positive delta of the 395 call. The spread delta is only about 20 percent of the outright call’sdelta. But for atrader wanting to focus on trading direction, the smaller delta can be asmall sacrifice for the benefit of significantly reduced theta and vega. Theta spread’srisk is about 7 percent that of the outright. The spread’svega risk is also less than 4 percent that of the outright 395 call. With the bull call spread, atrader can spread off much of the exposure to the unwanted risks and maintain adisproportionately higher greeks in the wanted exposure (delta).\nThese relationships change as the underlying moves higher. Remember, at-the-money (ATM) options have the greatest sensitivity to theta and vega. With Apple sitting at around the long strike, gamma and vega have their greatest positive value, and theta has its most negative value.\nExhibit 9.3\nshows the spread greeks given other underlying prices.\nEXHIBIT 9.3\nAAPL 395–405 bull call spread.\nAs the stock moves higher toward the 405 strike, the 395 call begins to move away from being at-the-money, and the 405 call moves toward being at-the-money. The at-the-money is the dominant strike when it comes to the characteristics of the spread greeks. Note the greeks position when the underlying is directly between the two strike prices: The long call has ceased to be the dominant influence on these metrics. Both calls influence the analytics pretty evenly. The time-decay risk has been entirely spread off. The volatility risk is mostly spread off. Gamma remains aminimal concern. When the greeks of the two calls balance each other, the result is adirectional play.\nAs AAPL continues to move closer to the 405-strike, it becomes the at-the-money option, with the dominant greeks. The gamma, theta, and vega of the 405 call outweigh those of the ITM 395 call. Vega is more negative. Positive theta now benefits the trade. The net gamma of the spread has turned negative. Because of the negative gamma, the delta has become smaller than it was when the stock was at $400. This means that the benefit of subsequent upward moves in the stock begins to wane. Recall that there is amaximum profit threshold with avertical spread. As the stock rises beyond $405, negative gamma makes the delta smaller and time decay becomes less beneficial. But at this point, the delta has done its work for the trader who bought this spread when the stock was trading around $395. The average delta on amove in the stock from $395 to $405 is about 0.10 in this case.\nWhen the stock is at the 405 strike, the characteristics of the trade are much different than they are when the stock is at the 395 strike. Instead of needing movement upward in the direction of the delta to combat the time decay of the long calls, the position can now sit tight at the short strike and reap the benefits of option decay. The key with this spread, and with all vertical spreads, is that the stock needs to move in the direction of the delta to the short strike.\nStrengths and Limitations\nThere are many instances when abull call spread is superior to other bullish strategies, such as along call, and there are times when it isn’t. Traders must consider both price and time.\nAbull call spread will always be cheaper than the outright call purchase. That’sbecause the cost of the long-call portion of the spread is partially offset by the premium of the higher-strike short call. Spending less for the same exposure is always abetter choice, but the exposure of the vertical is not exactly the same as that of the long call. The most obvious trade-off is the fact that profit is limited. For smaller moves—up to the price of the short strike—vertical spreads tend to be better trades than outright", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00019.html", "doc_id": "4b5634962ddf443342b894eb3f86c91f85007c1ded200d6241ae9f6ba27a7874", "chunk_index": 1}
{"text": "the same exposure is always abetter choice, but the exposure of the vertical is not exactly the same as that of the long call. The most obvious trade-off is the fact that profit is limited. For smaller moves—up to the price of the short strike—vertical spreads tend to be better trades than outright call purchases. Beyond the strike? Not so much.\nBut time is atrade-off, too. There have been countless times that Ihave talked with new traders who bought acall because they thought the stock was going up. They were right and still lost money. As the adage goes, timing is everything. The more time that passes, the more advantageous the lower-theta vertical spread becomes. When held until expiration, avertical spread can be abetter trade than an outright call in terms of percentage profit.\nIn the previous example, when Apple is at $391 with 40 days until expiration, the 395 call is worth 14.60 and the spread is worth 4.40. If Apple were to rise to be trading at $405 at expiration, the call rises to be worth 10, for aloss of 4.60 on the 14.60 debit paid. The spread also is worth 10. It yields again of about 127 percent on the initial $4.40 per share debit.\nBut look at this same trade if the move occurs before expiration. If Apple rallies to $405 after only acouple weeks, the outcome is much different. With four weeks still left until expiration, the 395 call is worth 19.85 with the underlying at $405. That’sa 36 percent gain on the 14.60. The spread is worth 5.70. That’sa 30 percent gain. The vertical spread must be held until expiration to reap the full benefits, which it accomplishes through erosion of the short option.\nThe long-call-only play (with asignificantly larger negative theta) is punished severely by time passing. The long call benefits more from aquick move in the underlying. And of course, if the stock were to rise to aprice greater than $405, in ashort amount of time—the best of both worlds for the outright call—the outright long 395 call would be emphatically superior to the spread.\nBear Call Spread\nThe next type of vertical spread is called abear call spread\n. Abear call spread is ashort call combined with along call that has ahigher strike price. Both calls are on the same underlying and share the same expiration month. In this case, the call being sold is the option of higher value. This call spread results in anet credit when the trade is put on and, therefore, is called acredit spread.\nThe bull call spread and the bear call spread are two sides of the same coin. The difference is that with the bull call spread, one is buying the call spread, and with the bear call spread, one is selling the call spread. An example of abear call spread can be shown using the same trade used earlier.\nHere we are selling one AAPL February (40-day) 395 call at 14.60 and buying the 405 call at 10.20. We are selling the 395–405 call at $4.40 per share, or $440.\nExhibit 9.4\nis an at-expiration diagram of the trade.\nEXHIBIT 9.4\nApple bear call spread.\nThe same three at-expiration outcomes are possible here as with the bull call spread: the stock can be above both strikes, between both strikes, or below both strikes. If the stock is below both strikes at expiration, both calls will expire worthless. The rights and obligations cease to exist. In this case, the entire credit of $440 is profit.\nIf AAPL is between the two strike prices at expiration, the 395-strike call will be in-the-money. The short call will get assigned and result in ashort stock position at expiration. The break-even price falls at $399.40—the short strike plus the $4.40 net premium. This is the price at which the stock will effectively be sold if assignment occurs.\nIf Apple is above both strikes at expiration, it means both calls are in-the-money. Stock is sold at $395 because of assignment and bought back at $405 through exercise. This leads to aloss of $10 per share on the negative scalp. Factoring in the $4.40-per-share credit makes the net loss only $5.60 per share with AAPL above $405 at February expiration.\nJust as the at-expiration diagram is the same but reversed, the greeks for this call spread will be similar to those in the bull call spread example except for the positive and negative signs. See\nExhibit 9.5\n.\nEXHIBIT 9.5\nApple 395–405 bear call spread.\nAcredit spread is commonly traded as an income-generating strategy. The idea is simple: sell the option closer-to-the-money and buy the more out-of-the-money (OTM) option—that is, sell volatility—and profit from nonmovement (above acertain point). In this example, with Apple at $391, aneutral to slightly bearish trader would think about selling this spread at 4.40 in hopes that the stock will remain below $395 until expiration. The best-case scenario is that the stock is below $395 at expiration and both options expire, resulting in a $4.40-per-share profit.\nThe strategy profits as long as Apple is under its break-even price, $399.40, at expiration. But this is not so much abearish strategy", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00019.html", "doc_id": "4b5634962ddf443342b894eb3f86c91f85007c1ded200d6241ae9f6ba27a7874", "chunk_index": 2}
{"text": "in below $395 until expiration. The best-case scenario is that the stock is below $395 at expiration and both options expire, resulting in a $4.40-per-share profit.\nThe strategy profits as long as Apple is under its break-even price, $399.40, at expiration. But this is not so much abearish strategy as it is anonbullish strategy. The maximum gain with acredit spread is the premium received, in this case $4.40 per share. Traders who thought AAPL was going to decline sharply would short it or buy aput. If they thought it would rise sharply, they’duse another strategy.\nFrom agreek perspective, when the trade is executed it’svery close to its highest theta price point—the 395 short strike price. This position theoretically collects $0.90 aday with Apple at around $395. As time passes, that theta rises. The key is that the stock remains at around $395 until the short option is just about worthless. The name of the game is sit and wait.\nAlthough the delta is negative, traders trading this spread to generate income want the spread to expire worthless so they can pocket the $4.40 per share. If Apple declines, profits will be made on delta, and theta profits will be foregone later. All that matters is the break-even point. Essentially, the idea is to sell anaked call with amaximum potential loss. Sell the 395s and buy the 405s for protection.\nIf the underlying decreases enough in the short term and significant profits from delta materialize, it is logical to consider closing the spread early. But it often makes more sense to close part of the spread. Consider that the 405-strike call is farther out-of-the-money and will lose its value before the 395 call.\nSay that after two weeks abig downward move occurs. Apple is trading at $325 ashare; the 405s are 0.05 bid at 0.10, and the 395s are 0.50 bid at 0.55. At this point, the lion’sshare of the profits can be taken early. Atrader can do so by closing only the 395 calls. Closing the 395s to eliminate the risk of negative delta and gamma makes sense. But does it make sense to close the 405s for 0.05? Usually not. Recouping this residual value accomplishes little. It makes more sense to leave them in your position in case the stock rebounds. If the stock proves it can move down $70; it can certainly move up $70. Because the majority of the profits were taken on the 395 calls, holding on to the 405s is like getting paid to own calls. In scenarios where abig move occurs and most of the profits can be taken early, it’soften best to hold the long calls, just in case. It’sawin-win situation.\nCredit and Debit Spread Similarities\nThe credit call spread and the debit call spread appear to be exactly opposite in every respect. Many novice traders perceive credit spreads to be fundamentally different from debit spreads. That is not necessarily so. Closer study reveals that these two are not so different after all.\nWhat if Apple’sstock price was higher when the trade was put on? What if the stock was at $405? First, the spread would have had more value. The 395 and 405 calls would both be worth more. Atrader could have sold the spread for a $5.65-per-share credit. The at-expiration diagram would look almost the same. See\nExhibit 9.6\n.\nEXHIBIT 9.6\nApple bear call spread initiated with Apple at $405.\nBecause the net premium is much higher in this example, the maximum gain is more—it is $5.65 per share. The breakeven is $400.65. The price points on the at-expiration diagram, however, have nothing to do with the greeks. The analytics from\nExhibit 9.5\nare the same either way.\nThe motivation for atrader selling this call spread, which has both options in-the-money, is different from that for the typical income generator. When the spread is sold in this context, the trader is buying volatility. Long gamma, long vega, negative theta. The trader here has atrade more like the one in the bull call spread example—except that instead of needing arally, the trader needs arout. The only difference is that the bull call spread has abullish delta, and the bear call spread has abearish delta.\nBear Put Spread\nThere is another way to take abearish stance with vertical spreads: the bear put spread. Abear put spread is along put plus ashort put that has alower strike price. Both puts are on the same underlying and share the same expiration month. This spread, however, is adebit spread because the more expensive option is being purchased.\nImagine that astock has had agood run-up in price. The chart shows asteady march higher over the past couple of months. Astudy of technical analysis, though, shows that the run-up may be pausing for breath. An oscillator, such as slow stochastics, in combination with the relative strength index (RSI), indicates that the stock is overbought. At the same time, the average directional movement index (ADX) confirms that the uptrend is slowing.\nFor traders looking for asmall pullback, abear put spread can be an excellent strategy. The goal is to see the stock drift down to the", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00019.html", "doc_id": "4b5634962ddf443342b894eb3f86c91f85007c1ded200d6241ae9f6ba27a7874", "chunk_index": 3}
{"text": "e strength index (RSI), indicates that the stock is overbought. At the same time, the average directional movement index (ADX) confirms that the uptrend is slowing.\nFor traders looking for asmall pullback, abear put spread can be an excellent strategy. The goal is to see the stock drift down to the short strike. So, like the other members of the vertical spread family, strike selection is important.\nLet’slook at an example of ExxonMobil (XOM). After the stock has rallied over atwo-month period to $80.55, atrader believes there will be ashort-term temporary pullback to $75. Instead of buying the June 80 puts for 1.75, the trader can buy the 75–80 put spread of the same month for 1.30 because the 75 put can be sold for 0.45.\n1\nIn this example, the June put has 40 days until expiration.\nExhibit 9.7\nillustrates the payout at expiration.\nEXHIBIT 9.7\nExxonMobil bear put spread.\nIf the trader is wrong and ExxonMobil is still above 80 at expiry, both puts expire and the 1.30 premium is lost. If ExxonMobil is between the two strikes, the 80 puts are ITM, resulting in an exercise, and the 75 puts are OTM and expire. The net effect is short stock at an effective price of $78.70. The effective sale price is found by taking the price at which the short stock is established when the puts are exercised—$80—minus the net 1.30 paid for the spread. This is the spread’sbreakeven at expiration.\nIf the trader is right and ExxonMobil is below both strikes at expiration, both puts are ITM, and the result is a 3.70 profit and no position. Why a 3.70 profit? The 80 puts are exercised, making the trader short at $80, and the 75 puts are assigned, so the short is bought back at $75 for apositive stock scalp of $5. Including the 1.30 debit for the spread in the profit and loss (P&(L)), the net profit is $3.70 per share when the stock is below both strikes at expiration.\nThis is abearish trade. But is the bear put spread necessarily abetter trade than buying an outright ATM put? No. The at-expiration diagram makes this clear. Profits are limited to $3.70 per share. This is an important difference. But because in this particular example, the trader expects the stock to retrace only to around $75, the benefits of lower cost and lower theta and vega risk can be well worth the trade-off of limited profit. The trader’sobjectives are met more efficiently by buying the spread. The goal is to profit from the delta move down from $80 to $75.\nExhibit 9.8\nshows the differences between the greeks of the outright put and the spread when the trade is put on with ExxonMobil at $80.55.\nEXHIBIT 9.8\nExxonMobil put vs. bear put spread (ExxonMobil @ $80.55).\n80 Put\n75–80 Put\nDelta\n−0.445\n−0.300\nGamma\n+0.080\n+0.041\nTheta\n−0.018\n−0.006\nVega\n+0.110\n+0.046\nAs in the call-spread examples discussed previously, the spread delta is smaller than the outright put’s. It appears ironic that the spread with the smaller delta is abetter trade in this situation, considering that the intent is to profit from direction. But it is the relative differences in the greeks besides delta that make the spread worthwhile given the trader’sgoal. Gamma, theta, and vega are proportionately much smaller than the delta in the spread than in the outright put. While the spread’sdelta is two thirds that of the put, its gamma is half, its theta one third, and its vega around 42 percent of the put’s.\nRetracements such as the one called for by the trader in this example can happen fast, sometimes over the course of aweek or two. It’snot necessarily bad if this move occurs quickly. If ExxonMobil drops by $5 right away, the short delta will make the position profitable.\nExhibit 9.9\nshows how the spread position changes as the stock declines from $80 to $75.\nEXHIBIT 9.9\n75–80 bear put spread as ExxonMobil declines.\nThe delta of this trade remains negative throughout the stock’sdescent to $75. Assuming the $5 drop occurs in one day, adelta averaging around −0.36 means about a 1.80 profit, or $180 per spread, for the $5 move (0.36 times $5 times 100). This is still afar cry from the spread’s $3.70 potential profit. Although the stock is at $75, the maximum profit potential has yet to be reached, and it won’tbe until expiration. How does the rest of the profit materialize? Time decay.\nThe price the trader wants the stock to reach is $75, but the assumption here is that the move happens very fast. The trade went from being along-volatility play—long gamma and vega—to ashort-vol play: short gamma and vega. The trader wanted movement when the stock was at $80 and wants no movement when the stock is at $75. When the trade changes characteristics by moving from one strike to another, the trader has to reconsider the stock’soutlook. The question is: if Ididn’thave this position on, would Iwant it now?\nThe trader has achoice to make: take the $180 profit—which represents a 138 percent profit on the 1.30 debit—or wait for theta to do its thing. The trader looking for aretracement would likely be inclined", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00019.html", "doc_id": "4b5634962ddf443342b894eb3f86c91f85007c1ded200d6241ae9f6ba27a7874", "chunk_index": 4}
{"text": "sider the stock’soutlook. The question is: if Ididn’thave this position on, would Iwant it now?\nThe trader has achoice to make: take the $180 profit—which represents a 138 percent profit on the 1.30 debit—or wait for theta to do its thing. The trader looking for aretracement would likely be inclined to take aprofit on the trade. Nobody ever went broke taking aprofit. But if the trader thinks the stock will sit tight for the remaining time until expiration, he will be happy with this income-generating position.\nAlthough the trade in the last, overly simplistic example did not reap its full at-expiration potential, it was by no means abad trade. Holding the spread until expiration is not likely to be part of atrader’splan. Buying the 80 put outright may be abetter play if the trader is expecting afast move. It would have abigger delta than the spread. Debit and credit spreads can be used as either income generators or as delta plays. When they’re used as delta plays, however, time must be factored in.\nBull Put Spread\nThe last of the four vertical spreads is abull put spread. Abull put spread is ashort put with one strike and along put with alower strike. Both puts are on the same underlying and in the same expiration cycle. Abull put spread is acredit spread because the more expensive option is being sold, resulting in anet credit when the position is established. Using the same options as in the bear put example:\nWith ExxonMobil at $80.55, the June 80 puts are sold for 1.75 and the June 75 puts are bought at 0.45. The trade is done for acredit of 1.30.\nExhibit 9.10\nshows the payout of this spread if it is held until expiration.\nEXHIBIT 9.10\nExxonMobil bull put spread.\nThe sale of this spread generates a 1.30 net credit, which is represented by the maximum profit to the right of the 80 strike. With ExxonMobil above $80 per share at expiration, both options expire OTM and the premium is all profit. Between the two strike prices, the 80 put expires in the money. If the ITM put is still held at expiration, it will be assigned. Upon assignment, the put becomes long stock, profiting with each tick higher up to $80, or losing with each tick lower to $75. If the 80 put is assigned, the effective price of the long stock will be $78.70. The assignment will “hit your sheets” as abuy at $80, but the 1.30 credit lowers the effective net cost to $78.70.\nIf the stock is below $75 at option expiration, both puts will be ITM. This is the worst case scenario, because the higher-struck put was sold. At expiration, the 80 puts would be assigned, the 75 puts exercised. That’sanegative scalp of $5 on the resulting stock. The initial credit lessens the pain by 1.30. The maximum possible loss with ExxonMobil below both strikes at expiration is $3.70 per spread.\nThe spread in this example is the flip side of the bear put spread of the previous example. Instead of buying the spread, as with the bear put, the spread in this case is sold.\nExhibit 9.11\nshows the analytics for the bull put spread.\nEXHIBIT 9.11\nGreeks for ExxonMobil 75–80 bull put spread.\nInstead of having ashort delta, as with the bear spread, the bull spread is long delta. There is negative theta with positive gamma and vega as XOM approaches the long strike—the 75s, in this case. There is also positive theta with negative gamma and vega around the short strike—the 80s.\nExhibit 9.11\nshows the characteristics that define the vertical spread. If one didn’tknow which particular options were being traded here, this could almost be atable of greeks for either a 75–80 bull put spread or a 75–80 bull call spread.\nLike the other three verticals, this spread can be adelta play or atheta play. Abullish trader may sell the spread if both puts are in-the-money. Imagine that XOM is trading at around $75. The spread will have apositive 0.364 delta, positive gamma, and negative theta. The spread as awhole is adecaying asset. It needs the underlying to rally to combat time decay.\nAbullish trader may also sell this spread if XOM is between the two strikes. In this case, with XOM at, say, $77, the delta is +0.388, and all other greeks are negligible. At this particular price point in the underlying, the trader has almost pure leveraged delta exposure. But this trade would be positioned for only asmall move, not much above $80. Aspeculator wanting to trade direction for asmall move while eliminating theta and vega risks achieves her objectives very well with avertical spread.\nAbullish-to-neutral trader would be inclined to sell this spread if ExxonMobil were around $80 or higher. Day by day, the 1.30 premium would start to come in. With 40 days until expiration, theta would be small, only 0.004. But if the stock remained at $80, this ATM put would begin decaying faster and faster. The objective of trading this spread for aneutral trader is selling future realized volatility—selling gamma to earn theta. Atrader can also trade avertical spread to profit from IV.\nVerticals and Volatility\nThe", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00019.html", "doc_id": "4b5634962ddf443342b894eb3f86c91f85007c1ded200d6241ae9f6ba27a7874", "chunk_index": 5}
{"text": ". But if the stock remained at $80, this ATM put would begin decaying faster and faster. The objective of trading this spread for aneutral trader is selling future realized volatility—selling gamma to earn theta. Atrader can also trade avertical spread to profit from IV.\nVerticals and Volatility\nThe IV component of avertical spread, although small compared with that of an outright call or put, is still important—especially for large traders with low margin and low commissions who can capitalize on small price changes efficiently. Whether it’sacall spread or aput spread, acredit spread or adebit spread, if the underlying is at the short option’sstrike, the spread will have anet negative vega. If the underlying is at the long option’sstrike, the spread will have positive vega. Because of this characteristic, there are three possible volatility plays with vertical spreads: speculating on IV changes when the underlying remains constant, profiting from IV changes resulting from movement of the underlying, and special volatility situations.\nVertical spreads offer alimited-risk way to speculate on volatility changes when the underlying remains fairly constant. But when the intent of avertical spread is to benefit from vega, one must always consider the delta—it’sthe bigger risk. Chapter 13 discusses ways to manage this risk by hedging with stock, astrategy called delta-neutral trading.\nNon-delta-neutral traders may speculate on vol with vertical spreads by assuming some delta risk. Traders whose forecast is vega bearish will sell the option with the strike closest to where the underlying is trading—that is, the ATM option—and buy an OTM strike. Traders would lean with their directional bias by choosing either acall spread or aput spread. As risk managers, the traders balance the volatility stance being taken against the additional risk of delta. Again, in this scenario, delta can hurt much more than help.\nIn the ExxonMobil bull put spread example, the trader would sell the 80-strike put if ExxonMobil were around $80 ashare. In this case, if the stock didn’tmove as time passed, theta would benefit from historical volatility being’slow—that is, from little stock movement. At first, the benefit would be only 0.004 per day, speeding up as expiration nears. And if implied volatility decreased, the trader would profit 0.04 for every 1 percent decline in IV. Small directional moves upward help alittle. But in the long run, those profits are leveled off by the fact that theta gets smaller as the stock moves higher above $80—more profit on direction, less on time.\nFor the delta player, bull call spreads and bull put spreads have apotential added benefit that stems from the fact that IV tends to decrease as stocks rise and increase when stocks fall. This offers additional opportunity to the bull spread player. With the bull call spread or the bull put spread, the trader gains on positive delta with arally. Once the underlying comes close to the short option’sstrike, vega is negative. If IV declines, as might be anticipated, there is afurther benefit of vega profits on top of delta profits. If the underlying declines, the trader loses on delta. But the pain can potentially be slightly lessened by vega profits. Vega will get positive as the underlying approaches the long strike, which will benefit from the firming of IV that often occurs when the stock drops. But this dual benefit is paid for in the volatility skew. In most stocks or indexes, the lower strikes—the ones being bought in abull spread—have higher IVs than the higher strikes, which are being sold.\nThen there are special market situations in which vertical spreads that benefit from volatility changes can be traded. Traders can trade vertical spreads to strategically position themselves for an expected volatility change. One example of such asituation is when astock is rumored to be atakeover target. Anatural instinct is to consider buying calls as an inexpensive speculation on ajump in price if the takeover is announced. Unfortunately, the IV of the call is often already bid up by others with the same idea who were quicker on the draw. Buying acall spread consisting of along ITM call and ashort OTM call can eliminate immediate vega risk and still provide wanted directional exposure.\nCertainly, with this type of trade, the trader risks being wrong in terms of direction, time, and volatility. If and when atakeover bid is announced, it will likely be for aspecific price. In this event, the stock price is unlikely to rise above the announced takeover price until either the deal is consummated or asecond suitor steps in and offers ahigher price to buy the company. If the takeover is a “cash deal,” meaning the acquiring company is tendering cash to buy the shares, the stock will usually sit in avery tight range below the takeover price for along time. In this event, implied volatility will often drop to very low levels. Being short an ATM call when the stock rallies will", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00019.html", "doc_id": "4b5634962ddf443342b894eb3f86c91f85007c1ded200d6241ae9f6ba27a7874", "chunk_index": 6}
{"text": "over is a “cash deal,” meaning the acquiring company is tendering cash to buy the shares, the stock will usually sit in avery tight range below the takeover price for along time. In this event, implied volatility will often drop to very low levels. Being short an ATM call when the stock rallies will let the trader profit from collapsing IV through negative vega.\nSay XYZ stock, trading at $52 ashare, is arumored takeover target at $60. When the rumors are first announced, the stock will likely rise, to say $55, with IV rising as well. Buying the 50–60 call spread will give atrader apositive delta and anegligible vega. If the rumors are realized and acash takeover deal is announced at $60, the trade gains on delta, and the spread will now have negative vega. The negative vega at the 60 strike gains on implied volatility declining, and the stock will sit close to $60, producing the benefits of positive theta. Win, win, win.\nThe Interrelations of Credit Spreads and Debit Spreads\nMany traders Iknow specialize in certain niches. Sometimes this is because they find something they know well and are really good at. Sometimes it’sbecause they have become comfortable and don’thave the desire to try anything new. I’ve seen this strategy specialization sometimes with traders trading credit spreads and debit spreads. I’ve had serial credit spread traders tell me credit spreads are the best trades in the world, much better than debit spreads. Habitual debit spread traders have likewise said their chosen spread is the best. But credit spreads and debit spreads are not so different. In fact, one could argue that they are really the same thing.\nConventionally, credit-spread traders have the goal of generating income. The short option is usually ATM or OTM. The long option is more OTM. The traders profit from nonmovement via time decay. Debit-spread traders conventionally are delta-bet traders. They buy the ATM or just out-of-the-money option and look for movement away from or through the long strike to the short strike. The common themes between the two are that the underlying needs to end up around the short strike price and that time has to pass to get the most out of either spread.\nWith either spread, movement in the underlying may be required, depending on the relationship of the underlying price to the strike prices of the options. And certainly, with acredit spread or debit spread, if the underlying is at the short strike, that option will have the most premium. For the trade to reach the maximum profit, it will need to decay.\nFor many retail traders, debit spreads and credit spreads begin to look even more similar when margin is considered. Margin requirements can vary from firm to firm, but verticals in retail accounts at option-friendly brokerage firms are usually margined in such away that the maximum loss is required to be deposited to hold the position (this assumes Regulation Tmargining). For all intents and purposes, this can turn the trader’scash position from acredit into adebit. From acash perspective, all vertical spreads are spreads that require adebit under these margin requirements. Professional traders and retail traders who are subject to portfolio margining are subject to more liberal margin rules.\nAlthough margin is an important concern, what we really care about as traders is risk versus reward. Acredit call spread and adebit put spread on the same underlying, with the same expiration month, sharing the same strike prices will also share the same theoretical risk profile. This is because call and put prices are bound together by put-call parity.\nBuilding a Box\nTwo traders, Sam and Isabel, share ajoint account. They have each been studying Johnson & Johnson (JNJ), which is trading at around $63.35 per share. Sam and Isabel, however, cannot agree on direction. Sam thinks Johnson & Johnson will rise over the next five weeks, and Isabel believes it will decline during that period.\nSam decides to buy the January 62.50 −65 call spread (January has 38 days until expiration in this example). Sam can buy this spread for 1.28. His maximum risk is 1.28. This loss occurs if Johnson & Johnson is below $62.50 at expiration, leaving both calls OTM. His maximum gain is 1.22, realized if Johnson & Johnson is above $65 (65–62.50–1.28). With Johnson & Johnson at $63.35, Sam’sdelta is long 0.29 and his other greeks are about flat.\nIsabel decides to buy the January 62.50–65 put spread for adebit of 1.22. Isabel’sbiggest potential loss is 1.22, incurred if Johnson & Johnson is above $65 ashare at expiration, leaving both puts OTM. Her maximum possible profit is 1.28, realized if the stock is below $62.50 at option expiration. With Johnson & Johnson at $63.35, Isabel has adelta that is short around 0.27 and is nearly flat gamma, theta, and vega.\nCollectively, if both Sam and Isabel hold their trades until expiration, it’sazero-sum game. With Johnson & Johnson below $62.50, Sam loses his investment of 1.28, but Isabel prof", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00019.html", "doc_id": "4b5634962ddf443342b894eb3f86c91f85007c1ded200d6241ae9f6ba27a7874", "chunk_index": 7}
{"text": "With Johnson & Johnson at $63.35, Isabel has adelta that is short around 0.27 and is nearly flat gamma, theta, and vega.\nCollectively, if both Sam and Isabel hold their trades until expiration, it’sazero-sum game. With Johnson & Johnson below $62.50, Sam loses his investment of 1.28, but Isabel profits. She cancels out Sam’sloss by making 1.28. Above $65, Sam makes 1.22 while Isabel loses the same amount, canceling out Sam’sgains. Between the two strikes, Sam has gains on his 62.50 call and Isabel has gains on her 65 put. The gains on the two options will total 2.50, the combined total spent on the spreads—another draw.\nEXHIBIT 9.12\nSam’slong call spread in Johnson & Johnson.\n62.50–65 Call Spread\nDelta\n+0.290\nGamma\n+0.001\nTheta\n−0.004\nVega\n+0.006\nEXHIBIT 9.13\nIsabel’slong put spread in Johnson & Johnson.\n62.50–65 Put Spread\nDelta\n−0.273\nGamma\n−0.001\nTheta\n+0.005\nVega\n−0.006\nThese two spreads were bought for acombined total of 2.50. The collective position, composed of the four legs of these two spreads, forms anew strategy altogether.\nThe two traders together have created abox. This box, which is empty of both profit and loss, is represented by greeks that almost entirely offset each other. Sam’spositive delta of 0.29 is mostly offset by Isabel’s −0.273 delta. Gamma, theta, and vega will mostly offset each other, too.\nChapter 6 described abox as long synthetic stock combined with short synthetic stock having adifferent strike price but the same expiration month. It can also be defined, however, as two vertical spreads: abull (bear) call spread plus abear (bull) put spread with the same strike prices and expiration month.\nThe value of abox equals the present value of the distance between the two strike prices (American-option models will also account for early exercise potential in the box’svalue). This 2.50 box, with 38 days until expiration at a 1 percent interest rate, has less than apenny of interest affecting its value. Boxes with more time until expiration will have ahigher interest rate component. If there was one year until expiration, the combined value of the two verticals would equal 2.475. This is simply the distance between the strikes minus interest (2.50–[2.50 × 0.01]).\nCredit spreads are often made up of OTM options. Traders betting against astock rising through acertain price tend to sell OTM call spreads. For astock at $50 per share, they might sell the 55 calls and buy the 60 calls. But because of the synthetic relationship that verticals have with one another, the traders could buy an ITM put spread for the same exposure, after accounting for interest. The traders could buy the 60 puts and sell the 55 puts. An ITM call (put) spread is synthetically equal to an OTM put (call) spread.\nVerticals and Beyond\nTraders who want to take full advantage of all that options have to offer can do so strategically by trading spreads. Vertical spreads truncate directional risk compared with strategies like the covered call or single-legged option trades. They also reduce option-specific risk, as indicated by their lower gamma, theta, and vega. But lowering risk both in absolute terms and in the greeks has atrade-off compared with buying options: limited profit potential. This trade-off can be beneficial, depending on the trader’sforecast. Debit spreads and credit spreads can be traded interchangeably to achieve the same goals. When along (short) call spread is combined with along (short) put spread, the product is abox. Chapter 10 describes other ways vertical spreads can be combined to form positions that achieve different trading objectives.\nNote\n1\n. Note that it is customary when discussing the purchase or sale of spreads to state the lower strike first, regardless of which is being bought or sold. In this case, the trader is buying the 75–80 put spread.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00019.html", "doc_id": "4b5634962ddf443342b894eb3f86c91f85007c1ded200d6241ae9f6ba27a7874", "chunk_index": 8}
{"text": "CHAPTER 10\nWing Spreads\nCondors and Butterflies\nThe “wing spread” family is aset of option strategies that is very popular, particularly among experienced traders. These strategies make it possible for speculators to accomplish something they could not possibly do by just trading stocks: They provide ameans to profit from atruly neutral market in asecurity. Stocks that don’tmove one iota can earn profits month after month for income-generating traders who trade these strategies.\nThese types of spreads have alot of moving parts and can be intimidating to newcomers. At their heart, though, they are rather straightforward break-even analysis trades that require little complex math to maintain. Asimple at-expiration diagram reveals in black and white the range in which the underlying stock must remain in order to have aprofitable position. However, applying the greeks and some of the mathematics discussed in previous chapters can help atrader understand these strategies on adeeper level and maximize the chance of success. This chapter will discuss condors and butterflies and how to put them into action most effectively.\nTaking Flight\nThere are four primary wing spreads: the condor, the iron condor, the butterfly, and the iron butterfly. Each of these spreads involves trading multiple options with three or four strikes prices. We can take these spreads at face value, we can consider each option as an individual component of the spread, or we can view the spreads as being made up of two vertical spreads.\nCondor\nAcondor is afour-legged option strategy that enables atrader to capitalize on volatility—increased or decreased. Traders can trade long or short iron condors.\nLong Condor\nLong one call (put) with strike A; short one call (put) with ahigher strike, B; short one call (put) at strike C, which is higher than B; and long one call (put) at strike D, which is higher than C. The distance between strike price Aand Bis equal to the distance between strike Cand strike D. The options are all on the same security, in the same expiration cycle, and either all calls or all puts.\nLong Condor Example\nBuy 1 XYZ November 70 call (A)\nSell 1 XYZ November 75 call (B)\nSell 1 XYZ November 90 call (C)\nBuy 1 XYZ November 95 call (D)\nShort Condor\nShort one call (put) with strike A; long one call (put) with ahigher strike, B; long one call (put) with astrike, C, that is higher than B; and short one call (put) with astrike, D, that is higher than C. The options must be on the same security, in the same expiration cycle, and either all calls or all puts. The differences in strike price between the vertical spread of strike prices Aand Band the strike prices of the vertical spread of strikes Cand Dare equal.\nShort Condor Example\nSell 1 XYZ November 70 call (A)\nBuy 1 XYZ November 75 call (B)\nBuy 1 XYZ November 90 call (C)\nSell 1 XYZ November 95 call (D)\nIron Condor\nAn iron condor is similar to acondor, but with amix of both calls and puts. Essentially, the condor and iron condor are synthetically the same.\nShort Iron Condor\nLong one put with strike A; short one put with ahigher strike, B; short one call with an even higher strike, C; and long one call with astill higher strike, D. The options are on the same security and in the same expiration cycle. The put credit spread has the same distance between the strike prices as the call credit spread.\nShort Iron Condor Example\nBuy 1 XYZ November 70 put (A)\nSell 1 XYZ November 75 put (B)\nSell 1 XYZ November 90 call (C)\nBuy 1 XYZ November 95 call (D)\nLong Iron Condor\nShort one put with strike A; long one put with ahigher strike, B; long one call with an even higher strike, C; and short one call with astill higher strike, D. The options are on the same security and in the same expiration cycle. The put debit spread (strikes Aand B) has the same distance between the strike prices as the call debit spread (strikes Cand D).\nLong Iron Condor Example\nSell 1 XYZ November 70 put (A)\nBuy 1 XYZ November 75 put (B)\nBuy 1 XYZ November 90 call (C)\nSell 1 XYZ November 95 call (D)\nButterflies\nButterflies are wing spreads similar to condors, but there are only three strikes involved in the trade—not four.\nLong Butterfly\nLong one call (put) with strike A; short two calls (puts) with ahigher strike, B; and long one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The difference in price between strikes Aand Bequals that between strikes Band C.\nLong Butterfly Example\nBuy 1 XYZ December 50 call (A)\nSell 2 XYZ December 60 call (B)\nBuy 1 XYZ December 70 call (C)\nShort Butterfly\nShort one call (put) with strike A; long two calls (puts) with ahigher strike, B; and short one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The vertical spread made up of the options with strike Aand strike Bhas the same distance between the st", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00020.html", "doc_id": "204d08362d1a6a3fabb5ec2c558a7bae0fc6ca96d7467f486d5a9ec52a3bdf5f", "chunk_index": 0}
{"text": "ls (puts) with ahigher strike, B; and short one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The vertical spread made up of the options with strike Aand strike Bhas the same distance between the strike prices of the vertical spread made up of the options with strike Band strike C.\nShort Butterfly Example\nSell 1 XYZ December 50 call\nBuy 2 XYZ December 60 call\nSell 1 XYZ December 70 call\nIron Butterflies\nMuch like the relationship of the condor to the iron condor, abutterfly has its synthetic equal as well: the iron butterfly.\nShort Iron Butterfly\nLong one put with strike A; short one put with ahigher strike, B; short one call with strike B; long one call with astrike higher than B, C. The options are on the same security and in the same expiration cycle. The distances between the strikes of the put spread and between the strikes of the call spread are equal.\nShort Iron Butterfly Example\nBuy 1 XYZ December 50 put (A)\nSell 1 XYZ December 60 put (B)\nSell 1 XYZ December 60 call (B)\nBuy 1 XYZ December 70 call (C)\nLong Iron Butterfly\nShort one put with strike A; long one put with ahigher strike, B; long one call with strike B; short one call with astrike higher than B, C. The options are on the same security and in the same expiration cycle. The distances between the strikes of the put spread and between the strikes of the call spread are equal. The put debit spread has the same distance between the strike prices as the call debit spread.\nLong Iron Butterfly Example\nSell 1 XYZ December 50 put\nBuy 1 XYZ December 60 put\nBuy 1 XYZ December 60 call\nSell 1 XYZ December 70 call\nThese spreads were defined in terms of both long and short for each strategy. Whether the spread is classified as long or short depends on whether it was established at acredit or adebit. Debit condors or butterflies are considered long spreads. And credit condors or butterflies are considered short spreads.\nThe words long and short mean little, though in terms of the spread as awhole. The important thing is which strikes have long options and which have short options. Acall debit spread is synthetically equal to aput credit spread on the same security, with the same expiration month and strike prices. That means along condor is synthetically equal to ashort iron condor, and along butterfly is synthetically equal to ashort iron butterfly, when the same strikes are used. Whichever position is constructed, the best-case scenario is to have debit spreads expire with both options in-the-money (ITM) and credit spreads expire with both options out-of-the-money (OTM).\nMany retail traders prefer trading these spreads for the purpose of generating income. In this case, atrader would sell the guts, or middle strikes, and buy the wings, or outer strikes. When atrader is short the guts, low realized volatility is usually the objective. For long butterflies and short iron butterflies, the stock needs to be right at the middle strike for the maximum payout. For long condors and short iron condors, the stock needs to be between the short strikes at expiration for maximum payout. In both instances, the wings are bought to limit potential losses of the otherwise naked options.\nLong Butterfly Example\nAtrader, Kathleen, has been studying United Parcel Service (UPS), which is trading at around $70.65. She believes UPS will trade sideways until July expiration. Kathleen buys the July 65–70–75 butterfly for 2.00. She executes the following legs:\nKathleen looks at her trade as two vertical spreads, the 65–70 bull (debit) call spread and the 70–75 bear (credit) call spread. Intuitively, she would want UPS to be at or above $70 at expiration for her bull call spread to have maximum value. But she has the seemingly conflicting goal of also wanting UPS to be at or below $70 to get the most from her 70–75 bear call spread. The ideal price for the stock to be trading at expiration in this example is right at $70 per share—the best of both worlds. The at-expiration diagram,\nExhibit 10.1\n, shows the profit or loss of all possible outcomes at expiration.\nEXHIBIT 10.1\nUPS 65–70–75 butterfly.\nIf the price of UPS shares declines below $65 at expiration, all these calls will expire. The entire 2.00 spent on the trade will be lost. If UPS is above $65 at expiration, the 65 call will be ITM and will be exercised. The call will profit like along position in 100 shares of the underlying. The maximum profit is reached if UPS is at $70 at expiration. Kathleen makes a 5.00 profit from $65 to $70 on her 65 calls. But because she paid 2.00 initially for the spread, her net profit at $70 is just 3.00. If UPS is above $70 ashare at expiration in this example, the two 70 calls will be assigned. The assignment of one call will offset the long stock acquired by the 65 calls being exercised. Assignment of the other call will create ashort position in the underlying. That short position loses as", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00020.html", "doc_id": "204d08362d1a6a3fabb5ec2c558a7bae0fc6ca96d7467f486d5a9ec52a3bdf5f", "chunk_index": 1}
{"text": "3.00. If UPS is above $70 ashare at expiration in this example, the two 70 calls will be assigned. The assignment of one call will offset the long stock acquired by the 65 calls being exercised. Assignment of the other call will create ashort position in the underlying. That short position loses as UPS moves higher up to $75 ashare, eating away at the 3.00 profit. If UPS is above $75 at expiration, the 75 call can be exercised to buy back the short stock position that resulted from the 70’sbeing assigned. The loss on the short stock between $70 and $75 will cost Kathleen 5.00, stripping her of her 3.00 profit and giving her anet loss of 2.00 to boot. End result? Above $75 at expiration, she has no position in the underlying and loses 2.00.\nAbutterfly is abreak-even analysis trade\n. This name refers to the idea that the most important considerations in this strategy are the breakeven points. The at-expiration diagram,\nExhibit 10.2\n, shows the break-even prices for this trade.\nEXHIBIT 10.2\nUPS 65–70–75 butterfly breakevens.\nIf the position is held until expiration and UPS is between $65 and $70 at that time, the 65 calls are exercised, resulting in long stock. The effective purchase price of that stock is $67. That’sthe strike price plus the cost of the spread; that’sthe lower break-even price. The other break-even is at $73. The net short position of 100 shares resulting from assignment of the 70 call loses more as the stock rises between $70 and $75. The entire 3.00 profit realized at the $70 share price is eroded when the stock reaches $73. Above $73, the trade produces aloss.\nKathleen’strading objective is to profit from UPS trading between $67 and $73 at expiration. The best-case scenario is that it declines only slightly from its price of $70.65 when the trade is established, to $70 per share.\nAlternatives\nKathleen had other alternative positions she could have traded to meet her goals. An iron butterfly with the same strike prices would have shown about the same risk/reward picture, because the two positions are synthetically equivalent. But there may, in some cases, be aslight advantage to trading the iron butterfly over the long butterfly. The iron butterfly uses OTM put options instead of ITM calls, meaning the bid-ask spreads may be tighter. This means giving up less edge to the liquidity providers.\nShe could have also bought acondor or sold an iron condor. With condor-family spreads, there is alower maximum profit potential but awider range in which that maximum payout takes place. For example, Kathleen could have executed the following legs to establish an iron condor:\nEssentially, Kathleen would be selling two credit spreads: the July 60–65 put spread for 0.30 and the July 75–80 call spread for 0.35.\nExhibit 10.3\nshows the payout at expiration of the UPS July 60–65–75–80 iron condor.\nEXHIBIT 10.3\nUPS 60–65–75–80 iron condor.\nAlthough the forecast and trading objectives may be similar to those for the butterfly, the payout diagram reveals some important differences. First, the maximum loss is significantly higher with acondor or iron condor. In this case, the maximum loss is 4.35. This unfortunate situation would occur if UPS were to drop to below $60 or rise above $80 by expiration. Below $60, the call spread expires, netting 0.35. But the put spread is ITM. Kathleen would lose anet of 4.70 on the put spread. The gain on the call spread combined with the loss on the put spread makes the trade aloser of 4.35 if the stock is below $60 at expiration. Above $80, the put spread is worthless, earning 0.30, but the call spread is aloser by 4.65. The gain on the put spread plus the loss on the call spread is anet loser of 4.35. Between $65 and $75, all options expire and the 0.65 credit is all profit.\nSo far, this looks like apretty lousy alternative to the butterfly. You can lose 4.35 but only make 0.65! Could there be any good reason for making this trade? Maybe. The difference is wiggle room. The breakevens are 2.65 wider in each direction with the iron condor.\nExhibit 10.4\nshows these prices on the graph.\nEXHIBIT 10.4\nUPS 60–65–75–80 iron condor breakevens.\nThe lower threshold for profit occurs at $64.35 and the upper at $75.65. With condor/iron condors, there can be agreater chance of producing awinning trade because the range is wider than that of the butterfly. This benefit, however, has atrade-off of lower potential profit. There is\nalways\naparallel relationship of risk and reward. When risk increases so does reward, and vice versa. This way of thinking should now be ingrained in your DNA. The risk of failure is less, so the payout is less. Because the odds of winning are higher, atrader will accept lower payouts on the trade.\nKeys to Success\nNo matter which trade is more suitable to Kathleen’srisk tolerance, the overall concept is the same: profit from little directional movement. Before Kathleen found astock on which to trade her spread, she will have sifted through myriad stocks to find those", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00020.html", "doc_id": "204d08362d1a6a3fabb5ec2c558a7bae0fc6ca96d7467f486d5a9ec52a3bdf5f", "chunk_index": 2}
{"text": "ower payouts on the trade.\nKeys to Success\nNo matter which trade is more suitable to Kathleen’srisk tolerance, the overall concept is the same: profit from little directional movement. Before Kathleen found astock on which to trade her spread, she will have sifted through myriad stocks to find those that she expects to trade in arange. She has afew tools in her trading toolbox to help her find good butterfly and condor candidates.\nFirst, Kathleen can use technical analysis as aguide. This is arather straightforward litmus test: does the stock chart show atrending, volatile stock or aflat, nonvolatile stock? For the condor, aquick glance at the past few months will reveal whether the stock traded between $65 and $75. If it did, it might be agood iron condor candidate. Although this very simplistic approach is often enough for many traders, those who like lots of graphs and numbers can use their favorite analyses to confirm that the stock is trading in arange. Drawing trendlines can help traders to visualize the channel in which astock has been trading. Knowing support and resistance is also beneficial. The average directional movement index (ADX) or moving average converging/diverging (MACD) indicator can help to show if there is atrend present. If there is, the stock may not be agood candidate.\nSecond, Kathleen can use fundamentals. Kathleen wants stocks with nothing on their agendas. She wants to avoid stocks that have pending events that could cause their share price to move too much. Events to avoid are earnings releases and other major announcements that could have an impact on the stock price. For example, adrug stock that has been trading in arange because it is awaiting Food and Drug Administration (FDA) approval, which is expected to occur over the next month, is not agood candidate for this sort of trade.\nThe last thing to consider is whether the numbers make sense. Kathleen’siron condor risks 4.35 to make 0.65. Whether this sounds like agood trade depends on Kathleen’srisk tolerance and the general environment of UPS, the industry, and the market as awhole. In some environments, the 0.65/4.35 payout-to-risk ratio makes alot of sense. For other people, other stocks, and other environments, it doesn’t.\nGreeks and Wing Spreads\nMuch of this chapter has been spent on how wing spreads perform if held until expiration, and little has been said of option greeks and their role in wing spreads. Greeks do come into play with butterflies and condors but not necessarily the same way they do with other types of option trades.\nThe vegas on these types of spreads are smaller than they are on many other types of strategies. For atypical nonprofessional trader, it’shard to trade implied volatility with condors or butterflies. The collective commissions on the four legs, as well as margin and capital considerations, put these out of reach for active trading. Professional traders and retail traders subject to portfolio margining are better equipped for volatility trading with these spreads.\nThe true strength of wing spreads, however, is in looking at them as break-even analysis trades much like vertical spreads. The trade is awinner if it is on the correct side of the break-even price. Wing spreads, however, are acombination of two vertical spreads, so there are two break-even prices. One of the verticals is guaranteed to be awinner. The stock can be either higher or lower at expiration—not both. In some cases, both verticals can be winners.\nConsider an iron condor. Instead of reaping one premium from selling one OTM call credit spread, iron condor sellers double dip by additionally selling an OTM put credit spread. They collect adouble credit, but only one of the credit spreads can be aloser at expiration. The trader, however, does have to worry about both directions independently.\nThere are two ways for greeks and volatility analysis to help traders trade wing spreads. One of them involves using delta and theta as tools to trade adirectional spread. The other uses implied volatility in strike selection decisions.\nDirectional Butterflies\nTrading abutterfly can be an excellent way to establish alow-cost, relatively low-risk directional trade when atrader has aspecific price target in mind. For example, atrader, Ross, has been studying Walgreen Co. (WAG) and believes it will rise from its current level of $33.50 to $36 per share over the next month. Ross buys abutterfly consisting of all OTM January calls with 31 days until expiration.\nHe executes the following legs:\nAs adirectional trade alternative, Ross could have bought just the January 35 call for 1.15. As acheaper alternative, he could have also bought the 35–36 bull call spread for 0.35. In fact, Ross actually does buy the 35–36 spread, but he also sells the January 36–37 call spread at 0.25 to reduce the cost of the bull call spread, investing only adime. The benefit of lower cost, however, comes with trade-offs.\nExhibit 10.5\ncompares the bull call spread with", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00020.html", "doc_id": "204d08362d1a6a3fabb5ec2c558a7bae0fc6ca96d7467f486d5a9ec52a3bdf5f", "chunk_index": 3}
{"text": "call spread for 0.35. In fact, Ross actually does buy the 35–36 spread, but he also sells the January 36–37 call spread at 0.25 to reduce the cost of the bull call spread, investing only adime. The benefit of lower cost, however, comes with trade-offs.\nExhibit 10.5\ncompares the bull call spread with abullish butterfly.\nEXHIBIT 10.5\nBull call spread vs. bull butterfly (Walgreen Co. at $33.50).\nThe butterfly has lower nominal risk—only 0.10 compared with 0.35 for the call spread. The maximum reward is higher in nominal terms, too—0.90 versus 0.65. The trade-off is what is given up. With both strategies, the goal is to have Walgreen Co. at $36 around expiration. But the bull call spread has more room for error to the upside. If the stock trades alot higher than expected, the butterfly can end up being alosing trade.\nGiven Ross’sexpectations in this example, this might be arisk he is willing to take. He doesn’texpect Walgreen Co. to close right at $36 on the expiration date. It could happen, but it’sunlikely. However, he’dhave to be wildly wrong to have the trade be aloser on the upside. It would be amuch larger move than expected for the stock to rise significantly above $36. If Ross strongly believes Walgreen Co. can be around $36 at expiration, the cost benefit of 0.10 vs. 0.35 may offset the upside risk above $37. As ageneral rule, directional butterflies work well in trending, low-volatility stocks.\nWhen Ross monitors his butterfly, he will want to see the greeks for this position as well.\nExhibit 10.6\nshows the trade’sanalytics with Walgreen Co. at $33.50.\nEXHIBIT 10.6\nWalgreen Co. 35–36–37 butterfly greeks (stock at $33.50, 31 days to expiration).\nDelta\n+0.008\nGamma\n−0.004\nTheta\n+0.001\nVega\n−0.001\nWhen the trade is first put on, the delta is small—only +0.008. Gamma is slightly negative and theta is very slightly positive. This is important information if Walgreen Co.’sascent happens sooner than Ross planned. The trade will show just asmall profit if the stock jumps to $36 per share right away. Ross’stheoretical gain will be almost unnoticeable. At $36 per share, the position will have its highest theta, which will increase as expiration approaches. Ross will have to wait for time to pass to see the trade reach its full potential.\nThis example shows the interrelation between delta and theta. We know from an at-expiration analysis that if Walgreen Co. moves from $33.50 to $36, the butterfly’sprofit will be 0.90 (the spread of $1 minus the 0.10 initial debit). If we distribute the 0.90 profit over the 2.50 move from $33.50 to $36, the butterfly gains about 0.36 per dollar move in Walgreen Co. (0.90/(36 − 33.50). This implies adelta of about 0.36.\nBut the delta, with 31 days until expiration and Walgreen Co. at $33.50, is only 0.008, and because of negative gamma this delta will get even smaller as Walgreen Co. rises. Butterflies, like the vertical spreads of which they are composed, can profit from direction but are never purely directional trades. Time is always afactor. It is theta, working in tandem with delta, that contributes to profit or peril.\nAbearish butterfly can be constructed as well. One would execute the trade with all OTM puts or all ITM calls. The concept is the same: sell the guts at the strike at which the stock is expected to be trading at expiration, and buy the wings for protection.\nConstructing Trades to Maximize Profit\nMany traders who focus on trading iron condors trade exchange-traded funds (ETFs) or indexes. Why? Diversification. Because indexes are made up of many stocks, they usually don’thave big gaps caused by surprise earnings announcements, takeovers, or other company-specific events. But it’snot just selecting the right underlying to trade that is the challenge. Atrader also needs to pick the right strike prices. Finding the right strike prices to trade can be something of an art, although science can help, as well.\nThree Looks at the Condor\nStrike selection is essential for asuccessful condor. If strikes are too close together or two far apart, the trade can become much less attractive.\nStrikes Too Close\nThe QQQs are options on the ETFs that track the Nasdaq 100 (QQQ). They have strikes in $1 increments, giving traders alot to choose from. With QQQ trading at around $55.95, consider the 54–55–57–58 iron condor. In this example, with 31 days until expiration, the following legs can be executed:\nIn this trade, the maximum profit is 0.63. The maximum risk is 0.37. This isn’tabad profit-to-loss ratio. The break-even price on the downside is $54.37 and on the upside is $57.63. That’sa $3.26 range—atight space for amover like the QQQ to occupy in amonth. The ETF can drop about only 2.8 percent or rise 3 percent before the trade becomes aloser. No one needs any fancy math to show that this is likely alosing proposition in the long run. While choosing closer strikes can lead to higher premiums, the range can be so constricting that it asphyxiates the possibility of profit.\nStrikes", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00020.html", "doc_id": "204d08362d1a6a3fabb5ec2c558a7bae0fc6ca96d7467f486d5a9ec52a3bdf5f", "chunk_index": 4}
{"text": "8 percent or rise 3 percent before the trade becomes aloser. No one needs any fancy math to show that this is likely alosing proposition in the long run. While choosing closer strikes can lead to higher premiums, the range can be so constricting that it asphyxiates the possibility of profit.\nStrikes Too Far\nStrikes too far apart can make for impractical trades as well.\nExhibit 10.7\nshows an options chain for the Dow Jones Industrial Average Index (DJX). These prices are from around 2007 when implied volatility (IV) was historically low, making the OTM options fairly low priced. In this example, DJX is around $135.20 and there are 51 days until expiration.\nEXHIBIT 10.7\nOptions chain for DJIA.\nIf the goal is to choose strikes that are far enough apart to be unlikely to come into play, atrader might be tempted to trade the 120–123–142–145 iron condor. With this wingspan, there is certainly agood chance of staying between those strikes—you could drive aproverbial truck through that range.\nThis would be agreat trade if it weren’tfor the prices one would have to accept to put it on. First, the 120 puts are offered at 0.25 and the 123 puts are 0.25 bid. This means that the put spread would be sold at zero! The maximum risk is 3.00, and the maximum gain is zero. Not areally good risk/reward. The 142–145 call spread isn’tmuch better: it can be sold for adime.\nAt the time, again alow-volatility period, many traders probably felt it was unlikely that the DJX will rise 5 percent in a 51-day period. Some traders may have considered trading asimilarly priced iron condor (though of course they’dhave to require some small credit for the risk). Alittle over ayear later the DJX was trading around 50 percent lower. Traders must always be vigilant of the possibility of volatility, even unexpected volatility and structure their risk/reward accordingly. Most traders would say the risk/reward of this trade isn’tworth it. Strikes too far apart have agreater chance of success, but the payoff just isn’tthere.\nStrikes with High Probabilities of Success\nSo how does atrader find the happy medium of strikes close enough together to provide rich premiums but far enough apart to have agood chance of success? Certainly, there is something to be said for looking at the prices at which atrade can be done and having asubjective feel for whether the underlying is likely to move outside the range of the break-even prices. Alittle math, however, can help quantify this likelihood and aid in the decision-making process.\nRecall that IV is read by many traders to be the market’sconsensus estimate of future realized volatility in terms of annualized standard deviation. While that is amouthful to say—or in this case, rather, an eyeful to read—when broken down it is not quite as intimidating as it sounds. Consider asimplified example in which an underlying security is trading at $100 ashare and the implied volatility of the at-the-money (ATM) options is 10 percent. That means, from astatistical perspective, that if the expected return for the stock is unchanged, the one-year standard deviations are at $90 and $110.\n1\nIn this case, there is about a 68 percent chance of the stock trading between $90 and $110 one year from now. IV then is useful information to atrader who wants to quantify the chances of an iron condor’sexpiring profitable, but there are afew adjustments that need to be made.\nFirst, because with an iron condor the idea is to profit from net short option premium, it usually makes more sense to sell shorter-term options to profit from higher rates of time decay. This entails trading condors composed of one- or two-month options. The IV needs to be deannualized and converted to represent the standard deviation of the underlying at expiration.\nThe first step is to compute the one-day standard deviation. This is found by dividing the implied volatility by the square root of the number of trading days in ayear, then multiplying by the square root of the number of trading days until expiration. The result is the standard deviation (σ) at the time of expiration stated as apercent. Next, multiply that percentage by the price of the underlying to get the standard deviation in absolute terms.\nThe formula\n2\nfor calculating the shorter-term standard deviation is as follows:\nThis value will be added to or subtracted from the price of the underlying to get the price points at which the approximate standard deviations fall.\nConsider an example using options on the Standard & Poor’s 500 Index (SPX). With 50 days until expiration, the SPX is at 1241 and the implied volatility is 23.2 percent. To find strike prices that are one standard deviation away from the current index price, we need to enter the values into the equation. We first need to know how many actual trading days are in the 50-day period. There are 35 business days during this particular 50-day period (there is one holiday and seven weekend days). We now have all the data we need to calculate", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00020.html", "doc_id": "204d08362d1a6a3fabb5ec2c558a7bae0fc6ca96d7467f486d5a9ec52a3bdf5f", "chunk_index": 5}
{"text": "rrent index price, we need to enter the values into the equation. We first need to know how many actual trading days are in the 50-day period. There are 35 business days during this particular 50-day period (there is one holiday and seven weekend days). We now have all the data we need to calculate which strikes to sell.\nThe lower standard deviation is 1134.55 (1241 − 106.45) and the upper is 1347.45 (1241 + 106.45). This means there would be about a 68 percent chance of SPX ending up between 1134.55 and 1347.45 at expiration. In this example, to have about atwo-thirds chance of success, one would sell the 1135 puts and the 1350 calls as part of the iron condor.\nBeing Selective\nThere is about atwo-thirds chance of the underlying staying between the upper and lower standard deviation points and about aone-third chance it won’t. Reasonably good odds. But the maximum loss of an iron condor will be more than the maximum profit potential. In fact, the max-profit-to-max-loss ratio is usually less than 1 to 3. For every $1 that can be made, often $4 or $5 will be at risk.\nThe pricing model determines fair value of an option based on the implied volatility set by the market. Again, many traders consider IV to be the market’sconsensus estimate of future realized volatility. Assuming the market is generally right and options are efficiently priced, in the long run, future stock volatility should be about the same as the implied volatility from options prices. That means that if all of your options trades are executed at fair value, you are likely to break even in the long run. The caveat is that whether the options market is efficient or not, retail or institutional traders cannot generally execute trades at fair value. They have to sell the bid (sell below theoretical value) and buy the offer (buy above theoretical value). This gives the trade astatistical disadvantage, called giving up the edge, from an expected return perspective.\nEven though you are more likely to win than to lose with each individual trade when strikes are sold at the one-standard-deviation point, the edge given up to the market in conjunction with the higher price tag on losers makes the trade astatistical loser in the long run. While this means for certain that the non-market-making trader is at aconstant disadvantage, trading condors and butterflies is no different from any other strategy. Giving up the edge is the plight of retail and institutional traders. To profit in the long run, atrader needs to beat the market, which requires careful planning, selectivity, and risk management.\nSavvy traders trade iron condors with strikes one standard deviation away from the current stock price only when they think there is more than atwo-thirds chance of market neutrality. In other words, if you think the market will be less volatile than the prices in the options market imply, sell the iron condor or trade another such premium-selling strategy. As discussed above, this opinion should reflect sound judgment based on some combination of technical analysis, fundamental analysis, volatility analysis, feel, and subjectivity.\nA Safe Landing for an Iron Condor\nAlthough traders can’tcontrol what the market does, they can control how they react to the market. Assume atrader has done due diligence in studying astock and feels it is aqualified candidate for aneutral strategy. With the stock at $90, a 16.5 percent implied volatility, and 41 days until expiration, the standard deviation is about 5. The trader sells the following iron condor:\nWith the stock at $90, directly between the two short strikes, the trade is direction neutral. The maximum profit is equal to the total premium taken in, which in this case is $800. The maximum loss is $4,200. There is about atwo-thirds chance of retaining the $800 at expiration.\nAfter one week, the overall market begins trending higher on unexpected bullish economic news. This stock follows suit and is now trading at $93, and concern is mounting that the rally will continue. The value of the spread now is about 1.10 per contract (we ignore slippage from trading on the bid-ask spreads of the four legs of the spread). This means the trade has lost $300 because it would cost $1,100 to buy back what the trader sold for atotal of $800.\nOne strategy for managing this trade looking forward is inaction. The philosophy is that sometimes these trades just don’twork out and you take your lumps. The philosophy is that the winners should outweigh the losers over the long term. For some of the more talented and successful traders with aproven track record, this may be aviable strategy, but there are more active options as well. Atrader can either close the spread or adjust it.\nThe two sets of data that must be considered in this decision are the prices of the individual options and the greeks for the trade.\nExhibit 10.8\nshows the new data with the stock at $93.\nEXHIBIT 10.8\nGreeks for iron condor with stock at $93.\nThe trade is no longer", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00020.html", "doc_id": "204d08362d1a6a3fabb5ec2c558a7bae0fc6ca96d7467f486d5a9ec52a3bdf5f", "chunk_index": 6}
{"text": "er close the spread or adjust it.\nThe two sets of data that must be considered in this decision are the prices of the individual options and the greeks for the trade.\nExhibit 10.8\nshows the new data with the stock at $93.\nEXHIBIT 10.8\nGreeks for iron condor with stock at $93.\nThe trade is no longer neutral, as it was when the underlying was at $90. It now has adelta of −2.54, which is like being short 254 shares of the underlying. Although the more time that passes the better—as indicated by the +0.230 theta—delta is of the utmost concern. The trader has now found himself short amarket that he thinks may rally.\nClosing the entire position is one alternative. To be sure, if you don’thave an opinion on the underlying, you shouldn’thave aposition. It’slike making abet on asporting event when you don’treally know who you think will win. The spread can also be dismantled piecemeal. First, the 85 puts are valued at $0.07 each. Buying these back is ano-brainer. In the event the stock does retrace, why have the positive delta of that leg working against you when you can eliminate the risk inexpensively now?\nThe 80 puts are worthless, offered at 0.05, presumably. There is no point in trying to sell these. If the market does turn around, they may benefit, resulting in an unexpected profit.\nThe 80 and 85 puts are the least of his worries, though. The concern is acontinuing rally. Clearly, the greater risk is in the 95–100 call spread. Closing the call spread for aloss eliminates the possibility of future losses and may be awise choice, especially if there is great uncertainty. Taking asmall loss now of only around $300 is abetter trade than risking atotal loss of $4,200 when you think there is astrong chance of that total loss occurring.\nBut if the trader is not merely concerned that the stock will rally but truly believes that there is agood chance it will, the most logical action is to position himself for that expected move. Although there are many ways to accomplish this, the simplest way is to buy to close the 95 calls to eliminate the position at that strike. This eliminates the short delta from the 95 calls, leading to anow-positive delta for the position as awhole. The new position after adjusting by buying the 85 puts and the 95 calls is shown in\nExhibit 10.9\n.\nEXHIBIT 10.9\nIron condor adjusted to strangle.\nThe result is along strangle: along call and along put of the same month with two different strikes. Strangles will be discussed in subsequent chapters. The 80 puts are far enough out-of-the-money to be fairly irrelevant. Effectively, the position is long ten 100-strike calls. This serves the purpose of changing the negative 2.54 delta into apositive 0.96 delta. The trader now has abullish position in the stock that he thinks will rally—amuch smarter position, given that forecast.\nThe Retail Trader versus the Pro\nIron condors are very popular trades among retail traders. These days one can hardly go to acocktail party and mention the word\noptions\nwithout hearing someone tell astory about an iron condor on which he’smade abundle of money trading. Strangely, no one ever tells stories about trades in which he has lost abundle of money.\nTwo of the strengths of this strategy that attract retail traders are its limited risk and high probability of success. Another draw of this type of strategy is that the iron condor and the other wing spreads offer something truly unique to the retail trader: away to profit from stocks that don’tmove. In the stock-trading world, the only thing that can be traded is direction—that is, delta. The iron condor is an approachable way for anonprofessional to dabble in nonlinear trading. The iron condor does agood job in eliminating delta—unless, of course, the stock moves and gamma kicks in. It is efficient in helping income-generating retail traders accomplish their goals. And when aloss occurs, although it can be bigger than the potential profits, it is finite.\nBut professional option traders, who have access to lots of capital and have very low commissions and margin requirements, tend to focus their efforts in other directions: they tend to trade volatility. Although iron condors are well equipped for profiting from theta when the stock cooperates, it is also possible to trade implied volatility with this strategy.\nThe examples of iron condors, condors, iron butterflies, and butterflies presented in this chapter so far have for the most part been from the perspective of the neutral trader: selling the guts and buying the wings. Atrader focusing on vega in any of these strategies may do just the opposite—buy the guts and sell the wings—depending on whether the trader is bullish or bearish on volatility.\nSay atrader, Joe, had abullish outlook on volatility in\nSalesforce.com\n(CRM). Joe could sell the following condor 100 times.\nIn this example, February is 59 days from expiration.\nExhibit 10.10\nshows the analytics for this trade with CRM at $104.32.\nEXHIBIT 10.10\nSalesforce.com\ncond", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00020.html", "doc_id": "204d08362d1a6a3fabb5ec2c558a7bae0fc6ca96d7467f486d5a9ec52a3bdf5f", "chunk_index": 7}
{"text": "sh on volatility.\nSay atrader, Joe, had abullish outlook on volatility in\nSalesforce.com\n(CRM). Joe could sell the following condor 100 times.\nIn this example, February is 59 days from expiration.\nExhibit 10.10\nshows the analytics for this trade with CRM at $104.32.\nEXHIBIT 10.10\nSalesforce.com\ncondor (\nSalesforce.com\nat $104.32).\nAs expected with the underlying centered between the two middle strikes, delta and gamma are about flat. As\nSalesforce.com\nmoves higher or lower, though, gamma and, consequently, delta will change. As the stock moves closer to either of the long strikes, gamma will become more positive, causing the delta to change favorably for Joe. Theta, however, is working against him with\nSalesforce.com\nat $104.32, costing $150 aday. In this instance, movement is good. Joe benefits from increased realized volatility. The best-case scenario would be if\nSalesforce.com\nmoves through either of the long strikes to, or through, either of the short strikes.\nThe prime objective in this example, though, is to profit from arise in IV. The position has apositive vega. The position makes or loses $400 with every point change in implied volatility. Because of the proportion of theta risk to vega risk, this should be ashort-term play.\nIf Joe were looking for asmall rise in IV, say five points, the move would have to happen within 13 calendar days, given the vega and theta figures. The vega gain on arise of five vol points would be $2,000, and the theta loss over 13 calendar days would be $1,950. If there were stock movement associated with the IV increase, that delta/gamma gain would offset some of the havoc that theta wreaked on the option premiums. However, if Joe traded astrategy like acondor as avol play, he would likely expect abigger volatility move than the five points discussed here as well as expecting increased realized volatility.\nAcondor bullish vol play works when you expect something to change astock’sprice action in the short term. Examples would be rumors of anew product’sbeing unveiled, aproduct recall, amanagement change, or some other shake-up that leads to greater uncertainty about the company’sfuture—good or bad. The goal is to profit from arise in IV, so the trade needs to be put on before the announcement occurs. The motto in option-volatility trading is “Buy the rumor; sell the news.” Usually, by the time the news is out, the increase in IV is already priced into option premiums. As uncertainty decreases, IV decreases as well.\nNotes\n1\n. It is important to note that in the real world, interest and expectations for future stock-price movement come into play. For simplicity’ssake, they’ve been excluded here.\n2\n. This is an approximate formula for estimating standard deviation. Although it is mathematically only an approximation, it is the convention used by many option traders. It is atraders’ short cut.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00020.html", "doc_id": "204d08362d1a6a3fabb5ec2c558a7bae0fc6ca96d7467f486d5a9ec52a3bdf5f", "chunk_index": 8}
{"text": "CHAPTER 11\nCalendar and Diagonal Spreads\nOption selling is aniche that attracts many retail and professional traders because it’spossible to profit from the passage of time. Calendar and diagonal spreads are practical strategies to limit risk while profiting from time. But these spreads are unique in many ways. In order to be successful with them, it is important to understand their subtle qualities.\nCalendar Spreads\nDefinition\n: Acalendar spread, sometimes called atime spread\nor ahorizontal spread\n, is an option strategy that involves buying one option and selling another option with the same strike price but with adifferent expiration date.\nAt-expiration diagrams do acalendar-spread trader little good. Why? At the expiration of the short-dated option, the trader is left with another option that may have time value. To estimate what the position will be worth when the short-term option expires, the value of the long-term option must be analyzed using the greeks. This is true of the variants of the calendar—double calendars, diagonals, and double diagonals—as well. This chapter will show how to analyze strategies that involve options with different expirations and discuss how and when to use them.\nBuying the Calendar\nThe calendar spread and all its variations are commonly associated with income-generating spreads. Using calendar spreads as income generators is popular among retail and professional traders alike. The process involves buying alonger-term at-the-money option and selling ashorter-term at-the-money (ATM) option. The options must be either both calls or both puts. Because this transaction results in anet debit—the longer-term option being purchased has ahigher premium than the shorter-term option being sold—this is referred to as buying the calendar.\nThe main intent of buying acalendar spread for income is to profit from the positive net theta of the position. Because the shorter-term ATM option decays at afaster rate than the longer-term ATM option, the net theta is positive. As for most income spreads, the ideal outcome occurs when the underlying is at the short strike (in this case, shared strike) when the shorter-term option expires. At this strike price, the long option has its highest value, while the short option expires without the trader’sgetting assigned. As long as the underlying remains close to the strike price, the value of the spread rises as time passes, because the short option decreases in value faster than the long option.\nFor example, atrader, Richard, watches Bed Bath & Beyond Inc. (BBBY) on aregular basis. Richard believes that Bed Bath & Beyond will trade in arange around $57.50 ashare (where it is trading now) over the next month. Richard buys the January–February 57.50 call calendar for 0.80. Assuming January has 25 days until expiration and February has 53 days, Richard will execute the following trade:\nRichard’sbest-case scenario occurs when the January calls expire at expiration and the February calls retain much of their value.\nIf Richard created an at-expiration P&(L) diagram for his position, he’dhave trouble because of the staggered expiration months. Ageneral representation would look something like\nExhibit 11.1\n.\nEXHIBIT 11.1\nBed Bath & Beyond January–February 57.50 calendar.\nThe only point on the diagram that is drawn with definitive accuracy is the maximum loss to the downside at expiration of the January call. The maximum loss if Bed Bath & Beyond falls low enough is 0.80—the debit paid for the spread. If Bed Bath & Beyond is below $57.50 at January expiration, the January 57.50 call expires worthless, and the February 57.50 call may or may not have residual value. If Bed Bath & Beyond declines enough, the February 57.50 call can lose all of its value, even with residual time until expiration. If the stock falls enough, the entire 0.80 debit would be aloss.\nIf Bed Bath & Beyond is above $57.50 at January expiration, the January 57.50 call will be trading at parity. It will be anegative-100-delta option, imitating short stock. If Bed Bath & Beyond is trading high enough, the February 57.50 call will become apositive-100-delta option trading at parity plus the interest calculated on the strike. The February deep-in-the-money option would imitate long stock. At a 2 percent interest rate, interest on the 57.50 strike is about 0.17. Therefore, Richard would essentially have ashort stock position from $57.50 from the January 57.50 call and would be essentially long stock from $57.50 plus 0.28 from the February call. The maximum loss to the upside is about 0.63 (0.80 − 0.17).\nThe maximum loss if Bed Bath & Beyond is trading over $57.50 at expiration is only an estimate that assumes there is no time value and that interest and dividends remain constant. Ultimately, the maximum loss will be 0.80, the premium paid, if there is no time value or carry considerations.\nThe maximum profit is gained if Bed Bath & Beyond is at $57.50 at expiration. At this price, the February", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00021.html", "doc_id": "669dabb01df06cbaf0dd52efb88991415fc13adbadbfec77d723f66adc06c013", "chunk_index": 0}
{"text": "t assumes there is no time value and that interest and dividends remain constant. Ultimately, the maximum loss will be 0.80, the premium paid, if there is no time value or carry considerations.\nThe maximum profit is gained if Bed Bath & Beyond is at $57.50 at expiration. At this price, the February 57.50 call is worth the most it can be worth without having the January 57.50 call assigned and creating negative deltas to the upside. But how much precisely is the maximum profit? Richard would have to know what the February 57.50 call would be worth with Bed Bath & Beyond stock trading at $57.50 at February expiration before he can know the maximum profit potential. Although Richard can’tknow for sure at what price the calls will be trading, he can use apricing model to estimate the call’svalue.\nExhibit 11.2\nshows analytics at January expiration.\nEXHIBIT 11.2\nBed Bath & Beyond January–February 57.50 call calendar greeks at January expiration.\nWith an unchanged implied volatility of 23 percent, an interest rate of two percent, and no dividend payable before February expiration, the February 57.50 calls would be valued at 1.53 at January expiration. In this best-case scenario, therefore, the spread would go from 0.80, where Richard purchased it, to 1.53, for again of 91 percent. At January expiration, with Bed Bath & Beyond at $57.50, the January call would expire; thus, the spread is composed of just the February 57.50 call.\nLet’snow go back in time and see how Richard figured this trade.\nExhibit 11.3\nshows the position when the trade is established.\nEXHIBIT 11.3\nBed Bath & Beyond January–February 57.50 call calendar.\nAsmall and steady rise in the stock price with enough time to collect theta is the recipe for success in this trade. As time passes, delta will flatten out if Bed Bath & Beyond is still right at-the-money. The delta of the January call that Richard is short will move closer to exactly −0.50. The February call delta moves toward exactly +0.50.\nGamma and theta will both rise if Bed Bath & Beyond stays around the strike. As expiration approaches, there is greater risk if there is movement and greater reward if there is not.\nVega is positive because the long-term option with the higher vega is the long leg of the spread. When trading calendars for income, implied volatility (IV) must be considered as apossible threat. Because it is Richard’sobjective to profit from Bed Bath & Beyond being at $57.50 at expiration, he will try to avoid vega risk by checking that the implied volatility of the February call is in the lower third of the 12-month range. He will also determine if there are any impending events that could cause IV to change. The less likely IV is to drop, the better.\nIf there is an increase in IV, that may benefit the profitability of the trade. But arise in IV is not really adesired outcome for two reasons. First, arise in IV is often more pronounced in the front month than in the months farther out. If this happens, Richard can lose more on the short call than he makes on the long call. Second, arise in IV can indicate anxiety and therefore agreater possibility for movement in the underlying stock. Richard doesn’twant IV to rock the boat. “Buy low, stay low” is his credo.\nRho is positive also. Arise in interest rates benefits the position because the long-term call is helped by the rise more than the short call is hurt. With only aone-month difference between the two options, rho is very small. Overall, rho is inconsequential to this trade.\nThere is something curious to note about this trade: the gamma and the vega. Calendar spreads are the one type of trade where gamma can be negative while vega is positive, and vice versa. While it appears—at least on the surface—that Richard wants higher IV, he certainly wants low realized volatility.\nBed Bath & Beyond January–February 57.50 Put Calendar\nRichard’sposition would be similar if he traded the January–February 57.50 put calendar rather than the call calendar.\nExhibit 11.4\nshows the put calendar.\nEXHIBIT 11.4\nBed Bath & Beyond January–February 57.50 put calendar.\nThe premium paid for the put spread is 0.75. Ahuge move in either direction means aloss. It is about the same gamma/theta trade as the 57.50 call calendar. At expiration, with Bed Bath & Beyond at $57.50 and IV unchanged, the value of the February put would be 1.45—a 93 percent gain. The position is almost exactly the same as the call calendar. The biggest difference is that the rho is negative, but that is immaterial to the trade. As with the call spread, being short the front-month option means negative gamma and positive theta; being long the back month means positive vega.\nManaging an Income-Generating Calendar\nLet’ssay that instead of trading aone-lot calendar, Richard trades it 20 times. His trade in this case is\nHis total cash outlay is $1,600 ($80 times 20). The greeks for this trade, listed in\nExhibit 11.5\n, are also 20 times the size of those in\nExhibit 11.3\n.\nEXHIBIT 11.5\n2", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00021.html", "doc_id": "669dabb01df06cbaf0dd52efb88991415fc13adbadbfec77d723f66adc06c013", "chunk_index": 1}
{"text": "ncome-Generating Calendar\nLet’ssay that instead of trading aone-lot calendar, Richard trades it 20 times. His trade in this case is\nHis total cash outlay is $1,600 ($80 times 20). The greeks for this trade, listed in\nExhibit 11.5\n, are also 20 times the size of those in\nExhibit 11.3\n.\nEXHIBIT 11.5\n20-Lot Bed Bath & Beyond January–February 57.50 call calendar.\nNote that Richard has a +0.18 delta. This means he’slong the equivalent of about 18 shares of stock—still pretty flat. Agamma of −0.72 means that if Bed Bath & Beyond moves $1 higher, his delta will be starting to get short; and if it moves $1 lower he will be longer, long 90 deltas.\nRichard can use the greeks to get afeel for how much the stock can move before negative gamma causes aloss. If Bed Bath & Beyond starts trending in either direction, Richard may need to react. His plan is to cover his deltas to continue the position.\nSay that after one week Bed Bath & Beyond has dropped $1 to $56.50. Richard will have collected seven days of theta, which will have increased slightly from $18 per day to $20 per day. His average theta during that time is about $19, so Richard’sprofit attributed to theta is about $133.\nWith abig-enough move in either direction, Richard’sdelta will start working against him. Since he started with adelta of +0.18 on this 20-lot spread and agamma of −0.72, one might think that his delta would increase to 0.90 with Bed Bath & Beyond adollar lower (18 − [−0.072 × 1.00]). But because aweek has passed, his delta would actually get somewhat more positive. The shorter-term call’sdelta will get smaller (closer to zero) at afaster rate compared to the longer-term call because it has less time to expiration. Thus, the positive delta of the long-term option begins to outweigh the negative delta of the short-term option as time passes.\nIn this scenario, Richard would have almost broken even because what would be lost on stock price movement, is made up for by theta gains. Richard can sell about 100 shares of Bed Bath & Beyond to eliminate his immediate directional risk and stem further delta losses. The good news is that if Bed Bath & Beyond declines more after this hedge, the profit from the short stock offsets losses from the long delta. The bad news is that if BBBY rebounds, losses from the short stock offset gains from the long delta.\nAfter Richard’shedge trade is executed, his delta would be zero. His other greeks remain unchanged. The idea is that if Bed Bath & Beyond stays at its new price level of $56.50, he reaps the benefits of theta increasing with time from $18 per day. Richard is accepting the new price level and any profits or losses that have occurred so far. He simply adjusts his directional exposure to azero delta.\nRolling and Earning a “Free” Call\nMany traders who trade income-generating strategies are conservative. They are happy to sell low IV for the benefits afforded by low realized volatility. This is the problem-avoidance philosophy of trading. Due to risk aversion, it’scommon to trade calendar spreads by buying the two-month option and selling the one-month option. This can allow traders to avoid buying the calendar in earnings months, and it also means ashorter time horizon, signifying less time for something unwanted to happen.\nBut there’sanother school of thought among time-spread traders. There are some traders who prefer to buy alonger-term option—six months to ayear—while selling aone-month option. Why? Because month after month, the trader can roll the short option to the next month. This is asimple tactic that is used by market makers and other professional traders as well as savvy retail traders. Here’show it works.\nXYZ stock is trading at $60 per share. Atrader has aneutral outlook over the next six months and decides to buy acalendar. Assuming that July has 29 days until expiration and December has 180, the trader will take the following position:\nThe initial debit here is 2.55. The goal is basically the same as for any time spread: collect theta without negative gamma spoiling the party. There is another goal in these trades as well: to roll the spread.\nAt the end of month one, if the best-case scenario occurs and XYZ is sitting at $60 at July expiration, the July 60 call expires. The December 60 call will then be worth 3.60, assuming all else is held constant. The positive theta of the short July call gives full benefits as the option goes from 1.45 to zero. The lower negative theta of the December call doesn’tbite into profits quite as much as the theta of ashort-term call would.\nThe profit after month one is 1.05. Profit is derived from the December call, worth 3.60 at July expiry, minus the 2.55 initial spread debit. This works out to about a 41 percent return. The profit is hardly as good as it would have been if ashort-term, less expensive August 60 call were the long leg of this spread.\nRolling the Spread\nThe July–December spread is different from short-term spreads, however. When the Julys expir", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00021.html", "doc_id": "669dabb01df06cbaf0dd52efb88991415fc13adbadbfec77d723f66adc06c013", "chunk_index": 2}
{"text": "pread debit. This works out to about a 41 percent return. The profit is hardly as good as it would have been if ashort-term, less expensive August 60 call were the long leg of this spread.\nRolling the Spread\nThe July–December spread is different from short-term spreads, however. When the Julys expire, the August options will have 29 days until expiration. If volatility is still the same, XYZ is still at $60, and the trader’sforecast is still neutral, the 29-day August 60 calls can be sold for 1.45. The trader can either wait until the Monday after July expiration and then sell the August 60s, or when the Julys are offered at 0.05 or 0.10, he can buy the Julys and sell the Augusts as aspread. In either case, it is called rolling the spread. When the August expires, he can sell the Septembers, and so on.\nThe goal is to get acredit month after month. At some point, the aggregate credit from the call sales each month is greater than the price initially paid for the long leg of the spread, thus eliminating the original net debit.\nExhibit 11.6\nshows how the monthly credits from selling the one-month calls aggregate over time.\nEXHIBIT 11.6\nA “free” call.\nAfter July has expired, 1.45 of premium is earned. After August expiration, the aggregate increases to 2.90. When the September calls, which have 36 days until expiration, are sold, another 1.60 is added to the total premium collected. Over three months—assuming the stock price, volatility, and the other inputs don’tchange—this trader collects atotal of 4.50. That’s 0.50 more than the price originally paid for the December 60 call leg of the spread.\nAt this point, he effectively owns the December call for free. Of course, this call isn’treally free; it’searned. It’spaid for with risk and maybe afew sleepless nights. At this point, even if the stock and, consequently, the December call go to zero, the position is still aprofitable trade because of the continued month-to-month rolling. This is now ano-lose situation.\nWhen the long call of the spread has been paid for by rolling, there are three choices moving forward: sell it, hold it, or continue writing calls against it. If the trader’sopinion calls for the stock to decline, it’slogical to sell the December call and take the residual value as profit. In this case, over three months the trade will have produced 4.50 in premium from the sale of three consecutive one-month calls, which is more than the initial purchase price of the December call. At September expiration, the premium that will be received for selling the December call is all profit, plus 0.50, which is the aggregate premium minus the initial cost of the December call.\nIf the outlook is for the underlying to rise, it makes sense to hold the call. Any appreciation in the value of the call resulting from delta gains as the underlying moves higher is good—$0.50 plus whatever the call can be sold for.\nIf the forecast is for XYZ to remain neutral, it’slogical to continue selling the one-month call. Because the December call has been financed by the aggregate short call premiums already, additional premiums earned by writing calls are profit with “free” protection. As long as the short is closed at its expiration, the risk of loss is eliminated.\nThis is the general nature of rolling calls in acalendar spread. It’sabeautiful plan when it works! The problem is that it is incredibly unlikely that the stock will stay right at $60 per share for five months. It’salmost inevitable that it will move at some point. It’slike agame of Russian roulette. At some point it’sgoing to be alosing proposition—you just don’tknow when. The benefit of rolling is that if the trade works out for afew months in arow, the long call is paid for and the risk of loss is covered by aggregate profits.\nIf we step outside this best-case theoretical world and consider what is really happening on aday-to-day basis, we can gain insight on how to manage this type of trade when things go wrong. Effectively, along calendar is atypical gamma/theta trade. Negative gamma hurts. Positive theta helps.\nIf we knew which way the stock was going, we would simply buy or sell stock to adjust to get long or short deltas. But, unfortunately, we don’t. Our only tool is to hedge by buying or selling stock as mentioned above to flatten out when gamma causes the position delta to get more positive or negative.\n1\nThe bottom line is that if the effect of gamma creates unwanted long deltas but the theta/gamma is still adesirable position, selling stock flattens out the delta. If the effect of gamma creates unwanted short deltas, buying stock flattens out the delta.\nTrading Volatility Term Structure\nThere are other reasons for trading calendar spreads besides generating income from theta. If there is skew in the term structure of volatility, which was discussed in Chapter 3, acalendar spread is away to trade volatility. The tactic is to buy the “cheap” month and sell the “expensive” month.\nSelling the Front, Buying t", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00021.html", "doc_id": "669dabb01df06cbaf0dd52efb88991415fc13adbadbfec77d723f66adc06c013", "chunk_index": 3}
{"text": "for trading calendar spreads besides generating income from theta. If there is skew in the term structure of volatility, which was discussed in Chapter 3, acalendar spread is away to trade volatility. The tactic is to buy the “cheap” month and sell the “expensive” month.\nSelling the Front, Buying the Back\nIf for aparticular stock, the February ATM calls are trading at 50 volatility and the May ATM calls are trading at 35 volatility, avol-calendar trader would buy the Mays and sell the Februarys. Sounds simple, right? The devil is in the details. We’ll look at an example and then discuss some common pitfalls with vol-trading calendars.\nGeorge has been studying the implied volatility of a $164.15 stock. George notices that front-month volatility has been higher than that of the other months for acouple of weeks. There is nothing in the news to indicate immediate risk of extraordinary movement occurring in this example.\nGeorge sees that he can sell the 22-day July 165 calls at a 45 percent IV and buy the 85-day September 165 calls at a 38 percent IV. George would like to buy the calendar spread, because he believes the July ATM volatility will drop down to around 38, where the September is trading. If he puts on this trade, he will establish the following position:\nWhat are George’srisks? Because he would be selling the short-term ATM option, negative gamma could be aproblem. The greeks for this trade, shown in\nExhibit 11.7\n, confirm this. The negative gamma means each dollar of stock price movement causes an adverse change of about 0.09 to delta. The spread’sdelta becomes shorter when the stock rises and longer when the stock falls. Because the position’sdelta is long 0.369 from the start, some price appreciation may be welcomed in the short term. The stock advance will yield profits but at adiminishing rate, as negative gamma reduces the delta.\nEXHIBIT 11.7\n10-lot July–September 165 call calendar.\nBut just looking at the net position greeks doesn’ttell the whole story. It is important to appreciate the fact that long calendar spreads such as this have long vegas. In this case, the vega is +1.522. But what does this number really mean? This vega figure means that if IV rises or falls in both the July and the September calls by the same amount, the spread makes or loses $152 per vol point.\nGeorge’splan, however, is to see the July’svolatility decline to converge with the September’s. He hopes the volatilities of the two months will move independently of each other. To better gauge his risk, he needs to look at the vega of each option. With the stock at $164.15 the vegas are as follows:\nIf George is right and July volatility declines 8 points, from 46 to 38, he will make $1,283 ($1.604 × 100 × 8).\nThere are acouple of things that can go awry. First, instead of the volatilities converging, they can diverge further. Implied volatility is aslave to the whims of the market. If the July IV continues to rise while the September IV stays the same, George loses $160 per vol point.\nThe second thing that can go wrong is the September IV declining along with the July IV. This can lead George into trouble, too. It depends the extent to which the September volatility declines. In this example, the vega of the September leg is about twice that of the July leg. That means that if the July volatility loses eight points while the September volatility declines four points, profits from the July calls will be negated by losses from the September calls. If the September volatility falls even more, the trade is aloser.\nIV is acommon cause of time-spread failure for market makers. When iin the front month rises, the volatility of the back-months sometimes does as well. When this happens, it’soften because market makers who sold front-month options to retail or institutional buyers buy the back-month options to hedge their short-gamma risk. If the market maker buys enough back-month options, he or she will accumulate positive vega. But when the market sells the front-month volatility back to the market makers, the back months drop, too, because market makers no longer need the back months for ahedge.\nTraders should study historical implied volatility to avoid this pitfall. As is always the case with long vega strategies, there is arisk of adecline in IV. Buying long-term options with implied volatility in the lower third of the 12-month IV range helps improve the chances of success, since the volatility being bought is historically cheap.\nThis can be tricky, however. If atrader looks back on achart of IV for an option class and sees that over the past six months it has ranged between 20 and 30 but nine months ago it spiked up to, say, 55, there must be areason. This solitary spike could be just an anomaly. To eliminate the noise from volatility charts, it helps to filter the data. News stories from that time period and historical stock charts will usually tell the story of why volatility spiked. Often, it is aone-time event that led", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00021.html", "doc_id": "669dabb01df06cbaf0dd52efb88991415fc13adbadbfec77d723f66adc06c013", "chunk_index": 4}
{"text": "there must be areason. This solitary spike could be just an anomaly. To eliminate the noise from volatility charts, it helps to filter the data. News stories from that time period and historical stock charts will usually tell the story of why volatility spiked. Often, it is aone-time event that led to the spike. Is it reasonable to include this unique situation when trying to get afeel for the typical range of implied volatility? Usually not. This is ajudgment call that needs to be made on acase-by-case basis. The ultimate objective of this exercise is to determine: “Is volatility cheap or expensive?”\nBuying the Front, Selling the Back\nAll trading is based on the principle of “buy low, sell high”—even volatility trading. With time spreads, we can do both at once, but we are not limited to selling the front and buying the back. When short-term options are trading at alower IV than long-term ones, there may be an opportunity to sell the calendar. If the IV of the front month is 17 and the back-month IV is 25, for example, it could be awise trade to buy the front and sell the back. But selling time spreads in this manner comes with its own unique set of risks.\nFirst, ashort calendar’sgreeks are the opposite of those of along calendar. This trade has negative theta with positive gamma. Asideways market hurts this position as negative theta does its damage. Each day of carrying the position is paid for with time decay.\nThe short calendar is also ashort-vega trade. At face value, this implies that adrop in IV leads to profit and that the higher the IV sold in the back month, the better. As with buying acalendar, there are some caveats to this logic.\nIf there is an across-the-board decline in IV, the net short vega will lead to aprofit. But an across-the-board drop in volatility, in this case, is probably not arealistic expectation. The front month tends to be more sensitive to volatility. It is acommon occurrence for the front month to be “cheap” while the back month is “expensive.”\nThe volatilities of the different months can move independently, as they can when one buys atime spread. There are acouple of scenarios that might lead to the back-month volatility’sbeing higher than the front month. One is high complacency in the short term. When the market collectively sells options in expectation of lackluster trading, it generally prefers to sell the short-term options. Why? Higher theta. Because the trade has less time until expiration, the trade has ashorter period of risk. Because of this, selling pressure can push down IV in the front-month options more than in the back. Again, the front month is more sensitive to changes in implied volatility.\nBecause volatility has peaks and troughs, this can be asmart time to sell acalendar. The focus here is in seeing the “cheap” front month rise back up to normal levels, not so much in seeing the “expensive” back month fall. This trade is certainly not without risk. If the market doesn’tmove, the negative theta of the short calendar leads to aslow, painful death for calendar sellers.\nAnother scenario in which the back-month volatility can trade higher than the front is when the market expects higher movement after the expiration of the short-term option but before the expiration of the long-term option. Situations such as the expectation of the resolution of alawsuit, aproduct announcement, or some other one-time event down the road are opportunities for the market to expect such movement. This strategy focuses on the back-month vol coming back down to normal levels, not on the front-month vol rising. This can be amore speculative situation for avolatility trade, and more can go wrong.\nThe biggest volatility risk in selling atime spread is that what goes up can continue to go up. The volatility disparity here is created by hedgers and speculators favoring long-term options, hence pushing up the volatility, in anticipation of abig future stock move. As the likely date of the anticipated event draws near, more buyers can be attracted to the market, driving up IV even further. Realized volatility can remain low as investors and traders lie in wait. This scenario is doubly dangerous when volatility rises and the stock doesn’tmove. Atrader can lose on negative theta and lose on negative vega.\nA Directional Approach\nCalendar spreads are often purchased when the outlook for the underlying is neutral. Sell the short-term ATM option; buy the long-term ATM option; collect theta. But with negative gamma, these trades are never really neutral. The delta is constantly changing, becoming more positive or negative. It’slike arubber band: at times being stretched in either direction but always demanding apull back to the strike. When the strike price being traded is not ATM, calendar spreads can be strategically traded as directional plays.\nBuying acalendar, whether using calls or puts, where the strike price is above the current stock price is abullish strategy. With calls, the positiv", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00021.html", "doc_id": "669dabb01df06cbaf0dd52efb88991415fc13adbadbfec77d723f66adc06c013", "chunk_index": 5}
{"text": "s demanding apull back to the strike. When the strike price being traded is not ATM, calendar spreads can be strategically traded as directional plays.\nBuying acalendar, whether using calls or puts, where the strike price is above the current stock price is abullish strategy. With calls, the positive delta of the long-term out-of-the-money (OTM) call will be greater than the negative delta of the short-term OTM call. For puts, the positive delta of the short-term in-the-money (ITM) put will be greater than the negative delta of the long-term ITM put.\nJust the opposite applies if the strike price is below the current stock price. The negative delta of the short-term ITM call is greater than the positive delta of the long-term ITM call. The negative delta of the long-term OTM put is greater than the positive delta of the short-term OTM put.\nWhen the position starts out with either apositive or negative delta, movement in the direction of the delta is necessary for the trade to be profitable. Negative gamma is also an important strategic consideration. Stock-price movement is needed, but not too much.\nBuying calendar spreads is like playing outfield in abaseball game. To catch afly ball, an outfielder must focus on both distance and timing. He must gauge how far the ball will be hit and how long it will take to get there. With calendars, the distance is the strike price—that’swhere the stock needs to be—and the time is the expiration day of the short month’soption: that’swhen it needs to be at the target price.\nFor example, with Wal-Mart (WMT) at $48.50, atrader, Pete, is looking for arise to about $50 over the next five or six weeks. Pete buys the August–September call calendar. In this example, August has 39 days until expiration and September has 74 days.\nExactly what does 50 cents buy Pete? The stock price sitting below the strike price means anet positive delta. This long time spread also has positive theta and vega. Gamma is negative.\nExhibit 11.8\nshows the specifics.\nEXHIBIT 11.8\n10-lot Wal-Mart August–September 50 call calendar.\nThe delta of this trade, while positive, is relatively small with 39 days left until August expiration. It’snot rational to expect aquick profit if the stock advances faster than expected. But ultimately, arise in stock price is the goal. In this example, Wal-Mart needs to rise to $50, and timing is everything. It needs to be at that price in 39 days. In the interim, amove too big and too fast in either direction hurts the trade because of negative gamma. Starting with Wal-Mart at $48.50, delta/gamma problems are worse to the downside.\nExhibit 11.9\nshows the effects of stock price on delta, gamma, and theta.\nEXHIBIT 11.9\nStock price movement and greeks.\nIf Wal-Mart moves lower, the delta gets more positive, racking up losses at ahigher rate. To add to Pete’swoes, theta becomes less of abenefit as the stock drifts lower. At $47 ashare, theta is about flat. With Wal-Mart trading even lower than $47, the positive theta of the August call is overshadowed by the negative theta of the September. Theta can become negative, causing the position to lose value as time passes.\nAbig move to the upside doesn’thelp either. If Wal-Mart rises just abit, the −0.323 gamma only lessens the benefit of the 0.563 delta. But above $50, negative gamma begins to cause the delta to become increasingly negative. Theta begins to wither away at higher stock prices as well.\nThe place to be is right at $50. The delta is flat and theta is highest. As long as Wal-Mart finds its way up to this price by the third Friday of August, life is good for Pete.\nThe In-or-Out Crowd\nPete could just as well have traded the Aug–Sep 50 put calendar in this situation. If he’dbeen bearish, he could have traded either the Aug–Sep 45 call spread or the Aug–Sep 45 put spread. Whether bullish or bearish, as mentioned earlier, the call calendar and the put calendar both function about the same. When deciding which to use, the important consideration is that one of them will be in-the-money and the other will be OTM. Whether you have an ITM spread or an OTM spread has potential implications for the success of the trade.\nThe bid-ask spreads tend to be wider for higher-delta, ITM options. Because of this, it can be more expensive to enter into an ITM calendar. Why? Trading options with wider markets requires conceding more edge. Take the following options series:\nBy buying the May 50 calls at 3.20, atrader gives up 0.10 of theoretical edge (3.20 is 0.10 higher than the theoretical value). Buying the put at 1.00 means buying only 0.05 over theoretical.\nBecause acalendar is atwo-legged spread, the double edge given up by trading the wider markets of two in-the-money options can make the out-of-the-money spread amore attractive trade. The issue of wider markets is compounded when rolling the spread. Giving up anickel or adime each month can add up, especially on nominally low-priced spreads. It can cut into ahigh percentage of profits.\nE", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00021.html", "doc_id": "669dabb01df06cbaf0dd52efb88991415fc13adbadbfec77d723f66adc06c013", "chunk_index": 6}
{"text": "kets of two in-the-money options can make the out-of-the-money spread amore attractive trade. The issue of wider markets is compounded when rolling the spread. Giving up anickel or adime each month can add up, especially on nominally low-priced spreads. It can cut into ahigh percentage of profits.\nEarly assignment can complicate ITM calendars made up of American options, as dividends and interest can come into play. The short leg of the spread could get assigned before the expiration date as traders exercise calls to capture the dividend. Short ITM puts may get assigned early because of interest.\nAlthough assignment is an undesirable outcome for most calendar spread traders, getting assigned on the short leg of the calendar spread may not necessarily create asignificantly different trade. If along put calendar, for example, has ashort front-month put that is so deep in-the-money that it is likely to get assigned, it is trading close to a 100 delta. It is effectively along stock position already. After assignment, when along stock position is created, the resulting position is long stock with adeep ITM long put—afairly delta-flat position.\nDouble Calendars\nDefinition\n: Adouble calendar spread is the execution of two calendar spreads that have the same months in common but have two different strike prices.\nExample\nSell 1 XYZ February 70 call\nBuy 1 XYZ March 70 call\nSell 1 XYZ February 75 call\nBuy 1 XYZ March 75 call\nDouble calendars can be traded for many reasons. They can be vega plays. If there is avolatility-time skew, adouble calendar is away to take aposition without concentrating delta or gamma/theta risk at asingle strike.\nThis spread can also be agamma/theta play. In that case, there are two strikes, so there are two potential focal points to gravitate to (in the case of along double calendar) or avoid (in the case of ashort double calendar).\nSelling the two back-month strikes and buying the front-month strikes leads to negative theta and positive gamma. The positive gamma creates favorable deltas when the underlying moves. Positive or negative deltas can be covered by trading the underlying stock. With positive gamma, profits can be racked up by buying the underlying to cover short deltas and subsequently selling the underlying to cover long deltas.\nBuying the two back-month strikes and selling the front-month strikes creates negative gamma and positive theta, just as in aconventional calendar. But the underlying stock has two target price points to shoot for at expiration to achieve the maximum payout.\nOften double calendars are traded as IV plays. Many times when they are traded as IV plays, traders trade the lower-strike spread as aput calendar and the higher-strike spread acall calendar. In that case, the spread is sometimes referred to as astrangle swap\n. Strangles are discussed in Chapter 15.\nTwo Courses of Action\nAlthough there may be many motivations for trading adouble calendar, there are only two courses of action: buy it or sell it. While, for example, the trader’sgoal may be to capture theta, buying adouble calendar comes with the baggage of the other greeks. Fully understanding the interrelationship of the greeks is essential to success. Option traders must take aholistic view of their positions.\nLet’slook at an example of buying adouble calendar. In this example, Minnesota Mining & Manufacturing (MMM) has been trading in arange between about $85 and $97 per share. The current price of Minnesota Mining & Manufacturing is $87.90. Economic data indicate no specific reasons to anticipate that Minnesota Mining & Manufacturing will deviate from its recent range over the next month—that is, there is nothing in the news, no earnings anticipated, and the overall market is stable. August IV is higher than October IV by one volatility point, and October implied volatility is in line with 30-day historical volatility. There are 38 days until August expiration, and 101 days until October expiration.\nThe Aug–Oct 85–90 double calendar can be traded at the following prices:\nMuch like atraditional calendar spread, the price points cannot be definitively plotted on a P&(L) diagram. What is known for certain is that at August expiration, the maximum loss is $3,200. While it’scomforting to know that there is limited loss, losing the entire premium that was paid for the spread is an outcome most traders would like to avoid. We also know the maximum gains occur at the strike prices; but not exactly what the maximum profit can be.\nExhibit 11.10\nprovides an alternative picture of the position that is useful in managing the trade on aday-to-day basis.\nEXHIBIT 11.10\n10-lot Minnesota Mining & Manufacturing Aug–Oct 85–90 double call calendar.\nThese numbers are agood representation of the position’srisk. Knowing that long calendars and long double calendars have maximum losses at the expiration of the short-term option equal to the net premiums paid, the max loss in this example is 3.20. Break-even prices are not r", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00021.html", "doc_id": "669dabb01df06cbaf0dd52efb88991415fc13adbadbfec77d723f66adc06c013", "chunk_index": 7}
{"text": "0 double call calendar.\nThese numbers are agood representation of the position’srisk. Knowing that long calendars and long double calendars have maximum losses at the expiration of the short-term option equal to the net premiums paid, the max loss in this example is 3.20. Break-even prices are not relevant to this position because they cannot be determined with any certainty. What is important is to get afeel for how much movement can hurt the position.\nTo make $19 aday in theta, a −0.468 gamma must be accepted. In the long run, $1 of movement is irrelevant. In fact, some movement is favorable because the ideal point for MMM to be at, at August expiration is either $85 or $90. So while small moves are acceptable, big moves are of concern. The negative gamma is an illustration of this warning.\nThe other risk besides direction is vega. Apositive 1.471 vega means the calendar makes or loses about $147 with each one-point across-the-board change in implied volatility. Implied volatility is arisk in all calendar trades. Volatility was one of the criteria studied when considering this trade. Recall that the August IV was one point higher than the October and that the October IV was in line with the 30-day historical volatility at inception of the trade.\nConsidering the volatility data is part of the due diligence when considering acalendar or adouble calendar. First, the (slightly) more expensive options (August) are being sold, and the cheaper ones are being bought (October). Astudy of the company reveals no news to lead one to believe that Minnesota Mining & Manufacturing should move at ahigher realized volatility than it currently is in this example. Therefore, the front month’shigher IV is not ared flag. Because the volatility of the October option (the month being purchased) is in line with the historical volatility, the trader could feel that he is paying areasonable price for this volatility.\nIn the end, the trade is evaluated on the underlying stock, realized volatility, and IV. The trade should be executed only after weighing all the available data. Trading is both cerebral and statistical in nature. It’sabout gaining astatistically better chance of success by making rational decisions.\nDiagonals\nDefinition\n: Adiagonal spread is an option strategy that involves buying one option and selling another option with adifferent strike price and with adifferent expiration date. Diagonals are another strategy in the time spread family.\nDiagonals enable atrader to exploit opportunities similar to those exploited by acalendar spread, but because the options in adiagonal spread have two different strike prices, the trade is more focused on delta. The name\ndiagonal\ncomes from the fact that the spread is acombination of ahorizontal spread (two different months) and avertical spread (two different strikes).\nSay it’s 22 days until January expiration and 50 days until February expiration. Apple Inc. (AAPL) is trading at $405.10. Apple has been in an uptrend heading toward the peak of its six-month range, which is around $420. Atrader, John, believes that it will continue to rise and hit $420 again by February expiration. Historical volatility is 28 percent. The February 400 calls are offered at a 32 implied volatility and the January 420 calls are bid on a 29 implied volatility. John executes the following diagonal:\nExhibit 11.11\nshows the analytics for this trade.\nEXHIBIT 11.11\nApple January–February 400–420 call diagonal.\nFrom the presented data, is this agood trade? The answer to this question is contingent on whether the position John is taking is congruent with his view of direction and volatility and what the market tells him about these elements.\nJohn is bullish up to August expiration, and the stock in this example is in an uptrend. Any rationale for bullishness may come from technical or fundamental analysis, but techniques for picking direction, for the most part, are beyond the scope of this book. Buying the lower strike in the February option gives this trade amore positive delta than astraight calendar spread would have. The trader’sdelta is 0.255, or the equivalent of about 25.5 shares of Apple. This reflects the trader’sdirectional view.\nThe volatility is not as easy to decipher. Aspecific volatility forecast was not stated above, but there are afew relevant bits of information that should be considered, whether or not the trader has aspecific view on future volatility. First, the historical volatility is 28 percent. That’slower than either the January or the February calls. That’snot ideal. In aperfect world, it’sbetter to buy below historical and sell above. To that point, the February option that John is buying has ahigher volatility than the January he is selling. Not so good either. Are these volatility observations deal breakers?\nA Good Ex-Skews\nIt’simportant to take skew into consideration. Because the January calls have ahigher strike price than the February calls, it’slogical for them to trade at", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00021.html", "doc_id": "669dabb01df06cbaf0dd52efb88991415fc13adbadbfec77d723f66adc06c013", "chunk_index": 8}
{"text": "ng has ahigher volatility than the January he is selling. Not so good either. Are these volatility observations deal breakers?\nA Good Ex-Skews\nIt’simportant to take skew into consideration. Because the January calls have ahigher strike price than the February calls, it’slogical for them to trade at alower implied volatility. Is this enough to justify the possibility of selling the lower volatility? Consider first that there is some margin for error. The bid-ask spreads of each of the options has avolatility disparity. In this case, both the January and February calls are 10 cents wide. That means with a January vega of 0.34 the bid-ask is about 0.29 vol points wide. The Februarys have a 0.57 vega. They are about 0.18 vol points wide. That accounts for some of the disparity. Natural vertical skew accounts for the rest of the difference, which is acceptable as long as the skew is not abnormally pronounced.\nAs for other volatility considerations, this diagonal has the rather unorthodox juxtaposition of positive vega and negative gamma seen with other time spreads. The trader is looking for amove upward, but not abig one. As the stock rises and Apple moves closer to the 420 strike, the positive delta will shrink and the negative gamma will increase. In order to continue to enjoy profits as the stock rises, John may have to buy shares of Apple to keep his positive delta. The risk here is that if he buys stock and Apple retraces, he may end up negative scalping stock. In other words, he may sell it back at alower price than he bought it. Using stock to adjust the delta in anegative-gamma play can be risky business. Gamma scalping is addressed further in Chapter 13.\nMaking the Most of Your Options\nThe trader from the previous example had atime-spread alternative to the diagonal: John could have simply bought atraditional time spread at the 420 strike. Recall that calendars reap the maximum reward when they are at the shared strike price at expiration of the short-term option. Why would he choose one over the other?\nThe diagonal in that example uses alower-strike call in the February than astraight 420 calendar spread and therefore has ahigher delta, but it costs more. Gamma, theta, and vega may be slightly lower with the in-the-money call, depending on how far from the strike price the ITM call is and how much time until expiration it has. These, however, are less relevant differences.\nThe delta of the February 400 call is about 0.57. The February 420 call, however, has only a 0.39 delta. The 0.18 delta difference between the calls means the position delta of the time spread will be only about 0.07 instead of about 0.25 of the diagonal—abig difference. But the trade-off for lower delta is that the February 420 call can be bought for 12.15. That means alower debit paid—that means less at risk. Conversely, though there is greater risk with the diagonal, the bigger delta provides abigger payoff if the trader is right.\nDouble Diagonals\nAdouble diagonal spread is the simultaneous trading of two diagonal spreads: one call spread and one put spread. The distance between the strikes is the same in both diagonals, and both have the same two expiration months. Usually, the two long-term options are more out-of-the-money than the two shorter-term options. For example\nBuy 1 XYZ May 70 put\nSell 1 XYZ March 75 put\nSell 1 XYZ March 85 call\nBuy 1 XYZ May 90 call\nLike many option strategies, the double diagonal can be looked at from anumber of angles. Certainly, this is atrade composed of two diagonal spreads—the March–May 70–75 put and the March–May 85–90 call. It is also two strangles—buying the May 70–90 strangle and selling the March 75–85 strangle. One insightful way to look at this spread is as an iron condor in which the guts are March options and the wings are May options.\nTrading adouble diagonal like this one, rather than atypically positioned iron condor, can offer afew advantages. The first advantage, of course, is theta. Selling short-term options and buying long-term options helps the trader reap higher rates of decay. Theta is the raison d’être of the iron condor. Asecond advantage is rolling. If the underlying asset stays in arange for along period of time, the short strangle can be rolled month after month. There may, in some cases, also be volatility-term-structure discrepancies on which to capitalize.\nAtrader, Paul, is studying JPMorgan (JPM). The current stock price is $49.85. In this example, JPMorgan has been trading in apretty tight range over the past few months. Paul believes it will continue to do so over the next month. Paul considers the following trade:\nPaul considers volatility. In this example, the JPMorgan ATM call, the August 50 (which is not shown here), is trading at 22.9 percent implied volatility. This is in line with the 20-day historical volatility, which is 23 percent. The August IV appears to be reasonably in line with the September volatility, after accounting for vertical skew. The IV of", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00021.html", "doc_id": "669dabb01df06cbaf0dd52efb88991415fc13adbadbfec77d723f66adc06c013", "chunk_index": 9}
{"text": "n ATM call, the August 50 (which is not shown here), is trading at 22.9 percent implied volatility. This is in line with the 20-day historical volatility, which is 23 percent. The August IV appears to be reasonably in line with the September volatility, after accounting for vertical skew. The IV of the August 52.50 calls is 1.5 points above that of the September 55 calls and the August 47.50 put IV is 1.6 points below the September 45 put IV. It appears that neither month’svolatility is cheap or expensive.\nExhibit 11.12\nshows the trade’sgreeks.\nEXHIBIT 11.12\n10-lot JPMorgan August–September 45–47.50–52.50–55 double diagonal.\nThe analytics of this trade are similar to those of an iron condor. Immediate directional risk is almost nonexistent, as indicated by the delta. But gamma and theta are high, even higher than they would be if this were astraight September iron condor, although not as high as if this were an August iron condor.\nVega is positive. Surely, if this were an August or a September iron condor, vega would be negative. In this example, Paul is indifferent as to whether vega is positive or negative because IV is fairly priced in terms of historical volatility and term structure. In fact, to play it close to the vest, Paul probably wants the smallest vega possible, in case of an IV move. Why take on the risk?\nThe motivation for Paul’sdouble diagonal was purely theta. The volatilities were all in line. And this one-month spread can’tbe rolled. If Paul were interested in rolling, he could have purchased longer-term options. But if he is anticipating asideways market for only the next month and feels that volatility could pick up after that, the one-month play is the way to go. After August expiration, Paul will have three choices: sell his Septembers, hold them, or turn them into atraditional iron condor by selling the September 47.50s and 52.50s. This depends on whether he is indifferent, expects high volatility, or expects low volatility.\nThe Strength of the Calendar\nSpreads in the calendar-spread family allow traders to take their trading to ahigher level of sophistication. More basic strategies, like vertical spreads and wing spreads, provide apractical means for taking positions in direction, realized volatility, and to some extent implied volatility. But because calendar-family spreads involve two expiration months, traders can take positions in the same market variables as with these more basic strategies and also in the volatility spread between different expiration months. Calendar-family spreads are veritable volatility spreads. This is apowerful tool for option traders to have at their disposal.\nNote\n1\n. Advanced hedging techniques are discussed in subsequent chapters.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00021.html", "doc_id": "669dabb01df06cbaf0dd52efb88991415fc13adbadbfec77d723f66adc06c013", "chunk_index": 10}
{"text": "CHAPTER 12\nDelta-Neutral Trading\nTrading Implied Volatility\nMany of the strategies covered so far have been option-selling strategies. Some had adirectional bias; some did not. Most of the strategies did have aprimary focus on realized volatility—especially selling it. These short volatility strategies require time. The reward of low stock volatility is theta. In general, most of the strategies previously covered were theta trades in which negative gamma was an unpleasant inconvenience to be dealt with.\nMoving forward, much of the remainder of this book will involve more in-depth discussions of trading both realized and implied volatility (IV), with afocus on the harmonious, and sometimes disharmonious, relationship between the two types. Much attention will be given to how IV trades in the option market, describing situations in which volatility moves are likely to occur and how to trade them.\nDirection Neutral versus Direction Indifferent\nIn the world of nonlinear trading, there are two possible nondirectional views of the underlying asset: direction neutral and direction indifferent. Direction neutral means the trader believes the stock will not trend either higher or lower. The trader is neutral in his or her assessment of the future direction of the asset. Short iron condors, long time spreads, and out-of-the-money (OTM) credit spreads are examples of direction-neutral strategies. These strategies generally have deltas close to zero. Because of negative gamma, movement is the bane of the direction-neutral trade.\nDirection indifferent means the trader may desire movement in the underlying but is indifferent as to whether that movement is up or down. Some direction-indifferent trades are almost completely insulated from directional movement, with afocus on interest or dividends instead. Examples of these types of trades are conversions, reversals, and boxes, which are described in Chapter 6, as well as dividend plays, which are described in Chapter 8.\nOther direction-indifferent strategies are long option strategies that have positive gamma. In these trades, the focus is on movement, but the direction of that movement is irrelevant. These are plays that are bullish on realized volatility. Yet other direction-indifferent strategies are volatility plays from the perspective of IV. These are trades in which the trader’sintent is to take abullish or bearish position in IV.\nDelta Neutral\nTo be truly direction neutral or direction indifferent means to have adelta equal to zero. In other words, there are no immediate gains if the underlying moves incrementally higher or lower. This zero-delta method of trading is called\ndelta-neutral trading\n.\nAdelta-neutral position can be created from any option position simply by trading stock to flatten out the delta. Avery basic example of adelta-neutral trade is along at-the-money (ATM) call with short stock.\nConsider atrade in which we buy 20 ATM calls that have a 50 delta and sell stock on adelta-neutral ratio.\nBuy 20 50-delta calls (long 1,000 deltas)\nShort 1,000 shares (short 1,000 deltas)\nIn this position, we are long 1,000 deltas from the calls (20 × 50) and short 1,000 deltas from the short sale of stock. The net delta of the position is zero. Therefore, the immediate directional exposure has been eliminated from the trade. But intuitively, there are other opportunities for profit or loss with this trade.\nThe addition of short stock to the calls will affect only the delta, not the other greeks. The long calls have positive gamma, negative theta, and positive vega.\nExhibit 12.1\nis asimplified representation of the greeks for this trade.\nEXHIBIT 12.1\n20-lot delta-neutral long call.\nWith delta not an immediate concern, the focus here is on gamma, theta, and vega. The +1.15 vega indicates that each one-point change in IV makes or loses $115 for this trade. Yet there is more to the volatility story. Each day that passes costs the trader $50 in time decay. Holding the position for an extended period of time can produce aloser even if IV rises. Gamma is potentially connected to the success of this trade, too. If the underlying moves in either direction, profit from deltas created by positive gamma may offset the losses from theta. In fact, abig enough move in either direction can produce aprofitable trade, regardless of what happens to IV.\nImagine, for amoment, that this trade is held until expiration. If the stock is below the strike price at this point, the calls expire. The resulting position is short 1,000 shares of stock. If the stock is above the strike price at expiration, the calls can be exercised, creating 2,000 shares of long stock. Because the trade is already short 1,000 shares, the resulting net position is long 1,000 shares (2,000 − 1,000). Clearly, the more the underlying stock moves in either direction the greater the profit potential. The underlying has to move far enough above or below the strike price to allow the beneficial gains from buying or sellin", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00023.html", "doc_id": "3a004316b42822802c31ed17edfd4ff69579302b06a280d1e03de165cb2548a7", "chunk_index": 0}
{"text": "1,000 shares, the resulting net position is long 1,000 shares (2,000 − 1,000). Clearly, the more the underlying stock moves in either direction the greater the profit potential. The underlying has to move far enough above or below the strike price to allow the beneficial gains from buying or selling stock to cover the option premium lost from time decay. If the trade is held until expiration, the underlying needs to move far enough to cover the entire premium spent on the calls.\nThe solid lines forming a Vin\nExhibit 12.2\nconceptually illustrate the profit or loss for this delta-neutral long call at expiration.\nEXHIBIT 12.2\nProfit-and-loss diagram for delta-neutral long-call trade.\nBecause of gamma, some deltas will be created by movement of the underlying before expiration. Gamma may lead to this being aprofitable trade in the short term, depending on time and what happens with IV. The dotted line illustrates the profit or loss of this trade at the point in time when the trade is established. Because the options may still have time value at this point—depending on how far from the strike price the stock is trading—the value of the position, as awhole, is higher than it will be if the calls are trading at parity at expiration. Regardless, the plan is for the stock to make amove in either direction. The bigger the move and the faster it happens, the better.\nWhy Trade Delta Neutral?\nAfew years ago, Iwas teaching aclass on option trading. Before the seminar began, Iwas talking with one of the students in attendance. Iasked him what he hoped to learn in the class. He said that he was really interested in learning how to trade delta neutral. When Iasked him why he was interested in that specific area of trading, he replied, “Ihear that’swhere all the big money is made!”\nThis observation, right or wrong, probably stems from the fact that in the past most of the trading in this esoteric discipline has been executed by professional traders. There are two primary reasons why the pros have dominated this strategy: high commissions and high margin requirements for retail traders. Recently, these two reasons have all but evaporated.\nFirst, the ultracompetitive world of online brokers has driven commissions for retail traders down to, in some cases, what some market makers pay. Second, the oppressive margin requirements that retail option traders were subjected to until 2007 have given way to portfolio margining.\nPortfolio Margining\nCustomer portfolio margining is amethod of calculating customer margin in which the margin requirement is based on the “up and down risk” of the portfolio. Before the advent of portfolio margining, retail traders were subject to strategy-based margining, also called Reg. Tmargining, which in many cases required asignificantly higher amount of capital to carry aposition than portfolio margining does.\nWith portfolio margining, highly correlated securities can be offset against each other for purposes of calculating margin. For example, SPX options and SPY options—both option classes based on the Standard & Poor’s 500 Index—can be considered together in the margin calculation. Abearish position in one and abullish position in the other may partially offset the overall risk of the portfolio and therefore can help to reduce the overall margin requirement.\nWith portfolio margining, many strategies are margined in such away that, from the point of view of this author, they are subject to amuch more logical means of risk assessment. Strategy-based margining required traders of some strategies, like aprotective put, to deposit significantly more capital than one could possibly lose by holding the position. The old rules require aminimum margin of 50 percent of the stock’svalue and up to 100 percent of the put premium. Aportfolio-margined protective put may require only afraction of what it would with strategy-based margining.\nEven though Reg. Tmargining is antiquated and sometimes unreasonable, many traders must still abide by these constraints. Not all traders meet the eligibility requirements to qualify for portfolio-based margining. There is aminimum account balance for retail traders to be eligible for this treatment. Abroker may also require other criteria to be met for the trader to benefit from this special margining. Ultimately, portfolio margining allows retail traders to be margined similarly to professional traders.\nThere are some traders, both professional and otherwise, who indeed have made “big money,” as the student in my class said, trading delta neutral. But, to be sure, there are successful and unsuccessful traders in many areas of trading. The real motivation for trading delta neutral is to take aposition in volatility, both implied and realized.\nTrading Implied Volatility\nWith atypical option, the sensitivity of delta overshadows that of vega. To try and profit from arise or fall in IV, one has to trade delta neutral to eliminate immediate directional sensitivity. There are many s", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00023.html", "doc_id": "3a004316b42822802c31ed17edfd4ff69579302b06a280d1e03de165cb2548a7", "chunk_index": 1}
{"text": "to take aposition in volatility, both implied and realized.\nTrading Implied Volatility\nWith atypical option, the sensitivity of delta overshadows that of vega. To try and profit from arise or fall in IV, one has to trade delta neutral to eliminate immediate directional sensitivity. There are many strategies that can be traded as delta-neutral IV strategies simply by adding stock. Throughout this chapter, Iwill continue using asingle option leg with stock, since it provides asimple yet practical example. It’simportant to note that delta-neutral trading does not refer to aspecific strategy; it refers to the fact that the trader is indifferent to direction. Direction isn’tbeing traded, volatility is.\nVolatility trading is fundamentally different from other types of trading. While stocks can rise to infinity or decline to zero, volatility can’t. Implied volatility, in some situations, can rise to lofty levels of 100, 200, or even higher. But in the long-run, these high levels are not sustainable for most stocks. Furthermore, an IV of zero means that the options have no extrinsic value at all. Now that we have established that the thresholds of volatility are not as high as infinity and not as low as zero, where exactly are they? The limits to how high or low IV can go are not lines in the sand. They are more like tides that ebb and flow, but normally come up only so far onto the beach.\nThe volatility of an individual stock tends to trade within arange that can be unique to that particular stock. This can be observed by studying achart of recent volatility. When IV deviates from the range, it is typical for it to return to the range. This is called\nreversion to the mean\n, which was discussed in Chapter 3. IV can get stretched in either direction like arubber band but then tends to snap back to its original shape.\nThere are many examples of situations where reversion to the mean enters into trading. In some, volatility temporarily dips below the typical range, and in some, it rises beyond the recent range. One of the most common examples is the rush and the crush.\nThe Rush and the Crush\nIn this situation, volatility rises before and falls after awidely anticipated news announcement, of earnings, for instance, or of a Food and Drug Administration (FDA) approval. In this situation, option buyers rush in and bid up IV. The more uncertainty—the more demand for insurance—the higher vol rises. When the event finally occurs and the move takes place or doesn’t, volatility gets crushed. The crush occurs when volatility falls very sharply—sometimes 10 points, 20 points, or more—in minutes. Traders with large vega positions appreciate the appropriateness of the term crush all too well. Volatility traders also affectionately refer to this sudden drop in IV by saying that volatility has gotten “whacked.”\nIn order to have afeel for whether implied volatility is high or low for aparticular stock, you need to know where it’sbeen. It’shelpful to have an idea of where realized volatility is and has been, too. To be sure, one analysis cannot be entirely separate from the other. Studying both implied and realized volatility and how they relate is essential to seeing the big picture.\nThe Inertia of Volatility\nSir Isaac Newton said that an object in motion tends to stay in motion unless acted upon by another force. Volatility acts much the same way. Most stocks tend to trade with acertain measurable amount of daily price fluctuations. This can be observed by looking at the stock’srealized volatility. If there is no outside force—some pivotal event that fundamentally changes how the stock is likely to behave—one would expect the stock to continue trading with the same level of daily price movement. This means IV (the market’sexpectation of future stock volatility) should be the same as realized volatility (the calculated past stock volatility).\nBut just as in physics, it seems there is always some friction affecting the course of what is in motion. Corporate earnings, Federal Reserve Board reports, apathy, lulls in the market, armed conflicts, holidays, rumors, and takeovers, among other market happenings all provide acatalyst for volatility changes. Divergences of realized and implied volatility, then, are commonplace. These divergences can create tradable conditions, some of which are more easily exploited than others.\nTo find these opportunities, atrader must conduct astudy of volatility. Volatility charts can help atrader visualize the big picture. This historical information offers acomparison of what is happening now in volatility with what has happened in the past. The following examples use avolatility chart to show how two different traders might have traded the rush and crush of an earnings report.\nVolatility Selling\nSusie Seller, avolatility trader, studies semiconductor stocks.\nExhibit 12.3\nshows the volatilities of a $50 chip stock. The circled area shows what happened before and after second-quarter earnings were reporte", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00023.html", "doc_id": "3a004316b42822802c31ed17edfd4ff69579302b06a280d1e03de165cb2548a7", "chunk_index": 2}
{"text": "t traders might have traded the rush and crush of an earnings report.\nVolatility Selling\nSusie Seller, avolatility trader, studies semiconductor stocks.\nExhibit 12.3\nshows the volatilities of a $50 chip stock. The circled area shows what happened before and after second-quarter earnings were reported in July. The black line is the IV, and the gray is the 30-day historical.\nEXHIBIT 12.3\nChip stock volatility before and after earnings reports.\nSource\n: Chart courtesy of\niVolatility.com\nIn mid-July, Susie did some digging to learn that earnings were to be announced on July 24, after the close. She was careful to observe the classic rush and crush that occurred to varying degrees around the last three earnings announcements, in October, January, and April. In each case, IV firmed up before earnings only to get crushed after the report. In mid-to-late July, she watched as IV climbed to the mid-30s (the rush) just before earnings. As the stock lay in wait for the report, trading came to aproverbial screeching halt, sending realized volatility lower, to about 13 percent. Susie waited for the end of the day just before the report to make her move. Before the closing bell, the stock was at $50. Susie sold 20 one-month 50-strike calls at 2.10 (a 35 volatility) and bought 1,100 shares of the underlying stock at $50 to become delta neutral.\nExhibit 12.4\nshows Susie’sposition.\nEXHIBIT 12.4\nDelta-neutral short ATM call, long stock position.\nHer delta was just about flat. The delta for the 50 calls was 0.54 per contract. Selling a 20-lot creates 10.80 short deltas for her overall position. After buying 1,100 shares, she was left long 0.20 deltas, about the equivalence of being long 20 shares. Where did her risk lie? Her biggest concern was negative gamma. Without even seeing achart of the stock’sprice, we can see from the volatility chart that this stock can have big moves on earnings. In October, earnings caused amore than 10-point jump in realized volatility, to its highest level during the year shown. Whether the stock rose or fell is irrelevant. Either event means risk for apremium seller.\nThe positive theta looks good on the surface, but in fact, theta provided Susie with no significant benefit. Her plan was “in and out and nobody gets hurt.” She got into the trade right before the earnings announcement and out as soon as implied volatility dropped off. Ideally, she’dlike to hold these types of trades for less than aday. The true prize is vega.\nSusie was looking for about a 10-point drop in IV, which this option class had following the October and January earnings reports. April had abig drop in IV, as well, of about eight or nine points. Ultimately, what Susie is looking for is reversion to the mean.\nShe gauges the normal level of volatility by observing where it is before and after the surges caused by earnings. From early November to mid- to late- December, the stock’s IV bounced around the 25 percent level. In the month of February, the IV was around 25. After the drop-off following April earnings and through much of May, the IV was closer to 20 percent. In June, IV was just above 25. Susie surmised from this chart that when no earnings event is pending, this stock’soptions typically trade at about a 25 percent IV. Therefore, anticipating a 10-point decline from 35 was reasonable, given the information available. If Susie gets it right, she stands to make $1,150 from vega (10 points × 1.15 vegas × 100).\nAs we can see from the right side of the volatility chart in\nExhibit 12.3\n, Susie did get it right. IV collapsed the next morning by just more than ten points. But she didn’tmake $1,150; she made less. Why? Realized volatility (gamma). The jump in realized volatility shown on the graph is afunction of the fact that the stock rallied $2 the day after earnings. Negative gamma contributed to negative deltas in the face of arallying market. This negative delta affected some of Susie’spotential vega profits.\nSo what was Susie’sprofit? On this trade she made $800. The next morning at the open, she bought back the 50-strike calls at 2.80 (25 IV) and sold the stock at $52. To compute her actual profit, she compared the prices of the spread when entering the trade with the prices of the spread when exiting.\nExhibit 12.5\nshows the breakdown of the trade.\nEXHIBIT 12.5\nProfit breakdown of delta-neutral trade.\nAfter closing the trade, Susie knew for sure what she made or lost. But there are many times when atrader will hold adelta-neutral position for an extended period of time. If Susie hadn’tclosed her trade, she would have looked at her marks to see her P&(L) at that point in time. Marks are the prices at which the securities are trading in the actual market, either in real time or at end of day. With most online brokers’ trading platforms or options-trading software, real-time prices are updated dynamically and always at their fingertips. The profit or loss is, then, calculated automatically by comparing the actual prices", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00023.html", "doc_id": "3a004316b42822802c31ed17edfd4ff69579302b06a280d1e03de165cb2548a7", "chunk_index": 3}
{"text": "trading in the actual market, either in real time or at end of day. With most online brokers’ trading platforms or options-trading software, real-time prices are updated dynamically and always at their fingertips. The profit or loss is, then, calculated automatically by comparing the actual prices of the opening transaction with the current marks.\nWhat Susie will want to know is why she made $800. Why not more? Why not less, for that matter? When trading delta neutral, especially with more complex trades involving multiple legs, amanual computation of each leg of the spread can be tedious. And to be sure, just looking at the profit or loss on each leg doesn’tprovide an explanation.\nSusie can see where her profits or losses came from by considering the profit or loss for each influence contributing to the option’svalue.\nExhibit 12.6\nshows the breakdown.\nEXHIBIT 12.6\nProfit breakdown by greek.\nDelta\nSusie started out long 0.20 deltas. A $2 rise in the stock price yielded a $40 profit attributable to that initial delta.\nGamma\nAs the stock rose, the negative delta of the position increased as aresult of negative gamma. The delta of the stock remained the same, but the negative delta of the 50 call grew by the amount of the gamma. Deriving an exact P&(L) attributable to gamma is difficult because gamma is adynamic metric: as the stock price changes, so can the gamma. This calculation assumes that gamma remains constant. Therefore, the gamma calculation here provides only an estimate.\nThe initial position gamma of −1.6 means the delta decreases by 3.2 with a $2 rise in the stock (–1.60 times the $2 rise in the stock price). Susie, then, would multiply −3.2 by $2 to find the loss on −3.2 deltas over a $2 rise. But she wasn’tshort 3.2 deltas for the whole $2. She started out with zero deltas attributable to gamma and ended up being 3.2 shorter from gamma over that $2 move. Therefore, if she assumes her negative delta from gamma grew steadily from 0 to −3.2, she can estimate her average delta loss over that move by dividing by 2.\nTheta\nSusie held this trade one day. Her total theta contributed 0.75 or $75 to her position.\nVega\nVega is where Susie made her money on this trade. She was able to buy her call back 10 IV points lower. The initial position vega was −1.15. Multiplying −1.15 by the negative 10-point crush of volatility yields avega profit of $1,150.\nConclusions\nStudying her position’s P&(L) by observing what happened in her greeks provides Susie with an alternate—and in some ways, better—method to evaluate her trade. The focus of this delta-neutral trade is less on the price at which Susie can buy the calls back to close the position than on the volatility level at which she can buy them back, weighed against the P&(L) from her other risks. Analyzing her position this way gives her much more information than just comparing opening and closing prices. Not only does she get agood estimate of how much she made or lost, but she can understand why as well.\nThe Imprecision of Estimation\nIt is important to notice that the P&(L) found by adding up the P&(L)’sfrom the greeks is slightly different from the actual P&(L). There are acouple of reasons for this. First, the change in delta resulting from gamma is only an estimate, because gamma changes as the stock price changes. For small moves in the underlying, the gamma change is less significant, but for larger moves, the rate of change of the gamma can be bigger, and it can be nonlinear. For example, as an option moves from being at-the-money (ATM) to being out-of-the-money (OTM), its gamma decreases. But as the option becomes more OTM, its gamma decreases at aslower rate.\nAnother reason that the P&(L) from the greeks is different from the actual P&(L) is that the greeks are derived from the option-pricing model and are therefore theoretical values and do not include slippage.\nFurthermore, the volatility input in this example is rounded abit for simplicity. For example, avolatility of 25 actually yielded atheoretical value of 2.796, while the call was bought at 2.80. Because some options trade at minimum price increments of anickel, and none trade in fractions of apenny, IV is often rounded.\nCaveat Venditor\nReversion to the mean holds the promise of profit in this trade, but Susie also knows that this strategy does not come without risks of loss. The mean to which volatility is expected to revert is not aconstant. This benchmark can and does change. In this example, if the company had an unexpectedly terrible quarter, the stock could plunge sharply. In some cases, this would cause IV to find anew, higher level at which to reside. If that had happened here, the trade could have been abig loser. Gamma and vega could both have wreaked havoc. In trading, there is no sure thing, no matter what the chart looks like. Remember, every ship on the bottom of the ocean has achart!\nVolatility Buying\nThis same earnings event could have been played entirely differently. Adifferent", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00023.html", "doc_id": "3a004316b42822802c31ed17edfd4ff69579302b06a280d1e03de165cb2548a7", "chunk_index": 4}
{"text": "have been abig loser. Gamma and vega could both have wreaked havoc. In trading, there is no sure thing, no matter what the chart looks like. Remember, every ship on the bottom of the ocean has achart!\nVolatility Buying\nThis same earnings event could have been played entirely differently. Adifferent trader, Bobby Buyer, studied the same volatility chart as Susie. It is shown again here as\nExhibit 12.7\n. Bobby also thought there would be arush and crush of IV, but he decided to take adifferent approach.\nEXHIBIT 12.7\nChip stock volatility before and after earnings reports.\nSource\n: Chart courtesy of\niVolatility.com\nAbout an hour before the close of business on July 21, just three days before earnings announcements, Bobby saw that he could buy volatility at 30 percent. In Bobby’sopinion, volatility seemed cheap with earnings so close. He believed that IV could rise at least five points over the next three days. Note that we have the benefit of 20/20 hindsight in the example.\nNear the end of the trading day, the stock was at $49.70. Bobby bought 20 33-day 50-strike calls at 1.75 (30 volatility) and sold short 1,000 shares of the underlying stock at $49.70 to become delta neutral.\nExhibit 12.8\nshows Bobby’sposition.\nEXHIBIT 12.8\nDelta-neutral long call, short stock position.\nWith the stock at $49.70, the calls had +0.51 delta per contract, or +10.2 for the 20-lot. The short sale of 1,000 shares got Bobby as close to delta-neutral as possible without trading an odd lot in the stock. The net position delta was +0.20, or about the equivalent of being long 20 shares of stock. Bobby’sobjective in this case is to profit from an increase in implied volatility leading up to earnings.\nWhile Susie was looking for reversion to the mean, Bobby hoped for afurther divergence. For Bobby, positive gamma looked like agood thing on the surface. However, his plan was to close the position just before earnings were released—before the vol crush and before the potential stock-price move. With realized volatility already starting to drop off at the time the trade was put on, gamma offered little promise of gain.\nAs fate would have it, IV did indeed increase. At the end of the day before the July earnings report, IV was trading at 35 percent. Bobby closed his trade by selling his 20-lot of the 50 calls at 2.10 and buying his 1,000 shares of stock back at $50.\nExhibit 12.9\nshows the P&(L) for each leg of the spread.\nEXHIBIT 12.9\nProfit breakdown.\nThe calls earned Bobby atotal of $700, while the stock lost $300. Of course, with this type of trade, it is not relevant which leg was awinner and which aloser. All that matters is the bottom line. The net P&(L) on the trade was again of $400. The gain in this case was mostly aproduct of IV’srising.\nExhibit 12.10\nshows the P&(L) per greek.\nEXHIBIT 12.10\nProfit breakdown by greek.\nDelta\nThe position began long 0.20 deltas. The 0.30-point rise earned Bobby a 0.06 point gain in delta per contract.\nGamma\nBobby had an initial gamma of +1.8. We will use 1.8 for estimating the P&(L) in this example, assuming gamma remained constant. A 0.30 rise in the stock price multiplied by the 1.8 gamma means that with the stock at $50, Bobby was long an additional 0.54 deltas. We can estimate that over the course of the 0.30 rise in the stock price, Bobby was long an average of 0.27 (0.54 ÷ 2). His P&(L) due to gamma, therefore, is again of about 0.08 (0.27 × 0.30).\nTheta\nBobby held this trade for three days. His total theta cost him 1.92 or $192.\nVega\nThe biggest contribution to Bobby’sprofit on this trade was made by the spike in IV. He bought 30 volatility and sold 35 volatility. His 1.20 position vega earned him 6.00, or $600.\nConclusions\nThe $422 profit is not exact, but the greeks provide agood estimate of the hows and the whys behind it. Whether they are used for forecasting profits or for doing apostmortem evaluation of atrade, consulting the greeks offers information unavailable by just looking at the transaction prices.\nBy thinking about all these individual pricing components, atrader can make better decisions. For example, about two weeks earlier, Bobby could have bought an IV level closer to 26 percent. Being conscious of his theta, however, he decided to wait. The $64-a-day theta would have cost him $896 over 14 days. That’smuch more that the $480 he could have made by buying volatility four points lower with his 1.20 vega.\nRisks of the Trade\nLike Susie’strade, Bobby’splay was not without risk. Certainly theta was aconcern, but in addition to that was the possibility that IV might not have played out as he planned. First, IV might not have risen enough to cover three days’ worth of theta. It needed to rise, in this case, about 1.6 volatility points for the 1.20 vega to cover the 1.92 theta loss. It might even have dropped. An earlier-than-expected announcement that the earnings numbers were right on target could have spoiled Bobby’strade. Or the market simply might not have reacted as expected; vol", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00023.html", "doc_id": "3a004316b42822802c31ed17edfd4ff69579302b06a280d1e03de165cb2548a7", "chunk_index": 5}
{"text": "CHAPTER 13\nDelta-Neutral Trading\nTrading Realized Volatility\nSo far, we’ve discussed many option strategies in which realized volatility is an important component of the trade. And while the management of these positions has been the focus of much of the discussion, the ultimate gain or loss for many of these strategies has been from movement in asingle direction. For example, with along call, the higher the stock rallies the better.\nBut increases or decreases in realized volatility do not necessarily have an exclusive relationship with direction. Recall that realized volatility is the annualized standard deviation of daily price movements. Take two similarly priced stocks that have had anet price change of zero over aone-month period. Stock Ahad small daily price changes during that period, rising $0.10 one day and falling $0.10 the next. Stock Bwent up or down by $5 each day for amonth. In this rather extreme example, Stock Bwas much more volatile than Stock A, regardless of the fact that the net price change for the period for both stocks was zero.\nAstock’svolatility—either high or low volatility—can be capitalized on by trading options delta neutral. Simply put, traders buy options delta neutral when they believe astock will have more movement and sell options delta neutral when they believe astock will move less.\nDelta-neutral option sellers profit from low volatility through theta. Every day that passes in which the loss from delta/gamma movement is less than the gain from theta is awinning day. Traders can adjust their deltas by hedging. Delta-neutral option buyers exploit volatility opportunities through atrading technique called gamma scalping.\nGamma Scalping\nIntraday trading is seldom entirely in one direction. Astock may close higher or lower, even sharply higher or lower, on the day, but during the day there is usually not asteady incremental rise or fall in the stock price. Atypical intraday stock chart has peaks and troughs all day long. Delta-neutral traders who have gamma don’tremain delta neutral as the underlying price changes, which inevitably it will. Delta-neutral trading is kind of amisnomer.\nIn fact, it is gamma trading in which delta-neutral traders engage. For long-gamma traders, the position delta gets more positive as the underlying moves higher and more negative as the underlying moves lower. An upward move in the underlying increases positive deltas, resulting in exponentially increasing profits. But if the underlying price begins to retrace downward, the gain from deltas can be erased as quickly as it was racked up.\nTo lock in delta gains, atrader can adjust the position to delta neutral again by selling short stock to cover long deltas. If the stock price declines after this adjustment, losses are curtailed thanks to the short stock. In fact, the delta will become negative as the underlying price falls, leading to growing profits. To lock in profits again, the trader buys stock to cover short deltas to once again become delta neutral.\nThe net effect is astock scalp. Positive gamma causes the delta-neutral trader to sell stock when the price rises and buy when the stock falls. This adds up to atrue, realized profit. So positive gamma is amoney-making machine, right? Not so fast. As in any business, the profits must be great enough to cover expenses. Theta is the daily cost of running this gamma-scalping business.\nFor example, atrader, Harry, notices that the intraday price swings in aparticular stock have been increasing. He takes abullish position in realized volatility by buying 20 off the 40-strike calls, which have a 50 delta, and selling stock on adelta-neutral ratio.\nBuy 20 40-strike calls (50 delta) (long 1,000 deltas)\nShort 1,000 shares at $40 (short 1,000 deltas)\nThe immediate delta of this trade is flat, but as the stock moves up or down, that will change, presenting gamma-scalping opportunities. Gamma scalping is the objective here. The position greeks in\nExhibit 13.1\nshow the relationship of the two forces involved in this trade: gamma and theta.\nEXHIBIT 13.1\nGreeks for 20-lot delta-neutral long call.\nThe relationship of gamma to theta in this sort of trade is paramount to its success. Gamma-scalping plays are not buy-and-hold strategies. This is active trading. These spreads need to be monitored intraday to take advantage of small moves in the underlying security. Harry will sell stock when the underlying rises and buy it when the underlying falls, taking aprofit with each stock trade. The goal for each day that passes is to profit enough from positive gamma to cover the day’stheta. But that’snot always as easy as it sounds. Let’sstudy what happens the first seven days after this hypothetical trade is executed. For the purposes of this example, we assume that gamma remains constant and that the trader is content trading odd lots of stock.\nDay One\nThe first day proves to be fairly volatile. The stock rallies from $40 to $42 early in the day. This creates apositive p", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00024.html", "doc_id": "40a16a986e2f5758935a7c56a5e71e43a04493722e9c7d16267522cc4a4cfe47", "chunk_index": 0}
{"text": "fter this hypothetical trade is executed. For the purposes of this example, we assume that gamma remains constant and that the trader is content trading odd lots of stock.\nDay One\nThe first day proves to be fairly volatile. The stock rallies from $40 to $42 early in the day. This creates apositive position delta of 5.60, or the equivalent of being long about 560 shares. At $42, Harry covers the position delta by selling 560 shares of the underlying stock to become delta neutral again.\nLater in the day, the market reverses, and the stock drops back down to $40 ashare. At this point, the position is short 5.60 deltas. Harry again adjusts the position, buying 560 shares to get flat. The stock then closes right at $40.\nThe net result of these two stock transactions is again of $1,070. How? The gamma scalp minus the theta, as shown below.\nThe volatility of day one led to it being aprofitable day. Harry scalped 560 shares for a $2 profit, resulting from volatility in the stock. If the stock hadn’tmoved as much, the delta would have been smaller, and the dollar amount scalped would have been smaller, leading to an exponentially smaller profit. If there had been more volatility, profits would have been exponentially larger. It would have led to abigger bite being taken out of the market.\nDay Two\nThe next day, the market is abit quieter. There is a $0.40 drop in the price of the stock, at which point the position delta is short 1.12. Harry buys 112 shares at $39.60 to get delta neutral.\nFollowing Harry’spurchase, the stock slowly drifts back up and is trading at $40 near the close. Harry decides to cover his deltas and sell 112 shares at $40. It is common to cover all deltas at the end of the day to get back to being delta neutral. Remember, the goal of gamma scalping is to trade volatility, not direction. Starting the next trading day with adelta, either positive or negative, means an often unwanted directional bias and unwanted directional risk. Tidying up deltas at the end of the day to get neutral is called going home flat.\nToday was not abanner day. Harry did not quite have the opportunity to cover the decay.\nDay Three\nOn this day, the market trends. First, the stock rises $0.50, at which point Harry sells 140 shares of stock at $40.50 to lock in gains from his delta and to get flat. However, the market continues to rally. At $41 ashare, Harry is long another 1.40 deltas and so sells another 140 shares. The rally continues, and at $41.50 he sells another 140 shares to cover the delta. Finally, at the end of the day, the stock closes at $42 ashare. Harry sells afinal 140 shares to get flat.\nThere was not any literal scalping of stock today. It was all selling. Nonetheless, gamma trading led to aprofitable day.\nAs the stock rose from $40 to $40.50, 140 deltas were created from positive gamma. Because the delta was zero at $40 and 140 at $40.50, the estimated average delta is found by dividing 140 in half. This estimated average delta multiplied by the $0.50 gain on the stock equals a $35 profit. The delta was zero after the adjustment made at $40.50, when 140 shares were sold. When the stock reached $41, another $35 was reaped from the average delta of 70 over the $0.50 move. This process was repeated every time the stock rose $0.50 and the delta was covered.\nDay Four\nDay four offers apleasant surprise for Harry. That morning, the stock opens $4 lower. He promptly covers his short delta of 11.2 by buying 1,120 shares of the stock at $38 ashare. The stock barely moves the rest of the day and closes at $38.\nAn exponentially larger profit was made because there was $4 worth of gains on the growing delta when the stock gapped open. The whole position delta was covered $4 lower, so both the delta and the dollar amount gained on that delta had achance to grow. Again, Harry can estimate the average delta over the $4 move to be half of 11.20. Multiplying that by the $4 stock advance gives him his gamma profit of $2,240. After accounting for theta, the net profit is $2,190.\nDays Five and Six\nDays five and six are the weekend; the market is closed.\nDay Seven\nThis is aquiet day after the volatility of the past week. Today, the stock slowly drifts up $0.25 by the end of the day. Harry sells 70 shares of stock at $38.25 to cover long deltas.\nThis day was aloser for Harry, as profits from gamma were not enough to cover his theta.\nArt and Science\nAlthough this was avery simplified example, it was typical of how aprofitable week of gamma scalping plays out. This stock had apretty volatile week, and overall the week was awinner: there were four losing days and three winners. The number of losing days includes the weekends. Weekends and holidays are big hurdles for long-gamma traders because of the theta loss. The biggest contribution to this being awinning week was made by the gap open on day four. Part of the reason was the sheer magnitude of the move, and part was the fact that the deltas weren’tcovered too soon, as they had be", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00024.html", "doc_id": "40a16a986e2f5758935a7c56a5e71e43a04493722e9c7d16267522cc4a4cfe47", "chunk_index": 1}
{"text": "holidays are big hurdles for long-gamma traders because of the theta loss. The biggest contribution to this being awinning week was made by the gap open on day four. Part of the reason was the sheer magnitude of the move, and part was the fact that the deltas weren’tcovered too soon, as they had been on day three.\nIn aperfect world, along-gamma trader will always buy the low of the day and sell the high of the day when covering deltas. This, unfortunately, seldom happens. Long-gamma traders are very often wrong when trading stock to cover deltas.\nBeing wrong can be okay on occasion. In fact, it can even be rewarding. Day three was profitable despite the fact that 140 shares were sold at $40.50, $41, and $41.50. The stock closed at $42; the first three stock trades were losers. Harry sold stock at alower price than the close. But the position still made money because of his positive gamma. To be sure, Harry would like to have sold all 560 shares at $42 at the end of the day. The day’sprofits would have been significantly higher.\nThe problem is that no one knows where the stock will move next. On day three, if the stock had topped out at $40.50 and Harry did not sell stock because he thought it would continue higher, he would have missed an opportunity. Gamma scalping is not an exact science. The art is to pick spots that capture the biggest moves possible without missing opportunities.\nThere are many methods traders have used to decide where to cover deltas when gamma scalping: the daily standard deviation, afixed percentage of the stock price, afixed nominal value, covering at acertain time of day, “market feel.” No system appears to be absolutely better than another. This is where it gets personal. Finding what works for you, and what works for the individual stocks you trade, is the art of this science.\nGamma, Theta, and Volatility\nClearly, more volatile stocks are more profitable for gamma scalping, right? Well . . . maybe. Recall that the higher the implied volatility, the lower the gamma and the higher the theta of at-the-money (ATM) options. In many cases, the more volatile astock, the higher the implied volatility (IV). That means that avolatile stock might have to move more for atrader to scalp enough stock to cover the higher theta.\nLet’slook at the gamma-theta relationship from another perspective. In this example, for 0.50 of theta, Harry could buy 2.80 gamma. This relationship is based on an assumed 25 percent implied volatility. If IV were 50 percent, theta for this 20 lot would be higher, and the gamma would be lower. At avolatility of 50, Harry could buy 1.40 gammas for 0.90 of theta. The gamma is more expensive from atheta perspective, but if the stock’sstatistical volatility is significantly higher, it may be worth it.\nGamma Hedging\nKnowing that the gamma and theta figures of\nExhibit 13.1\nare derived from a 25 percent volatility assumption offers abenchmark with which to gauge the potential profitability of gamma trading the options. If the stock’sstandard deviation is below 25 percent, it will be difficult to make money being long gamma. If it is above 25 percent, the play becomes easier to trade. There is more scalping opportunity, there are more opportunities for big moves, and there are more likely to be gaps in either direction. The 25 percent volatility input not only determines the option’stheoretical value but also helps determine the ratio of gamma to theta.\nA 25 percent or higher realized volatility in this case does not guarantee the trade’ssuccess or failure, however. Much of the success of the trade has to do with how well the trader scalps stock. Covering deltas too soon leads to reduced profitability. Covering too late can lead to missed opportunities.\nTrading stock well is also important to gamma sellers with the opposite trade: sell calls and buy stock delta neutral. In this example, atrader will sell 20 ATM calls and buy stock on adelta-neutral ratio.\nThis is abearish position in realized volatility. It is the opposite of the trade in the last example. Consider again that 25 percent IV is the benchmark by which to gauge potential profitability. Here, if the stock’svolatility is below 25, the chances of having aprofitable trade are increased. Above 25 is abit more challenging.\nIn this simplified example, adifferent trader, Mary, plays the role of gamma seller. Over the same seven-day period as before, instead of buying calls, Mary sold a 20 lot.\nExhibit 13.2\nshows the analytics for the trade. For the purposes of this example, we assume that gamma remains constant and the trader is content trading odd lots of stock.\nEXHIBIT 13.2\nGreeks for 20-lot delta-neutral short call.\nDay One\nThis was one of the volatile days. The stock rallied from $40 to $42 early in the day and had fallen back down to $40 by the end of the day. Big moves like this are hard to trade as ashort-gamma trader. As the stock rose to $42, the negative delta would have been increasing. That means losses were", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00024.html", "doc_id": "40a16a986e2f5758935a7c56a5e71e43a04493722e9c7d16267522cc4a4cfe47", "chunk_index": 2}
{"text": "This was one of the volatile days. The stock rallied from $40 to $42 early in the day and had fallen back down to $40 by the end of the day. Big moves like this are hard to trade as ashort-gamma trader. As the stock rose to $42, the negative delta would have been increasing. That means losses were adding up at an increasing rate. The only way to have stopped the hemorrhaging of money as the stock continued to rise would have been to buy stock. Of course, if Mary buys stock and the stock then declines, she has aloser.\nLet’sassume the best-case scenario. When the stock reached $42 and she had a −560 delta, Mary correctly felt the market was overbought and would retrace. Sometimes, the best trades are the ones you don’tmake. On this day, Mary traded no stock. When the stock reached $40 ashare at the end of the day, she was back to being delta neutral. Theta makes her awinner today.\nBecause of the way Mary handled her trade, the volatility of day one was not necessarily an impediment to it being profitable. Again, the assumption is that Mary made the right call not to negative scalp the stock. Mary could have decided to hedge her negative gamma when the stock reach $42 and the position delta was at −$560 by buying stock and then selling it at $40.\nThere are anumber of techniques for hedging deltas resulting from negative gamma. The objective of hedging deltas is to avoid losses from the stock trending in one direction and creating increasingly adverse deltas but not to overtrade stock and negative scalp.\nDay Two\nRecall that this day had asmall dip and then recovered to close again at $40. It is more reasonable to assume that on this day there was no negative scalping. A $0.40 decline is amore typical move in astock and nothing to be afraid of. The 112 delta created by negative gamma when the stock fell wouldn’tbe perceived as amajor concern by most traders in most situations. It is reasonable to assume Mary would take no action. Today, again, was awinner thanks to theta.\nDay Three\nDay three saw the stock price trending. It slowly drifted up $2. There would have been some judgment calls throughout this day. Again, delta-neutral trades are for active traders. Prepare to watch the market much of the day if implementing this kind of strategy.\nWhen the stock was at $41 ashare, Mary decided to guard against further advances in stock price and hedged her delta. At that point, the position would have had a −2.80 delta. She bought 280 shares at $41.\nAs the day progressed, the market proved Mary to be right. The stock rose to $42 giving the position adelta of −2.80 again. She covered her deltas at the end of the day by buying another 280 shares.\nCovering the negative deltas to get flat at $41 proved to be asmart move today. It curtailed an exponentially growing delta and let Mary take asmaller loss at $41 and get afresh start. While the day was aloser, it would have been $280 worse if she had not purchased stock at $41 before the run-up to $42. This is evidenced by the fact that she made a $280 profit on the 280 shares of stock bought at $41, since the stock closed at $42.\nDay Four\nDay four offered arather unpleasant surprise. This was the day that the stock gapped open $4 lower. This is the kind of day short-gamma traders dread. There is, of course, no right way to react to this situation. The stock can recover, heading higher; it can continue lower; or it can have adead-cat bounce, remaining where it is after the fall.\nStaring at aquite contrary delta of 11.20, Mary was forced to take action by selling stock. But how much stock was the responsible amount to sell for apure short-gamma trader not interested in trading direction? Selling 1,120 shares would bring the position back to being delta neutral, but the only way the trade would stay delta neutral would be if the stock stayed right where it was.\nHedging is always adifficult call for short-gamma traders. Long-gamma traders are taking aprofit on deltas with every stock trade that covers their deltas. Short-gamma traders are always taking aloss on delta. In this case, Mary decided to cover half her deltas by selling 560 shares. The other 560 deltas represent aloss, too; it’sjust not locked in.\nHere, Mary made the conscious decision not to go home flat. On the one hand, she was accepting the risk of the stock continuing its decline. On the other hand, if she had covered the whole delta, she would have been accepting the risk of the stock moving in either direction. Mary felt the stock would regain some of its losses. She decided to lead the stock alittle, going into the weekend with apositive delta bias.\nDays Five and Six\nDays five and six are the weekend.\nDay Seven\nThis was the quiet day of the week, and awelcome respite. On this day, the stock rose just $0.25. The rise in price helped abit. Mary was still long 560 deltas from Friday. Negative gamma took only asmall bite out of her profit.\nThe P&(L) can be broken down into the profit attributable to the starting delt", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00024.html", "doc_id": "40a16a986e2f5758935a7c56a5e71e43a04493722e9c7d16267522cc4a4cfe47", "chunk_index": 3}
{"text": "s the quiet day of the week, and awelcome respite. On this day, the stock rose just $0.25. The rise in price helped abit. Mary was still long 560 deltas from Friday. Negative gamma took only asmall bite out of her profit.\nThe P&(L) can be broken down into the profit attributable to the starting delta of the trade, the estimated loss from gamma, and the gain from theta.\nMary ends these seven days of trading worse off than she started. What went wrong? The bottom line is that she sold volatility on an asset that proved to be volatile. A $4 drop in price of a $42 dollar stock was abig move. This stock certainly moved at more than 25 percent volatility. Day four alone made this trade alosing proposition.\nCould Mary have done anything better? Yes. In aperfect world, she would not have covered her negative deltas on day 3 by buying 280 shares at $41 and another 280 at $42. Had she not, this wouldn’thave been such abad week. With the stock ending at $38.25, she lost $1,050 on the 280 shares she bought at $42 ($3.75 times 280) and lost $770 on the 280 shares bought at $41 ($2.75 times 280). Then again, if the stock had continued higher, rising beyond $42, those would have been good buys.\nMary can’tbeat herself up too much for protecting herself in away that made sense at the time. The stock’s $2 rally is more to blame than the fact that she hedged her deltas. That’sthe risk of selling volatility: the stock may prove to be volatile. If the stock had not made such amove, she wouldn’thave faced the dilemma of whether or not to hedge.\nConclusions\nThe same stock during the same week was used in both examples. These two traders started out with equal and opposite positions. They might as well have made the trade with each other. And although in this case the vol buyer (Harry) had apretty good week and the vol seller (Mary) had anot-so-good week, it’simportant to notice that the dollar value of the vol buyer’sprofit was not the same as the dollar value of the vol seller’sloss. Why? Because each trader hedged his or her position differently. Option trading is not azero-sum game.\nOption-selling delta-neutral strategies work well in low-volatility environments. Small moves are acceptable. It’sthe big moves that can blow you out of the water.\nLike long-gamma traders, short-gamma traders have many techniques for covering deltas when the stock moves. It is common to cover partial deltas, as Mary did on day four of the last example. Conversely, if astock is expected to continue along its trajectory up or down, traders will sometimes overhedge by buying more deltas (stock) than they are short or selling more than they are long, in anticipation of continued price rises. Daily standard deviation derived from implied volatility is acommon measure used by short-gamma players to calculate price points at which to enter hedges. Market feel and other indicators are also used by experienced traders when deciding when and how to hedge. Each trader must find what works best for him or her.\nSmileys and Frowns\nThe trade examples in this chapter have all involved just two components: calls and stock. We will explore delta-neutral strategies in other chapters that involve more moving parts. Regardless of the specific makeup of the position, the P&(L) of each individual leg is not of concern. It is the profitability of the position as awhole that matters. For example, after avolatile move in astock occurs, apositive-gamma trader like Harry doesn’tcare whether the calls or the stock made the profit on the move. The trader would monitor the net delta that was produced—positive or negative—and cover accordingly. The process is the same for anegative-gamma trader. In either case, it is gamma and delta that need to be monitored closely.\nGamma can make or break atrade. P&(L) diagrams are helpful tools that offer avisual representation of the effect of gamma on aposition. Many option-trading software applications offer P&(L) graphing applications to study the payoff of aposition with the days to expiration as an adjustable variable to study the same trade over time.\nP&(L) diagrams for these delta-neutral positions before the options’ expiration generally take one of two shapes: asmiley or afrown. The shape of the graph depends on whether the position gamma is positive or negative.\nExhibit 13.3\nshows atypical positive-gamma trade.\nEXHIBIT 13.3\nP&(L) diagram for apositive-gamma delta-neutral position/l.\nThis diagram is representative of the P&Lof adelta-neutral positive-gamma trade calculated using the prices at which the trade was executed. With this type of trade, it is intuitive that when the stock price rises or falls, profits increase because of favorably changing deltas. This is represented by the graph’ssmiley-face shape. The corners of the graph rise higher as the underlying moves away from the center of the graph.\nThe graph is atwo-dimensional snapshot showing that the higher or lower the underlying moves, the greater the profit. But there are", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00024.html", "doc_id": "40a16a986e2f5758935a7c56a5e71e43a04493722e9c7d16267522cc4a4cfe47", "chunk_index": 4}
{"text": "y changing deltas. This is represented by the graph’ssmiley-face shape. The corners of the graph rise higher as the underlying moves away from the center of the graph.\nThe graph is atwo-dimensional snapshot showing that the higher or lower the underlying moves, the greater the profit. But there are other dimensions that are not shown here, such as time and IV.\nExhibit 13.4\nshows the effects of time on atypical long-gamma trade.\nEXHIBIT 13.4\nThe effect of time on P&(L).\nAs time passes, the reduction in profit is reflected by the center point of the graph dipping farther into negative territory. That is the effect of time decay. The long options will have lost value at that future date with the stock still at the same price (all other factors held constant). Still, amove in either direction can lead to aprofitable position. Ultimately, at expiration, the payoff takes on arigid kinked shape.\nIn the delta-neutral long call examples used in this chapter the position becomes net long stock if the calls are in-the-money at expiration or net short stock if they are out-of-the-money and only the short stock remains. Volatility, as well, would move the payoff line vertically. As IV increases, the options become worth more at each stock price, and as IV falls, they are worth less, assuming all other factors are held constant.\nAdelta-neutral short-gamma play would have a P&(L) diagram quite the opposite of the smiley-faced long-gamma graph.\nExhibit 13.5\nshows what is called the short-gamma frown.\nEXHIBIT 13.5\nShort-gamma frown.\nAt first glance, this doesn’tlook like avery good proposition. The highest point on the graph coincides with aprofit of zero, and it only gets worse as the price of the underlying rises or falls. This is enough to make any trader frown. But again, this snapshot does not show time or volatility.\nExhibit 13.6\nshows the payout diagram as time passes.\nEXHIBIT 13.6\nThe effect of time on the short-gamma frown.\nAdecrease in value of the options from time decay causes an increase in profitability. This profit potential pinnacles at the center (strike) price at expiration. Rising IV will cause adecline in profitability at each stock price point. Declining IV will raise the payout on the Yaxis as profitability increases at each price point.\nSmileys and frowns are amere graphical representation of the technique discussed in this chapter: buying and selling realized volatility. These P&(L) diagrams are limited, because they show the payout only of stock-price movement. The profitability of direction-indifferent and direction-neutral trading is also influenced by time and implied volatility. These actively traded strategies are best evaluated on agamma-theta basis. Long-gamma traders strive each day to scalp enough to cover the day’stheta, while short-gamma traders hope to keep the loss due to adverse movement in the underlying lower than the daily profit from theta.\nThe strategies in this chapter are the same ones traded in Chapter 12. The only difference is the philosophy. Ultimately, both types of volatility are being traded using these and other option strategies. Implied and realized volatility go hand in hand.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00024.html", "doc_id": "40a16a986e2f5758935a7c56a5e71e43a04493722e9c7d16267522cc4a4cfe47", "chunk_index": 5}
{"text": "CHAPTER 14\nStudying Volatility Charts\nImplied and realized volatility are both important to option traders. But equally important is to understand how the two interact. This relationship is best studied by means of avolatility chart. Volatility charts are invaluable tools for volatility traders (and all option traders for that matter) in many ways.\nFirst, volatility charts show where implied volatility (IV) is now compared with where it’sbeen in the past. This helps atrader gauge whether IV is relatively high or relatively low. Vol charts do the same for realized volatility. The realized volatility line on the chart answers three questions:\nHave the past 30 days been more or less volatile for the stock than usual?\nWhat is atypical range for the stock’svolatility?\nHow much volatility did the underlying historically experience in the past around specific recurring events?\nWhen IV lines and realized volatility lines are plotted on the same chart, the divergences and convergences of the two spell out the whole volatility story for those who know how to read it.\nNine Volatility Chart Patterns\nEach individual stock and the options listed on it have their own unique realized and implied volatility characteristics. If we studied the vol charts of 1,000 stocks, we’dlikely see around 1,000 different volatility patterns. The number of permutations of the relationship of realized to implied volatility is nearly infinite, but for the sake of discussion, we will categorize volatility charts into nine general patterns.\n1\n1. Realized Volatility Rises, Implied Volatility Rises\nThe first volatility chart pattern is that in which both IV and realized volatility rise. In general, this kind of volatility chart can line up three ways: implied can rise more than realized volatility; realized can rise more than implied; or they can both rise by about the same amount. The chart below shows implied volatility rising at afaster rate than realized vol. The general theme in this case is that the stock’sprice movement has been getting more volatile, and the option prices imply even higher volatility in the future.\nThis specific type of volatility chart pattern is commonly seen in active stocks with alot of news. Stocks du jour, like some Internet stocks during the tech bubble of the late 1990s, story stocks like Apple (AAPL) around the release of the iPhone in 2007, have rising volatilities, with the IV outpacing the realized volatility. Sometimes individual stocks and even broad market indexes and exchange-traded funds (ETFs) see this pattern, when the market is declining rapidly, like in the summer of 2011.\nAdelta-neutral long-volatility position bought at the beginning of May, according to\nExhibit 14.1\n, would likely have produced awinner. IV took off, and there were sure to be plenty of opportunities to profit from gamma with realized volatility gaining strength through June and July.\nEXHIBIT 14.1\nRealized volatility rises, implied volatility rises.\nSource\n: Chart courtesy of\niVolatility.com\nLooking at the right side of the chart, in late July, with IV at around 50 percent and realized vol at around 35 percent, and without the benefit of knowing what the future will bring, it’sharder to make acall on how to trade the volatility. The IV signals that the market is pricing ahigher future level of stock volatility into the options. If the market is right, gamma will be good to have. But is the price right? If realized volatility does indeed catch up to implied volatility—that is, if the lines converge at 50 or realized volatility rises above IV—atrader will have agood shot at covering theta. If it doesn’t, gamma will be very expensive in terms of theta, meaning it will be hard to cover the daily theta by scalping gamma intraday.\nThe question is: why is IV so much higher than realized? If important news is expected to be released in the near future, it may be perfectly reasonable for the IV to be higher, even significantly higher, than the stock’srealized volatility. One big move in the stock can produce anice profit, as long as theta doesn’thave time to work its mischief. But if there is no news in the pipeline, there may be some irrational exuberance—in the words of ex-Fed chairman Alan Greenspan—of option buyers rushing to acquire gamma that is overvalued in terms of theta.\nIn fact, alack of expectation of news could indicate apotential bearish volatility play: sell volatility with the intent of profiting from daily theta and adecline in IV. This type of play, however, is not for the fainthearted. No one can predict the future. But one thing you can be sure of with this trade: you’re in for awild ride. The lines on this chart scream volatility. This means that negative-gamma traders had better be good and had better be right!\nIn this situation, hedgers and speculators in the market are buying option volatility of 50 percent, while the stock is moving at 35 percent volatility. Traders putting on adelta-neutral volatility-selling strate", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00025.html", "doc_id": "0655265ab9c35d1af167ef38abc4999e59c0208301996c6b66aa3c393d0db657", "chunk_index": 0}
{"text": "ity. This means that negative-gamma traders had better be good and had better be right!\nIn this situation, hedgers and speculators in the market are buying option volatility of 50 percent, while the stock is moving at 35 percent volatility. Traders putting on adelta-neutral volatility-selling strategy are taking the stance that this stock will not continue increasing in volatility as indicated by option prices; specifically, it will move at less than 50 percent volatility—hopefully alot less. They are taking the stance that the market’sexpectations are wrong.\nInstead of realized and implied volatility both trending higher, sometimes there is asharp jump in one or the other. When this happens, it could be an indication of aspecific event that has occurred (realized volatility) or news suddenly released of an expected event yet to come (implied volatility). Asharp temporary increase in IV is called aspike, because of its pointy shape on the chart. Aone-day surge in realized volatility, on the other hand, is not so much avolatility spike as it is arealized volatility mesa. Realized volatility mesas are shown in\nExhibit 14.2\n.\nEXHIBIT 14.2\nVolatility mesas.\nSource\n: Chart courtesy of\niVolatility.com\nThe patterns formed by the gray line in the circled areas of the chart shown below are the result of typical one-day surges in realized volatility. Here, the 30-day realized volatility rose by nearly 20 percentage points, from about 20 percent to about 40 percent, in one day. It remained around the 40 percent level for 30 days and then declined 20 points just as fast as it rose.\nWas this entire 30-day period unusually volatile? Not necessarily. Realized volatility is calculated by looking at price movements within acertain time frame, in this case, thirty business days. That means that areally big move on one day will remain in the calculation for the entire time. Thirty days after the unusually big move, the calculation for realized volatility will no longer contain that one-day price jump. Realized volatility can then drop significantly.\n2. Realized Volatility Rises, Implied Volatility Remains Constant\nThis chart pattern can develop from afew different market conditions. One scenario is aone-time unanticipated move in the underlying that is not expected to affect future volatility. Once the news is priced into the stock, there is no point in hedgers’ buying options for protection or speculators’ buying options for aleveraged bet. What has happened has happened.\nThere are other conditions that can cause this type of pattern to materialize. In\nExhibit 14.3\n, the IV was trading around 25 for several months, while the realized volatility was lagging. With hindsight, it makes perfect sense that something had to give—either IV needed to fall to meet realized, or realized would rise to meet market expectations. Here, indeed, the latter materialized as realized volatility had asteady rise to and through the 25 level in May. Implied, however remained constant.\nEXHIBIT 14.3\nRealized volatility rises, implied volatility remains constant.\nSource\n: Chart courtesy of\niVolatility.com\nTraders who were long volatility going into the May realized-vol rise probably reaped some gamma benefits. But those who got in “too early,” buying in January or February, would have suffered too great of theta losses before gaining any significant profits from gamma. Time decay (theta) can inflict aslow, painful death on an option buyer. By studying this chart in hindsight, it is clear that options were priced too high for agamma scalper to have afighting chance of covering the daily theta before the rise in May.\nThis wasn’tnecessarily an easy vol-selling trade before the May realized-vol rise, either, depending on the trader’stiming. In early February, realized did in fact rise above implied, making the short volatility trade much less attractive.\nTraders who sold volatility just before the increase in realized volatility in May likely ended up losing on gamma and not enough theta profits to make up for it. There was no volatility crush like what is often seen following aone-day move leading to sharply higher realized volatility. IV simply remained pretty steady throughout the month of May and well into June.\n3. Realized Volatility Rises, Implied Volatility Falls\nThis chart pattern can manifest itself in different ways. In this scenario, the stock is becoming more volatile, and options are becoming cheaper. This may seem an unusual occurrence, but as we can see in\nExhibit 14.4\n, volatility sometimes plays out this way. This chart shows two different examples of realized vol rising while IV falls.\nEXHIBIT 14.4\nRealized volatility rises, implied volatility falls.\nSource\n: Chart courtesy of\niVolatility.com\nThe first example, toward the left-hand side of the chart, shows realized volatility trending higher while IV is trending lower. Although fundamentals can often provide logical reasons for these volatility changes, sometimes they just can’t. Both i", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00025.html", "doc_id": "0655265ab9c35d1af167ef38abc4999e59c0208301996c6b66aa3c393d0db657", "chunk_index": 1}
{"text": "y falls.\nSource\n: Chart courtesy of\niVolatility.com\nThe first example, toward the left-hand side of the chart, shows realized volatility trending higher while IV is trending lower. Although fundamentals can often provide logical reasons for these volatility changes, sometimes they just can’t. Both implied and realized volatility are ultimately afunction of the market. There is anormal oscillation to both of these figures. When there is no reason to be found for avolatility change, it might be an opportunity. The potential inefficiency of volatility pricing in the options market sometimes creates divergences such as this one that vol traders scour the market in search of.\nIn this first example, after at least three months of IV’strading marginally higher than realized volatility, the two lines converge and then cross. The point at which these lines meet is an indication that IV may be beginning to get cheap.\nFirst, it’sapotentially beneficial opportunity to buy alower volatility than that at which the stock is actually moving. The gamma/theta ratio would be favorable to gamma scalpers in this case, because the lower cost of options compared with stock fluctuations could lead to gamma profits. Second, with IV at 35 at the first crossover on this chart, IV is dipping down into the lower part of its four-month range. One can make the case that it is getting cheaper from ahistorical IV standpoint. There is arguably an edge from the perspective of IV to realized volatility and IV to historical IV. This is an example of buying value in the context of volatility.\nFurthermore, if the actual stock volatility is rising, it’sreasonable to believe that IV may rise, too. In hindsight we see that this did indeed occur in\nExhibit 14.4\n, despite the fact that realized volatility declined.\nThe example circled on the right-hand side of the chart shows IV declining sharply while realized volatility rises sharply. This is an example of the typical volatility crush as aresult of an earnings report. This would probably have been agood trade for long volatility traders—even those buying at the top. Atrader buying options delta neutral the day before earnings are announced in this example would likely lose about 10 points of vega but would have agood chance to more than make up for that loss on positive gamma. Realized volatility nearly doubled, from around 28 percent to about 53 percent, in asingle day.\n4. Realized Volatility Remains Constant, Implied Volatility Rises\nExhibit 14.5\nshows that the stock is moving at about the same volatility from the beginning of June to the end of July. But during that time, option premiums are rising to higher levels. This is an atypical chart pattern. If this was aperiod leading up to an anticipated event, like earnings, one would anticipate realized volatility falling as the market entered await-and-see mode. But, instead, statistical volatility stays the same. This chart pattern may indicate apotential volatility-selling opportunity. If there is no news or reason for IV to have risen, it may simply be high tide in the normal ebb and flow of volatility.\nEXHIBIT 14.5\nRealized volatility remains constant, implied volatility rises.\nSource\n: Chart courtesy of\niVolatility.com\nIn this example, the historical volatility oscillates between 20 and 24 for nearly two months (the beginning of June through the end of July) as IV rises from 24 to over 30. The stock price is less volatile than option prices indicate. If there is no news to be dug up on the stock to lead one to believe there is avalid reason for the IV’strading at such alevel, this could be an opportunity to sell IV 5 to 10 points higher than the stock volatility. The goal here is to profit from theta or falling vega or both while not losing much on negative gamma. As time passes, if the stock continues to move at 20 to 23 vol, one would expect IV to fall and converge with realized volatility.\n5. Realized Volatility Remains Constant, Implied Volatility Remains Constant\nThis volatility chart pattern shown in\nExhibit 14.6\nis typical of aboring, run-of-the-mill stock with nothing happening in the news. But in this case, no news might be good news.\nEXHIBIT 14.6\nRealized volatility remains constant, implied volatility remains constant.\nSource\n: Chart courtesy of\niVolatility.com\nAgain, the gray is realized volatility and the black line is IV.\nIt’scommon for IV to trade slightly above or below realized volatility for extended periods of time in certain assets. In this example, the IV has traded in the high teens from late January to late July. During that same time, realized volatility has been in the low teens.\nThis is aprime environment for option sellers. From agamma/theta standpoint, the odds favor short-volatility traders. The gamma/theta ratio provides an edge, setting the stage for theta profits to outweigh negative-gamma scalping. Selling calls and buying stock delta neutral would be atrade to look at in this situation. But even more basic str", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00025.html", "doc_id": "0655265ab9c35d1af167ef38abc4999e59c0208301996c6b66aa3c393d0db657", "chunk_index": 2}
{"text": ". From agamma/theta standpoint, the odds favor short-volatility traders. The gamma/theta ratio provides an edge, setting the stage for theta profits to outweigh negative-gamma scalping. Selling calls and buying stock delta neutral would be atrade to look at in this situation. But even more basic strategies, such as time spreads and iron condors, are appropriate to consider.\nThis vol-chart pattern, however, is no guarantee of success. When the stock oscillates, delta-neutral traders can negative scalp stock if they are not careful by buying high to cover short deltas and then selling low to cover long deltas. Time-spread and iron condor trades can fail if volatility increases and the increase results from the stock trending in one direction. The advantage of buying IV lower than realized, or selling it above, is statistical in nature. Traders should use achart of the stock price in conjunction with the volatility chart to get amore complete picture of the stock’sprice action. This also helps traders make more informed decisions about when to hedge.\n6. Realized Volatility Remains Constant, Implied Volatility Falls\nExhibit 14.7\nshows two classic implied-realized convergences. From mid-September to early November, realized volatility stayed between 22 and 25. In mid-October the implied was around 33. Within the span of afew days, the implied vol collapsed to converge with the realized at about 22.\nEXHIBIT 14.7\nRealized volatility remains constant, implied volatility falls.\nSource\n: Chart courtesy of\niVolatility.com\nThere can be many catalysts for such adrop in IV, but there is truly only one reason: arbitrage. Although it is common for asmall difference between implied and realized volatility—1 to 3 points—to exist even for extended periods, bigger disparities, like the 7- to 10-point difference here cannot exist for that long without good reason.\nIf, for example, IV always trades significantly above the realized volatility of aparticular underlying, all rational market participants will sell options because they have agamma/theta edge. This, in turn, forces options prices lower until volatility prices come into line and the arbitrage opportunity no longer exists.\nIn\nExhibit 14.7\n, from mid-March to mid-May asimilar convergence took place but over alonger period of time. These situations are often the result of aslow capitulation of market makers who are long volatility. The traders give up on the idea that they will be able to scalp enough gamma to cover theta and consequently lower their offers to advertise their lower prices.\n7. Realized Volatility Falls, Implied Volatility Rises\nThis setup shown in\nExhibit 14.8\nshould now be etched into the souls of anyone who has been reading up to this point. It is, of course, the picture of the classic IV rush that is often seen in stocks around earnings time. The more uncertain the earnings, the more pronounced this divergence can be.\nEXHIBIT 14.8\nRealized volatility falls, implied volatility rises.\nSource\n: Chart courtesy of\niVolatility.com\nAnother classic vol divergence in which IV rises and realized vol falls occurs in adrug or biotech company when a Food and Drug Administration (FDA) decision on one of the company’snew drugs is imminent. This is especially true of smaller firms without big portfolios of drugs. These divergences can produce ahuge implied–realized disparity of, in some cases, literally hundreds of volatility points leading up to the announcement.\nAlthough rising IV accompanied by falling realized volatility can be one of the most predictable patterns in trading, it is ironically one of the most difficult to trade. When the anticipated news breaks, the stock can and often will make abig directional move, and in that case, IV can and likely will get crushed. Vega and gamma work against each other in these situations, as IV and realized volatility converge. Vol traders will likely gain on one vol and lose on the other, but it’svery difficult to predict which will have amore profound effect. Many traders simply avoid trading earnings events altogether in favor of less erratic opportunities. For most traders, there are easier ways to make money.\n8. Realized Volatility Falls, Implied Volatility Remains Constant\nThis volatility shift can be marked by avolatility convergence, divergence, or crossover.\nExhibit 14.9\nshows the realized volatility falling from around 30 percent to about 23 percent while IV hovers around 25. The crossover here occurs around the middle of February.\nEXHIBIT 14.9\nRealized volatility falls, implied volatility remains constant.\nSource\n: Chart courtesy of\niVolatility.com\nThe relative size of this volatility change makes the interpretation of the chart difficult. The last half of September saw around a 15 percent decline in realized volatility. The middle of October saw aone-day jump in realized of about 15 points. Historical volatility has had several dynamic moves that were larger and more abrupt than the seven-point decline over this", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00025.html", "doc_id": "0655265ab9c35d1af167ef38abc4999e59c0208301996c6b66aa3c393d0db657", "chunk_index": 3}
{"text": "the chart difficult. The last half of September saw around a 15 percent decline in realized volatility. The middle of October saw aone-day jump in realized of about 15 points. Historical volatility has had several dynamic moves that were larger and more abrupt than the seven-point decline over this six-week period. This smaller move in realized volatility is not necessarily an indication of avolatility event. It could reflect some complacency in the market. It could indicate aslow period with less trading, or it could simply be anatural contraction in the ebb and flow of volatility causing the calculation of recent stock-price fluctuations to wane.\nWhat is important in this interpretation is how the options market is reacting to the change in the volatility of the stock—where the rubber hits the road. The market’sapparent assessment of future volatility is unchanged during this period. When IV rises or falls, vol traders must look to the underlying stock for areason. The options market reacts to stock volatility, not the other way around.\nFinding fundamental or technical reasons for surges in volatility is easier than finding specific reasons for adecline in volatility. When volatility falls, it is usually the result of alack of news, leading to less price action. In this example, probably nothing happened in the market. Consequently, the stock volatility drifted lower. But it fell below the lowest IV level seen for the six-month period leading up to the crossover. It was probably hard to take aconfident stance in volatility immediately following the crossover. It is difficult to justify selling volatility when the implied is so cheap compared with its historic levels. And it can be hard to justify buying volatility when the options are priced above the stock volatility.\nThe two-week period before the realized line moved beneath the implied line deserves closer study. With the IV four or five points lower than the realized volatility in late January, traders may have been tempted to buy volatility. In hindsight, this trade might have been profitable, but there was surely no guarantee of this. Success would have been greatly contingent on how the traders managed their deltas, and how well they adapted as realized volatility fell.\nDuring the first half of this period, the stock volatility remained above implied. For an experienced delta-neutral trader, scalping gamma was likely easy money. With the oscillations in stock price, the biggest gamma-scalping risk would have been to cover too soon and miss out on opportunities to take bigger profits.\nUsing the one-day standard deviation based on IV (described in Chapter 3) might have produced early covering for long-gamma traders. Why? Because in late January, the standard deviation derived from IV was lower than the actual standard deviation of the stock being traded. In the latter half of the period being studied, the end of February on this chart, using the one-day standard deviation based on IV would have produced scalping that was too late. This would have led to many missed opportunities.\nTraders entering hedges at regular nominal intervals—every $0.50, for example—would probably have needed to decrease the interval as volatility ebbed. For instance, if in late January they were entering orders every $0.50, by late February they might have had to trade every $0.40.\n9. Realized Volatility Falls, Implied Volatility Falls\nThis final volatility-chart permutation incorporates afall of both realized and IV. The chart in\nExhibit 14.10\nclearly represents the slow culmination of ahighly volatile period. This setup often coincides with news of some scary event’sbeing resolved—alaw suit settled, unpopular upper management leaving, rumors found to be false, ahappy ending to political issues domestically or abroad, for example. After asharp sell-off in IV, from 75 to 55, in late October, marking the end of aperiod of great uncertainty, the stock volatility began asteady decline, from the low 50s to below 25. IV fell as well, although it remained abit higher for several months.\nEXHIBIT 14.10\nRealized volatility falls, implied volatility falls.\nSource\n: Chart courtesy of\niVolatility.com\nIn some situations where an extended period of extreme volatility appears to be coming to an end, there can be some predictability in how IV will react. To be sure, no one knows what the future holds, but when volatility starts to wane because aspecific issue that was causing gyrations in the stock price is resolved, it is common, and intuitive, for IV to fall with the stock volatility. This is another type of example of reversion to the mean.\nThere is apotential problem if the high-volatility period lasted for an extended period of time. Sometimes, it’shard to get afeel for what the mean volatility should be. Or sometimes, because of the event, the stock is fundamentally different—in the case of aspin-off, merger, or other corporate action, for example. When it is difficult or impossible to", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00025.html", "doc_id": "0655265ab9c35d1af167ef38abc4999e59c0208301996c6b66aa3c393d0db657", "chunk_index": 4}
{"text": "iod lasted for an extended period of time. Sometimes, it’shard to get afeel for what the mean volatility should be. Or sometimes, because of the event, the stock is fundamentally different—in the case of aspin-off, merger, or other corporate action, for example. When it is difficult or impossible to look back at astock’sperformance over the previous 6 to 12 months and appraise what the normal volatility should be, one can look to the volatility of other stocks in the same industry for some guidance.\nStocks that are substitutable for one another typically trade at similar volatilities. From arealized volatility perspective, this is rather intuitive. When one stock within an industry rises or falls, others within the same industry tend to follow. They trade similarly and therefore experience similar volatility patterns. If the stock volatility among names within one industry tends to be similar, it follows that the IV should be, too.\nRegardless which of the nine patterns discussed here show up, or how the volatilities line up, there is one overriding observation that’srepresentative of all volatility charts: vol charts are simply graphical representations of realized and implied volatility that help traders better understand the two volatilities’ interaction. But the divergences and convergences in the examples in this chapter have profound meaning to the volatility trader. Combined with acomparison of current and past volatility (both realized and implied), they give traders insight into how cheap or expensive options are.\nNote\n1\n. The following examples use charts supplied by\niVolatility.com\n. The gray line is the 30-day realized volatility, and the black line is the implied volatility.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00025.html", "doc_id": "0655265ab9c35d1af167ef38abc4999e59c0208301996c6b66aa3c393d0db657", "chunk_index": 5}
{"text": "CHAPTER 15\nStraddles and Strangles\nStraddles and strangles are the quintessential volatility strategies. They are the purest ways to buy and sell realized and implied volatility. This chapter discusses straddles and strangles, how they work, when to use them, what to look out for, and the differences between the two.\nLong Straddle\nDefinition\n: Buying one call and one put in the same option class, in the same expiration cycle, and with the same strike price.\nLinearly, the long straddle is the best of both worlds—long acall and aput. If the stock rises, the call enjoys the unlimited potential for profit while the put’slosses are decidedly limited. If the stock falls, the put’sprofit potential is bound only by the stock’sfalling to zero, while the call’spotential loss is finite. Directionally, this can be awin-win situation—as long as the stock moves enough for one option’sprofit to cover the loss on the other. The risk, however, is that this may not happen. Holding two long options means abig penalty can be paid for stagnant stocks.\nThe Basic Long Straddle\nThe long straddle is an option strategy to use when atrader is looking for abig move in astock but is uncertain which direction it will move. Technically, the Commodity Channel Index (CCI), Bollinger bands, or pennants are some examples of indicators which might signal the possibility of abreakout. Or fundamental data might call for arevaluation of the stock based on an impending catalyst. In either case, along straddle, is away for traders to position themselves for the expected move, without regard to direction. In this example, we’ll study ahypothetical $70 stock poised for abreakout. We’ll buy the one-month 70 straddle for 4.25.\nExhibit 15.1\nshows the payout of the straddle at expiration.\nEXHIBIT 15.1\nAt-expiration diagram for along straddle.\nAt expiration, with the stock at $70, neither the call nor the put is in-the-money. The straddle expires worthless, leaving aloss of 4.25 in its wake from erosion. If, however, the stock is above or below $70, either the call or the put will have at least some value. The farther the stock price moves from the strike price in either direction, the higher the net value of the options.\nAbove $70, the call has value. If the underlying is at $74.25 at expiration, the put will expire worthless, but the call will be worth 4.25—the price initially paid for the straddle. Above this break-even price, the trade is awinner, and the higher, the better. Below $70, the put has value. If the underlying is at $65.75 at expiration, the call expires, and the put is worth 4.25. Below this breakeven, the straddle is awinner, and the lower, the better.\nWhy It Works\nIn this basic example, if the underlying is beyond either of the break-even points at expiration, the trade is awinner. The key to understanding this is the fact that at expiration, the loss on one option is limited—it can only fall to zero—but the profit potential on the other can be unlimited.\nIn practice, most active traders will not hold astraddle until expiration. Even if the trade is not held to term, however, movement is still beneficial—in fact, it is more beneficial, because time decay will not have depleted all the extrinsic value of the options. Movement benefits the long straddle because of positive gamma. But movement is arace against the clock—arace against theta. Theta is the cost of trading the long straddle. Only pay it for as long as necessary. When the stock’svolatility appears poised to ebb, exit the trade.\nExhibit 15.2\nshows the P&(L) of the straddle both at expiration and at the time the trade was made.\nEXHIBIT 15.2\nLong straddle P&(L) at initiation and expiration.\nBecause this is ashort-term at-the-money (ATM) straddle, we will assume for simplicity that it has adelta of zero.\n1\nWhen the trade is consummated, movement can only help, as indicated by the dotted line on the exhibit. This is the classic graphic representation of positive gamma—the smiley face. When the stock moves higher, the call gains value at an increasing rate while the put loses value at adecreasing rate. When the stock moves lower, the put gains at an increasing rate while the call loses at adecreasing rate. This is positive gamma.\nThis still may not be an entirely fair representation of how profits are earned. The underlying is not required to move continuously in one direction for traders to reap gamma profits. As described in Chapter 13, traders can scalp gamma by buying and selling stock to offset long or short deltas created by movement in the underlying. When traders scalp gamma, they lock in profits as the stock price oscillates.\nThe potential for gamma scalping is an important motivation for straddle buyers. Gamma scalping astraddle gives traders the chance to profit from astock that has dynamic price swings. It should be second nature to volatility traders to understand that theta is the trade-off of gamma scalping.\nThe Big V\nGamma and theta are not alone in the straddle buye", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00027.html", "doc_id": "2e8922c1848a84fd77e846ef8955dcbda525ffe666cd33900c55cd83c338ae95", "chunk_index": 0}
{"text": "ation for straddle buyers. Gamma scalping astraddle gives traders the chance to profit from astock that has dynamic price swings. It should be second nature to volatility traders to understand that theta is the trade-off of gamma scalping.\nThe Big V\nGamma and theta are not alone in the straddle buyer’sthoughts. Vega is amajor consideration for astraddle buyer, as well. In astraddle, there are two long options of the same strike, which means double the vega risk of asingle-leg trade at that strike. With no short options in this spread, the implied-volatility exposure is concentrated. For example, if the call has avega of 0.05, the put’svega at that same strike will also be about 0.05. This means that buying one straddle gives the trader exposure of around 10 cents per implied volatility (IV) point. If IV rises by one point, the trader makes $10 per one-lot straddle, $20 for two points, and so on. If IV falls one point, the trader loses $10 per straddle, $20 for two points, and so on. Traders who want maximum positive exposure to volatility find it in long straddles.\nThis strategy is aprime example of the marriage of implied and realized volatility. Traders who buy straddles because they are bullish on realized volatility will also have bullish positions in implied volatility—like it or not. With this in mind, traders must take care to buy gamma via astraddle that it is not too expensive in terms of the implied volatility. Awinning gamma trade can quickly become aloser because of implied volatility. Likewise, traders buying straddles to speculate on an increase in implied volatility must take the theta risk of the trade very seriously. Time can eat away all atrade’svega profits and more. Realized and implied exposure go hand in hand.\nThe relationship between gamma and vega depends on, among other things, the time to expiration. Traders have some control over the amount of gamma relative to the amount of vega by choosing which expiration month to trade. The shorter the time until expiration, the higher the gammas and the lower the vegas of ATM options. Gamma traders may be better served by buying short-term contracts that coincide with the period of perceived high stock volatility.\nIf the intent of the straddle is to profit from vega, the choice of the month to trade depends on which month’svolatility is perceived to be too high or too low. If, for example, the front-month IV looks low compared with historical IV, current and historical realized volatility, and the expected future volatility, but the back months’ IVs are higher and more in line with these other metrics, there would be no point in buying the back-month options. In this case, traders would need to buy the month that they think is cheap.\nTrading the Long Straddle\nOption trading is all about optimizing the statistical chances of success. Along-straddle trade makes the most sense if traders think they can make money on both implied volatility and gamma. Many traders make the mistake of buying astraddle just before earnings are announced because they anticipate abig move in the stock. Of course, stock-price action is only half the story. The option premium can be extraordinarily expensive just before earnings, because the stock move is priced into the options. This is buying after the rush and before the crush. Although some traders are successful specializing in trading earnings, this is ahard way to make money.\nIdeally, the best time to buy volatility is before the move is priced in—that is, before everyone else does. This is conceptually the same as buying astock in anticipation of bullish news. Once news comes out, the stock rallies, and it is often too late to participate in profits. The goal is to get in at the beginning of the trend, not the end—the same goal as in trading volatility.\nAs in analyzing astock, fundamental and technical tools exist for analyzing volatility—namely, news and volatility charts. For fundamentals, buy the rumor, sell the news applies to the rush and crush of implied volatility. Previous chapters discussed fundamental events that affect volatility; be prepared to act fast when volatility-changing situations present themselves. With charts, the elementary concept of buy low, sell high is obvious, yet profound. Review Chapter 14 for guidance on reading volatility charts.\nWith all trading, getting in is easy. It’smanaging the position, deciding when to hedge and when to get out that is the tricky part. This is especially true with the long straddle. Straddles are intended to be actively managed. Instead of waiting for abig linear move to evolve over time, traders can take profits intermittently through gamma scalping. Furthermore, they hold the trade only as long as gamma scalping appears to be apromising opportunity.\nLegging Out\nThere are many ways to exiting astraddle. In the right circumstances, legging out is the preferred method. Instead of buying and selling stock to lock in profits and maintain delta neutrality, t", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00027.html", "doc_id": "2e8922c1848a84fd77e846ef8955dcbda525ffe666cd33900c55cd83c338ae95", "chunk_index": 1}
{"text": "ore, they hold the trade only as long as gamma scalping appears to be apromising opportunity.\nLegging Out\nThere are many ways to exiting astraddle. In the right circumstances, legging out is the preferred method. Instead of buying and selling stock to lock in profits and maintain delta neutrality, traders can reduce their positions by selling off some of the calls or puts that are part of the straddle. In this technique, when the underlying rises, traders sell as many calls as needed to reduce the delta to zero. As the underlying falls, they sell enough puts to reduce their position to zero delta. As the stock oscillates, they whittle away at the position with each hedging transaction. This serves the dual purpose of taking profits and reducing risk.\nAtrader, Susan, has been studying Acme Brokerage Co. (ABC). Susan has noticed that brokerage stocks have been fairly volatile in recent past.\nExhibit 15.3\nshows an analysis of Acme’svolatility over the past 30 days.\nEXHIBIT 15.3\nAcme Brokerage Co. volatility.\nStock Price\nRealized Volatility\nFront-Month Implied Volatility\n30-day high $78.66\n30-day high 47%\n30-day high 55%\n30-day low $66.94\n30-day low 36%\n30-day low 34%\nCurrent px $74.80\nCurrent vol 36%\nCurrent vol 36%\nDuring this period, Acme stock ranged more than $11 in price. In this example, Acme’svolatility is afunction of interest rate concerns and other macroeconomic issues affecting the brokerage industry as awhole. As the stock price begins to level off in the latter half of the 30-day period, realized volatility begins to ebb. The front month’s IV recedes toward recent lows as well. At this point, both realized and implied volatility converge at 36 percent. Although volatility is at its low for the past month, it is still relatively high for abrokerage stock under normal market conditions.\nSusan does not believe that the volatility plaguing this stock is over. She believes that an upcoming scheduled Federal Reserve Board announcement will lead to more volatility. She perceives this to be avolatility-buying opportunity. Effectively, she wants to buy volatility on the dip. Susan pays 5.75 for 20 July 75-strike straddles.\nExhibit 15.4\nshows the analytics of this trade with four weeks until expiration.\nEXHIBIT 15.4\nAnalytics for long 20 Acme Brokerage Co. 75-strike straddles.\nAs with any trade, the risk is that the trader is wrong. The risk here is indicated by the −2.07 theta and the +3.35 vega. Susan has to scalp an average of at least $207 aday just to break even against the time decay. And if IV continues to ebb down to alower, more historically normal, level, she needs to scalp even more to make up for vega losses.\nEffectively, Susan wants both realized and implied volatility to rise. She paid 36 volatility for the straddle. She wants to be able to sell the options at ahigher vol than 36. In the interim, she needs to cover her decay just to break even. But in this case, she thinks the stock will be volatile enough to cover decay and then some. If Acme moves at avolatility greater than 36, her chances of scalping profitably are more favorable than if it moves at less than 36 vol. The following is one possible scenario of what might have happened over two weeks after the trade was made.\nWeek One\nDuring the first week, the stock’svolatility tapered off abit more, but implied volatility stayed firm. After some oscillation, the realized volatility ended the week at 34 percent while IV remained at 36 percent. Susan was able to scalp stock reasonably well, although she still didn’tcover her seven days of theta. Her stock buys and sells netted again of $1,100. By the end of week one, the straddle was 5.10 bid. If she had sold the straddle at the market, she would have ended up losing $200.\nSusan decided to hold her position. Toward the end of week two, there would be the Federal Open Market Committee (FOMC) meeting.\nWeek Two\nThe beginning of the week saw IV rise as the event drew near. By the close on Tuesday, implied volatility for the straddle was 40 percent. But realized volatility continued its decline, which meant Susan was not able to scalp to cover the theta of Saturday, Sunday, Monday, and Tuesday. But, the straddle was now 5.20 bid, 0.10 higher than it had been on previous Friday. The rising IV made up for most of the theta loss. At this point, Susan could have sold her straddle to scratch her trade. She would have lost $1,100 on the straddle [(5.20 − 5.75) × 20] but made $1,100 by scalping gamma in the first week. Susan decided to wait and see what the Fed chairman had to say.\nBy week’send, the trade had proved to be profitable. After the FOMC meeting, the stock shot up more than $4 and just as quickly fell. It continued to bounce around abit for the rest of the week. Susan was able to lock in $5,200 from stock scalps. After much gyration over this two-week period, the price of Acme stock incidentally returned to around the same price it had been at when Susan bought her straddle: $74.50. As might h", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00027.html", "doc_id": "2e8922c1848a84fd77e846ef8955dcbda525ffe666cd33900c55cd83c338ae95", "chunk_index": 2}
{"text": "ll. It continued to bounce around abit for the rest of the week. Susan was able to lock in $5,200 from stock scalps. After much gyration over this two-week period, the price of Acme stock incidentally returned to around the same price it had been at when Susan bought her straddle: $74.50. As might have been expected after the announcement, implied volatility softened. By Friday, IV had fallen to 30. Realized volatility was sharply higher as aresult of the big moves during the week that were factored into the 30-day calculation.\nWith seven more days of decay and alower implied volatility, the straddle was 3.50 bid at midafternoon on Friday. Susan sold her 20-lot to close the position. Her profit for week two was $2,000.\nWhat went into Susan’sdecision to close her position? Susan had two objectives: to profit from arise in implied volatility and to profit from arise in realized volatility. The rise in IV did indeed occur, but not immediately. By Tuesday of the second week, vega profits were overshadowed by theta losses.\nGamma was the saving grace with this trade. The bulk of the gain occurred in week two when the Fed announcement was made. Once that event passed, the prospects for covering theta looked less attractive. They were further dimmed by the sharp drop in implied volatility from 40 to 30.\nIn this hypothetical scenario, the trade ended up profitable. This is not always the case. Here the profit was chiefly produced by one or two high-volatility days. Had the stock not been unusually volatile during this time, the trade would have been acertain loser. Even though implied volatility had risen four points by Tuesday of the second week, the trade did not yield aprofit. The time decay of holding two options can make long straddles atough strategy to trade.\nShort Straddle\nDefinition\n: Selling one call and one put in the same option class, in the same expiration cycle, and with the same strike price.\nJust as buying astraddle is apure way to buy volatility, selling astraddle is away to short it. When atrader’sforecast calls for lower implied and realized volatility, astraddle generates the highest returns of all volatility-selling strategies. Of course, with high reward necessarily comes high risk. Ashort straddle is one of the riskiest positions to trade.\nLet’slook at aone-month 70-strike straddle sold at 4.25.\nThe risk is easily represented graphically by means of a P&(L) diagram.\nExhibit 15.5\nshows the risk and reward of this short straddle.\nEXHIBIT 15.5\nShort straddle P&(L) at initiation and expiration.\nIf the straddle is held until expiration and the underlying is trading below the strike price, the short put is in-the-money (ITM). The lower the stock, the greater the loss on the +1.00 delta from the put. The trade as awhole will be aloser if the underlying is below the lower of the two break-even points—in this case $65.75. This point is found by subtracting the premium received from the strike. Before expiration, negative gamma adversely affects profits as the underlying falls. The lower the underlying is trading below the strike price, the greater the drain on P&(L) due to the positive delta of the short put.\nIt is the same proposition if the underlying is above $70 at expiration. But in this case, it is the short call that would be in-the-money. The higher the underlying price, the more the −1.00 delta adversely impacts P&(L). If at expiration the underlying is above the higher breakeven, which in this case is $74.25 (the strike plus the premium), the trade is aloser. The higher the underlying, the worse off the trade. Before expiration, negative gamma creates negative deltas as the underlying climbs above the strike, eating away at the potential profit, which is the net premium received.\nThe best-case scenario is that the underlying is right at $70 at the closing bell on expiration Friday. In this situation, neither option is ITM, meaning that the 4.25 premium is all profit. In reaping the maximum profit, both time and price play roles. If the position is closed before expiration, implied volatility enters into the picture as well.\nIt’simportant to note that just because neither option is ITM if the underlying is right at $70 at expiration, it doesn’tmean with certainty that neither option will be assigned. Sometimes options that are ATM or even out-of-the-money (OTM) get assigned. This can lead to apleasant or unpleasant surprise the Monday morning following expiration. The risk of not knowing whether or not you will be assigned—that is, whether or not you have aposition in the underlying security—is arisk to be avoided. It is the goal of every trader to remove unnecessary risk from the equation. Buying the call and the put for 0.05 or 0.10 to close the position is asmall price to pay when one considers the possibility of waking up Monday morning to find aloss of hundreds of dollars per contract because aposition you didn’teven know you owned had moved against you. Most traders avoid this risk, ref", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00027.html", "doc_id": "2e8922c1848a84fd77e846ef8955dcbda525ffe666cd33900c55cd83c338ae95", "chunk_index": 3}
{"text": "the call and the put for 0.05 or 0.10 to close the position is asmall price to pay when one considers the possibility of waking up Monday morning to find aloss of hundreds of dollars per contract because aposition you didn’teven know you owned had moved against you. Most traders avoid this risk, referred to as pin risk, by closing short options before expiration.\nThe Risks with Short Straddles\nLooking at an at-expiration diagram or even analyzing the gamma/theta relationship of ashort straddle may sometimes lead to afalse sense of comfort. Sometimes it looks as if short straddles need apretty big move to lose alot of money. So why are they definitely among the riskiest strategies to trade? That is amatter of perspective.\nOption trading is about risk management. Dealing with aproverbial train wreck every once in awhile is part of the game. But the big disasters can end one’strading career in an instant. Because of its potential—albeit sometimes small potential—for acolossal blowup, the short straddle is, indeed, one of the riskiest positions one can trade. That said, it has aplace in the arsenal of option strategies for speculative traders.\nTrading the Short Straddle\nAshort straddle is atrade for highly speculative traders who think asecurity will trade within adefined range and that implied volatility is too high. While along straddle needs to be actively traded, ashort straddle needs to be actively monitored to guard against negative gamma. As adverse deltas get bigger because of stock price movement, traders have to be on alert, ready to neutralize directional risk by offsetting the delta with stock or by legging out of the options. To be sure, with ashort straddle, every stock trade locks in aloss with the intent of stemming future losses. The ideal situation is that the straddle is held until expiration and expires with the underlying right at $70 with no negative-gamma scalping.\nShort-straddle traders must take alonger-term view of their positions than long-straddle traders. Often with short straddles, it is ultimately time that provides the payout. While long straddle traders would be inclined to watch gamma and theta very closely to see how much movement is required to cover each day’serosion, short straddlers are more inclined to focus on the at-expiration diagram so as not to lose sight of the end game.\nThere are some situations that are exceptions to this long-term focus. For example, when implied volatility gets to be extremely high for aparticular option class relative to both the underlying stock’svolatility and the historical implied volatility, one may want to sell astraddle to profit from afall in IV. This can lead to leveraged short-term profits if implied volatility does, indeed, decline.\nBecause of the fact that there are two short options involved, these straddles administer aconcentrated dose of negative vega. For those willing to bet big on adecline in implied volatility, ashort straddle is an eager croupier. These trades are delta neutral and double the vega of asingle-leg trade. But they’re double the gamma, too. As with the long straddle, realized and implied volatility levels are both important to watch.\nShort-Straddle Example\nFor this example, atrader, John, has been watching Federal XYZ Corp. (XYZ) for ayear. During the 12 months that John has followed XYZ, its front-month implied volatility has typically traded at around 20 percent, and its realized volatility has fluctuated between 15 and 20 percent. The past 30 days, however, have been abit more volatile.\nExhibit 15.6\nshows XYZ’srecent volatility.\nEXHIBIT 15.6\nXYZ volatility.\nStock Price\nRealized Volatility\nFront-Month Implied Volatility\n30-day high $111.71\n30-day high 26%\n30-day high 30%\n30-day low $102.05\n30-day low 21%\n30-day low 24%\nCurrent px $104.75\nCurrent vol 22%\nCurrent vol 26%\nThe stock volatility has begun to ease, trading now at a 22 volatility compared with the 30-day high of 26, but still not down to the usual 15-to-20 range. The stock, in this scenario, has traded in achannel. It currently lies in the lower half of its recent range. Although the current front-month implied volatility is in the lower half of its 30-day range, it’shistorically high compared with the 20 percent level that John has been used to seeing, and it’sstill four points above the realized volatility. John believes that the conditions that led to the recent surge in volatility are no longer present. His forecast is for the stock volatility to continue to ease and for implied volatility to continue its downtrend as well and revert to its long-term mean over the next week or two. John sells 10 September 105 straddles at 5.40.\nExhibit 15.7\nshows the greeks for this trade.\nEXHIBIT 15.7\nGreeks for short XYZ straddle.\nThe goal here is for implied volatility to fall to around 20. If it does, John makes $1,254 (6 vol points × 2.09 vega). He also thinks theta gains will outpace gamma losses. The following is atwo-week examination of one possible outco", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00027.html", "doc_id": "2e8922c1848a84fd77e846ef8955dcbda525ffe666cd33900c55cd83c338ae95", "chunk_index": 4}
{"text": "reeks for this trade.\nEXHIBIT 15.7\nGreeks for short XYZ straddle.\nThe goal here is for implied volatility to fall to around 20. If it does, John makes $1,254 (6 vol points × 2.09 vega). He also thinks theta gains will outpace gamma losses. The following is atwo-week examination of one possible outcome for John’strade.\nWeek One\nThe first week in this example was aprofitable one, but it came with challenges. John paid for his winnings with afew sleepless nights. On the Monday following his entry into the trade, the stock rose to $106. While John collected aweekend’sworth of time decay, the $1.25 jump in stock price ate into some of those profits and naturally made him uneasy about the future.\nAt this point, John was sitting on aprofit, but his position delta began to grow negative, to around −1.22 [(–1.18 × 1.25) + 0.26]. For a $104.75 stock, amove of $1.25—or just over 1 percent—is not out of the ordinary, but it put John on his guard. He decided to wait and see what happened before hedging.\nThe following day, the rally continued. The stock was at $107.30 by noon. His delta was around −3. In the face of an increasingly negative delta, John weighed his alternatives: He could buy back some of his calls to offset his delta, which would have the added benefit of reducing his gamma as well. He could buy stock to flatten out. Lastly, he could simply do nothing and wait. John felt the stock was overbought and might retrace. He also still believed volatility would fall. He decided to be patient and enter astop order to buy all of his deltas at $107.50 in case the stock continued trending up. The XYZ shares closed at $107.45 that day.\nThis time inaction proved to be the best action. The stock did retrace. Week one ended with Federal XYZ back down around $105.50. The IV of the straddle was at 23. The straddle finished up week one offered at $4.10.\nWeek Two\nThe future was looking bright at the start of week two until Wednesday. Wednesday morning saw XYZ gap open to $109. When you have ashort straddle, a $3.50 gap move in the underlying tends to instantly give you asinking feeling in the pit of your stomach. But the damage was truly not that bad. The offer in the straddle was 4.75, so the position was still awinner if John bought it back at this point.\nGamma/delta hurt. Theta helped. Acharacteristic that enters into this trade is volatility’schanging as aresult of movement in the stock price. Despite the fact that the stock gapped $3.50 higher, implied volatility fell by 1 percent, to 22. This volatility reaction to the underlying’srise in price is very common in many equity and index options. John decided to close the trade. Nobody ever went broke taking aprofit.\nThe trade in this example was profitable. Of course, this will not always be the case. Sometimes short straddles will be losers—sometimes big ones. Big moves and rising implied volatility can be perilous to short straddles and their writers. If the XYZ stock in the previous example had gapped up to $115—which is not an unreasonable possibility—John’strade would have been ugly.\nSynthetic Straddles\nStraddles are the pet strategy of certain professional traders who specialize in trading volatility. In fact, in the mind of many of these traders, astraddle is all there is. Any single-legged trade can be turned into astraddle synthetically simply by adding stock.\nChapter 6 discussed put-call parity and showed that, for all intents and purposes, aput is acall and acall is aput. For the most part, the greeks of the options in the put-call pair are essentially the same. The delta is the only real difference. And, of course, that can be easily corrected. As amatter of perspective, one can make the case that buying two calls is essentially the same as buying acall and aput, once stock enters into the equation.\nTake anon-dividend-paying stock trading at $40 ashare. With 60 days until expiration, a 25 volatility, and a 4 percent interest rate, the greeks of the 40-strike calls and puts of the straddle are as follows:\nEssentially, the same position can be created by buying one leg of the spread synthetically. For example, in addition to buying one 40 call, another 40 call can be purchased along with shorting 100 shares of stock to create a 40 put synthetically.\nCombined, the long call and the synthetic long put (long call plus short stock) creates asynthetic straddle. Along synthetic straddle could have similarly been constructed with along put and along synthetic call (long put plus long stock). Furthermore, ashort synthetic straddle could be created by selling an option with its synthetic pair.\nNotice the similarities between the greeks of the two positions. The synthetic straddle functions about the same as aconventional straddle. Because the delta and gamma are nearly the same, the up-and-down risk is nearly the same. Time and volatility likewise affect the two trades about the same. The only real difference is that the synthetic straddle might require abit more cash up", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00027.html", "doc_id": "2e8922c1848a84fd77e846ef8955dcbda525ffe666cd33900c55cd83c338ae95", "chunk_index": 5}
{"text": "dle functions about the same as aconventional straddle. Because the delta and gamma are nearly the same, the up-and-down risk is nearly the same. Time and volatility likewise affect the two trades about the same. The only real difference is that the synthetic straddle might require abit more cash up front, because it requires buying or shorting the stock. In practice, straddles will typically be traded in accounts with retail portfolio margining or professional margin requirements (which can be similar to retail portfolio margining). So the cost of the long stock or margin for short stock is comparatively small.\nLong Strangle\nDefinition\n: Buying one call and one put in the same option class, in the same expiration cycle, but with different strike prices. Typical long strangles involve an OTM call and an OTM put. Astrangle in which an ITM call and an ITM put are purchased is called along guts strangle.\nAlong strangle is similar to along straddle in many ways. They both require buying acall and aput on the same class in the same expiration month. They are both buying volatility. There are, however, some functional differences. These differences stem from the fact that the options have different strike prices.\nBecause there is distance between the strike prices, from an at-expiration perspective, the underlying must move more for the trade to show aprofit.\nExhibit 15.8\nillustrates the payout of options as part of along strangle on a $70 stock. The graph is much like that of\nExhibit 15.1\n, which shows the payout of along straddle. But the net cost here is only 1.00, compared with 4.25 for the straddle with the same time and volatility inputs. The cost is lower because this trade consists of OTM options instead of ATM options. The breakdown is as follows:\nEXHIBIT 15.8\nLong strangle at-expiration diagram.\nThe underlying has abit farther to go by expiration for the trade to have value. If the underlying is above $75 at expiration, the call is ITM and has value. If the underlying is below $65 at expiration, the put is ITM and has value. If the underlying is between the two strike prices at expiration both options expire and the 1.00 premium is lost.\nAn important difference between astraddle and astrangle is that if astrangle is held until expiration, its break-even points are farther apart than those of acomparable straddle. The 70-strike straddle in\nExhibit 15.1\nhad alower breakeven of $65.75 and an upper break-even of $74.25. The comparable strangle in this example has break-even prices of $64 and $76.\nBut what if the strangle is not held until expiration? Then the trade’sgreeks must be analyzed. Intuitively, two OTM options (or ITM ones, for that matter) will have lower gamma, theta, and vega than two comparable ATM options. This has atwo-handed implication when comparing straddles and strangles.\nOn the one hand, from arealized volatility perspective, lower gamma means the underlying must move more than it would have to for astraddle to produce the same dollar gain per spread, even intraday. But on the other hand, lower theta means the underlying doesn’thave to move as much to cover decay. Alower nominal profit but ahigher percentage profit is generally reaped by strangles as compared with straddles.\nAlong strangle composed of two OTM options will also give positive exposure to implied volatility but, again, not as much as an ATM straddle would. Positive vega really kicks in when the underlying is close to one of the strike prices. This is important when anticipating changes in the stock price and in IV.\nSay atrader expects implied volatility to rise as aresult of higher stock volatility. As the stock rises or falls, the strangle will move toward the price point that offers the highest vega (the strike). With astraddle, the stock will be moving away from the point with the highest vega. If the stock doesn’tmove as anticipated, the lower theta and vega of the strangle compared with the ATM straddle have aless adverse effect on P&L.\nLong-Strangle Example\nLet’sreturn to Susan, who earlier in this chapter bought astraddle on Acme Brokerage Co. (ABC). Acme currently trades at $74.80 ashare with current realized volatility at 36 percent. The stock’svolatility range for the past month was between 36 and 47. The implied volatility of the four-week options is 36 percent. The range over the past month for the IV of the front month has been between 34 and 55.\nAs in the long-straddle example earlier in this chapter, there is agreat deal of uncertainty in brokerage stocks revolving around interest rates, credit-default problems, and other economic issues. An FOMC meeting is expected in about one week’stime about whose possible actions analysts’ estimates vary greatly, from acut of 50 basis points to no cut at all. Add apending earnings release to the docket, and Susan thinks Acme may move quite abit.\nIn this case, however, instead of buying the 75-strike straddle, Susan pays 2.35 for 20 one-month 70–80 strangles.\nExhibit 15.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00027.html", "doc_id": "2e8922c1848a84fd77e846ef8955dcbda525ffe666cd33900c55cd83c338ae95", "chunk_index": 6}
{"text": "ions analysts’ estimates vary greatly, from acut of 50 basis points to no cut at all. Add apending earnings release to the docket, and Susan thinks Acme may move quite abit.\nIn this case, however, instead of buying the 75-strike straddle, Susan pays 2.35 for 20 one-month 70–80 strangles.\nExhibit 15.9\ncompares the greeks of the long ATM straddle with those of the long strangle.\nEXHIBIT 15.9\nLong straddle versus long strangle.\nThe cost of the strangle, at 2.35, is about 40 percent of the cost of the straddle. Of course, with two long options in each trade, both have positive gamma and vega and negative theta, but the exposure to each metric is less with the strangle. Assuming the same stock-price action, astrangle would enjoy profits from movement and losses from lack of movement that were similar to those of astraddle—just nominally less extreme.\nFor example, if Acme stock rallies $5, from $74.80 to $79.80, the gamma of the 75 straddle will grow the delta favorably, generating again of 1.50, or about 25 percent. The 70–80 strangle will make 1.15 from the curvature of the delta–almost a 50 percent gain.\nWith the straddle and especially the strangle, there is one more detail to factor in when considering potential P&L: IV changes due to stock price movement. IV is likely to fall as the stock rallies and rise as the stock declines. The profits of both the long straddle and the long strangle would likely be adversely affected by IV changes as the stock rose toward $79.80. And because the stock would be moving away from the straddle strike and toward one of the strangle strikes, the vegas would tend to become more similar for the two trades. The straddle in this example would have avega of 2.66, while the strangle’svega would be 2.67 with the underlying at $79.80 per share.\nShort Strangle\nDefinition\n: Selling one call and one put in the same option class, in the same expiration cycle, but with different strike prices. Typically, an OTM call and an OTM put are sold. Astrangle in which an ITM call and an ITM put are sold is called ashort guts strangle.\nAshort strangle is avolatility-selling strategy, like the short straddle. But with the short strangle, the strikes are farther apart, leaving more room for error. With these types of strategies, movement is the enemy. Wiggle room is the important difference between the short-strangle and short-straddle strategies. Of course, the trade-off for ahigher chance of success is lower option premium.\nExhibit 15.10\nshows the at-expiration diagram of ashort strangle sold at 1.00, using the same options as in the diagram for the long strangle.\nEXHIBIT 15.10\nShort strangle at-expiration diagram.\nNote that if the underlying is between the two strike prices, the maximum gain of 1.00 is harvested. With the stock below $65 at expiration, the short put is ITM, with a +1.00 delta. If the stock price is below the lower breakeven of $64 (the put strike minus the premium), the trade is aloser. The lower the stock, the bigger the loss. If the underlying is above $75, the short call is ITM, with a −1.00 delta. If the stock is above the upper breakeven of $76 (the call strike plus the premium), the trade is aloser. The higher the stock, the bigger the loss.\nIntuitively, the signs of the greeks of this strangle should be similar to those of ashort straddle—negative gamma and vega, positive theta. That means that increased realized volatility hurts. Rising IV hurts. And time heals all wounds—unless, of course, the wounds caused by gamma are greater than the net premium received.\nThis brings us to an important philosophical perspective that emphasizes the differences between long straddles and strangles and their short counterparts. Losses from rising vega are temporary; the time value of all options will be zero at expiration. But gamma losses can be permanent and profound. These short strategies have limited profit potential and unlimited loss potential. Although short-term profits (or losses) can result from IV changes, the real goal here is to capture theta.\nShort-Strangle Example\nLet’srevisit John, a Federal XYZ (XYZ) trader. XYZ is at $104.75 in this example, with an implied volatility of 26 percent and astock volatility of 22. Both implied and realized volatility are higher than has been typical during the past twelve months. John wants to sell volatility. In this example, he believes the stock price will remain in afairly tight range, causing realized volatility to revert to its normal level, in this case between 15 and 20 percent.\nHe does everything possible to ensure success. This includes scanning the news headlines on XYZ and its financials for areason not to sell volatility. Playing devil’sadvocate with oneself can uncover unforeseen yet valid reasons to avoid making bad trades. John also notes the recent price range, which has been between $111.71 and $102.05 over the past month. Once John commits to an outlook on the stock, he wants to set himself up for maximum gain if he’srigh", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00027.html", "doc_id": "2e8922c1848a84fd77e846ef8955dcbda525ffe666cd33900c55cd83c338ae95", "chunk_index": 7}
{"text": "il’sadvocate with oneself can uncover unforeseen yet valid reasons to avoid making bad trades. John also notes the recent price range, which has been between $111.71 and $102.05 over the past month. Once John commits to an outlook on the stock, he wants to set himself up for maximum gain if he’sright and, for that matter, to maximize his chances of being right. In this case, he decides to sell astrangle to give himself as much margin for error as possible. He sells 10 three-week 100–110 strangles at 1.80.\nExhibit 15.11\ncompares the greeks of this strangle with those of the 105 straddle.\nEXHIBIT 15.11\nShort straddle vs. short strangle.\nAs expected, the strangle’sgreeks are comparable to the straddle’sbut of less magnitude. If John’sintention were to capture adrop in IV, he’dbe better off selling the bigger vega of the straddle. Here, though, he wants to see the premium at zero at expiration, so the strangle serves his purposes better. What he is most concerned about are the breakevens—in this case, 98.20 and 111.8. The straddle has closer break-even points, of $99.60 and $110.40.\nDespite the fact that in this case, John is not really trading the greeks or IV per se, they still play an important role in his trade. First, he can use theta to plan the best strangle to trade. In this case, he sells the three-week strangle because it has the highest theta of the available months. The second month strangle has a −0.71 theta, and the third month has a −0.58 theta. With strangles, because the options are OTM, this disparity in theta among the tradable months may not always be the case. But for this trade, if he is still bearish on realized volatility after expiration, John can sell the next month when these options expire.\nCertainly, he will monitor his risk by watching delta and gamma. These are his best measures of directional exposure. He will consider implied volatility in the decision-making process, too. An implied volatility significantly higher than the realized volatility can be ared flag that the market expects something to happen, but there’sabigger payoff if there is no significant volatility. An IV significantly lower than the realized can indicate the risk of selling options too cheaply: the premium received is not high enough, based on how much the stock has been moving. Ideally, the IV should be above the realized volatility by between 2 and 20 percent, perhaps more for highly speculative traders.\nLimiting Risk\nThe trouble with short straddles and strangles is that every once in awhile the stock unexpectedly reacts violently, moving by three or more standard deviations. This occurs when there is atakeover, an extreme political event, alegal action, or some other extraordinary incident. These events can be guarded against by buying farther OTM options for protection. Essentially, instead of selling astraddle or astrangle, one sells an iron butterfly or iron condor. Then, when disaster strikes, it’snot acomplete catastrophe.\nHow Cheap Is Too Cheap?\nAt some point, the absolute premium simply is not worth the risk of the trade. For example, it would be unwise to sell atwo-month 45–55 strangle for 0.10 no matter what the realized volatility was. With the knowledge that there is always achance for abig move, it’shard to justify risking dollars to make adime.\nNote\n1\n. This depends on interest, dividends, and time to expiration. The delta will likely not be exactly zero.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00027.html", "doc_id": "2e8922c1848a84fd77e846ef8955dcbda525ffe666cd33900c55cd83c338ae95", "chunk_index": 8}
{"text": "CHAPTER 16\nRatio Spreads and Complex Spreads\nThe purpose of spreading is to reduce risk. Buying one contract and selling another can reduce some or all of atrade’srisks, as measured by the greeks, compared with simply holding an outright option. But creative traders have the ability to exercise great control over their greeks risk. They can practically eliminate risk in some greeks, while retaining risks in just the desired greeks. To do so, traders may have to use more complex, and less conventional spreads. These spreads often involve buying or selling options in quantities other than one-to-one ratios.\nRatio Spreads\nThe simplest versions of these strategies used by retail traders, institutional traders, proprietary traders, and others are referred to as\nratio spreads\n. In ratio spreads, options are bought and sold in quantities based on aratio. For example, a 1:3 spread is when one option is bought (or sold) and three are sold (or bought)—aratio of one to three. This kind of ratio spread would be called a “one-by-three.”\nHowever, some option positions can get alot more complicated. Market makers and other professional traders manage acomplex inventory of long and short options. These types of strategies go way beyond simple at-expiration diagrams. This chapter will discuss the two most common types of ratio spreads—backspreads and ratio vertical spreads—and also the delta-neutral position management of market makers and other professional traders.\nBackspreads\nDefinition\n: An option strategy consisting of more long options than short options having the same expiration month. Typically, the trader is long calls (or puts) in one series of options and short afewer number of calls (or puts) in another series with the same expiration month in the same option class. Some traders, such as market makers, refer generically to any delta-neutral long-gamma position as abackspread.\nShades of Gray\nIn its simplest form, trading abackspread is trading aone-by-two call or put spread and holding it until expiration in hopes that the underlying stock’sprice will make abig move, particularly in the more favorable direction. But holding abackspread to expiration as described has its challenges. Let’slook at ahypothetical example of abackspread held to term and its at-expiration diagram.\nWith the stock at $71 and one month until March expiration:\nIn this example, there is acredit of 3.20 from the sale of the 70 call and adebit of 1.10 for each of the two 75 calls. This yields atotal net credit of 1.00 (3.20 − 1.10 − 1.10). Let’sconsider how this trade performs if it is held until expiration.\nIf the stock falls below $70 at expiration, all the calls expire and the 1.00 credit is all profit. If the stock is between $70 and $75 at expiration, the 70 call is in-the-money (ITM) and the −1.00 delta starts racking up losses above the breakeven of $71 (the strike plus the credit). At $75 ashare this trade suffers its maximum potential loss of $4. If the stock is above $75 at expiration, the 75 calls are ITM. The net delta of +1.00, resulting from the +2.00 deltas of the 75 calls along with the −1.00 delta of the 70 call, makes money as the stock rises. To the upside, the trade is profitable once the stock is at ahigh enough price for the gain on the two 75 calls to make up for the loss on the 70 call. In this case, the breakeven is $79 (the $4 maximum potential loss plus the strike price of 75).\nWhile it’sgood to understand this at-expiration view of this trade, this diagram is abit misleading. What does the trader of this spread want to have happen? If the trader is bearish, he could find abetter way to trade his view than this, which limits his gains to 1.00—he could buy aput. If the trader believes the stock will make avolatile move in either direction, the backspread offers adecidedly limited opportunity to the downside. Astraddle or strangle might be abetter choice. And if the trader is bullish, he would have to be very bullish for this trade to make sense. The underlying needs to rise above $79 just to break even. If instead he just bought 2 of the 75 calls for 1.10, the maximum risk would be 2.20 instead of 4, the breakeven would be $77.20 instead of $79, and profits at expiration would rack up twice as fast above the breakeven, since the trader is net long two calls instead of one. Why would atrader ever choose to trade abackspread?\nEXHIBIT 16.1\nBackspread at expiration.\nThe backspread is acomplex spread that can be fully appreciated only when one has athorough knowledge of options. Instead of waiting patiently until expiration, an experienced backspreader is more likely to gamma scalp intermittent opportunities. This requires trading alarge enough position to make scalping worthwhile. It also requires appropriate margining (either professional-level margin requirements or retail portfolio margining). For example, this 1:2 contract backspread has adelta of −0.02 and agamma of +0.05. Fewer than 10 deltas could be scalped if th", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00028.html", "doc_id": "73fc246bbbe60ff983eeab4443312e5b9f6cfcc18ad387b1d757f11e98e2503c", "chunk_index": 0}
{"text": "ing alarge enough position to make scalping worthwhile. It also requires appropriate margining (either professional-level margin requirements or retail portfolio margining). For example, this 1:2 contract backspread has adelta of −0.02 and agamma of +0.05. Fewer than 10 deltas could be scalped if the stock moves up and down by one point. It becomes amore practical trade as the position size increases. Of course, more practical doesn’tnecessarily guarantee it will be more profitable. The market must cooperate!\nBackspread Example\nLet’ssay a 20:40 contract backspread is traded. (\nNote\n: In trader lingo this is still called aone-by-two; it is just traded 20 times.) The spread price is still 1.00 credit per contract; in this case, that’s $2,000. But with this type of trade, the spread price is not the best measure of risk or reward, as it is with some other kinds of spreads. Risk and reward are best measured by delta, gamma, theta, and vega.\nExhibit 16.2\nshows this trade’sgreeks.\nEXHIBIT 16.2\nGreeks for 20:40 backspread with the underlying at $71.\nBackspreads are volatility plays. This spread has a +1.07 vega with the stock at $71. It is, therefore, abullish implied volatility (IV) play. The IV of the long calls, the 75s, is 30 percent, and that of the 70s is 32 percent. Much as with any other volatility trade, traders would compare current implied volatility with realized volatility and the implied volatility of recent past and consider any catalysts that might affect stock volatility. The objective is to buy an IV that is lower than the expected future stock volatility, based on all available data. The focus of traders of this backspread is not the dollar credit earned. They are more interested in buying a 30 volatility—that’sthe focus.\nBut the 75 calls’ IV is not the only volatility figure to consider. The short options, the 70s, have implied volatility of 32 percent. Because of their lower strike, the IV is naturally higher for the 70 calls. This is vertical skew and is described in Chapter 3. The phenomenon of lower strikes in the same option class and with the same expiration month having higher IV is very common, although it is not always the case.\nBackspreads usually involve trading vertical skew. In this spread, traders are buying a 30 volatility and selling a 32 volatility. In trading the skew, the traders are capturing two volatility points of what some traders would call edge by buying the lower volatility and selling the higher.\nBased on the greeks in\nExhibit 16.2\n, the goal of this trade appears fairly straightforward: to profit from gamma scalping and rising IV. But, sadly, what appears to be straightforward is not.\nExhibit 16.3\nshows the greeks of this trade at various underlying stock prices.\nEXHIBIT 16.3\n70–75 backspread greeks at various stock prices.\nNotice how the greeks change with the stock price. As the stock price moves lower through the short strike, the 70 strike calls become the more relevant options, outweighing the influence of the 75s. Gamma and vega become negative, and theta becomes positive. If the stock price falls low enough, this backspread becomes avery different position than it was with the stock price at $71. Instead of profiting from higher implied and realized volatility, the spread needs alower level of both to profit.\nThis has important implications. First, gamma traders must approach the backspread alittle differently than they would most spreads. The backspread traders must keep in mind the dynamic greeks of the position. With atrade like along straddle, in which there are no short options, traders scalping gamma simply buy to cover short deltas as the stock falls and sell to cover long deltas as the stock rises. The only risks are that the stock may not move enough to cover theta or that the traders may cover deltas too soon to maximize profits.\nWith the backspread, the changing gamma adds one more element of risk. In this example, buying stock to flatten out delta as the stock falls can sometimes be apremature move. Traders who buy stock may end up with more long deltas than they bargained for if the stock falls into negative-gamma territory.\nExhibit 16.3\nshows that with the stock at $68, the delta for this trade is −2.50. If the traders buy 250 shares at $68, they will be delta neutral. If the stock subsequently falls to $62 ashare, instead of being short 1.46 deltas, as the figure indicates, they will be long 1.04 because of the 250 shares they bought. These long deltas start to hurt as the stock continues lower. Backspreaders must therefore anticipate stock movements to avoid overhedging. The traders in this example may decide to lean short if the stock shows signs of weakness.\nLeaning short means that if the delta is −2.50 at $68 ashare, the traders may decide to underhedge by buying just 100 or 200 shares. If the stock continues to fall and negative gamma kicks in, this gives the traders some cushion to the downside. The short delta of the position moves clos", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00028.html", "doc_id": "73fc246bbbe60ff983eeab4443312e5b9f6cfcc18ad387b1d757f11e98e2503c", "chunk_index": 1}
{"text": "f weakness.\nLeaning short means that if the delta is −2.50 at $68 ashare, the traders may decide to underhedge by buying just 100 or 200 shares. If the stock continues to fall and negative gamma kicks in, this gives the traders some cushion to the downside. The short delta of the position moves closer to being flat as the stock falls. Because there is along strike and ashort strike in this delta-neutral position, trading ratio spreads is like trading along and ashort volatility position at the same time. Trading backspreads is not an exact science. The stock has just as good achance of rising as it does of falling, and if it does rise and the traders have underhedged at $68, they will not participate in all the gains they would have if they had fully hedged by buying 250 shares of stock. If trading were easy, everyone would do it!\nBackspreaders must also be conscious of the volatility of each leg of the spread. There is an inherent advantage in this example to buying the lower volatility of the 75 calls and selling the higher volatility of the 70 calls. But there is also implied risk. Equity prices and IV tend to have an inverse relationship. When stock prices fall—especially if the drop happens quickly—IV will often rise. When stock prices rise, IV often falls.\nIn this backspread example, as the stock price falls to or through the short strike, vega becomes negative in the face of apotentially rising IV. As the stock price rises into positive vega turf, there is the risk of IV’sdeclining. Adynamic volatility forecast should be part of abackspread-trading plan. One of the volatility questions traders face in this example is whether the two-point volatility skew between the two strike prices is enough to compensate for the potential adverse vega move as the stock price changes.\nPut backspreads have the opposite skew/volatility issues. Buying two lower-strike puts against one higher-strike put means the skew is the other direction—buying the higher IV and selling the lower. The put backspread would have long gamma/vega to the downside and short gamma/vega to the upside. But if the vega firms up as the stock falls into positive-vega territory, it would be in the trader’sfavor. As the stock rises, leading to negative vega, there is the potential for vega profits if IV indeed falls. There are alot of things to consider when trading abackspread. Agood trader needs to think about them all before putting on the trade.\nRatio Vertical Spreads\nDefinition\n: An option strategy consisting of more short options than long options having the same expiration month. Typically, the trader is short calls (or puts) in one series of options and long afewer number of calls (or puts) in another series in the same expiration month on the same option class.\nAratio vertical spread, like abackspread, involves options struck at two different prices—one long strike and one short. That means that it is avolatility strategy that may be long or short gamma or vega depending on where the underlying price is at the time. The ratio vertical spread is effectively the opposite of abackspread. Let’sstudy aratio vertical using the same options as those used in the backspread example.\nWith the stock at $71 and one month until March expiration:\nIn this case, we are buying one ITM call and selling two OTM calls. The relationship of the stock price to the strike price is not relevant to whether this spread is considered aratio vertical spread. Certainly, all these options could be ITM or OTM at the time the trade is initiated. It is also not important whether the trade is done for adebit or acredit. If the stock price, time to expiration, volatility, or number of contracts in the ratio were different, this could just as easily been acredit ratio vertical.\nExhibit 16.4\nillustrates the payout of this strategy if both legs of the 1:2 contract are still open at expiration.\nEXHIBIT 16.4\nShort ratio spread at expiration.\nThis strategy is amirror image of the backspread discussed previously in this chapter. With limited risk to the downside, the maximum loss to the trade is the initial debit of 1 if the stock is below $70 at expiration and all the calls expire. There is amaximum profit potential of 4 if the stock is at the short strike at expiration. There is unlimited loss potential, since ashort net delta is created on the upside, as one short 75 call is covered by the long 70 call, and one is naked. The breakevens are at $71 and $79.\nLow Volatility\nWith the stock at $71, gamma and vega are both negative. Just as the backspread was along volatility play at this underlying price, this ratio vertical is ashort-vol play here. As in trading ashort straddle, the name of the game is low volatility—meaning both implied and realized.\nThis strategy may require some gamma hedging. But as with other short volatility delta-neutral trades, the fewer the negative scalps, the greater the potential profit. Delta covering should be implemented in situations where it looks", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00028.html", "doc_id": "73fc246bbbe60ff983eeab4443312e5b9f6cfcc18ad387b1d757f11e98e2503c", "chunk_index": 2}
{"text": "of the game is low volatility—meaning both implied and realized.\nThis strategy may require some gamma hedging. But as with other short volatility delta-neutral trades, the fewer the negative scalps, the greater the potential profit. Delta covering should be implemented in situations where it looks as if the stock will trend deep into negative-gamma territory. Murphy’s Law of trading dictates that delta covering will likely be wrong at least as often as it is right.\nRatio Vertical Example\nLet’sexamine atrade of 20 contracts by 40 contracts.\nExhibit 16.5\nshows the greeks for this ratio vertical.\nEXHIBIT 16.5\nShort ratio vertical spread greeks.\nBefore we get down to the nitty-gritty of the mechanics and management of this trade—the how—let’sfirst look at the motivations for putting the trade on—the why. For the cost of 1.00 per spread, this trader gets aleveraged position if the stock rises moderately. The profits max out with the stock at the short-strike target price—$75—at expiration.\nAnother possible profit engine is IV. Because of negative vega, there is the chance of taking aquick profit if IV falls in the interim. But short-term losses are possible, too. IV can rise, or negative gamma can hurt the trader. Ultimately, having naked calls makes this trade not very bullish. Abig move north can really hurt.\nBasically, this is adelta-neutral-type short-volatility play that wins the most if the stock is at $75 at expiration. One would think about making this trade if the mechanics fit the forecast. If this trader were amore bullish than indicated by the profit and loss diagram, amore-balanced bull call spread would be abetter strategy, eliminating the unlimited upside risk. If upside risk were acceptable, this trader could get more aggressive by trading the spread one-by-three. That would result in acredit of 0.05 per spread. There would then be no ultimate risk below $70 but rather a 0.05 gain. With double the naked calls, however, there would be double punishment if the stock rallied strongly beyond the upside breakeven.\nUltimately, mastering options is not about mastering specific strategies. It’sabout having athorough enough understanding of the instrument to be flexible enough to tailor aposition around aforecast. It’sabout minimizing the unwanted risks and optimizing exposure to the intended risks. Still, there always exists atrade-off in that where there is the potential for profit, there is the possibility of loss—you can always be wrong.\nRecalling the at-expiration diagram and examining the greeks, the best-case scenario is intuitive: the stock at $75 at expiration. The biggest theta would be right at that strike. But that strike price is also the center of the biggest negative gamma. It is important to guard against upward movement into negative delta territory, as well as movement lower where the position has aslightly positive delta.\nExhibit 16.6\nshows what happens to the greeks of this trade as the stock price moves.\nEXHIBIT 16.6\nRatio vertical spread at various prices for the underlying.\nAs the stock begins to rise from $71 ashare, negative deltas grow fast in the short term. Careful trend monitoring is necessary to guard against arally. The key, however, is not in knowing what will happen but in skillfully hedging against the unknown. The talented option trader is adisciplined risk manager, not aclairvoyant.\nOne of the risks that the trader willingly accepted when placing this trade was short gamma. But when the stock moves and deltas are created, decisions have to be made. Did the catalyst(s)—if any—that contributed to the rise in stock price change the outlook for volatility? If not, the decision is simply whether or not to hedge by buying stock. However, if it appears that volatility is on the rise, it is not just adelta decision. Atrader may consider buying some of the short options back to reduce volatility exposure.\nIn this example, if the stock rises and it’sfeared that volatility may increase, agood choice may be to buy back some of the short 75-strike calls. This has the advantage of reducing delta (buy enough deltas to flatten out) and reducing gamma and vega. Of course, the downside to this strategy is that in purchasing the calls, aloss is likely to be locked in. Unless alot of time has passed or implied volatility has dropped sharply, the calls will probably be bought at ahigher price than they were sold.\nIf the stock makes aviolent move upward, aloss will be incurred. Whether this loss is locked in by closing all or part of the position, the account will still be down in value. The decision to buy the calls back at aloss is based on looking forward. Nothing good can come of looking back.\nHow Market Makers Manage Delta-Neutral Positions\nWhile market makers are not position traders per se, they are expert position managers. For the most part, market makers make their living by buying the bid and selling the offer. In general, they don’tact; they react. Most of their trades are initi", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00028.html", "doc_id": "73fc246bbbe60ff983eeab4443312e5b9f6cfcc18ad387b1d757f11e98e2503c", "chunk_index": 3}
{"text": ".\nHow Market Makers Manage Delta-Neutral Positions\nWhile market makers are not position traders per se, they are expert position managers. For the most part, market makers make their living by buying the bid and selling the offer. In general, they don’tact; they react. Most of their trades are initiated by taking the other side of what other people want to do and then managing the risk of the positions they accumulate.\nThe business of amarket maker is much like that of acasino. Acasino takes the other side of people’sbets and, in the long run, has astatistical (theoretical) edge. For market makers, because theoretical value resides in the middle of the bid and the ask, these accommodating trades lead to atheoretical profit—that is, the market maker buys below theoretical value and sells above. Actual profit—cold, hard cash you can take to the bank—is, however, dependent on sound management of the positions that are accumulated.\nMy career as amarket maker was on the floor of the Chicago Board Options Exchange (CBOE) from 1998 to 2005. Because, over all, the trades Imade had atheoretical edge, Ihoped to trade as many contracts as possible on my markets without getting too long or too short in any option series or any of my greeks.\nAs aresult of reacting to order flow, market makers can accumulate alarge number of open option series for each class they trade, resulting in asingle position. For example,\nExhibit 16.7\nshows aposition Ihad in Ford Motor Co. (F) options as amarket maker.\nEXHIBIT 16.7\nMarket-maker position in Ford Motor Co. options.\nWith all the open strikes, this position is seemingly complex. There is not aspecific name for this type of “spread.” The position was accumulated over along period of time by initiating trades via other traders selling options to me at prices Iwanted to buy them—my bid—and buying options from me at prices Iwanted to sell them—my offer. Upon making an option trade, Ineeded to hedge directional risk immediately. Iusually did so by offsetting my option trades by taking the opposite delta position in the stock—especially on big-delta trades. Through this process of providing liquidity to the market, Ibuilt up option-centric risk.\nTo manage this risk Ineeded to watch my other greeks. To be sure, trying to draw a P&Ldiagram of this position would be afruitless endeavor.\nExhibit 16.8\nshows the risk of this trade in its most distilled form.\nEXHIBIT 16.8\nAnalytics for market-maker position in Ford Motor Co. (stock at $15.72).\nDelta\n+1,075\nGamma\n−10,191\nTheta\n+1,708\nVega\n+7,171\nRho\n−33,137\nThe +1,075 delta shows comparatively small directional risk relative to the −10,191 gamma. Much of the daily task of position management would be to carefully guard against movement by delta hedging when necessary to earn the $1,708 per day theta.\nMuch of the negative gamma/positive theta comes from the combined 1,006 short January 15 calls and puts. (Note that because this position is traded delta neutral, the net long or short options at each strike is what matters, not whether the options are calls or puts. Remember that in delta-neutral trading, aput is acall, and acall is aput.) The positive vega stems from the fact that the position is long 1,927 January 2003 20-strike options.\nAlthough this position has alot going on, it can be broken down many ways. Having long LEAPS options and short front-month options gives this position the feel of atime spread. One way to think of where most of the gamma risk is coming from is to bear in mind that the 15 strike is synthetically short 503 straddles (1,006 options ÷ two). But this position overall is not like astraddle. There are more strikes involved—alot more. There is more short gamma to the downside if the price of Ford falls toward $12.50. To the upside, the 17.50 strike is long acombined total of 439 options. Looking at just the 15 and 17.50 strikes, we can see something that looks more like aratio spread: 1,006:439. If the stock were at $17.50, the gamma would be around +5,000.\nWith the stock at $15.72, there is realized volatility risk of Frallying, but with gamma changing from negative to positive as the stock rallies, the risk of movement decreases quickly. The 20 strike is short 871 options which brings the position back to negative-gamma territory. Having alternating long and short strikes, sometimes called abutterflied position, is ahandy way for market makers to reduce risk. Aposition is perfectly butterflied if it has alternating long and short strikes with the same number of contracts.\nThrough Your Longs to Your Shorts\nWith market-maker-type positions consisting of many strikes, the greatest profit is gained if the underlying security moves through the longs to the shorts. This provides kind of awin-win scenario for greeks traders. In this situation, traders get the benefit of long gamma as the stock moves higher or lower through the long strike. They also reap the benefits of theta when the stock sits at the short strike.\nTrading Fla", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00028.html", "doc_id": "73fc246bbbe60ff983eeab4443312e5b9f6cfcc18ad387b1d757f11e98e2503c", "chunk_index": 4}
{"text": "through the longs to the shorts. This provides kind of awin-win scenario for greeks traders. In this situation, traders get the benefit of long gamma as the stock moves higher or lower through the long strike. They also reap the benefits of theta when the stock sits at the short strike.\nTrading Flat\nMost market makers like to trade flat—that is, profit from the bid-ask spread and strive to lower exposure to direction, time, volatility, and interest as much as possible. But market makers are at the mercy of customer orders, or paper, as it’sknown in the industry. If someone sells, say, the March 75 calls to amarket maker at the bid, the best-case scenario is that moments later someone else buys the same number of the same calls—the March 75s, in this case—from that same market maker at the offer. This is locking in aprofit.\nUnfortunately, this scenario seldom plays out this way. In my seven years as amarket maker, Ican count on one hand the number of times the option gods smiled upon me in such away as to allow me to immediately scalp an option. Sometimes, the same option will not trade again for aweek or longer. Very low-volume options trade “by appointment only.” Amarket maker trading illiquid options may hold the position until it expires, having no chance to get out at areasonable price, often taking aloss on the trade.\nMore typically, if amarket maker buys an option, he must sell adifferent option to lessen the overall position risk. The skills these traders master are to lower bids and offers on options when they are long gamma and/or vega and to raise bids and offers on options when they are short gamma and/or vega. This raising and lowering of markets is done to manage risk.\nEffectively, this is your standard high school economics supply-and-demand curves in living color. When the market demands (buys) all the options that are supplied (offered) at acertain price, the price rises. When the market supplies (sells) all the options demanded (bid) at aprice level, the price falls. The catalyst of supply and demand is the market maker and his risk tolerance. But instead of the supply and demand for individual options, it is supply and demand for gamma, theta, and vega. This is trading option greeks.\nHedging the Risk\nDelta is the easiest risk for floor traders to eliminate quickly. It becomes second nature for veteran floor traders to immediately hedge nearly every trade with the underlying. Remember, these liquidity providers are in the business of buying option bids and selling option offers, not speculating on direction.\nThe next hurdle is to trade out of the option-centric risk. This means that if the market maker is long gamma, he needs to sell options; if he’sshort gamma, he needs to buy some. Same with theta and vega. Market makers move their bids and offers to avoid being saddled with too much gamma, theta, and vega risk. Experienced floor traders are good at managing option risk by not biting off more than they can chew. They strive to never buy or sell more options than they can spread off by selling or buying other options. This breed of trader specializes in trading the spread and managing risk, not in predicting the future. They’re market makers, not market takers.\nTrading Skew\nThere are some trading strategies for which market makers have anatural propensity that stems from their daily activity of maintaining their positions. While money managers who manage equity funds get to know the fundamentals of the stocks they trade very well, options market makers know the volatility of the option classes they trade. When they adjust their markets in reacting to order flow, it’s, mechanically, implied volatility that they are raising or lowering to change theoretical values. They watch this figure very carefully and trade its subtle changes.\nAcharacteristic of options that many market makers and some other active professional traders observe and trade is the volatility skew. Savvy traders watch the implied volatility of the strikes above the at-the-money (ATM)—referred to as\ncalls\n, for simplicity—compared with the strikes below the ATM, referred to as\nputs\n. In most stocks, there typically exists a “normal” volatility skew inherent to options on that stock. When this skew gets out of line, there may be an opportunity.\nSay for aparticular option class, the call that is 10 percent OTM typically trades about four volatility points lower than the put that is 10 percent OTM. For example, for a $50 stock, the 55 calls are trading at a 21 IV and the 45 puts are trading at a 25 volatility. If the 45 puts become bid higher, say, nine points above where the calls are offered—for instance, the puts are bid at 32 volatility bid while the calls are offered at 23 vol—atrader can speculate on the skew reverting back to its normal relationship by selling the puts, buying the calls, and hedging the delta by selling the right amount of stock.\nThis position—long acall, short aput with adifferent strike, and short stoc", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00028.html", "doc_id": "73fc246bbbe60ff983eeab4443312e5b9f6cfcc18ad387b1d757f11e98e2503c", "chunk_index": 5}
{"text": "atility bid while the calls are offered at 23 vol—atrader can speculate on the skew reverting back to its normal relationship by selling the puts, buying the calls, and hedging the delta by selling the right amount of stock.\nThis position—long acall, short aput with adifferent strike, and short stock on adelta-neutral ratio—is called arisk reversal. The motive for risk reversals is to capture vega as the skew realigns itself. But there are many risk factors that require careful attention.\nFirst, as in other positions consisting of both long and short strikes, the gamma, theta, and vega of the position will vary from positive to negative depending on the price of the underlying. Risk-reversal traders must be prepared to trade long gamma (and battle time decay) when the stock rallies closer to the long-call strike and trade short gamma (and assume the risk of possible increased realized volatility) when the stock moves closer to the short-put strike.\nAs for vega, being short implied volatility on the downside and long on the upside is inherently apotentially bad position whichever way the stock moves. Why? As equities decline in price, the implied volatility of their options tends to rise. But the downside is where the risk reversal has its short vega. Furthermore, as equities rally, their IV tends to fall. That means the long vega of the upside hurts as well.\nWhen Delta Neutral Isn’t Direction Indifferent\nMany dynamic-volatility option positions, such as the risk reversal, have vega risk from potential IV changes resulting from the stock’smoving. This is indirectly adirectional risk. While having adelta-neutral position hedges against the rather straightforward directional risk of the position delta, this hidden risk of stock movement is left unhedged. In some circumstances, adelta-lean can help abate some of the vega risk of stock-price movement.\nSay an option position has fairly flat greeks at the current stock price. Say that given the way this particular position is set up, if the stock rises, the position is still fairly flat, but if the stock falls, short lower-strike options will lead to negative gamma and vega. One way to partially hedge this position is to lean short deltas—that is, instead of maintaining atotally flat delta, have aslightly short delta. That way, if the stock falls, the trade profits some on the short stock to partially offset some of the anticipated vega losses. The trade-off of this hedge is that if the stock rises, the trade loses on the short delta.\nDelta leans are more of an art than ascience and should be used as ahedge only by experienced vol traders. They should be one part of awell-orchestrated plan to trade the delta, gamma, theta, and vega of aposition. And, to be sure, adelta lean should be entered into amodel for simulation purposes before executing the trade to study the up-and-down risk of the position. If the lean reduces the overall risk of the position, it should be implemented. But if it creates asituation where there is an anticipated loss if the stock moves in either direction and there is little hope of profiting from the other greeks, the lean is not the answer—closing the position is.\nManaging Multiple-Class Risk\nMost traders hold option positions in more than one option class. As an aside, Irecommend doing so, capital and experience permitting. In my experience, having positions in multiple classes psychologically allows for acertain level of detachment from each individual position. Most traders can make better decisions if they don’thave all their eggs in one basket.\nBut holding aportfolio of option positions requires one more layer of risk management. The trader is concerned about the delta, gamma, theta, vega, and rho not only of each individual option class but also of the portfolio as awhole. The trader’sportfolio is actually one big position with alot of moving parts. To keep it running like awell-oiled machine requires monitoring and maintaining each part to make sure they are working together. To have the individual trades work in harmony with one another, it is important to keep awell-balanced series of strategies.\nOption trading requires diversification, just like conventional linear stock trading or investing. Diversification of the option portfolio is easily measured by studying the portfolio greeks. By looking at the net greeks of the portfolio, the trader can get some idea of exposure to overall risk in terms of delta, gamma, theta, vega, and rho.", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00028.html", "doc_id": "73fc246bbbe60ff983eeab4443312e5b9f6cfcc18ad387b1d757f11e98e2503c", "chunk_index": 6}
{"text": "CHAPTER 17\nPutting the Greeks into Action\nThis book was intended to arm the reader with the knowledge of the greeks needed to make better trading decisions. As the preface stated, this book is not so much ahow-to guide as ahow-come tutorial. It is step one in athree-step learning process:\nStep One: Study\n. First, aspiring option traders must learn as much as possible from books such as this one and from other sources, such as articles, both in print and online, and from classes both in person and online. After completing this book, the reader should have asolid base of knowledge of the greeks.\nStep Two: Paper Trade\n. Atruly deep understanding requires practice, practice, and more practice! Fortunately, much of this practice can be done without having real money on the line. Paper trading—or simulated trading—in which one trades real markets but with fake money is step two in the learning process. Ihighly recommend paper trading to kick the tires on various types of strategies and to see how they might work differently in reality than you thought they would in theory.\nStep Three: Showtime\n! Even the most comprehensive academic study or windfall success with paper profits doesn’tgive one atrue feel for how options work in the real world. There are some lessons that must be learned from the black and the blue. When there’sreal money on the line, you will trade differently—at least in the beginning. It’shuman nature to be cautious with wealth. This is not abad thing. But emotions should not override sound judgment. Start small—one or two lots per trade—until you can make rational decisions based on what you have learned, keeping emotions in check.\nThis simple three-step process can take years of diligent work to get it right. But relax. Getting rich quick is truly apoor motivation for trading options. Option trading is abeautiful thing! It’sabout winning. It’sabout beating the market. It’sabout being smart. Don’tget me wrong—wealth can be anice by-product. I’ve seen many people who have made alot of money trading options, but it takes hard work. For every successful option trader I’ve met, I’ve met many more who weren’twilling to put in the effort, who brashly thought this is easy, and failed miserably.\nTrading Option Greeks\nTraders must take into account all their collective knowledge and experience with each and every trade. Now that you’re armed with knowledge of the greeks, use it! The greeks come in handy in many ways.\nChoosing between Strategies\nAvery important use of the greeks is found in selecting the best strategy for agiven situation. Consider asimple bullish thesis on astock. There are plenty of bullish option strategies. But given abullish forecast, which option strategy should atrader choose? The answer is specific to each unique opportunity. Trading is situational.\nExample 1\nImagine atrader, Arlo, is studying the following chart of Agilent Technologies Inc. (A). See\nExhibit 17.1\n.\nEXHIBIT 17.1\nAgilent Technologies Inc. daily candles.\nSource\n: Chart courtesy of Livevol\n®\nPro (\nwww.livevol.com\n)\nThe stock has been in an uptrend for six weeks or so. Close-to-close volatility hasn’tincreased much. But intraday volatility has increased greatly as indicated by the larger candles over the past 10 or so trading sessions. Earnings is coming up in aweek in this example, however implied volatility has not risen much. It is still “cheap” relative to historical volatility and past implied volatility. Arlo is bullish. But how does he play it? He needs to use what he knows about the greeks to guide his decision.\nArlo doesn’twant to hold the trade through earnings, so it will be ashort-term trade. Thus, theta is not much of aconcern. The low-priced volatility guides his strategy selection in terms of vega. Arlo certainly wouldn’twant ashort-vega trade. Not with the prospect of implied volatility potential rising going into earnings. In fact, he’dactually want abig positive vega position. That rules out anaked/cash-secured put, put credit spread and the likes.\nHe can probably rule out vertical spreads all together. He doesn’tneed to spread off theta. He doesn’twant to spread off vega. Positive gamma is attractive for this sort of trade. He wouldn’twant to spread that off either. Plus, the inherent time component of spreads won’twork well here. As discussed in Chapter 9, the bulk of vertical spreads profits (or losses) take time to come to fruition. The deltas of acall spread are smaller than an outright call. Profits would come from both delta and theta, if the stock rises to the short strike and positive theta kicks in.\nThe best way for Arlo to play this opportunity is by buying acall. It gives him all the greeks attributes he wants (comparatively big positive delta, gamma and vega) and the detriment (negative theta) is not amajor issue.\nHe’dthen select among in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM) calls and the various available expiration cycles. In this case, because positive gamma", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00029.html", "doc_id": "78581b4ca723c037caca00c3cd34c1e5cb1f4a121ae7614204420be1a1650c1c", "chunk_index": 0}
{"text": "ibutes he wants (comparatively big positive delta, gamma and vega) and the detriment (negative theta) is not amajor issue.\nHe’dthen select among in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM) calls and the various available expiration cycles. In this case, because positive gamma is attractive and theta is not an issue, he’dlean toward afront month (in this case, three week) option. The front month also benefits him in terms of vega. Though the vegas are smaller for short-term options, if there is arise in implied volatility leading up to earnings, the front month will likely rise much more than the rest. Thus, the trader has apossibility for profits from vega.\nExample 2\nAtrader, Luke, is studying the following chart for United States Steel Corp. (X). See\nExhibit 17.2\n.\nEXHIBIT 17.2\nUnited States Steel Corp. daily candles.\nSource\n: Chart courtesy of Livevol\n®\nPro (\nwww.livevol.com\n)\nThis stock is in asteady uptrend, which Luke thinks will continue. Earnings are out and there are no other expected volatility events on the horizon. Luke thinks that over the next few weeks, United States Steel can go from its current price of around $31 ashare to about $34. Volatility is midpriced in this example—not cheap, not expensive.\nThis scenario is different than the previous one. Luke plans to potentially hold this trade for afew weeks. So, for Luke, theta is an important concern. He cares somewhat about volatility, too. He doesn’tnecessarily want to be long it in case it falls; he doesn’twant to be short it in case it rises. He’dlike to spread it off; the lower the vega, the better (positive or negative). Luke really just wants delta play that he can hold for afew weeks without all the other greeks getting in the way.\nFor this trade, Luke would likely want to trade adebit call spread with the long call somewhat ITM and the short call at the $34 strike. This way, Luke can start off with nearly no theta or vega. He’ll retain some delta, which will enable the spread to profit if United States Steel rises and as it approaches the 34 strike, positive theta will kick in.\nThis spread is superior to apure long call because of its optimized greeks. It’ssuperior to an OTM bull put spread in its vega position and will likely produce ahigher profit with the strikes structured as such too, as it would have abigger delta.\nIntegrating greeks into the process of selecting an option strategy must come natural to atrader. For any given scenario, there is one position that best exploits the opportunity. In any option position, traders need to find the optimal greeks position.\nManaging Trades\nOnce the trade is on, the greeks come in handy for trade management. The most important rule of trading is\nKnow Thy Risk\n. Knowing your risk means knowing the influences that expose your position to profit or peril in both absolute and incremental terms. At-expiration diagrams reveal, in no uncertain terms, what the bottom-line risk points are when the option expires. These tools are especially helpful with simple short-option strategies and some long-option strategies. Then traders need the greeks. After all, that’swhat greeks are: measurements of option risk. The greeks give insight into atrade’sexposure to the other pricing factors. Traders must know the greeks of every trade they make. And they must always know the net-portfolio greeks at all times. These pricing factors ultimately determine the success or failure of each trade, each portfolio, and eventually each trader.\nFurthermore, always—and Ido mean always—traders must know their up and down risk, that is, the directional risk of the market moving up or down certain benchmark intervals. By definition, moves of three standard deviations or more are very infrequent. But they happen. In this business anything can happen. Take the “flash crash of 2010 in which the Dow Jones Industrial Average plunged more than 1,000 points in “aflash.” In my trading career, I’ve seen some surprises. Traders have to plan for the worst.\nIt’snot too hard to tell your significant other, “Sorry I’mlate, but Ihit unexpected traffic. Ijust couldn’tplan for it.” But to say, “Sorry, Ilost our life savings, and the kids’ college fund, and our house because the market made an unexpected move. Icouldn’tplan for it,” won’tgo over so well. The fact is, you\ncan\nplan for it. And as an option trader, you have to. The bottom line is, expect the unexpected because the unexpected will sometimes happen. Traders must use the greeks and up and down risk, instead of relying on other common indicators, such as the HAPI.\nThe HAPI: The Hope and Pray Index\nSo you bought acall spread. At the opening bell the next morning, you find that the market for the underlying has moved lower—alot lower. You have aloss on your hands. What do you do? Keep apositive attitude? Wear your lucky shirt? Pray to the options gods? When traders finds themselves hoping and praying—Iswear I’ll never do that again if Ican just get out of this po", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00029.html", "doc_id": "78581b4ca723c037caca00c3cd34c1e5cb1f4a121ae7614204420be1a1650c1c", "chunk_index": 1}
{"text": "find that the market for the underlying has moved lower—alot lower. You have aloss on your hands. What do you do? Keep apositive attitude? Wear your lucky shirt? Pray to the options gods? When traders finds themselves hoping and praying—Iswear I’ll never do that again if Ican just get out of this position!—it is probably time for them to take their losses and move on to the next trade. The Hope and Pray Index is acontraindicator. Typically, the higher it is, the worse the trade.\nThere are two numbers atrader can control: the entry price and the exit price. All of the other flashing green and red numbers on the screen are out of the trader’scontrol. Savvy traders observe what the market does and make decisions on whether and when to enter aposition and when to exit. Traders who think about their positions in terms of probability make better decisions at both of these critical moments.\nIn entering atrade, traders must consider their forecast, their assessment of the statistical likelihood of success, the potential payout and loss, and their own tolerance for risk. Having considered these criteria helps the traders stay the course and avoid knee-jerk reactions when the market moves in the wrong direction. Trading is easy when positions make money. It is how traders deal with adverse positions that separates good traders from bad.\nGood traders are good at losing money. They take losses quickly and let profits run. Accepting, before entering the trade, the statistical nature of trading can help traders trade their positions with less emotion. It then becomes amatter of competent management of those positions based on their knowledge of the factors affecting option values: the greeks. Learning to think in terms of probability is among the most difficult challenges for anew options trader.\nChapter 5 discussed my Would I Do It Now? Rule, in which atrader asks himself: if Ididn’tcurrently have this position, would Iput it on now at current market prices? This rule is ahandy technique to help traders filter out the noise in their heads that clouds judgment and to help them to make rational decisions on whether to hold aposition, close it out or adjust it.\nAdjusting\nSometimes the position atrader starts off with is not the position he or she should have at present. Sometimes positions need to be changed, or adjusted, to reflect current market conditions. Adjusting is very important to option traders. To be good at adjusting, traders need to use the greeks.\nImagine atrader makes the following trade in Halliburton Company (HAL) when the stock is trading $36.85.\nSell 10 February 35–36–38–39 iron condors at 0.45\nFebruary has 10 days until expiration in this example. The greeks for this trade are as follows:\nDelta: −6.80\nGamma: −119.20\nTheta: +21.90\nVega: −12.82\nThe trader has aneutral outlook, which can be inferred by the near-flat delta. But what if the underlying stock begins to rise? Gamma starts kicking in. The trader can end up with ashort-biased delta that loses exponentially if the stock continues to climb. If Halliburton rises (or falls for that matter) the trader needs to recalibrate his outlook. Surely, if the trader becomes bullish based on recent market activity, he’dwant to close the trade. If the trader is bearish, he’dprobably let the negative delta go in hopes of making back what was lost from negative gamma. But what if the trader is still neutral?\nAneutral trader needs aposition that has greeks which reflect that outlook. The trader would want to get delta back towards zero. Further, depending on how much the stock rises, theta could start to lose its benefit. If Halliburton approaches one of the long strikes, theta could move toward zero, negating the benefit of this sort of trade all together. If after the stock rises, the trader is still neutral at the new underlying price level, he’dlikely adjust to get delta and theta back to desired territory.\nAcommon adjustment in this scenario is to roll the call-credit-spread legs of the iron condor up to higher strikes. The trader would buy ten 38 calls and sell ten 39 calls to close the credit spread. Then the trader would buy 10 of the 39 calls as sell 10 of the 40 calls to establish an adjusted position that is short a 10 lot of the February 35–36–39–40 iron condor.\nThis, of course, is just one possible adjustment atrader can make. But the common theme among all adjustments is that the trader’sgreeks must reflect the trader’soutlook. The position greeks best describe what the position is—that is, how it profits or loses. When the market changes it affects the dynamic greeks of aposition. If the market changes enough to make atrader’sposition greeks no longer represent his outlook, the trader must adjust the position (adjust the greeks) to put it back in line with expectations.\nIn option trading there are an infinite number of uses for the greeks. From finding trades, to planning execution, to managing and adjusting them, to planning exits; the greeks are tru", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00029.html", "doc_id": "78581b4ca723c037caca00c3cd34c1e5cb1f4a121ae7614204420be1a1650c1c", "chunk_index": 2}
{"text": "sent his outlook, the trader must adjust the position (adjust the greeks) to put it back in line with expectations.\nIn option trading there are an infinite number of uses for the greeks. From finding trades, to planning execution, to managing and adjusting them, to planning exits; the greeks are truly atrader’sbest resource. They help traders see potential and actual position risk. They help traders project potential and actual trade profitability too. Without the greeks, atrader is at adisadvantage in every aspect of option trading. Use the greeks on each and every trade, and exploit trades to their greatest potential.\nIwish you good luck\n!\nFor me, trading option greeks has been alabor of love through the good trades and the bad. To succeed in the long run at greeks trading—or any endeavor, for that matter—requires enjoying the process. Trading option greeks can be both challenging and rewarding. And remember, although option trading is highly statistical and intellectual in nature, alittle luck never hurt! That said, good luck trading!", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00029.html", "doc_id": "78581b4ca723c037caca00c3cd34c1e5cb1f4a121ae7614204420be1a1650c1c", "chunk_index": 3}
{"text": "ze profit\nStandard deviation\nand historical volatility\nStandard & Poor’s Depositary Receipts (SPDRs or Spiders)\nStraddles\nlong\nbasic\ntrading\nshort\nrisks with\ntrading\nsynthetic\nStrangles\nlong\nexample\nshort\npremium\nrisk, limiting\nStrategies and At-Expiration Diagrams\nbuy call\nbuy put\nfactors affecting option prices, measuring incremental changes in\nsell call\nsell put\nStrike price\nSupply and demand\nSynthetic stock\nstrategies\nconversion\nmarket makers\npin risk\nreversal\nTechnical analysis\nTeenie buyers\nTeenie sellers\nTheta\neffect of moneyness and stock price on\neffects of volatility and time on\npositive or negative\nrisk\ntaking the day out\nTime value\nTrading strategies\nValue\nVega\neffect of implied volatility on\neffect of moneyness on\neffect of time on\nimplied volatility (IV) and\nVertical spreads\nbear call\nbear put\nbox, building\nbull call\nbull put\ncredit and debit\ninterrelations of\nsimilarities in\nand volatility\nVolatility\nbuying and selling\nteenie buyers\nteenie sellers\ncalculating data\ndirection neutral, direction biased, and direction indifferent\nexpected\nCBOE Volatility Index®\nimplied\nstock\nhistorical (HV)\nstandard deviation\nimplied (IV)\nand direction\nHV-IV divergence\ninertia\nrelationship of HV and IV\nselling\nsupply and demand\nrealized\ntrading\nskew\nterm structure\nvertical\nvertical spreads and\nVolatility charts, studying\npatterns\nimplied and realized volatility rise\nrealized volatility falls, implied volatility falls\nrealized volatility falls, implied volatility remains constant\nrealized volatility falls, implied volatility rises\nrealized volatility remains constant, implied volatility falls\nrealized volatility remains constant, implied volatility remains constant\nrealized volatility remains constant, implied volatility rises\nrealized volatility rises, implied volatility falls\nrealized volatility rises, implied volatility remains constant\nVolatility-selling strategies\nprofit potential\ncovered call\ncovered put\ngamma-theta relationship\ngreeks and income generation\nnaked call\nshort naked puts\nsimilarities\nWould I Do It Now? Rule\nVolume\nWeeklys\nSM\nWing spreads\nbutterflies\ndirectional\nlong\nshort\niron\ncondors\niron\nlong\nshort\ngreeks and\nkeys to success\nretail trader vs. pro\ntrades, constructing to maximize profit\nWould I Do It Now? Rule", "source": "eBooks\\Trading Options Greeks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00031.html", "doc_id": "2bd87d71b9f89b914e4db9ad1e15a8cf05d1704fb5487ec645cce547e6cfb2b2", "chunk_index": 1}
{"text": "Foreword\nThe past several years have brought about aresurgence in market volatility\nand options volume unlike anything that has been seen since the close of the\ntwentieth century. As markets have become more interdependent,\ninterrelated, and international, the U.S. listed option markets have solidified\ntheir place as the most liquid and transparent venue for risk management\nand hedging activities of the world’slargest economy. Technology,\ncompetition, innovation, and reliability have become the hallmarks of the\nindustry, and our customer base has benefited tremendously from this\nongoing evolution.\nHowever, these advances can be properly tapped only when the users of\nthe product continue to expand their knowledge of the options product and\nits unique features. Education has always been the driver of growth in our\nbusiness, and it will be the steward of the next generation of options traders.\nDan Passarelli’snew and updated book Trading Option Greeks is anecessity for customers and traders alike to ensure that they possess the\nknowledge to succeed and attain their objectives in the high-speed, highly\ntechnical arena that the options market has become.\nThe retail trader of the past has given way to anew retail trader of the\npresent—one with an increased level of technology, support, capital\ntreatment, and product selection. The impact of the staggering growth in\nsuch products as the CBOE Holdings’ VIX options and futures, and the\nliterally dozens of other products tied to it, have made the volatility asset\nclass anew, unique, and permanent pillar of today’soption markets.\nDan’supdated book continues his mission of supporting, preparing, and\nreinforcing the trader’sunderstanding of pricing, volatility, market\nterminology, and strategy, in away that few other books have been able.\nUsing aperspective forged from years as an options market maker,\nprofessional trader, and customer, Dan has once again provided aresource\nfor those who wish to know best how the option markets behave today, and\nhow they are likely to continue to behave in the future. It is important to\nunderstand not only what happens in the options space, but also why it", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:15", "doc_id": "75e028ae63cf6fb6c9e6031ee0675380feceaeb72740961602e417d0f17510a0", "chunk_index": 0}
{"text": "Preface\nI’ve always been fascinated by trading. When Iwas young, I’dsee traders\non television, in their brightly colored jackets, shouting on the seemingly\nchaotic trading floor, and I’dmarvel at them. What awonderful job that\nmust be! These traders seemed to me to be very different from the rest of\nus. It’sall so very esoteric.\nIt is easy to assume that professional traders have closely kept secrets to\ntheir ways of trading—something that secures success in trading for them,\nbut is out of reach for everyone else. In fact, nothing could be further from\nthe truth. If there are any “secrets” of professional traders, this book will\nexpose them.\nTrue enough, in years past there have been some barriers to entry to\ntrading success that did indeed make it difficult for nonprofessionals to\nsucceed. For example, commissions, bid-ask spreads, margin requirements,\nand information flow all favored the professional trader. Now, these barriers\nare gone. Competition among brokers and exchanges—as well as the\nubiquity of information as propagated on the Internet—has torn down those\nwalls. The only barrier left between the Average Joe and the options pro is\nthat of knowledge. Those who have it will succeed; those who do not will\nfail.\nTo be sure, the knowledge held by successful traders is not that of what\nwill happen in the future; it is the knowledge of how to manage the\nuncertainty. No matter what our instincts tell us, we do not know what will\nhappen in the future with regard to the market. As Socrates put it, “The only\ntrue wisdom is in knowing you know nothing.” The masters of option\ntrading are masters of managing the risk associated with what they don’tknow—the risk of uncertainty.\nAs an instructor, I’ve talked to many traders who were new to options\nwho told me, “Imade atrade based on what Ithought was going to happen.\nIwas right, but my position lost money!” Choosing the right strategy makes\nall the difference when it comes to mastery of risk management and", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:17", "doc_id": "261c40a9dfc177304e67a00f1f9e1e90d33b4e212aa0e8b665be0edee877d98b", "chunk_index": 0}
{"text": "ultimate trading success. Knowing which option strategy is the right\nstrategy for agiven situation comes with knowledge and experience.\nAll option strategies are differentiated by their unique risk characteristics.\nSome are more sensitive to directional movement of the underlying asset\nthan others; some are more affected by time passing than others. The exact\nexposure positions have to these market influences determines the success\nof individual trades and, indeed, the long-term success of the trader who\nknows how to exploit these risk characteristics. These option-value\nsensitivities can be controlled when atrader understands the option greeks.\nOption greeks are metrics used to measure an option’ssensitivity to\ninfluences on its price. This book will provide the reader with an\nunderstanding of these metrics, to help the reader truly master the risk of\nuncertainty associated with option trading.\nSuccessful traders strive to create option positions with risk-reward\nprofiles that benefit them the most in agiven situation. Atrader’sobjectives\nwill dictate the right strategy for the right situation. Traders can tailor aposition to fit aspecific forecast with respect to the time horizon; the degree\nof bullishness, bearishness, neutrality, or volatility in the underlying stock;\nand the desired amount of leverage. Furthermore, they can exploit\nopportunities unique to options. They can trade option greeks. This opens\nthe door to many new opportunities.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:18", "doc_id": "6618d3e14a88dbd3dbe4d1db689c273777650b17021c3a07b6a765e74b9d4e56", "chunk_index": 0}
{"text": "Trading Strategies\nBuying stock is atrading strategy that most people understand. In practical\nterms, traders who buy stock are generally not concerned with the literal\nownership stake in acorporation, just the opportunity to profit if the stock\nrises. Although it’simportant for traders to understand that the price of astock is largely tied to the success or failure of the corporation, it’sessential\nto keep in mind exactly what the objective tends to be for trading astock: to\nprofit from changes in its price. Abullish position can also be taken in the\noptions market. The most basic example is buying acall.\nAbearish position can be taken by trading stock or options, as well. If\ntraders expect the value of astock they own to fall, they will sell the stock.\nThis eliminates the risk of losses from the stock’sfalling. If the traders do\nnot own the stock that they think will decline, they can take amore active\nstance and short it. The short-seller borrows the stock from aparty that\nowns it and then sells the borrowed shares to another party. The goal of\nselling stock short is to later repurchase the shares at alower price before\nreturning the stock to its owner. It is simply reversing the order of “buy\nlow/sell high.” The risk is that the stock rises and shares have to be bought\nat ahigher price than that at which they were sold. Although shorting stock\ncan lead to profits when the market cooperates, in the options market, there\nare alternative ways to profit from falling prices. The most basic example is\nbuying aput.\nAtrader can use options to take abullish or bearish position, given adirectional forecast. Sideways, nontrending stocks and their antithesis,\nvolatile stocks, can be traded as well. In the later market conditions, profit\nor loss can be independent of whether the stock rises or falls. Opportunity\nin option trading is not necessarily black and white—not necessarily up and\ndown. Option trading is nonlinear. Consequently, more opportunities can be\nexploited by trading options than by trading stock.\nOption traders must consider the time period in question, the volatility\nexpected during this period, interest rates, and dividends. Along with the\nstock price, these factors make up the dynamic components of an option’svalue. These individual factors can be isolated, measured, and exploited.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:20", "doc_id": "62095d6651cd7953061fc4d5a960503435a32d8f66c5ac3530448d48bd295954", "chunk_index": 0}
{"text": "This Second Edition of Trading\nOption Greeks\nThis book addresses the complex price behavior of options by discussing\noption greeks from both atheoretical and apractical standpoint. There is\nsome tactical discussion throughout, although the objective of this book is\nto provide education to the reader. This book is meant to be less ahow-to\nmanual than ahow-come tutorial.\nThis informative guide will give the retail trader alook inside the mind of\naprofessional trader. It will help the professional trader better understand\nthe essential concepts of his craft. Even the novice trader will be able to\napply these concepts to basic options strategies. Comprehensive knowledge\nof the greeks can help traders to avoid common pitfalls and increase profit\npotential.\nMuch of this book is broken down into adiscussion of individual\nstrategies. Although the nuances of each specific strategy are not relevant,\npresenting the material this way allows for adiscussion of very specific\nsituations in which greeks come into play. Many of the concepts discussed\nin asection on one option strategy can be applied to other option strategies.\nAs in the first edition of Trading Option Greeks , Chapter 1 discusses\nbasic option concepts and definitions. It was written to be areview of the\nbasics for the intermediate to advanced trader. For newcomers, it’sessential\nto understand these concepts before moving forward.\nAdetailed explanation of option greeks begins in Chapter 2. Be sure to\nleave abookmark in this chapter, as you will flip to it several times while\nreading the rest of the book and while studying the market thereafter.\nChapter 3 introduces volatility. The same bookmark advice can be applied\nhere, as well. Chapters 4 and 5 explore the minds of option traders. What\nare the risks they look out for? What are the opportunities they seek? These\nchapters also discuss direction-neutral and direction-indifferent trading. The\nremaining chapters take the reader from concept to application, discussing", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:22", "doc_id": "9b74bab5024bc5b8047e72be5c579e48616f57e4db30f2188cd8daadd0849361", "chunk_index": 0}
{"text": "Contractual Rights and Obligations\nThe option buyer is the party who owns the right inherent in the contract.\nThe buyer is referred to as having along position and may also be called the\nholder, or owner, of the option. The right doesn’tlast forever. At some point\nthe option will expire. At expiration, the owner may exercise the right or, if\nthe option has no value to the holder, let it expire without exercising it. But\nhe need not hold the option until expiration. Options are transferable—they\ncan be traded intraday in much the same way as stock is traded. Because it’suncertain what the underlying stock price of the option will be at expiration,\nmuch of the time this right has value before it expires. The uncertainty of\nstock prices, after all, is the raison d’être of the option market.\nAlong position in an option contract, however, is fundamentally different\nfrom along position in astock. Owning corporate stock affords the\nshareholder ownership rights, which may include the right to vote in\ncorporate affairs and the right to receive dividends. Owning an option\nrepresents strictly the right either to buy the stock or to sell it, depending on\nwhether it’sacall or aput. Option holders do not receive dividends that\nwould be paid to the shareholders of the underlying stock, nor do they have\nvoting rights. The corporation has no knowledge of the parties to the option\ncontract. The contract is created by the buyer and seller of the option and\nmade available by being listed on an exchange.\nThe party to the contract who is referred to as the option seller, also called\nthe option writer, has ashort position in the option. Instead of having aright\nto take aposition in the underlying stock, as the buyer does, the seller\nincurs an obligation to potentially either buy or sell the stock. When atrader\nwho is long an option exercises, atrader with ashort position gets assigned\n. Assignment means the trader with the short option position is called on to\nfulfill the obligation that was established when the contract was sold.\nShorting an option is fundamentally different from shorting astock.\nCorporations have aquantifiable number of outstanding shares available for\ntrading, which must be borrowed to create ashort position, but establishing\nashort position in an option does not require borrowing; the contract is\nsimply created. The strategy of shorting stock is implemented statistically", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:27", "doc_id": "b77a8d93342ca9ba624b5acc89015eb6b7322ca00ce0bbda3e9ab8bd723c7e7e", "chunk_index": 0}
{"text": "Open Interest and Volume\nTraders use many types of market data to make trading decisions. Two\nitems that are often studied but sometimes misunderstood are volume and\nopen interest. Volume, as the name implies, is the total number of contracts\ntraded during atime period. Often, volume is stated on aone-day basis, but\ncould be stated per week, month, year, or otherwise. Once anew period\n(day) begins, volume begins again at zero. Open interest is the number of\ncontracts that have been created and remain outstanding. Open interest is arunning total.\nWhen an option is first listed, there are no open contracts. If Trader Aopens along position in anewly listed option by buying aone-lot, or one\ncontract, from Trader B, who by selling is also opening aposition, acontract is created. One contract traded, so the volume is one. Since both\nparties opened aposition and one contract was created, the open interest in\nthis particular option is one contract as well. If, later that day, Trader Bcloses his short position by buying one contract from Trader C, who had no\nposition to start with, the volume is now two contracts for that day, but open\ninterest is still one. Only one contract exists; it was traded twice. If the next\nday, Trader Cbuys her contract back from Trader A, that day’svolume is\none and the open interest is now zero.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:30", "doc_id": "45976355b272046b3e70e0f6b99c925ec2e0071cfa71fe06cc197087c4fafbbc", "chunk_index": 0}
{"text": "The Options Clearing Corporation\nRemember when Wimpy would tell Popeye, “I’ll gladly pay you Tuesday\nfor ahamburger today.” Did Popeye ever get paid for those burgers? In acontract, it’svery important for each party to hold up his end of the bargain\n—especially when there is money at stake. How does atrader know the\nparty on the other side of an option contract will in fact do that? That’swhere the Options Clearing Corporation (OCC) comes into play.\nThe OCC ultimately guarantees every options trade. In 2010, that was\nalmost 3.9 billion listed-options contracts. The OCC accomplishes this\nthrough many clearing members. Here’show it works: When Trader Xbuys\nan option through abroker, the broker submits the trade information to its\nclearing firm. The trader on the other side of this transaction, Trader Y, who\nis probably amarket maker, submits the trade to his clearing firm. The two\nclearing firms (one representing Trader X’sbuy, the other representing\nTrader Y’ssell) each submit the trade information to the OCC, which\n“matches up” the trade.\nIf Trader Ybuys back the option to close the position, how does that\naffect Trader Xif he wants to exercise it? It doesn’t. The OCC, acting as an\nintermediary, assigns one of its clearing members with acustomer that is\nshort the option in question to deliver the stock to Trader X’sclearing firm,\nwhich in turn delivers the stock to Trader X. The clearing member then\nassigns one of its customers who is short the option. The clearing member\nwill assign the trader either randomly or first in, first out. Effectively, the\nOCC is the ultimate counterparty to both the exercise and the assignment.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:31", "doc_id": "61cdbff1155e7ba5a01fc3b6754b4bc1d511a29e6fda7894c7c82fef59ea81e6", "chunk_index": 0}
{"text": "Standardized Contracts\nExchange-listed options contracts are standardized, meaning the terms of\nthe contract, or the contract specifications, conform to acustomary\nstructure. Standardization makes the terms of the contracts intuitive to the\nexperienced user.\nTo understand the contract specifications in atypical equity option,\nconsider an example:\nBuy 1 IBM December 170 call at 5.00\nQuantity\nIn this example, one contract is being purchased. More could have been\npurchased, but not less—options cannot be traded in fractional units.\nOption Series, Option Class, and Contract Size\nAll calls or puts of the same class, the same expiration month, and the same\nstrike price are called an option series . For example, the IBM December\n170 calls are aseries. Options series are displayed in an option chain on an\nonline broker’suser interface. An option chain is afull or partial list of the\noptions that are listed on an underlying.\nOption class means agroup of options that represent the same underlying.\nHere, the option class is denoted by the symbol IBM—the contract\nrepresents rights on International Business Machines Corp. (IBM) shares.\nBuying one contract usually gives the holder the right to buy or to sell 100\nshares of the underlying stock. This number is referred to as contract size .\nThough this is usually the case, there are times when the contract size is\nsomething other than 100 shares of astock. This situation may occur after\ncertain types of stock splits, spin-offs, or stock dividends, for example. In\nthe minority of cases in which the one contract represents rights on\nsomething besides 100 shares, there may be more than one class of options\nlisted on astock.\nAfairly unusual example was presented by the Ford Motor Company\noptions in the summer of 2000. In June 2000, Ford spun off Visteon", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:32", "doc_id": "4ee9e94f3c8ddb8bc7ff604af2c92dbc12d570d619af5503821e7636199a8fc5", "chunk_index": 0}
{"text": "Corporation. Then, in August 2000, Ford offered shareholders achoice of\nconverting their shares into (a) new shares of Ford plus $20 cash per share,\n(b) new Ford stock plus fractional shares with an aggregate value of $20, or\n(c) new Ford stock plus acombination of more new Ford stock and cash.\nThere were three classes of options listed on Ford after both of these\nchanges: Frepresented 100 shares of the new Ford stock; XFO represented\n100 shares of Ford plus $20 per share ($2,000) plus cash in lieu of $1.24;\nand FOD represented 100 shares of new Ford, 13 shares of Visteon, and\n$2,001.24.\nSometimes these changes can get complicated. If there is ever aquestion\nas to what the underlying is for an option class, the authority is the OCC. Alot of time, money, and stress can be saved by calling the OCC at 888-\nOPTIONS and clarifying the matter.\nExpiration Month\nOptions expire on the Saturday following the third Friday of the stated\nmonth, which in this case is December. The final trading day for an option\nis commonly the day before expiration—here, the third Friday of\nDecember. There are usually at least four months listed for trading on an\noption class. There may be atotal of six months if Long-Term Equity\nAnticiPation Securities® or LEAPS® are listed on the class. LEAPS can have\none year to about two-and-a-half years until expiration. Some underlyings\nhave one-week options called WeeklysSM listed on them.\nStrike Price\nThe price at which the option holder owns the right to buy or to sell the\nunderlying is called the strike price, or exercise price. In this example, the\nholder owns the right to buy the stock at $170 per share. There is method to\nthe madness regarding how strike prices are listed. Strike prices are\ngenerally listed in $1, $2.50, $5, or $10 increments, depending on the value\nof the strikes and the liquidity of the options.\nThe relationship of the strike price to the stock price is important in\npricing options. For calls, if the stock price is above the strike price, the call\nis in-the-money (ITM). If the stock and the strike prices are close, the call is", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:33", "doc_id": "8ca331b59cd8e4385a44f6d55e965e3ddb4f96db7c4221bb63406add26d91102", "chunk_index": 0}
{"text": "at-the-money (ATM). If the stock price is below the strike price the call is\nout-of-the-money (OTM). This relationship is just the opposite for puts. If\nthe stock price is below the strike price, the put is in-the-money. If the stock\nprice and the strike price are about the same, the put is at-the-money. And,\nif the stock price is above the put strike, it is out-of-the-money.\nOption Type\nThere are two types of options: calls and puts. Calls give the holder the\nright to buy the underlying and the writer the obligation to sell the\nunderlying. Puts give the holder the right to sell the underlying and the\nwriter the obligation to buy the underlying.\nPremium\nThe price of an option is called its premium. The premium of this option is\n$5. Like stock prices, option premiums are stated in dollars and cents per\nshare. Since the option represents 100 shares of IBM, the buyer of this\noption will pay $500 when the transaction occurs. Certain types of spreads\nmay be quoted in fractions of apenny.\nAn option’spremium is made up of two parts: intrinsic value and time\nvalue. Intrinsic value is the amount by which the option is in-the-money.\nFor example, if IBM stock were trading at 171.30, this 170-strike call\nwould be in-the-money by 1.30. It has 1.30 of intrinsic value. The\nremaining 3.70 of its $5 premium would be time value.\nOptions that are out-of-the-money have no intrinsic value. Their values\nconsist only of time premium. Sometimes options have no time value left.\nOptions that consist of only intrinsic value are trading at what traders call\nparity . Time value is sometimes called premium over parity .\nExercise Style\nOne contract specification that is not specifically shown here is the exercise\nstyle. There are two main exercise styles: American and European.\nAmerican-exercise options can be exercised, and therefore assigned,\nanytime after the contract is entered into until either the trader closes the", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:34", "doc_id": "d8469736842ccf6872d6f3f298ca1778386c7187369f8a5553a6009a1fa46988", "chunk_index": 0}
{"text": "ETF Options\nExchange-traded funds are vehicles that represent ownership in afund or\ninvestment trust. This fund is made up of abasket of an underlying index’ssecurities—usually equities. The contract specifications of ETF options are\nsimilar to those of equity options. Let’slook at an example.\nOne actively traded optionable ETF is the Standard & Poor’s Depositary\nReceipts (SPDRs or Spiders). Spider shares and options trade under the\nsymbol SPY. Exercising one SPY call gives the exerciser along position of\n100 shares of Spiders at the strike price of the option. Expiration for ETF\noptions typically falls on the same day as for equity options—the Saturday\nfollowing the third Friday of the month. The last trading day is the Friday\nbefore. ETF options are American exercise. Traders of ETFs should be\naware of the relationship between the price of the ETF shares and the value\nof the underlying index. For example, the stated value of the Spiders is\nabout one tenth the stated value of the S&P 500. The PowerShares QQQ\nETF, representing the Nasdaq 100, is about one fortieth the stated value of\nthe Nasdaq 100.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:37", "doc_id": "c44d2376882aaa3a1e7b43a95b44fce133d578dcaac7e2a414e3c1501ebaab16", "chunk_index": 0}
{"text": "Strategies and At-Expiration\nDiagrams\nOne of the great strengths of options is that there are so many different\nways to use them. There are simple, straightforward strategies like buying acall. And there are complex spreads with creative names like jelly roll, guts,\nand iron butterfly. Aspread is astrategy that involves combining an option\nwith one or more other options or stock. Each component of the spread is\nreferred to as aleg. Each spread has its own unique risk and reward\ncharacteristics that make it appropriate for certain market outlooks.\nThroughout this book, many different spreads will be discussed in depth.\nFor now, it’simportant to understand that all spreads are made up of acombination of four basic option positions: buy call, sell call, buy put, and\nsell put. Understanding complex option strategies requires understanding\nthese basic positions and their common, practical uses. When learning\noptions, it’shelpful to see what the option’spayout is if it is held until\nexpiration.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:40", "doc_id": "4909bb0f600fbbf51788e4668c17f34a6faaf9b8e4d4e065e637ac6f260e199c", "chunk_index": 0}
{"text": "Buy Call\nWhy buy the right to buy the stock when you can simply buy the stock? All\noption strategies have trade-offs, and the long call is no different. Whether\nthe stock or the call is preferable depends greatly on the trader’sforecast\nand motivations.\nConsider along call example:\nBuy 1 INTC June 22.50 call at 0.85.\nIn this example, atrader is bullish on Intel (INTC). He believes Intel will\nrise at least 20 percent, from $22.25 per share to around $27 by June\nexpiration, about two months from now. He is concerned, however, about\ndownside risk and wants to limit his exposure. Instead of buying 100 shares\nof Intel at $22.25—atotal investment of $2,225—the trader buys 1 INTC\nJune 22.50 call at 0.85, for atotal of $85.\nThe trader is paying 0.85 for the right to buy 100 shares of Intel at $22.50\nper share. If Intel is trading below the strike price of $22.50 at expiration,\nthe call will expire and the total premium of 0.85 will be lost. Why? The\ntrader will not exercise the right to buy the stock at a $22.50 if he can buy it\ncheaper in the market. Therefore, if Intel is below $22.50 at expiration, this\ncall will expire with no value.\nHowever, if the stock is trading above the strike price at expiration, the\ncall can be exercised, in which case the trader may purchase the stock\nbelow its trading price. Here, the call has value to the trader. The higher the\nstock, the more the call is worth. For the trade to be profitable, at expiration\nthe stock must be trading above the trader’sbreak-even price. The break-\neven price for along call is the strike price plus the premium paid—in this\nexample, $23.35 per share. The point here is that if the call is exercised, the\neffective purchase price of the stock upon exercise is $23.35. The stock is\nliterally bought at the strike price, which is $22.50, but the premium of 0.85\nthat the trader has paid must be taken into account. Exhibit 1.1 illustrates\nthis example.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:41", "doc_id": "803c6c544633fafba01025b75648803cca52d5618232a8f08cba49b9433f599e", "chunk_index": 0}
{"text": "EXHIBIT 1.2 Long Intel call vs. long Intel stock.\nThe thin dotted line represents owning 100 shares of Intel at $22.25.\nProfits are unlimited, but the risk is substantial—the stock can go to zero.\nHerein lies the trade-off. The long call has unlimited profit potential with\nlimited risk. Whenever an option is purchased, the most that can be lost is\nthe premium paid for the option. But the benefit of reduced risk comes at acost. If the stock is above the strike at expiration, the call will always\nunderperform the stock by the amount of the premium.\nBecause of this trade-off, conservative traders will sometimes buy acall\nrather than the associated stock and sometimes buy the stock rather than the\ncall. Buying acall can be considered more conservative when the volatility\nof the stock is expected to rise. Traders are willing to risk acomparatively\nsmall premium when alarge price decline is feared possible. Instead, in an\ninterest-bearing vehicle, they harbor the capital that would otherwise have\nbeen used to purchase the stock. The cost of this protection is acceptable to\nthe trader if high-enough price advances are anticipated. In terms of\npercentage, much higher returns and losses are possible with the long call.\nIf the stock is trading at $27 at expiration, as the trader in this example\nexpected, the trader reaps a 429 percent profit on the $0.85 investment", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:43", "doc_id": "8dbb32fde25ef043dcbeb020a6fb542950fdc8eba4ba51df3184c89a97ce1dea", "chunk_index": 0}
{"text": "Sell Call\nSelling acall creates the obligation to sell the stock at the strike price. Why\nis atrader willing to accept this obligation? The answer is option premium.\nIf the position is held until expiration without getting assigned, the entire\npremium represents aprofit for the trader. If assignment occurs, the trader\nwill be obliged to sell stock at the strike price. If the trader does not have along position in the underlying stock (anaked call), ashort stock position\nwill be created. Otherwise, if stock is owned (acovered call), that stock is\nsold. Whether the trader has aprofit or aloss depends on the movement of\nthe stock price and how the short call position was constructed.\nConsider anaked call example:\nSell 1 TGT October 50 call at 1.45\nIn this example, Target Corporation (TGT) is trading at $49.42. Atrader,\nSam, believes Target will continue to be trading below $50 by October\nexpiration, about two months from now. Sam sells 1 Target two-month 50\ncall at 1.45, opening ashort position in that series. Exhibit 1.3 will help\nexplain the expected payout of this naked call position if it is held until\nexpiration.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:45", "doc_id": "e9613de69ed27efafe328ea4cebf7be850192696fdf799ac37539f914f8157a1", "chunk_index": 0}
{"text": "EXHIBIT 1.3 Naked Target call.\nIf TGT is trading below the exercise price of 50, the call will expire\nworthless. Sam keeps the 1.45 premium, and the obligation to sell the stock\nceases to exist. If Target is trading above the strike price, the call will be in-\nthe-money. The higher the stock is above the strike price, the more intrinsic\nvalue the call will have. As aseller, Sam wants the call to have little or no\nintrinsic value at expiration. If the stock is below the break-even price at\nexpiration, Sam will still have aprofit. Here, the break-even price is $51.45\n—the strike price plus the call premium. Above the break-even, Sam has aloss. Since stock prices can rise to infinity (although, for the record, Ihave\nnever seen this happen), the naked call position has unlimited risk of loss.\nBecause ashort stock position may be created, anaked call position must\nbe done in amargin account. For retail traders, many brokerage firms\nrequire different levels of approval for different types of option strategies.\nBecause the naked call position has unlimited risk, establishing it will\ngenerally require the highest level of approval—and ahigh margin\nrequirement.\nAnother tactical consideration is what Sam’sobjective was when he\nentered the trade. His goal was to profit from the stock’sbeing below $50", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:46", "doc_id": "e944c8dc1c731a1864bdc8ea73669daedc4e4e1a33d5af63b2746cf330e989d7", "chunk_index": 0}
{"text": "during this two-month period—not to short the stock. Because equity\noptions are American exercise and can be exercised/assigned any time from\nthe moment the call is sold until expiration, ashort stock position cannot\nalways be avoided. If assigned, the short stock position will extend Sam’speriod of risk—because stock doesn’texpire. Here, he will pay one\ncommission shorting the stock when assignment occurs and one more when\nhe buys back the unwanted position. Many traders choose to close the naked\ncall position before expiration rather than risk assignment.\nIt is important to understand the fundamental difference between buying\ncalls and selling calls. Buying acall option offers limited risk and unlimited\nreward. Selling anaked call option, however, has limited reward—the call\npremium—and unlimited risk. This naked call position is not so much\nbearish as not bullish . If Sam thought the stock was going to zero, he\nwould have chosen adifferent strategy.\nNow consider acovered call example:\nBuy 100 shares TGT at $49.42\nSell 1 TGT October 50 call at 1.45\nUnlimited and risk are two words that don’tsit well together with many\ntraders. For that reason, traders often prefer to sell calls as part of aspread.\nBut since spreads are strategies that involve multiple components, they have\ndifferent risk characteristics from an outright option. Perhaps the most\ncommonly used call-selling spread strategy is the covered call (sometimes\ncalled acovered write or abuy-write ). While selling acall naked is away\nto take advantage of a “not bullish” forecast, the covered call achieves adifferent set of objectives.\nAfter studying Target Corporation, another trader, Isabel, has aneutral to\nslightly bullish forecast. With Target at $49.42, she believes the stock will\nbe range-bound between $47 and $51.50 over the next two months, ending\nwith October expiration. Isabel buys 100 shares of Target at $49.42 and\nsells 1 TGT October 50 call at 1.45. The implications for the covered-call\nstrategy are twofold: Isabel must be content to own the stock at current\nlevels, and—since she sold the right to buy the stock at $50, that is, a 50\ncall, to another party—she must be willing to sell the stock if the price rises\nto or through $50 per share. Exhibit 1.4 shows how this covered call\nperforms if it is held until the call expires.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:47", "doc_id": "65620eed164bb59224f06f510e9ffdf1b7fe58b2ae3db55285daaea234bb8f89", "chunk_index": 0}
{"text": "EXHIBIT 1.4 Target covered call.\nThe solid kinked line represents the covered call position, and the thin,\nstraight dotted line represents owning the stock outright. At the expiration\nof the call option, if Target is trading below $50 per share—the strike price\n—the call expires and Isabel is left with along position of 100 shares plus\n$1.45 per share of expired-option premium. Below the strike, the buy-write\nalways outperforms simply owning the stock by the amount of the\npremium. The call premium provides limited downside protection; the stock\nIsabel owns can decline $1.45 in value to $47.97 before the trade is aloser.\nIn the unlikely event the stock collapses and becomes worthless, this\nlimited downside protection is not so comforting. Ultimately, Isabel has\n$47.97 per share at risk.\nThe trade-off comes if Target is above $50 at expiration. Here, assignment\nwill likely occur, in which case the stock will be sold. The call can be\nassigned before expiration, too, causing the stock to be called away early.\nBecause the covered call involves this obligation to sell the sock at the\nstrike price, upside potential is limited. In this case, Isabel’sprofit potential\nis $2.03. The stock can rise from $49.42 to $50—a $0.58 profit—plus $1.45\nof option premium.\nIsabel does not want the stock to decline too much. Below $47.97, the\ntrade is aloser. If the stock rises too much, the stock is sold prematurely and", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:48", "doc_id": "5ccfb285366dda100ee869bd5d3c2ece4da76deb6788134872fde39c44215d80", "chunk_index": 0}
{"text": "Sell Put\nSelling aput has many similarities to the covered call strategy. We’ll\ndiscuss the two positions and highlight the likenesses. Chapter 6 will detail\nthe nuts and bolts of why these similarities exist.\nConsider an example of selling aput:\nSell 1 BA January 65 put at 1.20\nIn this example, trader Sam is neutral to moderately bullish on Boeing (BA)\nbetween now and January expiration. He is not bullish enough to buy BA at\nthe current market price of $69.77 per share. But if the shares dropped\nbelow $65, he’dgladly scoop some up. Sam sells 1 BA January 65 put at\n1.20. The at-expiration diagram in Exhibit 1.5 shows the P&(L) of this trade\nif it is held until expiration.\nEXHIBIT 1.5 Boeing short put.\nAt the expiration of this option, if Boeing is above $65, the put expires\nand Sam retains the premium of $1.20. The obligation to buy stock expires\nwith the option. Below the strike, put owners will be inclined to exercise\ntheir option to sell the stock at $65. Therefore, those short the put, as Sam is\nin this example, can expect assignment. The break-even price for the\nposition is $63.80. That is the strike price minus the option premium. If", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:50", "doc_id": "257429e7bcba8eeab0886438d3f94b61cf243ac9754b95fbccbce553e955fd95", "chunk_index": 0}
{"text": "assigned, this is the effective purchase price of the stock. The obligation to\nbuy at $65 is fulfilled, but the $1.20 premium collected makes the purchase\neffectively $63.80. Here, again, there is limited profit opportunity ($1.20 if\nthe stock is above the strike price) and seemingly unlimited risk (the risk of\npotential stock ownership at $63.80) if Boeing is below the strike price.\nWhy would atrader short aput and willingly assume this substantial risk\nwith comparatively limited reward? There are anumber of motivations that\nmay warrant the short put strategy. In this example, Sam had the twin goals\nof profiting from aneutral to moderately bullish outlook on Boeing and\nbuying it if it traded below $65. The short put helps him achieve both\nobjectives.\nMuch like the covered call, if the stock is above the strike at expiration,\nthis trader reaches his maximum profit potential—in this case 1.20. And if\nthe price of Boeing is below the strike at expiration, Sam has ownership of\nthe stock from assignment. Here, astrike price that is lower than the current\nstock level is used. The stock needs to decline in order for Sam to get\nassigned and become long the stock. With this strategy, he was able to\nestablish atarget price at which he would buy the stock. Why not use alimit\norder? If the put is assigned, the effective purchase price is $63.80 even if\nthe stock price is above this price. If the put is not assigned, the premium is\nkept.\nAconsideration every trader must make before entering the short put\nposition is how the purchase of the stock will be financed in the event the\nput is assigned. Traders hoping to acquire the stock will often hold enough\ncash in their trading account to secure the purchase of the stock. This is\ncalled acash-secured put . In this example, Sam would hold $6,380 in his\naccount in addition to the $120 of option premium received. This affords\nhim enough free capital to fund the $6,500 purchase of stock the short put\ndictates. More speculative traders may be willing to buy the stock on\nmargin, in which case the trader will likely need around 50 percent of the\nstock’svalue.\nSome traders sell puts without the intent of ever owning the stock. They\nhope to profit from alow-volatility environment. Just as the short call is anot-bullish stance on the underlying, the short put is anot-bearish play. As\nlong as the underlying is above the strike price at expiration, the option", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:51", "doc_id": "11253242afd90a436f5f2a7429d634fed95accc56b34bb09c4cc0e1f54e0b5e3", "chunk_index": 0}
{"text": "Buy Put\nBuying aput gives the holder the right to sell stock at the strike price. Of\ncourse, puts can be apart of ahost of different spreads, but this chapter\ndiscusses the two most basic and common put-buying strategies: the long\nput and the protective put. The long put is away to speculate on abearish\nmove in the underlying security, and the protective put is away to protect along position in the underlying security.\nConsider along put example:\nBuy 1 SPY May 139 put at 2.30\nIn this example, the Spiders have had agood run up to $140.35. Trader\nIsabel is looking for a 10 percent correction in SPY between now and the\nend of May, about three months away. She buys 1 SPY May 139 put at 2.30.\nThis put gives her the right to sell 100 shares of SPY at $139 per share.\nExhibit 1.6 shows Isabel’s P&(L) if the put is held until expiration.\nEXHIBIT 1.6 SPY long put.\nIf SPY is above the strike price of 139 at expiration, the put will expire\nand the entire premium of 2.30 will be lost. If SPY is below the strike price\nat expiration, the put will have value. It can be exercised, creating ashort\nposition in the Spiders at an effective price of $136.70 per share. This price", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:53", "doc_id": "0f3e66085c85fafd7540c6a2b665a1a440dc083c2a131c17c2cb960cf2b85e3c", "chunk_index": 0}
{"text": "is found by subtracting the premium paid, 2.30, from the strike price, 139.\nThis is the point at which the position breaks even. If SPY is below $136.70\nat expiration, Isabel has aprofit. Profits will increase on atick-for-tick\nbasis, with downward movements in SPY down to zero. The long put has\nlimited risk and substantial reward potential.\nAn alternative for Isabel is to short the ETF at the current price of\n$140.35. But ashort position in the underlying may not be as attractive to\nher as along put. The margin requirements for short stock are significantly\nhigher than for along put. Put buyers must post only the premium of the put\n—that is the most that can be lost, after all.\nThe margin requirement for short stock reflects unlimited loss potential.\nMargin requirements aside, risk is avery real consideration for atrader\ndeciding between shorting stock and buying aput. If the trader expects high\nvolatility, he or she may be more inclined to limit upside risk while\nleveraging downside profit potential by buying aput. In general, traders buy\noptions when they expect volatility to increase and sell them when they\nexpect volatility to decrease. This will be acommon theme throughout this\nbook.\nConsider aprotective put example:\nThis is an example of asituation in which volatility is expected to\nincrease.\nOwn 100 shares SPY at 140.35\nBuy 1 SPY May139 put at 2.30\nAlthough Isabel bought aput because she was bearish on the Spiders, adifferent trader, Kathleen, may buy aput for adifferent reason—she’sbullish but concerned about increasing volatility. In this example, Kathleen\nhas owned 100 shares of Spiders for some time. SPY is currently at\n$140.35. She is bullish on the market but has concerns about volatility over\nthe next two or three months. She wants to protect her investment. Kathleen\nbuys 1 SPY May 139 put at 2.30. (If Kathleen bought the shares of SPY and\nthe put at the same time, as aspread, the position would be called amarried\nput.)\nKathleen is buying the right to sell the shares she owns at $139.\nEffectively, it is an insurance policy on this asset. Exhibit 1.7 shows the risk\nprofile of this new position.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:54", "doc_id": "2a4bdbddd92c36a253db68bf87f01fd9b810af1420e2f8a2ab8335589f702435", "chunk_index": 0}
{"text": "EXHIBIT 1.7 SPY protective put.\nThe solid kinked line is the protective put (put and stock), and the thin\ndotted line is the outright position in SPY alone, without the put. The most\nKathleen stands to lose with the protective put is $3.65 per share. SPY can\ndecline from $140.35 to $139, creating aloss of $1.35, plus the $2.30\npremium spent on the put. If the stock does not fall and the insuring put\nhence does not come into play, the cost of the put must be recouped to\njustify its expense. The break-even point is $142.65.\nThis position implies that Kathleen is still bullish on the Spiders. When\ntraders believe astock or ETF is going to decline, they sell the shares.\nInstead, Kathleen sacrifices 1.6 percent of her investment up front by\npurchasing the put for $2.30. She defers the sale of SPY until the period of\nperceived risk ends. Her motivation is not to sell the ETF; it is to hedge\nvolatility.\nOnce the anticipated volatility is no longer aconcern, Kathleen has achoice to make. She can let the option run its course, holding it to\nexpiration, at which point it will either expire or be exercised; or she can\nsell the option before expiration. If the option is out-of-the-money, it may\nhave residual time value prior to expiration that can be recouped. If it is in-\nthe-money, it will have intrinsic value and maybe time value as well. In this\nsituation, Kathleen can look at this spread as two trades—one that has", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:55", "doc_id": "83ce8477817468822a5a859176148d870f1901a1e0f083dd049c01dd6319cca6", "chunk_index": 0}
{"text": "CHAPTER 2\nGreek Philosophy\nMy wife, Kathleen, is not an options trader. Au contraire. However, she,\nlike just about everyone, uses them from time to time—though without\nreally thinking about it. She was on eBay the other day bidding on apair of\nshoes. The bid was $45 with three days left to go. She was concerned about\nthe price rising too much and missing the chance to buy them at what she\nthought was agood price. She noticed, though, that someone else was\nselling the same shoes with abuy-it-now price of $49—agood-enough\nprice in her opinion. Kathleen was effectively afforded acall option. She\nhad the opportunity to buy the shoes at (the strike price of) $49, aright she\ncould exercise until the offer expired.\nThe biggest difference between the option in the eBay scenario and the\nsort of options discussed in this book is transferability. Actual options are\ntradable—they can be bought and sold. And it is the contract itself that has\nvalue—there is one more iteration of pricing.\nFor example, imagine the $49 opportunity was acoupon or certificate that\nguaranteed the price of $49, which could be passed along from one person\nto another. And there was the chance that the $49-price guarantee could\nrepresent adiscount on the price paid for the shoes—maybe abig discount\n—should the price of the shoes rise in the eBay auction. The certificate\nguaranteeing the $49 would have value. Anyone planning to buy the shoes\nwould want the safety of knowing they were guaranteed not to pay more\nthan $49 for the shoes. In fact, some people would even consider paying to\nbuy the certificate itself if they thought the price of the shoes might rise\nsignificantly.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:58", "doc_id": "300c3e9939f9da309b4f78b1227fde86a552619d2c1faa7be6d199a29d53dabb", "chunk_index": 0}
{"text": "Price vs. Value: How Traders Use\nOption-Pricing Models\nLike in the common-life example just discussed, the right to buy or sell an\nunderlying security—that is, an option—can have value, too. The specific\nvalue of an option is determined by supply and demand. There are several\nvariables in an option contract, however, that can influence atrader’swillingness to demand (desire to buy) or supply (desire to sell) an option at\nagiven price. For example, atrader would rather own—that is, there would\nbe higher demand for—an option that has more time until expiration than ashorter-dated option, all else held constant. And atrader would rather own acall with alower strike than ahigher strike, all else kept constant, because it\nwould give the right to buy at alower price.\nSeveral elements contribute to the value of an option. It took academics\nmany years to figure out exactly what those elements are. Fischer Black and\nMyron Scholes together pioneered research in this area at the University of\nChicago. Ultimately, their work led to a Nobel Prize for Myron Scholes.\nFischer Black died before he could be honored.\nIn 1973, Black and Scholes published apaper called “The Pricing of\nOptions and Corporate Liabilities” in the Journal of Political Economy ,\nthat introduced the Black-Scholes option-pricing model to the world. The\nBlack-Scholes model values European call options on non-dividend-paying\nstocks. Here, for the first time, was awidely accepted model illustrating\nwhat goes into the pricing of an option. Option prices were no longer wild\nguesswork. They could now be rationalized. Soon, additional models and\nalterations to the Black-Scholes model were developed for options on\nindexes, dividend-paying stocks, bonds, commodities, and other optionable\ninstruments. All the option-pricing models commonly in use today have\nslightly different means but achieve the same end: the option’stheoretical\nvalue. For American-exercise equity options, six inputs are entered into any\noption-pricing model to generate atheoretical value: stock price, strike\nprice, time until expiration, interest rate, dividends, and volatility.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:59", "doc_id": "639b75cb6bd983c242a1458e7cca518735f3d93354dd1c08d235e66a4ddd8976", "chunk_index": 0}
{"text": "Theoretical value—what aconcept! Atrader plugs six numbers into apricing model, and it tells him what the option is worth, right? Well, in\npractical terms, that’snot exactly how it works. An option is worth what the\nmarket bears. Economists call this price discovery. The price of an option is\ndetermined by the forces of supply and demand working in afree and open\nmarket. Herein lies an important concept for option traders: the difference\nbetween price and value.\nPrice can be observed rather easily from any source that offers option\nquotes (web sites, your broker, quote vendors, and so on). Value is\ncalculated by apricing model. But, in practice, the theoretical value is really\nnot an output at all. It is already known: the market determines it. The trader\nrectifies price and value by setting the theoretical value to fall between the\nbid and the offer of the option by adjusting the inputs to the model.\nProfessional traders often refer to the theoretical value as the fair value of\nthe option.\nAt this point, please note the absence of the mathematical formula for the\nBlack-Scholes model (or any other pricing model, for that matter).\nAlthough the foundation of trading option greeks is mathematical, this book\nwill keep the math to aminimum—which is still quite abit. The focus of\nthis book is on practical applications, not academic theory. It’sabout\nlearning to drive the car, not mastering its engineering.\nThe trader has an equation with six inputs equaling one known output.\nWhat good is this equation? An option-pricing model helps atrader\nunderstand how market forces affect the value of an option. Five of the six\ninputs are dynamic; the only constant is the strike price of the option in\nquestion. If the price of the option changes, it’sbecause one or more of the\nfive variable inputs has changed. These variables are independent of each\nother, but they can change in harmony, having either acumulative or net\neffect on the option’svalue. An option trader needs to be concerned with the\nrelationship of these variables (price, time, volatility, interest). This\nmultidimensional view of asset pricing is unique to option traders.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:60", "doc_id": "b057731a679d8a1f42063dde844370ac6b43ef55269e1896890d86d2ff9ae4ac", "chunk_index": 0}
{"text": "Delta\nThe five figures commonly used by option traders are represented by Greek\nletters: delta, gamma, theta, vega, rho. The figures are referred to as option\ngreeks. Vega, of course, is not an actual letter of the greek alphabet, but in\nthe options vernacular, it is considered one of the greeks.\nThe greeks are aderivation of an option-pricing model, and each Greek\nletter represents aspecific sensitivity to influences on the option’svalue. To\nunderstand concepts represented by these five figures, we’ll start with delta,\nwhich is defined in four ways:\n1. The rate of change of an option value relative to achange in the\nunderlying stock price.\n2. The derivative of the graph of an option value in relation to the stock\nprice.\n3. The equivalent of underlying shares represented by an option\nposition.\n4. The estimate of the likelihood of an option expiring in-the-money. 1\nDefinition 1 : Delta (Δ) is the rate of change of an option’svalue relative\nto achange in the price of the underlying security. Atrader who is bullish\non aparticular stock may choose to buy acall instead of buying the\nunderlying security. If the price of the stock rises by $1, the trader would\nexpect to profit on the call—but by how much? To answer that question, the\ntrader must consider the delta of the option.\nDelta is stated as apercentage. If an option has a 50 delta, its price will\nchange by 50 percent of the change of the underlying stock price. Delta is\ngenerally written as either awhole number, without the percent sign, or as adecimal. So if an option has a 50 percent delta, this will be indicated as\n0.50, or 50. For the most part, we’ll use the former convention in our\ndiscussion.\nCall values increase when the underlying stock price increases and vice\nversa. Because calls have this positive correlation with the underlying, they\nhave positive deltas. Here is asimplified example of the effect of delta on\nan option:", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:61", "doc_id": "b64adf8aef4a2313f9e5daf2efff368aebe4bda42054cb2cd3fa9d5bcfa30cf8", "chunk_index": 0}
{"text": "Consider a $60 stock with acall option that has a 0.50 delta and is trading\nfor 3.00. Considering only the delta, if the stock price increases by $1, the\ntheoretical value of the call will rise by 0.50. That’s 50 percent of the stock\nprice change. The new call value will be 3.50. If the stock price decreases\nby $1, the 0.50 delta will cause the call to decrease in value by 0.50, from\n3.00 to 2.50.\nPuts have anegative correlation to the underlying. That is, put values\ndecrease when the stock price rises and vice versa. Puts, therefore, have\nnegative deltas. Here is asimplified example of the delta effect on a −0.40-\ndelta put:\nAs the stock rises from $60 to $61, the delta of −0.40 causes the put value\nto go from $2.25 to $1.85. The put decreases by 40 percent of the stock\nprice increase. If the stock price instead declined by $1, the put value would\nincrease by $0.40, to $2.65.\nUnfortunately, real life is abit more complicated than the simplified\nexamples of delta used here. In reality, the value of both the call and the put\nwill likely be higher with the stock at $61 than was shown in these\nexamples. We’ll expand on this concept later when we tackle the topic of\ngamma.\nDefinition 2 : Delta can also be described another way. Exhibit 2.1 shows\nthe value of acall option with three months to expiration at avariable stock\nprice. As the stock price rises, the call is worth more; as the stock price\ndeclines, the call value moves toward zero. Mathematically, for any given\npoint on the graph, the derivative will show the rate of change of the option\nprice. The delta is the first derivative of the graph of the option price\nrelative to the stock price .", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:62", "doc_id": "ee124d4dd44a835376fb26f084ebe3acc7c643e57d6e6af241783405ec65155e", "chunk_index": 0}
{"text": "EXHIBIT 2.1 Call value compared with stock price.\nDefinition 3 : In terms of absolute value (meaning that plus and minus\nsigns are ignored), the delta of an option is between 1.00 and 0. Its price can\nchange in tandem with the stock, as with a 1.00 delta; or it cannot change at\nall as the stock moves, as with a 0 delta; or anything in between. By\ndefinition, stock has a 1.00 delta—it is the underlying security. A $1 rise in\nthe stock yields a $100 profit on around lot of 100 shares. Acall with a\n0.60 delta rises by $0.60 with a $1 increase in the stock. The owner of acall\nrepresenting rights on 100 shares earns $60 for a $1 increase in the\nunderlying. It’sas if the call owner in this example is long 60 shares of the\nunderlying stock. Delta is the option’sequivalent of aposition in the\nunderlying shares .\nAtrader who buys five 0.43-delta calls has aposition that is effectively\nlong 215 shares—that’s 5 contracts × 0.43 deltas × 100 shares. In option\nlingo, the trader is long 215 deltas. Likewise, if the trader were short five\n0.43-delta calls, the trader would be short 215 deltas.\nThe same principles apply to puts. Being long 10 0.59-delta puts makes\nthe trader short atotal of 590 deltas, aposition that profits or loses like\nbeing short 590 shares of the underlying stock. Conversely, if the trader\nwere short 10 0.59-delta puts, the trader would theoretically make $590 if\nthe stock were to rise $1 and lose $590 if the stock fell by $1—just like\nbeing long 590 shares.\nDefinition 4 : The final definition of delta is considered the trader’sdefinition. It’smathematically imprecise but is used nonetheless as ageneral rule of thumb by option traders. Atrader would say the delta is astatistical approximation of the likelihood of the option expiring in-the-", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:63", "doc_id": "82b6a6c32fce05afa9a0fc583dea90c89d322a9db45c0195d4a617e84694209d", "chunk_index": 0}
{"text": "Dynamic Inputs\nOption deltas are not constants. They are calculated from the dynamic\ninputs of the pricing model—stock price, time to expiration, volatility, and\nso on. When these variables change, the changes affect the delta. These\nchanges can be mathematically quantified—they are systematic.\nUnderstanding these patterns and other quirks as to how delta behaves can\nhelp traders use this tool more effectively. Let’sdiscuss afew observations\nabout the characteristics of delta.\nFirst, call and put deltas are closely related. Exhibit 2.2 is apartial option\nchain of 70-day calls and puts in Rambus Incorporated (RMBS). The stock\nwas trading at $21.30 when this table was created. In Exhibit 2.2 , the 20\ncalls have a 0.66 delta.\nEXHIBIT 2.2 RMBS Option chain with deltas.\nNotice the deltas of the put-call pairs in this exhibit. As ageneral rule, the\nabsolute value of the call delta plus the absolute value of the put delta add\nup to close to 1.00. The reason for this has to do with amathematical\nrelationship called put-call parity, which is briefly discussed later in this\nchapter and described in detail in Chapter 6. But with equity options, the\nput-call pair doesn’talways add up to exactly 1.00.\nSometimes the difference is simply due to rounding. But sometimes there\nare other reasons. For example, the 30-strike calls and puts in Exhibit 2.2\nhave deltas of 0.14 and −0.89, respectively. The absolute values of the\ndeltas add up to 1.03. Because of the possibility of early exercise of\nAmerican options, the put delta is abit higher than the call delta would", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:65", "doc_id": "e6937f5e5187b0f7e3ced008461d352e4c6d36747c80f89d71ce419c3623b2b5", "chunk_index": 0}
{"text": "Moneyness and Delta\nThe next observation is the effect of moneyness on the option’sdelta.\nMoneyness describes the degree to which the option is in- or out-of-the-\nmoney. As ageneral rule, options that are in-the-money (ITM) have deltas\ngreater than 0.50. Options that are out-of-the-money (OTM) have deltas\nless than 0.50. Finally, options that are at-the-money (ATM) have deltas that\nare about 0.50. The more in-the-money the option is, the closer to 1.00 the\ndelta is. The more out-of-the-money, the closer the delta is to 0.\nBut ATM options are usually not exactly 0.50. For ATMs, both the call\nand the put deltas are generally systematically avalue other than 0.50.\nTypically, the call has ahigher delta than 0.50 and the put has alower\nabsolute value than 0.50. Incidentally, the call’stheoretical value is\ngenerally greater than the put’swhen the options are right at-the-money as\nwell. One reason for this disparity between exactly at-the-money calls and\nputs is the interest rate. The more time until expiration, the more effect the\ninterest rate will have, and, therefore, the higher the call’stheoretical and\ndelta will be relative to the put.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:67", "doc_id": "509af93635d3883f340fcc6501010e2a58fd1a01b1a0ab10cd6bbc266be4a5f6", "chunk_index": 0}
{"text": "Effect of Time on Delta\nIn aclose contest, the last few minutes of afootball game are often the most\nexciting—not because the players run faster or knock heads harder but\nbecause one strategic element of the game becomes more and more\nimportant: time. The team that’sin the lead wants the game clock to run\ndown with no interruption to solidify its position. The team that’slosing\nuses its precious time-outs strategically. The more playing time left, the less\ncertain defeat is for the losing team.\nAlthough mathematically imprecise, the trader’sdefinition can help us\ngain insight into how time affects option deltas. The more time left until an\noption’sexpiration, the less certain it is whether the option will be ITM or\nOTM at expiration. The deltas of both the ITM and the OTM options reflect\nthat uncertainty. The more time left in the life of the option, the closer the\ndeltas tend to gravitate to 0.50. A 0.50 delta represents the greatest level of\nuncertainty—acoin toss. Exhibit 2.3 shows the deltas of ahypothetical\nequity call with astrike price of 50 at various stock prices with different\ntimes until expiration. All other parameters are held constant.\nEXHIBIT 2.3 Estimated delta of 50-strike call—impact of time.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:68", "doc_id": "33f79ba31f55956319f2391b5913c9b0dcb7e00690aed8de7e48ac4354638ee6", "chunk_index": 0}
{"text": "Effect of Volatility on Delta\nThe level of volatility affects option deltas as well. We’ll discuss volatility\nin more detail in future chapters, but it’simportant to address it here as it\nrelates to the concept of delta. Exhibit 2.4 shows how changing the\nvolatility percentage (explained further in Chapter 3), as opposed to the\ntime to expiration, affects option deltas. In this table, the delta of acall with\n91 days until expiration is studied.\nEXHIBIT 2.4 Estimated delta of 50-strike call—impact of volatility.\nNotice the effect that volatility has on the deltas of this option with the\nunderlying stock at various prices. In this table, at alow volatility with the\ncall deep in- or out-of-the-money, the delta is very large or very small,\nrespectively. At 10 percent volatility with the stock at $58 ashare, the delta\nis 1.00. At that same volatility level with the stock at $42 ashare, the delta\nis 0.\nBut at higher volatility levels, the deltas change. With the stock at $58, a\n45 percent volatility gives the 50-strike call a 0.79 delta—much smaller\nthan it was at the low volatility level. With the stock at $42, a 45-percent\nvolatility returns a 0.30 delta for the call. Generally speaking, ITM option\ndeltas are smaller given ahigher volatility assumption, and OTM option\ndeltas are bigger with ahigher volatility.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:71", "doc_id": "740d138a9349077301a1c0a607c00289f60e62200db890e7e776e6e840e2c6f9", "chunk_index": 0}
{"text": "Gamma\nThe strike price is the only constant in the pricing model. When the stock\nprice moves relative to this constant, the option in question becomes more\nin-the-money or out-of-the-money. This means the delta changes. This\nisolated change is measured by the option’sgamma, sometimes called\ncurvature .\nGamma (Γ) is the rate of change of an option’sdelta given achange in\nthe price of the underlying security . Gamma is conventionally stated in\nterms of deltas per dollar move. The simplified examples above under\nDefinition 1 of delta, used to describe the effect of delta, had one important\npiece of the puzzle missing: gamma. As the stock price moved higher in\nthose examples, the delta would not remain constant. It would change due\nto the effect of gamma. The following example shows how the delta would\nchange given a 0.04 gamma attributed to the call option.\nThe call in this example starts as a 0.50-delta option. When the stock\nprice increases by $1, the delta increases by the amount of the gamma. In\nthis example, delta increases from 0.50 to 0.54, adding 0.04 deltas. As the\nstock price continues to rise, the delta continues to move higher. At $62, the\ncall’sdelta is 0.58.\nThis increase in delta will affect the value of the call. When the stock\nprice first begins to rise from $60, the option value is increasing at arate of\n50 percent—the call’sdelta at that stock price. But by the time the stock is\nat $61, the option value is increasing at arate of 54 percent of the stock\nprice. To estimate the theoretical value of the call at $61, we must first\nestimate the average change in the delta between $60 and $61. The average\ndelta between $60 and $61 is roughly 0.52. It’sdifficult to calculate the\naverage delta exactly because gamma is not constant; this is discussed in\nmore detail later in the chapter. Amore realistic example of call values in\nrelation to the stock price would be as follows:", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:73", "doc_id": "5c7b2de476447bdc298404f8e9fc9a52f9da7fbd3c57419a2cd488de674c171f", "chunk_index": 0}
{"text": "Each $1 increase in the stock shows an increase in the call value about\nequal to the average delta value between the two stock prices. If the stock\nwere to decline, the delta would get smaller at adecreasing rate.\nAs the stock price declines from $60 to $59, the option delta decreases\nfrom 0.50 to 0.46. There is an average delta of about 0.48 between the two\nstock prices. At $59 the new theoretical value of the call is 2.52. The\ngamma continues to affect the option’sdelta and thereby its theoretical\nvalue as the stock continues its decline to $58 and beyond.\nPuts work the same way, but because they have anegative delta, when\nthere is apositive stock-price movement the gamma makes the put delta\nless negative, moving closer to 0. The following example clarifies this.\nAs the stock price rises, this put moves more and more out-of-the-money.\nIts theoretical value is decreasing by the rate of the changing delta. At $60,\nthe delta is −0.40. As the stock rises to $61, the delta changes to −0.36. The\naverage delta during that move is about −0.38, which is reflected in the\nchange in the value of the put.\nIf the stock price declines and the put moves more toward being in-the-\nmoney, the delta becomes more negative—that is, the put acts more like ashort stock position.\nHere, the put value rises by the average delta value between each\nincremental change in the stock price.\nThese examples illustrate the effect of gamma on an option without\ndiscussing the impact on the trader’sposition. When traders buy options,\nthey acquire positive gamma. Since gamma causes options to gain value at", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:74", "doc_id": "2e697441163b73813e26db7221d79004de9851532415f1c580ab0916ea8a7769", "chunk_index": 0}
{"text": "afaster rate and lose value at aslower rate, (positive) gamma helps the\noption buyer. Atrader buying one call or put in these examples would have\n+0.04 gamma. Buying 10 of these options would give the trader a +0.4\ngamma.\nWhen traders sell options, gamma works against them. When options lose\nvalue, they move toward zero at aslower rate. When the underlying moves\nadversely, gamma speeds up losses. Selling options yields anegative\ngamma position. Atrader selling one of the above calls or puts would have\n−0.04 gamma per option.\nThe effect of gamma is less significant for small moves in the underlying\nthan it is for bigger moves. On proportionately large moves, the delta can\nchange quite abit, making abig difference in the position’s P&(L). In\nExhibit 2.1 , the left side of the diagram showed the call price not\nincreasing at all with advances in the stock—a 0 delta. The right side\nshowed the option advancing in price 1-to-1 with the stock—a 1.00 delta.\nBetween the two extremes, the delta changes. From this diagram another\ndefinition for gamma can be inferred: gamma is the second derivative of the\ngraph of the option price relative to the stock price. Put another way,\ngamma is the first derivative of agraph of the delta relative to the stock\nprice. Exhibit 2.5 illustrates the delta of acall relative to the stock price.\nEXHIBIT 2.5 Call delta compared with stock price.\nNot only does the delta change, but it changes at achanging rate. Gamma\nis not constant. Moneyness, time to expiration, and volatility each have an\neffect on the gamma of an option.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:75", "doc_id": "27c1e4a88e19f238b621ce81b8da49d9216217c25edc10991527e54d53dc90db", "chunk_index": 0}
{"text": "Dynamic Gamma\nWhen options are far in-the-money or out-of-the-money, they are either\n1.00 delta or 0 delta. At the extremes, small changes in the stock price will\nnot cause the delta to change much. When an option is at-the-money, it’sadifferent story. Its delta can change very quickly.\nITM and OTM options have alow gamma.\nATM options have arelatively high gamma.\nExhibit 2.6 is an example of how moneyness translates into gamma on\nQQQ calls.\nEXHIBIT 2.6 Gamma of QQQ calls with QQQ at $44.\nWith QQQ at $44, 92 days until expiration, and aconstant volatility input\nof 19 percent, the 36- and 54-strike calls are far enough in- and out-of-the-\nmoney, respectively, that if the Qs move asmall amount in either direction\nfrom the current price of $44, the movement won’tchange their deltas\nmuch at all. The chances of their money status changing between now and\nexpiration would not be significantly different statistically given asmall\nstock price change. They have the smallest gammas in the table.\nThe highest gammas shown here are around the ATM strike prices. (Note\nthat because of factors not yet discussed, the strike that is exactly at-the-\nmoney may not have the highest gamma. The highest gamma is likely to\noccur at aslightly higher strike price.) Exhibit 2.7 shows agraph of the\ncorresponding numbers in Exhibit 2.6 .", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:76", "doc_id": "268af0330b83447540ef6ead10d695579b0b5ed295731b19624111daa1f74ff5", "chunk_index": 0}
{"text": "At seven days until expiration, there is less time for price action in the\nstock to change the expected moneyness at expiration of ITMs or OTMs.\nATM options, however, continue to be in play. Here, the ATM gamma is\napproaching 0.35. But the strikes below 41 and above 48 have 0 gamma.\nSimilarly-priced securities that tend to experience bigger price swings\nmay have strikes $3 away-from-the-money with seven-day gammas greater\nthan zero. The volatility of the underlying will affect gamma, too. Exhibit\n2.9 shows the same 19 percent volatility QQQ calls in contrast with agraph\nof the gamma if the volatility is doubled.\nEXHIBIT 2.9 Gamma as volatility changes.\nRaising the volatility assumption flattens the curve, causing ITM and\nOTM to have higher gamma while lowering the gamma for ATMs.\nShort-term ATM options with low volatility have the highest gamma.\nLower gamma is found in ATMs when volatility is higher and it is lower for\nITMs and OTMs and in longer-dated options.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:78", "doc_id": "3f4b1b6f60a75e640b8ab67d3b2773b629d35ec2424237aa1cc989a8e4b08940", "chunk_index": 0}
{"text": "Theta\nOption prices can be broken down into two parts: intrinsic value and time\nvalue. Intrinsic value is easily measurable. It is simply the ITM part of the\npremium. Time value, or extrinsic value, is what’sleft over—the premium\npaid over parity for the option. All else held constant, the more time left in\nthe life of the option, the more valuable it is—there is more time for the\nstock to move. And as the useful life of an option decreases, so does its time\nvalue.\nThe decline in the value of an option because of the passage of time is\ncalled time decay, or erosion. Incremental measurements of time decay are\nrepresented by the Greek letter theta (θ). Theta is the rate of change in an\noption’sprice given aunit change in the time to expiration . What exactly is\nthe unit involved here? That depends.\nSome providers of option greeks will display thetas that represent one\nday’sworth of time decay. Some will show thetas representing seven days\nof decay. In the case of aone-day theta, the figure may be based on aseven-\nday week or on aweek counting only trading days. The most common and,\narguably, most useful display of this figure is the one-day theta based on the\nseven-day week. There are, after all, seven days in aweek, each day of\nwhich can see an occurrence with the potential to cause arevaluation in the\nstock price (that is, news can come out on Saturday or Sunday). The one-\nday theta based on aseven-day week will be used throughout this book.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:79", "doc_id": "7348a6d056fbbc51dc117e11b633959c1fcd37103783629da52606dcec3fc44f", "chunk_index": 0}
{"text": "Taking the Day Out\nWhen the number of days to expiration used in the pricing model declines\nfrom, say, 32 days to 31 days, the price of the option decreases by the\namount of the theta, all else held constant. But when is the day “taken out”?\nIt is intuitive to think that after the market closes, the model is changed to\nreflect the passing of one day’stime. But, in fact, this change is logically\nanticipated and may be priced in early.\nIn the earlier part of the week, option prices can often be observed getting\ncheaper relative to the stock price sometime in the middle of the day. This is\nbecause traders will commonly take the day out of their model during\ntrading hours after the underlying stabilizes following the morning\nbusiness. On Fridays and sometimes Thursdays, traders will take all or part\nof the weekend out. Commonly, by Friday afternoon, traders will be using\nMonday’sdays to value their options.\nWhen option prices are seen getting cheaper on, say, a Friday, how can\none tell whether this is the effect of the market taking the weekend out or achange in some other input, such as volatility? To some degree, it doesn’tmatter. Remember, the model is used to reflect what the market is doing,\nnot the other way around. In many cases, it’slogical to presume that small\ndevaluations in option prices intraday can be attributed to the routine of the\nmarket taking the day out.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:80", "doc_id": "c29e14b117e74e379dd3a3b10c45526db00a34576e3dbbba240e8479105969bd", "chunk_index": 0}
{"text": "Friend or Foe?\nTheta can be agood thing or abad thing, depending on the position. Theta\nhurts long option positions; whereas it helps short option positions. Take an\n80-strike call with atheoretical value of 3.16 on astock at $82 ashare. The\n32-day 80 call has atheta of 0.03. If atrader owned one of these calls, the\ntrader’sposition would theoretically lose 0.03, or $0.03, as the time until\nexpiration change from 32 to 31 days. This trader has anegative theta\nposition. Atrader short one of these calls would have an overnight\ntheoretical profit of $0.03 attributed to theta. This trader would have apositive theta.\nTheta affects put traders as well. Using all the same modeling inputs, the\n32-day 80-strike put would have atheta of 0.02. Aput holder would\ntheoretically lose $0.02 aday, and aput writer would theoretically make\n$0.02. Long options carry with them negative theta; short options carry\npositive theta.\nAhigher theta for the call than for the put of the same strike price is\ncommon when an interest rate greater than zero is used in the pricing\nmodel. As will be discussed in greater detail in the section on rho, interest\ncauses the time value of the call to be higher than that of the corresponding\nput. At expiration, there is no time value left in either option. Because the\ncall begins with more time value, its premium must decline at afaster rate\nthan that of the put. Most modeling software will attribute the disparate\nrates of decline in value all to theta, whereas some modeling interfaces will\nmake clear the distinction between the effect of time decay and the effect of\ninterest on the put-call pair.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:81", "doc_id": "515cf7ec5e94d6158c34b4c4ed151c113ddd1bddb1995a9aa58d07b9d31db34b", "chunk_index": 0}
{"text": "The Effect of Moneyness and Stock Price\non Theta\nTheta is not aconstant. As variables influencing option values change, theta\ncan change, too. One such variable is the option’smoneyness. Exhibit 2.10\nshows theoretical values (theos), time values, and thetas for 3-month\noptions on Adobe (ADBE). In this example, Adobe is trading at $31.30 ashare with three months until expiration. The more ITM acall or aput gets,\nthe higher its theoretical value. But when studying an option’stime decay,\none needs to be concerned only with the option’stime value, because\nintrinsic value is not subject to time decay.\nEXHIBIT 2.10 Adobe theos and thetas (Adobe at $31.30).\nThe ATM options shown here have higher time value than ITM or OTM\noptions. Hence, they have more time premium to lose in the same three-\nmonth period. ATM options have the highest rate of decay, which is\nreflected in higher thetas. As the stock price changes, the theta value will\nchange to reflect its change in moneyness.\nIf this were ahigher-priced stock, say, 10 times the stock price used in\nthis example, with all other inputs held constant, the option values, and\ntherefore the thetas, would be higher. If this were astock trading at $313,\nthe 325-strike call would have atheoretical value of 16.39 and aone-day", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:82", "doc_id": "435922ce21158467d06c861d7b840461d4fe384799bd07f248d76620dab1bd73", "chunk_index": 0}
{"text": "The Effects of Volatility and Time on\nTheta\nStock price is not the only factor that affects theta values. Volatility and\ntime to expiration come into play here as well. The volatility input to the\npricing model has adirect relationship to option values. The higher the\nvolatility, the higher the value of the option. Higher-valued options decay at\nafaster rate than lower-valued options—they have to; their time values will\nboth be zero at expiration. All else held constant, the higher the volatility\nassumption, the higher the theta.\nThe days to expiration have adirect relationship to option values as well.\nAs the number of days to expiration decreases, the rate at which an option\ndecays may change, depending on the relationship of the stock price to the\nstrike price. ATM options tend to decay at anonlinear rate—that is, they\nlose value faster as expiration approaches—whereas the time values of ITM\nand OTM options decay at asteadier rate.\nConsider ahypothetical stock trading at $70 ashare. Exhibit 2.11 shows\nhow the theoretical values of the 75-strike call and the 70-strike call decline\nwith the passage of time, holding all other parameters constant.\nEXHIBIT 2.11 Rate of decay: ATM vs. OTM.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:84", "doc_id": "10f49eeb94e7a921a6927e6e62b742e78a67a0c61799bdb80db2d9553bb42c37", "chunk_index": 0}
{"text": "Vega\nOver the past decade or so, computers have revolutionized option trading.\nOptions traded through an online broker are filled faster than you can say,\n“Oops! Imeant to click on puts.” Now trading is facilitated almost entirely\nonline by professional and retail traders alike. Market and trading\ninformation is disseminated worldwide in subseconds, making markets all\nthe more efficient. And the tools now available to the common retail trader\nare very powerful as well. Many online brokers and other web sites offer\nhigh-powered tools like screeners, which allow traders to sift through\nthousands of options to find those that fit certain parameters.\nUsing ascreener to find ATM calls on same-priced stocks—say, stocks\ntrading at $40 ashare—can yield aresult worth talking about here. One $40\nstock can have a 40-strike call trading at around 0.50, while adifferent $40\nstock can have a 40 call with the same time to expiration trading at more\nlike 2.00. Why? The model doesn’tknow the name of the company, what\nindustry it’sin, or what its price-to-earnings ratio is. It is amathematical\nequation with six inputs. If five of the inputs—the stock price, strike price,\ntime to expiration, interest rate, and dividends—are identical for two\ndifferent options but they’re trading at different prices, the difference must\nbe the sixth variable, which is volatility.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:86", "doc_id": "ed7b48bd8a830854a759ad062306016612ff27ae8831e5968179f71fedd58f38", "chunk_index": 0}
{"text": "Implied Volatility (IV) and Vega\nThe volatility component of option values is called implied volatility (IV).\n(For more on implied volatility and how it relates to vega, see Chapter 3.)\nIV is apercentage, although in practice the percent sign is often omitted.\nThis is the value entered into apricing model, in conjunction with the other\nvariables, that returns the option’stheoretical value. The higher the\nvolatility input, the higher the theoretical value, holding all other variables\nconstant. The IV level can change and often does—sometimes dramatically.\nWhen IV rises or falls, option prices rise and fall in line with it. But by how\nmuch?\nThe relationship between changes in IV and changes in an option’svalue\nis measured by the option’svega. Vega is the rate of change of an option’stheoretical value relative to achange in implied volatility . Specifically, if\nthe IV rises or declines by one percentage point, the theoretical value of the\noption rises or declines by the amount of the option’svega, respectively.\nFor example, if acall with atheoretical value of 1.82 has avega of 0.06 and\nIV rises one percentage point from, say, 17 percent to 18 percent, the new\ntheoretical value of the call will be 1.88—it would rise by 0.06, the amount\nof the vega. If, conversely, the IV declines 1 percentage point, from 17\npercent to 16 percent, the call value will drop to 1.76—that is, it would\ndecline by the vega.\nAput with the same expiration month and the same strike on the same\nunderlying will have the same vega value as its corresponding call. In this\nexample, raising or lowering IV by one percentage point would cause the\ncorresponding put value to rise or decline by $0.06, just like the call.\nAn increase in IV and the consequent increase in option value helps the\nP&(L) of long option positions and hurts short option positions. Buying acall or aput establishes along vega position. For short options, the opposite\nis true. Rising IV adversely affects P&(L), whereas falling IV helps.\nShorting acall or put establishes ashort vega position.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:87", "doc_id": "c73cdaa98578b03c1c284bc54bfa4f0e1aa033d7ed219cbd8ed471101dfee167", "chunk_index": 0}
{"text": "The Effect of Moneyness on Vega\nLike the other greeks, vega is asnapshot that is afunction of multiple facets\nof determinants influencing option value. The stock price’srelationship to\nthe strike price is amajor determining factor of an option’svega. IV affects\nonly the time value portion of an option. Because ATM options have the\ngreatest amount of time value, they will naturally have higher vegas. ITM\nand OTM options have lower vega values than those of the ATM options.\nExhibit 2.13 shows an example of 186-day options on AT&T Inc. (T),\ntheir time value, and the corresponding vegas.\nEXHIBIT 2.13 AT&Ttheos and vegas (Tat $30, 186 days to Expry, 20%\nIV).\nNote that the 30-strike calls and puts have the highest time values. This\nstrike boasts the highest vega value, at 0.085. The lower the time premium,\nthe lower the vega—therefore, the less incremental IV changes affect the\noption. Since higher-priced stocks have higher time premium (in absolute\nterms, not necessarily in percentage terms) they will have higher vega.\nIncidentally, if this were a $300 stock instead of a $30 stock, the 186-day\nATMs would have a 0.850 vega, if all other model inputs remain the same.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:88", "doc_id": "91ffbb105e0b7c2b35bc1bb91f0bf600526a7d149bb23abbded9a265c157cfe9", "chunk_index": 0}
{"text": "Put-Call Parity\nPut and call values are mathematically bound together by an equation\nreferred to as put-call parity. In its basic form, put-call parity states:\nwhere\nc = call value,\nPV(x) = present value of the strike price,\np = put value, and\ns = stock price.\nThe put-call parity assumes that options are not exercised before\nexpiration (that is, that they are European style). This version of the put-call\nparity is for European options on non-dividend-paying stocks. Put-call\nparity can be modified to reflect the values of options on stocks that pay\ndividends. In practice, equity-option traders look at the equation in aslightly different way:\nTraders serious about learning to trade options must know put-call parity\nbackward and forward. Why? First, by algebraically rearranging this\nequation, it can be inferred that synthetically equivalent positions can be\nestablished by simply adding stock to an option. Again, aput is acall; acall\nis aput.\nand\nFor example, along call is synthetically equal to along stock position\nplus along put on the same strike, once interest and dividends are figured\nin. Asynthetic long stock position is created by buying acall and selling aput of the same month and strike. Understanding synthetic relationships is\nintrinsic to understanding options. Amore comprehensive discussion of\nsynthetic relationships and tactical considerations for creating synthetic\npositions is offered in Chapter 6.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:92", "doc_id": "49126054f535c39070bb8c8271bece4794f20132d618ec645223b0810e5c7137", "chunk_index": 0}
{"text": "Put-call parity also aids in valuing options. If put-call parity shows adifference in the value of the call versus the value of the put with the same\nstrike, there may be an arbitrage opportunity. That translates as “riskless\nprofit.” Buying the call and selling it synthetically (short put and short\nstock) could allow aprofit to be locked in if the prices are disparate.\nArbitrageurs tend to hold synthetic put and call prices pretty close together.\nGenerally, only professional traders can capture these types of profit\nopportunities, by trading big enough positions to make very small profits (apenny or less per contract sometimes) matter. Retail traders may be able to\ntake advantage of adisparity in put and call values to some extent, however,\nby buying or selling the synthetic as asubstitute for the actual option if the\nposition can be established at abetter price synthetically.\nAnother reason that aworking knowledge of put-call parity is essential is\nthat it helps attain abetter understanding of how changes in the interest rate\naffect option values. The greek rho measures this change. Rho is the rate of\nchange in an option’svalue relative to achange in the interest rate.\nAlthough some modeling programs may display this number differently,\nmost display arho for the call and arho for the put, both illustrating the\nsensitivity to aone-percentage-point change in the interest rate. When the\ninterest rate rises by one percentage point, the value of the call increases by\nthe amount of its rho and the put decreases by the amount of its rho.\nLikewise, when the interest rate decrease by one percentage point, the value\nof the call decreases by its rho and the put increases by its rho. For example,\nacall with arho of 0.12 will increase $0.12 in value if the interest rate used\nin the model is increased by one percentage point. Of course, interest rates\nusually don’trise or fall one percentage point in one day. More commonly,\nrates will have incremental changes of 25 basis points. That means acall\nwith a 0.12 rho will theoretically gain $0.03 given an increase of 0.25\npercentage points.\nMathematically, this change in option value as aproduct of achange in\nthe interest rate makes sense when looking at the formula for put-call parity.\nand", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:93", "doc_id": "899df1771bdc8dfbf6f3529c3c18012c51e102a946d5ea9115ff9bb860d96f17", "chunk_index": 0}
{"text": "But the change makes sense intuitively, too, when acall is considered as acheaper substitute for owning the stock. For example, compare a $100 stock\nwith athree-month 60-strike call on that same stock. Being so far ITM,\nthere would likely be no time value in the call. If the call can be purchased\nat parity, which alternative would be asuperior investment, the call for $40\nor the stock for $100? Certainly, the call would be. It costs less than half as\nmuch as the stock but has the same reward potential; and the $60 not spent\non the stock can be invested in an interest-bearing account. This interest\nadvantage adds value to the call. Raising the interest rate increases this\nvalue, and lowering it decreases the interest component of the value of the\ncall.\nAsimilar concept holds for puts. Professional traders often get ashort-\nstock rebate on proceeds from ashort-stock sale. This is simply interest\nearned on the capital received when the stock is shorted. Is it better to pay\ninterest on the price of aput for aposition that gives short exposure or to\nreceive interest on the credit from shorting the stock? There is an interest\ndisadvantage to owning the put. Therefore, arise in interest rates devalues\nputs.\nThis interest effect becomes evident when comparing ATM call and put\nprices. For example, with interest at 5 percent, three-month options on an\n$80 stock that pays a $0.25 dividend before option expiration might look\nsomething like this:\nThe ATM call is higher in theoretical value than the ATM put by $0.75.\nThat amount can be justified using put-call parity:\n(Here, simple interest of $1 is calculated as 80 × 0.05 × [90 / 360] = 1.)\nChanges in market conditions are kept in line by the put-call parity. For\nexample, if the price of the call rises because of an increase in IV, the price\nof the put will rise in step. If the interest rate rises by aquarter of apercentage point, from 5 percent to 5.25 percent, the interest calculated for\nthree months on the 80-strike will increase from $1 to $1.05, causing the", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:94", "doc_id": "7e2d3fefb5996aaae498c2e3838082482e7f08a8376cad5e39dcf921087fcb26", "chunk_index": 0}
{"text": "The Effect of Time on Rho\nThe more time until expiration, the greater the effect interest rate changes\nwill have on options. In the previous example, a 25-basis-point change in\nthe interest rate on the 80-strike based on athree-month period caused achange of 0.05 to the interest component of put-call parity. That is, 80 ×\n0.0025 × (90/360) = 0.05. If alonger period were used in the example—say,\none year—the effect would be more profound; it will be $0.20: 80 × 0.0025\n× (360/360) = 0.20. This concept is evident when the rhos of options with\ndifferent times to expiration are studied.\nExhibit 2.16 shows the rhos of ATM Procter & Gamble Co. (PG) calls\nwith various expiration months. The 750-day Long-Term Equity\nAnticiPation Securities (LEAPS) have arho of 0.858. As the number of\ndays until expiration decreases, rho decreases. The 22-day calls have arho\nof only 0.015. Rho is usually afairly insignificant factor in the value of\nshort-term options, but it can come into play much more with long-term\noption strategies involving LEAPS.\nEXHIBIT 2.16 The effect of time on rho (Procter & Gamble @ $64.34)", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:96", "doc_id": "e29796a4e0862837ba0e56250fe8ad73df21c7928528427e0c1fe6b2257933a5", "chunk_index": 0}
{"text": "Why the Numbers Don’t Don’t Always\nAdd Up\nThere will be many times when studying the rho of options in an option\nchain will reveal seemingly counterintuitive results. To be sure, the numbers\ndon’talways add up to what appears logical. One reason for this is\nrounding. Another is that traders are more likely to use simple interest in\ncalculating value, whereas the model uses compound interest. Hard-to-\nborrow stocks and stocks involved in mergers and acquisitions may have\nput-call parities that don’twork out right. But another, more common and\nmore significant fly in the ointment is early exercise.\nSince the interest input in put-call parity is afunction of the strike price, it\nis reasonable to expect that the higher the strike price, the greater the effect\nof interest on option prices will be. For European options, this is true to alarge extent, in terms of aggregate impact of interest on the call and put pair.\nStrikes below the price where the stock is trading have ahigher rho\nassociated with the call relative to the put, whereas strikes above the stock\nprice have ahigher rho associated with the put relative to the call.\nEssentially, the more in-the-money an option is, the higher its rho. But with\nEuropean options, observing the aggregate of the absolute values of the call\nand put rhos would show ahigher combined rho the higher the strike.\nWith American options, the put can be exercised early. Atrader will\nexercise aput before expiration if the alternative—being short stock and\nreceiving ashort stock rebate—is awiser choice based on the price of the\nput. Professional traders may own stock as ahedge against aput. They may\nexercise deep ITM puts (1.00-delta puts) to avoid paying interest on capital\ncharges related to the stock. The potential for early exercise is factored into\nmodels that price American options. Here, when puts get deeper in-the-\nmoney—that is, more apt to be exercised—the rho decreases. When the\nstrike price is very high relative to the stock price—meaning the put is very\ndeep ITM—and there is little or no time value left to the call or the put, the\naggregate put-call rho can be zero. Rho is discussed in greater detail in\nChapter 7.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:97", "doc_id": "5c7dbe7a70e710e61b49dd90cc6adfe2bc04018d8a7a5bda6b9e344409cef78d", "chunk_index": 0}
{"text": "Where to Find Option Greeks\nThere are many sources from which to obtain greeks. The Internet is an\nexcellent resource. Googling “option greeks” will display links to over four\nmillion web pages, many of which have real-time greeks or an option\ncalculator. An option calculator is asimple interface that accepts the input\nof the six variables to the model and yields atheoretical value and the\ngreeks for asingle option.\nSome web sites devoted to option education, such as\nMarketTaker.com/option_modeling , have free calculators that can be used\nfor modeling positions and using the greeks.\nIn practice, many of the option-trading platforms commonly in use have\nsophisticated analytics that involve greeks. Most options-friendly online\nbrokers provide trading platforms that enable traders to conduct\ncomprehensive manipulations of the greeks. For example, traders can look\nat the greeks for their positions up or down one, two, or three standard\ndeviations. Or they can see what happens to their position greeks if IV or\ntime changes. With many trading platforms, position greeks are updated in\nreal time with changes in the stock price—an invaluable feature for active\ntraders.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:99", "doc_id": "f9f4186f4df7ae35187fe357b2a0d3e3a3d9244f3a9dd230a9d0a305c0fae256", "chunk_index": 0}
{"text": "Caveats with Regard to Online\nGreeks\nOften, online greeks are one click away, requiring little effort on the part of\nthe trader. Having greeks calculated automatically online is aquick and\nconvenient way to eyeball greeks for an option. But there is one major\nproblem with online greeks: reliability.\nFor active option traders, greeks are essential. There is no point in using\nthese figures if their accuracy cannot be assured. Experienced traders can\noften spot these inaccuracies aproverbial mile away.\nWhen looking at greeks from an online source that does not require you\nto enter parameters into amodel (as would be the case with professional\noption-trading platforms), special attention needs to be paid to the\nrelationship of the option’stheoretical values to the bid and offer. One must\nbe cautious if the theoretical value of the option lies outside the bid-ask\nspread. This scenario can exist for brief periods of time, but arbitrageurs\ntend to prevent this from occurring routinely. If several options in achain\nall have theoretical values below the bid or above the offer, there is\nprobably aproblem with one or more of the inputs used in the model.\nRemember, an option-pricing model is just that: amodel. It reflects what is\noccurring in the market. It doesn’ttell where an option should be trading.\nThe complex changes that occur intraday in the market—taking the day\nor weekend out, changes in stock price, volatility, and the interest rate—are\nnot always kept current. The user of the model must keep close watch. It’snot reasonable to expect the computer to do the thinking for you.\nAutomatically calculated greeks can be used as astarting point. But before\nusing these figures in the decision-making process, the trader may have to\noverride the parameters that were used in the online calculation to make the\ntheos line up with market prices. Professional traders will ignore online\ngreeks altogether. They will use the greeks that are products of the inputs\nthey entered in their trading software. It comes down to this: if you want\nsomething done right, do it yourself.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:100", "doc_id": "3bd1c338bb673dd6a1c841e4294dbadbdc5fe81a82904da348b13b540e173a84", "chunk_index": 0}
{"text": "CHAPTER 3\nUnderstanding Volatility\nMost option strategies involve trading volatility in one way or another. It’seasy to think of trading in terms of direction. But trading volatility?\nVolatility is an abstract concept; it’sadifferent animal than the linear\ntrading paradigm used by most conventional market players. As an option\ntrader, it is essential to understand and master volatility.\nMany traders trade without asolid understanding of volatility and its\neffect on option prices. These traders are often unhappily surprised when\nvolatility moves against them. They mistake the adverse option price\nmovements that result from volatility for getting ripped off by the market\nmakers or some other market voodoo. Or worse, they surrender to the fact\nthat they simply don’tunderstand why sometimes these unexpected price\nmovements occur in options. They accept that that’sjust the way it is.\nPart of what gets in the way of aready understanding of volatility is\ncontext. The term volatility can have afew different meanings in the\noptions business. There are three different uses of the word volatility that an\noption trader must be concerned with: historical volatility, implied\nvolatility, and expected volatility.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:103", "doc_id": "f24d6795acf45a7c3f534e9ceddc6877441459d81dc72f705d7b16e964e32eec", "chunk_index": 0}
{"text": "Implied Volatility\nVolatility is one of the six inputs of an option-pricing model. Some of the\nother inputs—strike price, stock price, the number of days until expiration,\nand the current interest rate—are easily observable. Past dividend policy\nallows an educated guess as to what the dividend input should be. But\nwhere can volatility be found?\nAs discussed in Chapter 2, the output of the pricing model—the option’stheoretical value—in practice is not necessarily an output at all. When\noption traders use the pricing model, they commonly substitute the actual\nprice at which the option is trading for the theoretical value. Avalue in the\nmiddle of the bid-ask spread is often used. The pricing model can be\nconsidered to be acomplex algebra equation in which any variable can be\nsolved for. If the theoretical value is known—which it is—it along with the\nfive known inputs can be combined to solve for the unknown volatility.\nImplied volatility (IV) is the volatility input in apricing model that, in\nconjunction with the other inputs, returns the theoretical value of an option\nmatching the market price.\nFor aspecific stock price, agiven implied volatility will yield aunique\noption value. Take astock trading at $44.22 that has the 60-day 45-strike\ncall at atheoretical value of $1.10 with an 18 percent implied volatility\nlevel. If the stock price remains constant, but IV rises to 19 percent, the\nvalue of the call will rise by its vega, which in this case is about 0.07. The\nnew value of the call will be $1.17. Raising IV another point, to 20 percent,\nraises the theoretical value by another $0.07, to $1.24. The question is:\nWhat would cause implied volatility to change?", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:109", "doc_id": "b9856fec4fed10824fb067064a0593e83c7a90f1fbfbd0ab3c3bb6d53d29616b", "chunk_index": 0}
{"text": "Supply and Demand: Not Just a Good\nIdea, It’sthe Law!\nOptions are an excellent vehicle for speculation. However, the existence of\nthe options market is better justified by the primary economic purpose of\noptions: as arisk management tool. Hedgers use options to protect their\nassets from adverse price movements, and when the perception of risk\nincreases, so does demand for this protection. In this context, risk means\nvolatility—the potential for larger moves to the upside and downside. The\nrelative prices of options are driven higher by increased demand for\nprotective options when the market anticipates greater volatility. And option\nprices are driven lower by greater supply—that is, selling of options—when\nthe market expects lower volatility. Like those of all assets, option prices\nare subject to the law of supply and demand.\nWhen volatility is expected to rise, demand for options is not limited to\nhedgers. Speculative traders would arguably be more inclined to buy acall\nthan to buy the stock if they are bullish but expect future volatility to be\nhigh. Calls require alower cash outlay. If the stock moves adversely, there\nis less capital at risk, but still similar profit potential.\nWhen volatility is expected to be low, hedging investors are less inclined\nto pay for protection. They are more likely to sell back the options they may\nhave bought previously to recoup some of the expense. Options are adecaying asset. Investors are more likely to write calls against stagnant\nstocks to generate income in anticipated low-volatility environments.\nSpeculative traders will implement option-selling strategies, such as short\nstrangles or iron condors, in an attempt to capitalize on stocks they believe\nwon’tmove much. The rising supply of options puts downward pressure on\noption prices.\nMany traders sum up IV in two words: fear and greed . When option\nprices rise and fall, not because of changes in the stock price, time to\nexpiration, interest rates, or dividends, but because of pure supply and\ndemand, it is implied volatility that is the varying factor. There are many\ncontributing factors to traders’ willingness to demand or supply options.\nAnticipation of events such as earnings reports, Federal Reserve", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:110", "doc_id": "a94fd9e3319e0a405bde45437d43719504316614f973acd3b01dd96be271e3c2", "chunk_index": 0}
{"text": "announcements, or the release of other news particular to an individual\nstock can cause anxiety, or fear, in traders and consequently increase\ndemand for options that causes IV to rise. IV can fall when there is\ncomplacency in the market or when the anticipated news has been\nannounced and anxiety wanes. “Buy the rumor, sell the news” is often\nreflected in option implied volatility. When there is little fear of market\nmovement, traders use options to squeeze out more profits—greed.\nArbitrageurs, such as market makers who trade delta neutral—astrategy\nthat will be discussed further in Chapters 12 and 13—must be relentlessly\nconscious of implied volatility. When immediate directional risk is\neliminated from aposition, IV becomes the traded commodity. Arbitrageurs\nwho focus their efforts on trading volatility (colloquially called vol traders )\ntend to think about bids and offers in terms of IV. In the mind of avol\ntrader, option prices are translated into volatility levels. Atrader may look at\naparticular option and say it is 30 bid at 31 offer. These values do not\nrepresent the prices of the options but rather the corresponding implied\nvolatilities. The meaning behind the trader’sremark is that the market is\nwilling to buy implied volatility at 30 percent and sell it at 31 percent. The\nactual prices of the options themselves are much less relevant to this type of\ntrader.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:111", "doc_id": "ae1db187d61171b623399af5698a92a1b9bb461b1bd2dac4667d326da7853112", "chunk_index": 0}
{"text": "Should HV and IV Be the Same?\nMost option positions have exposure to volatility in two ways. First, the\nprofitability of the position is usually somewhat dependent on movement\n(or lack of movement) of the underlying security. This is exposure to HV.\nSecond, profitability can be affected by changes in supply and demand for\nthe options. This is exposure to IV. In general, along option position\nbenefits when volatility—both historical and implied—increases. Ashort\noption position benefits when volatility—historical and implied—decreases.\nThat said, buying options is buying volatility and selling options is selling\nvolatility.\nThe Relationship of HV and IV\nIt’sintuitive that there should exist adirect relationship between the HV and\nIV. Empirically, this is often the case. Supply and demand for options, based\non the market’sexpectations for asecurity’svolatility, determines IV.\nIt is easy to see why IV and HV often act in tandem. But, although HV\nand IV are related, they are not identical. There are times when IV and HV\nmove in opposite directions. This is not so illogical, if one considers the key\ndifference between the two: HV is calculated from past stock price\nmovements; it is what has happened. IV is ultimately derived from the\nmarket’sexpectation for future volatility.\nIf astock typically has an HV of 30 percent and nothing is expected to\nchange, it can be reasonable to expect that in the future the stock will\ncontinue to trade at a 30 percent HV. By that logic, assuming that nothing is\nexpected to change, IV should be fairly close to HV. Market conditions do\nchange, however. These changes are often regular and predictable. Earnings\nreports are released once aquarter in many stocks, Federal Open Market\nCommittee meetings happen regularly, and dates of other special\nannouncements are often disclosed to the public in advance. Although the\noutcome of these events cannot be predicted, when they will occur often\ncan be. It is around these widely anticipated events that HV-IV divergences\noften occur.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:112", "doc_id": "5ed72586a6841e872accf2ebd7a47f9fea1454f212eeae680cbf8831022d2d73", "chunk_index": 0}
{"text": "Expected Stock Volatility\nOption traders must have an even greater focus on volatility, as it plays amuch bigger role in their profitability—or lack thereof. Because options can\ncreate highly leveraged positions, small moves can yield big profits or\nlosses. Option traders must monitor the likelihood of movement in the\nunderlying closely. Estimating what historical volatility (standard deviation)\nwill be in the future can help traders quantify the probability of movement\nbeyond acertain price point. This leads to better decisions about whether to\nenter atrade, when to adjust aposition, and when to exit.\nThere is no way of knowing for certain what the future holds. But option\ndata provide traders with tools to develop expectations for future stock\nvolatility. IV is sometimes interpreted as the market’sestimate of the future\nvolatility of the underlying security. That makes it aready-made estimation\ntool, but there are two caveats to bear in mind when using IV to estimate\nfuture stock volatility.\nThe first is that the market can be wrong. The market can wrongly price\nstocks. This mispricing can lead to acorrection (up or down) in the prices\nof those stocks, which can lead to additional volatility, which may not be\npriced in to the options. Although there are traders and academics believe\nthat the option market is fairly efficient in pricing volatility, there is aroom\nfor error. There is the possibility that the option market can be wrong.\nAnother caveat is that volatility is an annualized figure—the annualized\nstandard deviation. Unless the IV of a LEAPS option that has exactly one\nyear until expiration is substituted for the expected volatility of the\nunderlying stock over exactly one year, IV is an incongruent estimation for\nthe future stock volatility. In practice, the IV of an option must be adjusted\nto represent the period of time desired.\nThere is acommon technique for deannualizing IV used by professional\ntraders and retail traders alike. 1 The first step in this process to deannualize\nIV is to turn it into aone-day figure as opposed to one-year figure. This is\naccomplished by dividing IV by the square root of the number of trading\ndays in ayear. The number many traders use to approximate the number of", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:115", "doc_id": "d86268adcc60a63d5d2a2f8a4dc210928d908276d53c84a61586c101e9fc259f", "chunk_index": 0}
{"text": "trading days per year is 256, because its square root is around number: 16.\nThe formula is\nFor example, a $100 stock that has an at-the-money (ATM) call trading at\na 32 percent volatility implies that there is about a 68 percent chance that\nthe underlying stock will be between $68 and $132 in one year’stime—\nthat’s $100 ± ($100 × 0.32). The estimation for the market’sexpectation for\nthe volatility of the stock for one day in terms of standard deviation as apercentage of the price of the underlying is computed as follows:\nIn one day’stime, based on an IV of 32 percent, there is a 68 percent\nchance of the stock’sbeing within 2 percent of the stock price—that’sbetween $98 and $102.\nThere may be times when it is helpful for traders to have avolatility\nestimation for aperiod of time longer than one day—aweek or amonth, for\nexample. This can be accomplished by multiplying the one-day volatility by\nthe square root of the number of trading days in the relevant period. The\nequation is as follows:\nIf the period in question is one month and there are 22 business days\nremaining in that month, the same $100 stock with the ATM call trading at a\n32 percent implied volatility would have aone-month volatility of 9.38\npercent.\nBased on this calculation for one month, it can be estimated that there is a\n68 percent chance of the stock’sclosing between $90.62 and $109.38 based\non an IV of 32 percent.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:116", "doc_id": "e5881398c0ecd84e3226da7dbe56a799fbfe089444bfd738fad8cf9620877866", "chunk_index": 0}
{"text": "Expected Implied Volatility\nAlthough there is agreat deal of science that can be applied to calculating\nexpected actual volatility, developing expectations for implied volatility is\nmore of an art. This element of an option’sprice provides more risk and\nmore opportunity. There are many traders who make their living distilling\ndirection out of their positions and trading implied volatility. To be\nsuccessful, atrader must forecast IV.\nConceptually, trading IV is much like trading anything else. Atrader who\nthinks astock is going to rise will buy the stock. Atrader who thinks IV is\ngoing to rise will buy options. Directional stock traders, however, have\nmany more analysis tools available to them than do vol traders. Stock\ntraders have both technical analysis (TA) and fundamental analysis at their\ndisposal.\nTechnical Analysis\nThere are scores, perhaps hundreds, of technical tools for analyzing stocks,\nbut there are not many that are available for analyzing IV. Technical\nanalysis is the study of market data, such as past prices or volume, which is\nmanipulated in such away that it better illustrates market activity. TA\nstudies are usually represented graphically on achart.\nDeveloping TA tools for IV is more of achallenge than it is for stocks.\nOne reason is that there is simply alot more data to manage—for each\nstock, there may be hundreds of options listed on it. The only practical way\nof analyzing options from a TA standpoint is to use implied volatility. IV is\nmore useful than raw historical option prices themselves. Information for\nboth IV and HV is available in the form of volatility charts, or vol charts.\n(Vol charts are discussed in detail in Chapter 14.) Volatility charts are\nessential for analyzing options because they give more complete\ninformation.\nTo get aclear picture of what is going on with the price of an option (the\ngoal of technical analysis for any asset), just observing the option price does\nnot supply enough information for atrader to work with. It’sincomplete.\nFor example, if acall rises in value, why did it rise? What greek contributed", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:117", "doc_id": "87b566a45f1a7094949f994f81cca93d04f9b71178dbbe2d14d864f5fbd88140", "chunk_index": 0}
{"text": "to its value increase? Was it delta because the underlying stock rose? Or\nwas it vega because volatility rose? How did time decay factor in? Using avolatility chart in conjunction with aconventional stock chart (and being\naware of time decay) tells the whole, complete, story.\nAnother reason historical option prices are not used in TA is the option\nbid-ask spread. For most stocks, the difference between the bid and the ask\nis equal to avery small percentage of the stock’sprice. Because options are\nhighly leveraged instruments, their bid-ask width can equal amuch higher\npercentage of the price.\nIf atrader uses the last trade to graph an option’sprice, it could look as if\navery large percentage move has occurred when in fact it has not. For\nexample, if the option trades asmall contract size on the bid (0.80), then on\nthe offer (0.90) it would appear that the option rose 12.5 percent in value.\nThis large percentage move is nothing more than market noise. Using\nvolatility data based off the midpoint-of-the-market theoretical value\neliminates such noise.\nFundamental Analysis\nFundamental analysis can have an important role in developing\nexpectations for IV. Fundamental analysis is the study of economic factors\nthat affect the value of an asset in order to determine what it is worth. With\nstocks, fundamental analysis may include studying income statements,\nbalance sheets, and earnings reports. When the asset being studied is IV,\nthere are fewer hard facts available. This is where the art of analyzing\nvolatility comes into play.\nEssentially, the goal is to understand the psychology of the market in\nrelation to supply and demand for options. Where is the fear? Where is the\ncomplacency? When are news events anticipated? How important are they?\nUltimately, the question becomes: what is the potential for movement in the\nunderlying? The greater the chance of stock movement, the more likely it is\nthat IV will rise. When unexpected news is announced, IV can rise quickly.\nThe determination of the fundamental relevance of surprise announcements\nmust be made quickly.\nUnfortunately, these questions are subjective in nature. They require the\ntrader to apply intuition and experience on acase-by-case basis. But there", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:118", "doc_id": "d0bb823e93e08b1566beccb8466da50526b51ea67265bdf81a714ff5df726df5", "chunk_index": 0}
{"text": "are afew observations to be made that can help atrader make better-\neducated decisions about IV.\nReversion to the Mean\nThe IVs of the options on many stocks and indexes tend to trade in arange\nunique to those option classes. This is referred to as the mean—or average\n—volatility level. Some securities will have smaller mean IV ranges than\nothers. The range being observed should be established for aperiod long\nenough to confirm that it is atypical IV for the security, not just atemporary anomaly. Traders should study IV over the most recent 6-month\nperiod. When IV has changed significantly during that period, a 12-month\nstudy may be necessary. Deviations from this range, either above or below\nthe established mean range, will occur from time to time. When following abreakout from the established range, it is common for IV to revert back to\nits normal range. This is commonly called reversion to the mean among\nvolatility watchers.\nThe challenge is recognizing when things change and when they stay the\nsame. If the fundamentals of the stock change in such away as to give the\noptions market reason to believe the stock will now be more or less volatile\non an ongoing basis than it typically has been in the recent past, the IV may\nnot revert to the mean. Instead, anew mean volatility level may be\nestablished.\nWhen considering the likelihood of whether IV will revert to recent levels\nafter it has deviated or find anew range, the time horizon and changes in\nthe marketplace must be taken into account. For example, between 1998\nand 2003 the mean volatility level of the SPX was around 20 percent to 30\npercent. By the latter half of 2006, the mean IV was in the range of 10\npercent to 13 percent. The difference was that between 1998 and 2003 was\nthe buildup of “the tech bubble,” as it was called by the financial media.\nMarket volatility ultimately leveled off in 2003.\nIn alater era, between the fall of 2010 and late summer of 2011 SPX\nimplied volatility settled in to trade mostly between 12 and 20 percent. But\nin August 2011, as the European debt crisis heated up, anew, more volatile\nrange between 24 and 40 percent reigned for some time.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:119", "doc_id": "8b21fc6c27e6928ae5a764aa612dec7287b0cfa07f86d8aaebb8214b7abcc82f", "chunk_index": 0}
{"text": "CBOE Volatility Index\n®\nOften traders look to the implied volatility of the market as awhole for\nguidance on the IV of individual stocks. Traders use the Chicago Board\nOptions Exchange (CBOE) Volatility Index® , or VIX® , as an indicator of\noverall market volatility.\nWhen people talk about the market, they are talking about abroad-based\nindex covering many stocks on many diverse industries. Usually, they are\nreferring to the S&P 500. Just as the IV of astock may offer insight about\ninvestors’ feelings about that stock’sfuture volatility, the volatility of\noptions on the S&P 500—SPX options—may tell something about the\nexpected volatility of the market as awhole.\nVIX is an index published by the Chicago Board Options Exchange that\nmeasures the IV of ahypothetical 30-day option on the SPX. A 30-day\noption on the SPX only truly exists once amonth—30 days before\nexpiration. CBOE computes ahypothetical 30-day option by means of aweighted average of the two nearest-term months.\nWhen the S&P 500 rises or falls, it is common to see individual stocks\nrise and fall in sympathy with the index. Most stocks have some degree of\nmarket risk. When there is aperception of higher risk in the market as awhole, there can consequently be aperception of higher risk in individual\nstocks. The rise or fall of the IV of SPX can translate into the IV of\nindividual stocks rising or falling.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:121", "doc_id": "1c7df6339520926b9939e5b83054dd5d87f0dd3eb1ed4ff7258079af6c93bd37", "chunk_index": 0}
{"text": "Implied Volatility and Direction\nWho’safraid of falling stock prices? Logically, declining stocks cause\nconcern for investors in general. There is confirmation of that statement in\nthe options market. Just look at IV. With most stocks and indexes, there is\nan inverse relationship between IV and the underlying price. Exhibit 3.2\nshows the SPX plotted against its 30-day IV, or the VIX.\nEXHIBIT 3.2 SPX vs. 30-day IV (VIX).\nThe heavier line is the SPX, and the lighter line is the VIX. Note that as\nthe price of SPX rises, the VIX tends to decline and vice versa. When the\nmarket declines, the demand for options tends to increase. Investors hedge\nby buying puts. Traders speculate on momentum by buying puts and\nspeculate on aturnaround by buying calls. When the market moves higher,\ninvestors tend to sell their protection back and write covered calls or cash-\nsecured puts. Option speculators initiate option-selling strategies. There is\nless fear when the market is rallying.\nThis inverse relationship of IV to the price of the underlying is not unique\nto the SPX; it applies to most individual stocks as well. When astock", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:122", "doc_id": "3682f480513de7bf5cedf7b5f250b6738ae99b8450c1e0fb4c8b0748bc75ac30", "chunk_index": 0}
{"text": "Calculating Volatility Data\nAccurate data are essential for calculating volatility. Many of the volatility\ndata that are readily available are useful, but unfortunately, some are not.\nHV is avalue that is easily calculated from publicly accessible past closing\nprices of astock. It’srather straightforward. Traders can access HV from\nmany sources. Retail traders often have access to HV from their brokerage\nfirm. Trading firms or clearinghouses often provide professional traders\nwith HV data. There are some excellent online resources for HV as well.\nHV is acalculation with little subjectivity—the numbers add up how they\nadd up. IV, however, can be abit more ambiguous. It can be calculated\ndifferent ways to achieve different desired outcomes; it is user-centric. Most\nof the time, traders consider the theoretical value to be between the bid and\nthe ask prices. On occasion, however, atrader will calculate IV for the bid,\nthe ask, the last trade price, or, sometimes, another value altogether. There\nmay be avalid reason for any of these different methods for calculating IV.\nFor example, if atrader is long volatility and aspires to reduce his position,\ncalculating the IV for the bid shows him what IV level can be sold to\nliquidate his position.\nFirms, online data providers, and most options-friendly brokers offer IV\ndata. Past IV data is usually displayed graphically in what is known as avolatility chart or vol chart. Current IV is often displayed along with other\ndata right in the option chain. One note of caution: when the current IV is\ndisplayed, however, it should always be scrutinized carefully. Was the bid\nused in calculating this figure? What about the ask? How long ago was this\ncalculation made? There are many questions that determine the accuracy of\nacurrent IV, and rarely are there any answers to support the number.\nTraders should trust only IV data they knowingly generated themselves\nusing apricing model.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:124", "doc_id": "a7323c3726d51400eb09863d294c4a662af74c1c6397995749259886a0d46e6d", "chunk_index": 0}
{"text": "Term Structure of Volatility\nTerm structure of volatility—also called monthly skew or horizontal skew\n—is the relationship among the IVs of options in the same class with the\nsame strike but with different expiration months. IV, again, is often\ninterpreted as the market’sestimate of future volatility. It is reasonable to\nassume that the market will expect some months to be more volatile than\nothers. Because of this, different expiration cycles can trade at different IVs.\nFor example, if acompany involved in amajor product-liability lawsuit is\nexpecting averdict on the case to be announced in two months, the one-\nmonth IV may be low, as the stock is not expected to move much until the\nsuit is resolved. The two-month volatility may be much higher, however,\nreflecting the expectations of abig move in the stock up or down,\ndepending on the outcome.\nThe term structure of volatility also varies with the normal ebb and flow\nof volatility within the business cycle. In periods of declining volatility, it is\ncommon for the month with the least amount of time until expiration, also\nknown as the front month, to trade at alower volatility than the back\nmonths, or months with more time until expiration. Conversely, when\nvolatility is rising, the front month tends to have ahigher IV than the back\nmonths.\nExhibit 3.3 shows historical option prices and their corresponding IVs for\n32.5-strike calls on General Motors (GM) during aperiod of low volatility.\nEXHIBIT 3.3 GM term structure of volatility.\nIn this example, no major news is expected to be released on GM, and\noverall market volatility is relatively low. The February 32.5 call has the\nlowest IV, at 32 percent. Each consecutive month has ahigher IV than the", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:126", "doc_id": "bf7c0c265e5197653caf1b72b4581a9064aaba5ea8c17487ebfc09d6870ff7c7", "chunk_index": 0}
{"text": "previous month. Agraduated increasing or decreasing IV for each\nconsecutive expiration cycle is typical of the term structure of volatility.\nUnder normal circumstances, the front month is the most sensitive to\nchanges in IV. There are two reasons for this. First, front-month options are\ntypically the most actively traded. There is more buying and selling\npressure. Their IV is subject to more activity. Second, vegas are smaller for\noptions with fewer days until expiration. This means that for the same\nmonetary change in an option’svalue, the IV needs to move more for short-\nterm options.\nExhibit 3.4 shows the same GM options and their corresponding vegas.\nEXHIBIT 3.4 GM vegas.\nIf the value of the September 32.5 calls increases by $0.10, IV must rise\nby 1 percentage point. If the February 32.5 calls increase by $0.10, IV must\nrise 3 percentage points. As expiration approaches, the vega gets even\nsmaller. With seven days until expiration, the vega would be about 0.014.\nThis means IV would have to change about 7 points to change the call value\n$0.10.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:127", "doc_id": "6fba9dce2d8cdad832fa95f9d6b2b908517491fa34a199b93d556b3b9362cfc7", "chunk_index": 0}
{"text": "Vertical Skew\nThe second type of skew found in option IV is vertical skew, or strike skew.\nVertical skew is the disparity in IV among the strike prices within the same\nmonth for an option class. The options on most stocks and indexes\nexperience vertical skew. As ageneral rule, the IV of downside options—\ncalls and puts with strike prices lower than the at-the-money (ATM) strike\n—trade at higher IVs than the ATM IV. The IV of upside options—calls and\nputs with strike prices higher than the ATM strike—typically trade at lower\nIVs than the ATM IV.\nThe downside is often simply referred to as puts and the upside as calls.\nThe rationale for this lingo is that OTM options (puts on the downside and\ncalls on the upside) are usually more actively traded than the ITM options.\nBy put-call parity, aput can be synthetically created from acall, and acall\ncan be synthetically created from aput simply by adding the appropriate\nlong or short stock position.\nExhibit 3.5 shows the vertical skew for 86-day options on Citigroup Inc.\n(C) on atypical day, with IVs rounded to the nearest tenth.\nEXHIBIT 3.5 Citigroup vertical skew.\nNotice the IV of the puts (downside options) is higher than that of the\ncalls (upside options), with the 31 strike’svolatility more than 10 points\nhigher than that of the 38 strike. Also, the difference in IV per unit change", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:128", "doc_id": "ea21a7ed6ff27befe40a6169ff7dea08d73872e758e73cd4d31c87a3a37def28", "chunk_index": 0}
{"text": "in the strike price is higher for the downside options than it is for the upside\nones. The difference between the IV of the 31 strike is 2 full points higher\nthan the 32 strike, which is 1.8 points higher than the 33 strike. But the 36\nstrike’s IV is only 1.1 points higher than the 37 strike, which is also just 1.1\npoints higher than the 38 strike.\nThis incremental difference in the IV per strike is often referred to as the\nslope. The puts of most underlyings tend to have agreater slope to their\nskew than the calls. Many models allow values to be entered for the upside\nslope and the downside slope that mathematically increase or decrease IVs\nof each strike incrementally. Some traders believe the slope should be astraight line, while others believe it should be an exponentially sloped line.\nIf the IVs were graphed, the shape of the skew would vary among asset\nclasses. This is sometimes referred to as the volatility smile or sneer,\ndepending on the shape of the IV skew. Although Exhibit 3.5 is atypical\nparadigm for the slope for stock options, bond options and other commodity\noptions would have differently shaped skews. For example, grain options\ncommonly have calls with higher IVs than the put IVs.\nVolatility skew is dependent on supply and demand. Greater demand for\ndownside protection may cause the overall IV to rise, but it can cause the\nIV of puts to rise more relative to the calls or vice versa. There are many\ntraders who make their living trading volatility skew.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:129", "doc_id": "677545d1187f7dfdc14a7e298ec24f25ddf28926d4c9be4ec3822683359b0690", "chunk_index": 0}
{"text": "Long ATM Call\nKim is atrader who is bullish on the Walt Disney Company (DIS) over the\nshort term. The time horizon of her forecast is three weeks. Instead of\nbuying 100 shares of Disney at $35.10 per share, Kim decides to buy one\nDisney March 35 call at $1.10. In this example, March options have 44\ndays until expiration. How can Kim profit from this position? How can she\nlose?\nExhibit 4.1 shows the profit and loss (P&(L)) for the call at different time\nperiods. The top line is when the trade is executed; the middle, dotted line is\nafter three weeks have passed; and the bottom, darker line is at expiration.\nKim wants Disney to rise in price, which is evident by looking at the graph\nfor any of the three time horizons. She would anticipate aloss if the stock\nprice declines. These expectations are related to the position’sdelta, but that\nis not the only risk exposure Kim has. As indicated by the three different\nlines in Exhibit 4.1 , the call loses value over time. This is called theta risk .\nShe has other risk exposure as well. Exhibit 4.2 lists the greeks for the DIS\nMarch 35 call.\nEXHIBIT 4.1 P&(L) of Disney 35 call.\nEXHIBIT 4.2 Greeks for 35 Disney call.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:132", "doc_id": "0e2b5b2b3fa38c6d1883ad5b5b3f7dca264e9ce2311e97e7e601730b4ea517af", "chunk_index": 0}
{"text": "Delta 0.57\nGamma0.166\nTheta −0.013\nVega 0.048\nRho 0.023\nKim’simmediate directional exposure is quantified by the delta, which is\n0.57. Delta is immediate directional exposure because it’ssubject to change\nby the amount of the gamma. The positive gamma of this position helps\nKim by increasing the delta as Disney rises and decreasing it as it falls.\nKim, however, has time working against her—theta. At this point, she\ntheoretically loses $0.013 per day. Since her call is close to being at-the-\nmoney, she would anticipate her theta becoming more negative as\nexpiration approaches if Disney’sshare price remains unchanged. She also\nhas positive vega exposure. Aone-percentage-point increase in implied\nvolatility (IV) earns Kim just under $0.05. Aone-point decrease costs her\nabout $0.05. With so few days until expiration, the 35-strike call has very\nlittle rho exposure. Afull one-percentage-point change in the interest rate\nchanges her call’svalue by only $0.023.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:133", "doc_id": "195de6f8ae9c818165fd848fb3413df6ebd062991f92c00c939463958eb9aa9d", "chunk_index": 0}
{"text": "Delta\nSome of Kim’srisks warrant more concern than others. With this position,\ndelta is of the greatest concern, followed by theta. Kim expects the call to\nrise in value and accepts the risk of decline. Delta exposure was her main\nrationale for establishing the position. She expects to hold it for about three\nweeks. Kim is willing to accept the trade-off of delta exposure for theta,\nwhich will cost her three weeks of erosion of option premium. If the\nanticipated delta move happens sooner than expected, Kim will have less\ndecay. Exhibit 4.3 shows the value of her 35 call at various stock prices\nover time. The left column is the price of Disney. The top row is the number\nof days until expiration.\nEXHIBIT 4.3 Disney 35 call price–time matrix–value.\nThe effect of delta is evident as the stock rises or falls. When the position\nis established (44 days until expiration), the change in the option price if the\nstock were to move from $35 to $36 is 0.62 (1.66 − 1.04). Between stock\nprices of $36 and $37, the option gains 0.78 (2.44 −1.66). If the stock were\nto decline in value from $35 to $34, the option loses 0.47 (1.04 − 0.57). The\noption gains value at afaster rate as the stock rises and loses value at aslower rate as the stock falls. This is the effect of gamma.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:134", "doc_id": "d88e99bc726f5fca1a4539615c3251d83dcefd13c05ae9065d4dc50059c56883", "chunk_index": 0}
{"text": "Vega\nAfter delta and theta, vega is the next most influential contributor to Kim’sprofit or peril. With Disney at $35.10, the 1.10 premium for the 35-strike\ncall represents $1 of time value—all of which is vulnerable to changes in\nIV. The option’s 1.10 value returns an IV of about 19 percent, given the\nfollowing inputs:\nStock: $35.10\nStrike: 35\nDays to expiration: 44\nInterest: 5.25 percent\nNo dividend paid during this period\nConsequently, the vega is 0.048. What does the 0.048 vega tell Kim?\nGiven the preceding inputs, for each point the IV rises or falls, the option’svalue gains or loses about $0.05.\nSome of the inputs, however, will change. Kim anticipates that Disney\nwill rise in price. She may be right or wrong. Either way, it is unlikely that\nthe stock will remain exactly at $35.10 to option expiration. The only\ncertainty is that time will pass.\nBoth price and time will change Kim’svega exposure. Exhibit 4.5 shows\nthe changing vega of the 35 call as time and the underlying price change.\nEXHIBIT 4.5 Disney 35 call price–time matrix–vega.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:137", "doc_id": "14cdcabf68c12fa310655128a38cb4543652529aa5b85077d03b18cd47af61dc", "chunk_index": 0}
{"text": "When comparing Exhibit 4.5 to Exhibit 4.3 , it’seasy to see that as the\ntime value of the option declines, so does Kim’sexposure to vega. As time\npasses, vega gets smaller. And as the call becomes more in- or out-of-the-\nmoney, vega gets smaller. Since she plans to hold the position for around\nthree weeks, she is not concerned about small fluctuations in IV in the\ninterim.\nIf indeed the rise in price that Kim anticipates comes to pass, vega\nbecomes even less of aconcern. With 23 days to expiration and DIS at $37,\nthe call value is 2.21. The vega is $0.018. If IV decreases as the stock price\nrises—acommon occurrence—the adverse effect of vega will be minimal.\nEven if IV declines by 5 points, to ahistorically low IV for DIS, the call\nloses less than $0.10. That’sless than 5 percent of the new value of the\noption.\nIf dividend policy changes or the interest rate changes, the value of Kim’scall will be affected as well. Dividends are often fairly predictable.\nHowever, alarge unexpected dividend payment can have asignificant\nadverse impact on the value of the call. For example, if asurprise $3\ndividend were announced, owning the stock would become greatly\npreferable to owning the call. This preference would be reflected in the call\npremium. This is ascenario that an experienced trader like Kim will realize\nis apossibility, although not aprobability. Although she knows it can", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:138", "doc_id": "3b23e8b510bca3c194ee07594a56fc2de5a4ea6d358d4c970eb873e2972e3afc", "chunk_index": 0}
{"text": "Rho\nFor all intents and purposes, rho is of no concern to Kim. In recent years,\ninterest rate changes have not been amajor issue for option traders. In the\nAlan Greenspan years of Federal Reserve leadership, changes in the interest\nrate were usually announced at the regularly scheduled Federal Open\nMarket Committee (FOMC) meetings, with but afew exceptions. Ben\nBernanke, likewise, changed interest rates fairly predictably, when he made\nany rate changes at all. In these more stable periods, if there is no FOMC\nmeeting scheduled during the life of the call, it’sunlikely that rates will\nchange. Even if they do, the rho with 44 days to expiration is only 0.023.\nThis means that if rates change by awhole percentage point—which is four\ntimes the most common incremental change—the call value will change by\nalittle more than $0.02. In this case, this is an acceptable risk. With 23 days\nto expiration, the ATM 35 call has arho of only 0.011.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:140", "doc_id": "1a893475ac36bc58f29a14d4b905b5a223ce0d5b94d629f95a8574fdd406b450", "chunk_index": 0}
{"text": "Tweaking Greeks\nWith this position, some risks are of greater concern than others. Kim may\nwant more exposure to some greeks and less to others. What if she is\nconcerned that her forecasted price increase will take longer than three\nweeks? She may want less exposure to theta. What if she is particularly\nconcerned about adecline in IV? She may want to decrease her vega.\nConversely, she may believe IV will rise and therefore want to increase her\nvega.\nKim has many ways at her disposal to customize her greeks. All of her\nalternatives come with trade-offs. She can buy more calls, increasing her\ngreek positions in exact proportion. She can buy or sell stock or options\nagainst her call, creating aspread. The simplest way to alter her exposure to\noption greeks is to choose adifferent call to buy. Instead of buying the ATM\ncall, Kim can buy acall with adifferent relationship to the current stock\nprice.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:141", "doc_id": "211818806491a88d636565f15bf7142dbd83820506dc1071bf5a800d7682238c", "chunk_index": 0}
{"text": "Long OTM Call\nKim can reduce her exposure to theta and vega by buying an OTM call. The\ntrade-off here is that she also reduces her immediate delta exposure.\nDepending on how much Kim believes Disney will rally, this may or may\nnot be aviable trade-off. Imagine that instead of buying one Disney March\n35 call, Kim buys one Disney March 37.50 call, for 0.20.\nThere are afew observations to be made about this alternative position.\nFirst, the net premium, and therefore overall risk, is much lower, 0.20\ninstead of 1.10. From an expiration standpoint, the breakeven at expiration\nis $37.70 (the strike price plus the call premium). Since Kim plans on\nexiting the position after about three weeks, the exact break-even point at\nthe expiration of the contract is irrelevant. But the concept is the same: the\nstock needs to rise significantly. Exhibit 4.6 shows how Kim’sconcerns\ntranslate into greeks.\nEXHIBIT 4.6 Greeks for Disney 35 and 37.50 calls.\n35 Call37.50 Call\nDelta 0.57 0.185\nGamma0.1660.119\nTheta −0.013−0.007\nVega 0.0480.032\nRho 0.0230.007\nThis table compares the ATM call with the OTM call. Kim can reduce her\ntheta to half that of the ATM call position by purchasing an OTM. This is\ncertainly afavorable difference. Her vega is lower with the 37.50 call, too.\nThis may or may not be afavorable difference. That depends on Kim’sopinion of IV.\nOn the surface, the disparity in delta appears to be ahighly unfavorable\ntrade-off. The delta of the 37.50 call is less than one third of the delta of the\n35 call, and the whole motive for entering into this trade is to trade\ndirection! Although this strategy is very delta oriented, its core is more\nfocused on gamma and theta.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:142", "doc_id": "9e8a170c1c1a845cb03d915d455b7626249bfa8752fd8dfe17403a854cf6cfdd", "chunk_index": 0}
{"text": "The gamma of the 37.50 call is about 72 percent that of the 35 call. But\nthe theta of the 37.50 call is about half that of the 35 call. Kim is improving\nher gamma/theta relationship by buying the OTM, but with the call being so\nfar out-of-the-money and so inexpensive, the theta needs to be taken with agrain of salt. It is ultimately gamma that will make or break this delta play.\nThe price of the option is 0.20—arather low premium. In order for the\ncall to gain in value, delta has to go to work with help from gamma. At this\npoint, the delta is small, only 0.185. If Kim’sforecast is correct and there is\nabig move upward, gamma will cause the delta to increase, and therefore\nalso the premium to increase exponentially. The call’ssensitivity to gamma,\nhowever, is dynamic.\nExhibit 4.7 shows how the gamma of the 37.50 call changes as the stock\nprice moves over time. At any point in time, gamma is highest when the call\nis ATM. However, so is theta. Kim wants to reap as much benefit from\ngamma as possible while minimizing her exposure to theta. Ideally, she\nwants Disney to rally through the strike price—through the high gamma\nand back to the low theta. After three weeks pass, with 23 days until\nexpiration, if Disney is at $37 ashare, the gamma almost doubles, to 0.237.\nWhen the call is ATM, the delta increases at its fastest rate. As Disney rises\nabove the strike, the gamma figures in the table begin to decline.\nEXHIBIT 4.7 Disney 37.50 call price–time matrix–gamma.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:143", "doc_id": "d87814809227b1c1638a824997b8c4bf2e3fb36ba1b778792a527d989f82d8ef", "chunk_index": 0}
{"text": "The sooner the price rise occurs, the better. It means less time for theta to\neat away profits. If Kim must hold the position for the entire three weeks,\nshe needs agood pop in the stock to make it worth her while. At a $37 share\nprice, the call is worth about 0.50, assuming all other market influences\nremain constant. That’sabout a 150 percent profit. At $38, Exhibit 4.9\nreveals the call value to be 1.04. That’sa 420 percent profit.\nOn one hand, it’shard for atrader like Kim not to get excited about the\nprospect of making 420 percent on an 8 percent move in astock. On the\nother hand, Kim has to put things in perspective. When the position is\nestablished, the call has a 0.185 delta. By the trader’sdefinition of delta,\nthat means the call is estimated to have about an 18.5 percent chance of\nexpiring in-the-money. More than four out of five times, this position will\nbe trading below the strike at expiration.\nAlthough Kim is not likely to hold the position until expiration, this\nobservation tells her something: she’sstarting in the hole. She is more likely\nto lose than to win. She needs to be compensated well for her risk on the\nwinners to make up for the more prevalent losers.\nBuying OTM calls can be considered more speculative than buying ITM\nor ATM calls. Unlike what the at-expiration diagrams would lead one to\nbelieve, OTM calls are not simply about direction. There’sabit more to it.\nThey are really about gamma, time, and the magnitude of the stock’smove", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:145", "doc_id": "b180a2c0f8e331458675b5cc37994f8a91ff3950505a29b1bbf4795f4fa19328", "chunk_index": 0}
{"text": "Long ITM Call\nKim also has the alternative to buy an ITM call. Instead of the 35 or 37.50\ncall, she can buy the 32.50. The 32.50 call shares some of the advantages\nthe 37.50 call has over the 35 call, but its overall greek characteristics make\nit avery different trade from the two previous alternatives. Exhibit 4.10\nshows acomparison of the greeks of the three different calls.\nEXHIBIT 4.10 Greeks for Disney 32.50, 35, and 37.50 calls.\nLike the 37.50 call, the 32.50 has alower gamma, theta, and vega than the\nATM 35-strike call. Because the call is ITM, it has ahigher delta: 0.862. In\nthis example, Kim can buy the 32.50 call for 3. That’s 0.40 over parity (3 −\n[35.10 − 32.50] = 0.40). There is not much time value, but more than the\n37.50 call has. Thus, theta is of some concern. Ultimately, the ITMs have\n0.40 of time value to lose compared with the 0.20 of the OTM calls. Vega is\nalso of some concern, but not as much as in the other alternatives because\nthe vega of the 32.50 is lower than the 35s or the 37.50s. Gamma doesn’thelp much as the stock rallies—it will get smaller as the stock price rises.\nGamma will, however, slow losses somewhat if the stock declines by\ndecreasing delta at an increasing rate.\nIn this case, the greek of greatest consequence is delta—it is amore\npurely directional play than the other alternatives discussed. Exhibit 4.11\nshows the matrix of the delta of the 32.50 call.\nEXHIBIT 4.11 Disney 32.50 call price–time matrix–delta.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:147", "doc_id": "191da56eb756b055f13c0394e9684efde8a0a1fc69aed392519eb3606bb90e33", "chunk_index": 0}
{"text": "Long ATM Put\nThe beauty of the free market is that two people can study all the available\ninformation on the same stock and come up with completely different\noutlooks. First of all, this provides for entertaining television on the\nbusiness-news channels when the network juxtaposes an outspoken bullish\nanalyst with an equally unreserved bearish analyst. But differing opinions\nalso make for arobust marketplace. Differing opinions are the oil that\ngreases the machine that is price discovery. From amarket standpoint, it’swhat makes the world go round.\nIt is possible that there is another trader, Mick, in the market studying\nDisney, who arrives at the conclusion that the stock is overpriced. Mick\nbelieves the stock will decline in price over the next three weeks. He\ndecides to buy one Disney March 35 put at 0.80. In this example, March has\n44 days to expiration.\nMick initiates this long put position to gain downside exposure, but along\nwith his bearish position comes option-specific risk and opportunity. Mick\nis buying the same month and strike option as Kim did in the first example\nof this chapter: the March 35 strike. Despite the different directional bias,\nMick’sposition and Kim’sposition share many similarities. Exhibit 4.13\noffers acomparison of the greeks of the Disney March 35 call and the\nDisney March 35 put.\nEXHIBIT 4.13 Greeks for Disney 35 call and 35 put.\nCall Put\nDelta 0.57 −0.444\nGamma0.1660.174\nTheta −0.013−0.009\nVega 0.0480.048\nRho 0.023−0.015\nThe first comparison to note is the contrasting deltas. The put delta is\nnegative, in contrast to the call delta. The absolute value of the put delta is\nclose to 1.00 minus the call delta. The put is just slightly OTM, so its delta", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:150", "doc_id": "f3ef66d932ed2d02623b2bc02a8a11fb48cba79b54e0ded7074d460d3d053a37", "chunk_index": 0}
{"text": "is just under 0.50, while that of the call is just over 0.50. The disparate, yet\nrelated deltas represent the main difference between these two trades.\nThe difference between the gamma of the 35 put and that of the\ncorresponding call is fairly negligible: 0.174 versus 0.166, respectively. The\ngamma of this ATM put will enter into the equation in much the same way\nas the gamma of the ATM call. The put’snegative delta will become more\nnegative as the stock declines, drawing closer to −1.00. It will get less\nnegative as the stock price rises, drawing closer to zero. Gamma is\nimportant here, because it helps the delta. Delta, however, still remains the\nmost important greek. Exhibit 4.14 illustrates how the 35 put delta changes\nas time and price change.\nEXHIBIT 4.14 Disney 35 put price–time matrix–delta.\nSince this put is ATM, it starts out with abig enough delta to offer the\ndirectional exposure Mick desires. The delta can change, but gamma\nensures that it always changes in Mick’sfavor. Exhibit 4.15 shows how the\nvalue of the 35 put changes with the stock price.\nEXHIBIT 4.15 Disney 35 put price–time matrix–value.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:151", "doc_id": "a28cc5862083c46f361bc0878c2a9db049e7665af8cb1627f82a6c9ff082327a", "chunk_index": 0}
{"text": "Over time, adecline of only 10 percent in the stock yields high\npercentage returns. This is due to the leveraged directional nature of this\ntrade—delta.\nWhile the other greeks are not of primary concern, they must be\nmonitored. At the onset, the 0.80 premium is all time value and, therefore\nsubject to the influences of time decay and volatility. This is where trading\ngreeks comes into play.\nConventional trading wisdom says, “Cut your losses early, and let your\nprofits run.” When trading astock, that advice is intellectually easy to\nunderstand, although psychologically difficult to follow. Buyers of options,\nespecially ATM options, must follow this advice from the standpoint of\ntheta. Options are decaying assets. The time premium will be zero at\nexpiration. ATMs decay at an increasing nonlinear rate. Exiting along\nposition before getting too close to expiration can cut losses caused by an\nincreasing theta. When to cut those losses, however, will differ from trade\nto trade, situation to situation, and person to person.\nWhen buying options, accepting some loss of premium due to time decay\nshould be part of the trader’splan. It comes with the territory. In this\nexample, Mick is willing to accept about three weeks of erosion. Mick\nneeds to think about what his put will be worth, not just if the underlying\nrises or falls but also if it doesn’tmove at all. At the time the position is", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:152", "doc_id": "6172fae2acfe6fc6b6ce87822b1da3a376b40df345e5dc8f244503e039557f41", "chunk_index": 0}
{"text": "established, the theta is 0.009, just under apenny. If Disney share price is\nunchanged when three weeks pass, his theta will be higher. Exhibit 4.16\nshows how thetas and theoretical values change over time if DIS stock\nremains at $35.10.\nEXHIBIT 4.16 Disney 35 put—thetas and theoretical values.\nMick needs to be concerned not only about what the theta is now but what\nit will be when he plans on exiting the position. His plan is to exit the trade\nin about three weeks, at which point the put theta will be −0.013. If he\namortizes his theta over this three-week period, he theoretically loses an\naverage of about 0.01 aday during this time if nothing else changes. The\naverage daily theta is calculated here by subtracting the value of the put at\n23 days to expiration from its value when the trade was established to find\nthe loss of premium attributed to time decay, then dividing by the number\nof days until expiration.\nSince the theta doesn’tchange much over the first three weeks, Mick can\neyeball the theta rather easily. As expiration approaches and theta begins to\ngrow more quickly, he’ll need to do the math.\nAt nine days to expiration, the theoretical value of Mick’sput is about\n0.35, assuming all other variables are held constant. By that time, he will\nhave lost 0.45 (0.80 − 0.35) due to erosion over the 35-day period he held\nthe position if the stock hasn’tmoved. Mick’saverage daily theta during\nthat period is about 0.0129 (0.45 ÷ 35). The more time he holds the trade,\nthe greater aconcern is theta. Mick must weigh his assessment of the\nlikelihood of the option’sgaining value from delta against the risk of\nerosion. If he holds the trade for 35 days, he must make 0.0129 on average\nper day from delta to offset theta losses. If the forecast is not realized within\nthe expected time frame or if the forecast changes, Mick needs to act fast to\ncurtail average daily theta losses.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:153", "doc_id": "58bd492102530ce89808e57cc8668637b94b754650293b33f255fb18c7220f9b", "chunk_index": 0}
{"text": "Finding the Right Risk\nMick could lower the theta of his position by selecting aput with agreater\nnumber of days to expiration. This alternative has its own set of trade-offs:\nlower gamma and higher vega than the 44-day put. He could also select an\nITM put or an OTM put. Like Kim’scall alternatives, the OTM put would\nhave less exposure to time decay, lower vega, lower gamma, and alower\ndelta. It would have alower premium, too. It would require abigger price\ndecline than the ATM put and would be more speculative.\nThe ITM put would also have lower theta, vega, and gamma, but it would\nhave ahigher delta. It would take on more of the functionality of ashort\nstock position in much the same way that Kim’s ITM call alternative did for\nalong stock position. In its very essence, however, an option trade, ITM or\notherwise, is still fundamentally different than astock trade.\nStock has a 1.00 delta. The delta of astock never changes, so it has zero\ngamma. Stock is not subject to time decay and has no volatility component\nto its pricing. Even though ITM options have deltas that approach 1.00 and\nother greeks that are relatively low, they have two important differences\nfrom an equity. The first is that the greeks of options are dynamic. The\nsecond is the built-in leverage feature of options.\nThe relationship of an option’sstrike price to the stock price can change\nconstantly. Options that are ITM now may be OTM tomorrow and vice\nversa. Greeks that are not in play at the moment may be later. Even if there\nis no time value in the option now because it is so far away-from-the-\nmoney, there is the potential for time premium to become acomponent of\nthe option’sprice if the stock moves closer to the strike price. Gamma,\ntheta, and vega always have the potential to come into play.\nSince options are leveraged by nature, small moves in the stock can\nprovide big profits or big losses. Options can also curtail big losses if used\nfor hedging. Long option positions can reap triple-digit percentage gains\nquickly with afavorable move in the underlying. Even though 100 percent\nof the premium can be lost just as easily, one option contract will have far\nless nominal exposure than asimilar position in the stock.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:154", "doc_id": "16daaec3741aecd1f8baddbc720bfa4a021761cbf076787856cf0a5f3de149ed", "chunk_index": 0}
{"text": "It’s All About Volatility\nWhat are Kim and Mick really trading? Volatility. The motivation for\nbuying an option as opposed to buying or shorting the stock is volatility. To\nsome degree, these options have exposure to both flavors of volatility—\nimplied volatility and historical volatility (HV). The positions in each of the\nexamples have positive vega. Their values are influenced, in part, by IV.\nOver time, IV begins to lose its significance if the option is no longer close\nto being at-the-money.\nThe main objective of each of these trades is to profit from the volatility\nof the stock’sprice movement, called future stock volatility or future\nrealized volatility. The strategies discussed in this chapter are contingent on\nvolatility being one directional. The bigger the move in the trader’sforecasted direction the better. Volatility in the form of an adverse\ndirectional move results in adecline in premium. The gamma in these long\noption positions makes volatility in the right direction more beneficial and\nvolatility in the wrong direction less costly.\nThis phenomenon is hardly unique to the long call and the long put.\nAlthough some basic strategies, such as the ones studied in this chapter,\ndepend on aparticular direction, many don’t. Except for interest rate\nstrategies and perhaps some arbitrage strategies, all option trades are\nvolatility trades in one way or another. In general, option strategies can be\ndivided into two groups: volatility-buying strategies and volatility-selling\nstrategies. The following is abreakdown of common option strategies into\ncategories of volatility-buying strategies and volatility-selling strategies:\nVolatility-Selling Strategies Volatility-Buying Strategies\nShort Call, Short Put, Covered Call, Covered Put,\nBull Call Spread, Bear Call Spread, Bull Put\nSpread, Bear Put Spread, Short Straddle, Short\nStrangle, Guts, Ratio Call Spread, Calendar,\nButterfly, Iron Butterfly, Broken-Wing Butterfly,\nCondor, Iron Condor, Diagonals, Double Diagonals,\nRisk Reversals/Collars.\nLong Call, Long Put, Bull Call Spread, Bear\nCall Spread, Bull Put Spread, Bear Put Spread,\nLong Straddle, Long Strangle, Guts, Back\nSpread, Calendar, Butterfly, Iron Butterfly,\nBroken-Wing Butterfly, Condor, Iron Condor,\nDiagonals, Double Diagonals, Risk\nReversals/Collars.\nLong option strategies appear in the volatility-buying group because they\nhave positive gamma and positive vega. Short option strategies appear in", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:155", "doc_id": "933ba1238b75c07421e8bfb8c1711bea561618bef96d8e7b0db98b43091e60dc", "chunk_index": 0}
{"text": "Direction Neutral, Direction Biased, and\nDirection Indifferent\nAs typically traded, volatility-selling option strategies are direction neutral.\nThis means that the position has the greatest results if the underlying price\nremains in arange—that is, neutral. Although some option-selling strategies\n—for example, anaked put—may have apositive or negative delta in the\nshort term, profit potential is decidedly limited. This means that if traders\nare expecting abig move, they are typically better off with option-buying\nstrategies.\nOption-buying strategies can be either direction biased or direction\nindifferent. Direction-biased strategies have been shown throughout this\nchapter. They are delta trades. Direction-indifferent strategies are those that\nbenefit from increased volatility in the underlying but where the direction of\nthe move is irrelevant to the profitability of the trade. Movement in either\ndirection creates awinner.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:157", "doc_id": "caa11f9222879fe6b44e3e794f52b7b82342c0b036f5d8a193b736eda749795e", "chunk_index": 0}
{"text": "Are You a Buyer or a Seller?\nThe question is: which is better, selling volatility or buying volatility? Ihave attended option seminars with instructors (many of whom Iregard\nwith great respect) teaching that volatility-selling strategies, or income-\ngenerating strategies, are superior to buying options. Ialso know option\ngurus that tout the superiority of buying options. The answer to the question\nof which is better is simple: it’sall amatter of personal preference.\nWhen Ibegan trading on the floor of Chicago Board Options Exchange\n(CBOE) in the 1990s, Iquickly became aware of adichotomy among my\nmarket-making peers. Those making markets on the floor of the exchange at\nthat time were divided into two groups: teenie buyers and teenie sellers.\nTeenie Buyers\nBefore options traded in decimals (dollars and cents) like they do today, the\nlowest price increment in which an option could be traded was one\nsixteenth of adollar—ateenie . Teenie buyers were market makers who\nwould buy back OTM options at one sixteenth to eliminate short positions.\nThey would sometimes even initiate long OTM option positions at ateenie,\ntoo. The focus of the teenie-buyer school of thought was the fact that long\noptions have unlimited reward, while short options have unlimited risk. An\noption purchased so far OTM that it was offered at one sixteenth is unlikely\nto end up profitable, but it’san inexpensive lottery ticket. At worst, the\ntrader can only lose ateenie. Teenie buyers felt being short OTM options\nthat could be closed by paying asixteenth was an unreasonable risk.\nTeenie Sellers\nTeenie sellers, however, focused on the fact that options offered at one\nsixteenth were far enough OTM that they were very likely to expire\nworthless. This appears to be free money, unless the unexpected occurs, in\nwhich case potential losses can be unlimited. Teenie sellers would routinely\nsave themselves $6.25 (one sixteenth of adollar per contract representing\n100 shares) by selling their long OTMs at ateenie to close the position.\nThey sometimes would even initiate short OTM contracts at one sixteenth.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:158", "doc_id": "b84b217a99125664ee1fcb7bdfec5b5594fcdf9353c7a03f5d538b8e335f865d", "chunk_index": 0}
{"text": "These long-option or short-option biases hold for other types of strategies\nas well. Volatility-selling positions, such as the iron condor, can be\nconstructed to have limited risk. The paradigm for these strategies is they\ntend to produce winners more often than not. But when the position loses,\nthe trader loses more than he would stand to profit if the trade worked out\nfavorably.\nHerein lies the issue of preference. Long-option traders would rather trade\nBabe Ruth–style. For years, Babe Ruth was the record holder for the most\nhome runs. At the same time, he was also the record holder for the most\nstrikeouts. The born fighters that are option buyers accept the fact that they\nwill have more strikeouts, possibly many more strikeouts, than winning\ntrades. But the strategy dictates that the profit on one winner more than\nmakes up for the string of small losers.\nShort-option traders, conversely, like to have everything cool and\ncopacetic. They like the warm and fuzzy feeling they get from the fact that\nmonth after month they tend to generate winners. The occasional loser that\nnullifies afew months of profits is all part of the game.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:159", "doc_id": "409fa95de43a7b54c3692893ce8e25afd6bd8e8e410ef3dbf5f7c84defef2edb", "chunk_index": 0}
{"text": "Options and the Fair Game\nThere may be astatistical advantage to buying stock as opposed to shorting\nstock, because the market has historically had apositive annualized return\nover the long run. Astatistical advantage to being either an option buyer or\nan option seller, however, should not exist in the long run, because the\noption market prices IV. Assuming an overall efficient market for pricing\nvolatility into options, there should be no statistical advantage to\nsystematically buying or selling options. 1\nConsider agame consisting of one six-sided die. Each time aone, two, or\nthree is rolled, the house pays the player $1. Each time afour, five, or six is\nrolled, the house pays zero. What is the most aplayer would be willing to\npay to play this game? If the player paid nothing, the house would be at atremendous disadvantage, paying $1 50 percent of the time and nothing the\nother 50 percent of the time. This would not be afair game from the house’sperspective, as it would collect no money. If the player paid $1, the player\nwould get his dollar back when one, two, or three came up. Otherwise, he\nwould lose his dollar. This is not afair game from the player’sperspective.\nThe chances of winning this game are 3 out of 6, or 50–50. If this game\nwere played thousands of times, one would expect to receive $1 half the\ntime and receive nothing the other half of the time. The average return per\nroll one would expect to receive would be $0.50, that’s ($1 × 50 percent +\n$0 × 50 percent). This becomes afair game with an entrance fee of $0.50.\nNow imagine asimilar game in which asix-sided die is rolled. This time\nif aone is rolled, the house pays $1. If any other number is rolled, the house\npays nothing. What is afair price to play this game? The same logic and the\nsame math apply. There is apercent chance of aone coming up and the\nplayer receiving $1. And there is apercent chance of each of the other\nfive numbers being rolled and the player receiving nothing. Mathematically,\nthis translates to: \n percent \n percent). Fair value for achance to play this game is about $0.1667 per roll.\nThe fair game concept applies to option prices as well. The price of the\ngame, or in this case the price of the option, is determined by the market in", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:160", "doc_id": "dd402038f818d09c7e6aaaac23e76064d226b50afae923a6e28fe470695869c9", "chunk_index": 0}
{"text": "CHAPTER 5\nAn Introduction to Volatility-Selling Strategies\nAlong with death and taxes, there is one other fact of life we can all count\non: the time value of all options ultimately going to zero. What an alluring\nconcept! In abusiness where expected profits can be thwarted by an\nunexpected turn of events, this is one certainty traders can count on. Like all\ncertainties in the financial world, there is away to profit from this fact, but\nit’snot as easy as it sounds. Alas, the potential for profit only exists when\nthere is risk of loss.\nIn order to profit from eroding option premiums, traders must implement\noption-selling strategies, also known as volatility-selling strategies. These\nstrategies have their own set of inherent risks. Selling volatility means\nhaving negative vega—the risk of implied volatility rising. It also means\nhaving negative gamma—the risk of the underlying being too volatile. This\nis the nature of selling volatility. The option-selling trader does not want the\nunderlying stock to move—that is, the trader wants the stock to be less\nvolatile. That is the risk.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:163", "doc_id": "edfd2d69fdccb69069dec35d938c08713888e77423d033114acda1ed8e4e3e8a", "chunk_index": 0}
{"text": "Greeks and Income Generation\nWith volatility-selling strategies (sometimes called income-generating\nstrategies), greeks are often overlooked. Traders simply dismiss greeks as\nunimportant to this kind of trade. There is some logic behind this reasoning.\nTime decay provides the profit opportunity. In order to let all of time\npremium erode, the position must be held until expiration. Interim changes\nin implied volatility are irrelevant if the position is held to term. The\ngamma-theta loses some significance if the position is held until expiration,\ntoo. The position has either passed the break-even point on the at-expiration\ndiagram, or it has not. Incremental daily time decay–related gains are not\nthe ultimate goal. The trader is looking for all the time premium, not\nportions of it.\nSo why do greeks matter to volatility sellers? Greeks allow traders to be\nflexible. Consider short-term-momentum stock traders. The traders buy astock because they believe it will rise over the next month. After one week,\nif unexpected bearish news is announced causing the stock to break through\nits support lines, the traders have adecision to make. Short-term speculative\ntraders very often choose to cut their losses and exit the position early rather\nthan risk alarger loss hoping for arecovery.\nVolatility-selling option traders are often faced with the same dilemma. If\nthe underlying stays in line with the traders’ forecast, there is little to worry\nabout. But if the environment changes, the traders have to react. Knowing\nthe greeks for aposition can help traders make better decisions if they plan\nto close the position before expiration.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:166", "doc_id": "dcbd7507f7d0fcef890f4f66c509ceea9b903320a021f2bd4fef50ab69731fa8", "chunk_index": 0}
{"text": "Naked Call\nAnaked call is when atrader shorts acall without having stock or other\noptions to cover or protect it. Since the call is uncovered, it is one of the\nriskier trades atrader can make. Recall the at-expiration diagram for the\nnaked call from Chapter 1, Exhibit 1.3 : Naked TGT Call. Theoretically,\nthere is limited reward and unlimited risk. Yet there are times when\nexperienced traders will justify making such atrade. When astock has been\ntrading in arange and is expected to continue doing so, traders may wait\nuntil it is near the top of the channel, where there is resistance, and then\nshort acall.\nFor example, atrader, Brendan, has been studying achart of Johnson &\nJohnson (JNJ). Brendan notices that for afew months the stock has trading\nbeen in achannel between $60 and $65. As he observes Johnson & Johnson\nbeginning to approach the resistance level of $65 again, he considers selling\nacall to speculate on the stock not rising above $65. Before selling the call,\nBrendan consults other technical analysis tools, like ADX/DMI, to confirm\nthat there is no trend present. ADX/DMI is used by some traders as afilter\nto determine the strength of atrend and whether the stock is overbought or\noversold. In this case, the indicator shows no strong trend present. Brendan\nthen performs due diligence. He studies the news. He looks for anything\nspecific that could cause the stock to rally. Is the stock atakeover target?\nBrendan finds nothing. He then does earnings research to find out when\nthey will be announced, which is not for almost two more months.\nNext, Brendan pulls up an option chain on his computer. He finds that\nwith the stock trading around $64 per share, the market for the November\n65 call (expiring in four weeks) is 0.66 bid at 0.68 offer. Brendan considers\nwhen Johnson & Johnson’searnings report falls. Although recent earnings\nhave seldom been amajor concern for Johnson & Johnson, he certainly\nwants to sell an option expiring before the next earnings report. The\nNovember fits the mold. Brendan sells ten of the November 65 calls at the\nbid price of 0.66.\nBrendan has arather straightforward goal. He hopes to see Johnson &\nJohnson shares remain below $65 between now and expiration. If he is", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:167", "doc_id": "f9a741cc1186d686523aef2657051483cdd5e8b11f7f5300360905c45d034854", "chunk_index": 0}
{"text": "right, he stands to make $660. If he is wrong? Exhibit 5.1 shows how\nBrendan’scalls hold up if they are held until expiration.\nEXHIBIT 5.1 Naked Johnson & Johnson call at expiration.\nConsidering the risk/reward of this trade, Brendan is rightfully concerned\nabout abig upward move. If the stock begins to rally, he must be prepared\nto act fast. Brendan must have an idea in advance of what his pain threshold\nis. In other words, at what price will he buy back his calls and take aloss if\nJohnson & Johnson moves adversely?\nHe decides he will buy all 10 of his calls back at 1.10 per contract if the\ntrade goes against him. (1.10 is an arbitrary price used for illustrative\npurposes. The actual price will vary, based on the situation and the risk\ntolerance of the trader. More on when to take profits and losses is discussed\nin future chapters.) He may choose to enter agood-till-canceled (GTC)\nstop-loss order to buy back his calls. Or he may choose to monitor the stock\nand enter the order when he sees the calls offered at 1.10—amental stop\norder. What Brendan needs to know is: How far can the stock price advance\nbefore the calls are at 1.10?\nBrendan needs to examine the greeks of this trade to help answer this\nquestion. Exhibit 5.2 shows the hypothetical greeks for the position in this\nexample.\nEXHIBIT 5.2 Greeks for short Johnson & Johnson 65 call (per contract).", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:168", "doc_id": "dbda9e97f38d755d9262bdebbe0c6ced2d613fb7dee52a5059d7a213b3ecb81c", "chunk_index": 0}
{"text": "Delta −0.34\nGamma−0.15\nTheta 0.02\nVega −0.07\nThe short call has anegative delta. It also has negative gamma and vega,\nbut it has positive time decay (theta). As Johnson & Johnson ticks higher,\nthe delta increases the nominal value of the call. Although this is not adirectional trade per se, delta is acrucial element. It will have abig impact\non Brendan’sexpectations as to how high the stock can rise before he must\ntake his loss.\nFirst, Brendan considers how much the option price can move before he\ncovers. The market now is 0.66 bid at 0.68 offer. To buy back his calls at\n1.10, they must be offered at 1.10. The difference between the offer now\nand the offer price at which Brendan will cover is 0.42 (that’s 1.10 − 0.68).\nBrendan can use delta to convert the change in the ask prices into astock\nprice change. To do so, Brendan divides the change in the option price by\nthe delta.\nThe −0.34 delta indicates that if JNJ rises $1.24, the calls should be\noffered at 1.10.\nBrendan takes note that the bid-ask spreads are typically 0.01 to 0.03\nwide in near-term Johnson & Johnson options trading under 1.00. This is\nnot necessarily the case in other option classes. Less liquid names have\nwider spreads. If the spreads were wider, Brendan would have more\nslippage. Slippage is the difference between the assumed trade price and the\nactual price of the fill as aproduct of the bid-ask spread. It’sthe difference\nbetween theory and reality. If the bid-ask spread had atypical width of, say,\n0.70, the market would be something more like 0.40 bid at 1.10 offer. In\nthis case, if the stock moved even afew cents higher, Brendan could not\nbuy his calls back at his targeted exit price of 1.10. The tighter markets\nprovide lower transaction costs in the form of lower slippage. Therefore,\nthere is more leeway if the stock moves adversely when there are tighter\nbid-ask option spreads.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:169", "doc_id": "70f83ed93ae5234f64283f0358a00528e4a6677c419bcec1c530618009a9ea49", "chunk_index": 0}
{"text": "But just looking at delta only tells apart of the story. In reality, the delta\ndoes not remain constant during the price rise in Johnson & Johnson but\ninstead becomes more negative. Initially, the delta is −0.34 and the gamma\nis −0.15. After arise in the stock price, the delta will be more negative by\nthe amount of the gamma. To account for the entire effect of direction,\nBrendan needs to take both delta and gamma into account. He needs to\nestimate the average delta based on gamma during the stock price move.\nThe formula for the change in stock price is\nTaking into account the effect of gamma as well as delta, Johnson &\nJohnson needs to rise only $1.01, in order for Brendan’scalls to be offered\nat his stop-loss price of 1.10.\nWhile having apredefined price point to cover in the event the underlying\nrises is important, sometimes traders need to think on their feet. If material\nnews is announced that changes the fundamental outlook for the stock,\nBrendan will have to adjust his plan. If the news leads Brendan to become\nbullish on the stock, he should exit the trade at once, taking asmall loss\nnow instead of the bigger loss he would expect later. If the trader is\nuncertain as to whether to hold or close the position, the Would I Do It\nNow? rule is auseful rule of thumb.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:170", "doc_id": "1ae4581862e84f2b26f445ac45d3841ac88b6e11a29251556c722efac9c12102", "chunk_index": 0}
{"text": "Would I Do It Now? Rule\nTo follow this rule, ask yourself, “If Idid not already have this position,\nwould Ido it now? Would Iestablish the position at the current market\nprices, given the current market scenario?” If the answer is no, then the\nsolution is simple: Exit the trade.\nFor example, if after one week material news is released and Johnson &\nJohnson is trading higher, at $64.50 per share, and the November 65 call is\ntrading at 0.75, Brendan must ask himself, based on the price of the stock\nand all known information, “If Iwere not already short the calls, would Ishort them now at the current price of 0.75, with the stock trading at\n$64.50?”\nBrendan’sopinion of the stock is paramount in this decision. If, for\nexample, based on the news that was announced he is now bullish, he\nwould likely not want to sell the calls at 0.75—he only gets $0.09 more in\noption premium and the stock is 0.50 closer to the strike. If, however, he is\nnot bullish, there is more to consider.\nTheta can be of great use in decision making in this situation. As the\nnumber of days until expiration decreases and the stock approaches $65\n(making the option more at-the-money), Brendan’stheta grows more\npositive. Exhibit 5.3 shows the theta of this trade as the underlying rises\nover time.\nEXHIBIT 5.3 Theta of Johnson & Johnson.\nWhen the position is first established, positive theta comforts Brendan by\nshowing that with each passing day he gets alittle closer to his goal—to\nhave the 65 calls expire out-of-the-money (OTM) and reap aprofit of the\nentire 66-cent premium. Theta becomes truly useful if the position begins to\nmove against him. As Johnson & Johnson rises, the trade gets more", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:171", "doc_id": "82e5508ed7c0e3f6927e22c0702bc094f10fa4988d635bf7c4ed28630cd53bd3", "chunk_index": 0}
{"text": "precarious. His negative delta increases. His negative gamma increases. His\ngoal becomes more out of reach. In conjunction with delta and gamma,\ntheta helps Brendan decide whether the risk is worth the reward.\nIn the new scenario, with the stock at $64.50, Brendan would collect $18\naday (1.80 × 10 contracts). Is the risk of loss in the short run worth earning\n$18 aday? With Johnson & Johnson at $64.50, would Brendan now short\n10 calls at 0.75 to collect $18 aday, knowing that each day may bring acontinued move higher in the stock? The answer to this question depends on\nBrendan’sassessment of the risk of the underlying continuing its ascent. As\ntime passes, if the stock remains closer to the strike, the daily theta rises,\nproviding more reward. Brendan must consider that as theta—the reward—\nrises, so does gamma: arisk factor.\nAsmall but noteworthy risk is that implied volatility could rise. The\nnegative vega of this position would, then, adversely affect the profitability\nof this trade. It will make Brendan’s 1.10 cover-point approach faster\nbecause it makes the option more expensive. Vega is likely to be of less\nconsequence because it would ultimately take the stock’srising though the\nstrike price for the trade to be aloser at expiration.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:172", "doc_id": "a1d78bc6a0ac7e55e8eb358492e65dd0c06b338bb83cc3e300c3e81a24621a44", "chunk_index": 0}
{"text": "Short Naked Puts\nAnother trader, Stacie, has also been studying Johnson & Johnson. Stacie\nbelieves Johnson & Johnson is on its way to test the $65 resistance level yet\nagain. She believes it may even break through $65 this time, based on\nstrong fundamentals. Stacie decides to sell naked puts. Anaked put is ashort put that is not sold in conjunction with stock or another option.\nWith the stock around $64, the market for the November 65 put is 1.75\nbid at 1.80. Stacie likes the fact that the 65 puts are slightly in-the-money\n(ITM) and thus have ahigher delta. If her price rise comes sooner than\nexpected, the high delta may allow her to take aprofit early. Stacie sells 10\nputs at 1.75.\nIn the best-case scenario, Stacie retains the entire 1.75. For that to happen,\nshe will need to hold this position until expiration and the stock will have to\nrise to be trading above the 65 strike. Logically, Stacie will want to do an\nat-expiration analysis. Exhibit 5.4 shows Stacie’snaked put trade if she\nholds it until expiration.\nEXHIBIT 5.4 Naked Johnson & Johnson put at expiration.\nWhile harvesting the entire premium as aprofit sounds attractive, if\nStacie can take the bulk of her profit early, she’ll be happy to close the\nposition and eliminate her risk—nobody ever went broke taking aprofit.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:173", "doc_id": "bf98252018199849889b1ffc1b274049c4815ce951b2f071fadcc86562e5e598", "chunk_index": 0}
{"text": "Furthermore, she realizes that her outlook may be wrong: Johnson &\nJohnson may decline. She may have to close the position early—maybe for\naprofit, maybe for aloss. Stacie also needs to study her greeks. Exhibit 5.5\nshows the greeks for this trade.\nEXHIBIT 5.5 Greeks for short Johnson & Johnson 65 put (per contract).\nDelta 0.65\nGamma−0.15\nTheta 0.02\nVega −0.07\nThe first item to note is the delta. This position has adirectional bias. This\nbias can work for or against her. With apositive 0.65 delta per contract, this\nposition has adirectional sensitivity equivalent to being long around 650\nshares of the stock. That’sthe delta × 100 shares × 10 contracts.\nStacie’strade is not just abullish version of Brendan’s. Partly because of\nthe size of the delta, it’sdifferent—specific directional bias aside. First, she\nwill handle her trade differently if it is profitable.\nFor example, if over the next week or so Johnson & Johnson rises $1,\npositive delta and negative gamma will have anet favorable effect on\nStacie’sprofitability. Theta is small in comparison and won’thave too much\nof an effect. Delta/gamma will account for adecrease in the put’stheoretical value of about $0.73. That’sthe estimated average delta times\nthe stock move, or [0.65 + (–0.15/2)] × 1.00.\nStacie’sactual profit would likely be less than 0.73 because of the bid-ask\nspread. Stacie must account for the fact that the bid-ask is 0.05 wide (1.75–\n1.80). Because Stacie would buy to close this position, she should consider\nthe 0.73 price change relative to the 1.80 offer, not the 1.75 trade price—\nthat is, she factors in anickel of slippage. Thus, she calculates, that the puts\nwill be offered at 1.07 (that’s 1.80 − 0.73) when the stock is at $65. That is\nagain of $0.68.\nIn this scenario, Stacie should consider the Would I Do It Now? rule to\nguide her decision as to whether to take her profit early or hold the position\nuntil expiration. Is she happy being short ten 65 puts at 1.07 with Johnson\n& Johnson at $65? The premium is lower now. The anticipated move has\nalready occurred, and she still has 28 days left in the option that could allow", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:174", "doc_id": "3bb19dc70b0eb086289100cca2f1cf07cb7c03e5308462a80de2899e2c3baf28", "chunk_index": 0}
{"text": "for the move to reverse itself. If she didn’thave the trade on now, would she\nsell ten 65 puts at 1.07 with Johnson & Johnson at $65? Based on her\noriginal intention, unless she believes strongly now that abreakout through\n$65 with follow-through momentum is about to take place, she will likely\ntake the money and run.\nStacie also must handle this trade differently from Brendan in the event\nthat the trade is aloser. Her trade has ahigher delta. An adverse move in the\nunderlying would affect Stacie’strade more than it would Brendan’s. If\nJohnson & Johnson declines, she must be conscious in advance of where\nshe will cover.\nStacie considers both how much she is willing to lose and what potential\nstock-price action will cause her to change her forecast. She consults astock chart of Johnson & Johnson. In this example, we’ll assume there is\nsome resistance developing around $64 in the short term. If this resistance\nlevel holds, the trade becomes less attractive. The at-expiration breakeven is\n$63.25, so the trade can still be awinner if Johnson & Johnson retreats. But\nStacie is looking for the stock to approach $65. She will no longer like the\nrisk/reward of this trade if it looks like that price rise won’toccur. She\nmakes the decision that if Johnson & Johnson bounces off the $64 level\nover the next couple weeks, she will exit the position for fear that her\noutlook is wrong. If Johnson & Johnson drifts above $64, however, she will\nride the trade out.\nIn this example, Stacie is willing to lose 1.00 per contract. Without taking\ninto account theta or vega, that 1.00 loss in the option should occur at astock price of about $63.28. Theta is somewhat relevant here. It helps\nStacie’spotential for profit as time passes. As time passes and as the stock\nrises, so will theta, helping her even more. If the stock moves lower (against\nher) theta helps ease the pain somewhat, but the further in-the-money the\nput, the lower the theta.\nVega can be important here for two reasons: first, because of how implied\nvolatility tends to change with market direction, and second, because it can\nbe read as an indication of the market’sexpectations.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:175", "doc_id": "0caedd1dc7eb918f562899f76f91662ffb3b1ea6fc53529ae71e7cabe411d1c7", "chunk_index": 0}
{"text": "The Double Whammy\nWith the stock around $64, there is anegative vega of about seven cents. As\nthe stock moves lower, away from the strike, the vega gets abit smaller.\nHowever, the market conditions that would lead to adecline in the price of\nJohnson & Johnson would likely cause implied volatility (IV) to rise. If the\nstock drops, Stacie would have two things working against her—delta and\nvega—adouble whammy. Stacie needs to watch her vega. Exhibit 5.6\nshows the vega of Stacie’sput as it changes with time and direction.\nEXHIBIT 5.6 Johnson & Johnson 65 put vega.\nIf after one week passes Johnson & Johnson gaps lower to, say, $63.00 ashare, the vega will be 0.043 per contract. If IV subsequently rises 5 points\nas aresult of the stock falling, vega will make Stacie’sputs theoretically\nworth 21.5 cents more per contract. She will lose $215 on vega (that’s 0.043\nvega × 5 volatility points × 10 contracts) plus the adverse delta/gamma\nmove.\nAgap opening will cause her to miss the opportunity to stop herself out at\nher target price entirely. Even if the stock drifts lower, her targeted stop-loss\nprice will likely come sooner than expected, as the option price will likely\nincrease both by delta/gamma and vega resulting from rising volatility. This\ncan cause her to have to cover sooner, which leaves less room for error.\nWith this trade, increases in IV due to market direction can make it feel as if\nthe delta is greater than it actually is as the market declines. Conversely, IV\nsoftening makes it feel as if the delta is smaller than it is as the market rises.\nThe second reason IV has importance for this trade (as for most other\nstrategies) is that it can give some indication of how much the market thinks\nthe stock can move. If IV is higher than normal, the market perceives there", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:176", "doc_id": "7eaccb001c514e0032d983b0ae27ca0dc89f1b62e43784be766ef4c70b9327ec", "chunk_index": 0}
{"text": "to be more risk than usual of future volatility. The question remains: Is the\nhigher premium worth the risk?\nThe answer to this question is subjective. Part of the answer is based on\nStacie’sassessment of future volatility. Is the market right? The other part is\nbased on Stacie’srisk tolerance. Is she willing to endure the greater price\nswings associated with the potentially higher volatility? This can mean\ngetting whipsawed, which is exiting aposition after reaching astop-loss\npoint only to see the market reverse itself. The would-be profitable trade is\nclosed for aloss. Higher volatility can also mean ahigher likelihood of\ngetting assigned and acquiring an unwanted long stock position.\nCash-Secured Puts\nThere are some situations where higher implied volatility may be abeneficial trade-off. What if Stacie’smotivation for shorting puts was\ndifferent? What if she would like to own the stock, just not at the current\nmarket price? Stacie can sell ten 65 puts at 1.75 and deposit $63,250 in her\ntrading account to secure the purchase of 1,000 shares of Johnson &\nJohnson if she gets assigned. The $63,250 is the $65 per share she will pay\nfor the stock if she gets assigned, minus the 1.75 premium she received for\nthe put × $100 × 10 contracts. Because the cash required to potentially\npurchase the stock is secured by cash sitting ready in the account, this is\ncalled acash-secured put.\nHer effective purchase price if assigned is $63.25—the same as her\nbreakeven at expiration. The idea with this trade is that if Johnson &\nJohnson is anywhere under $65 per share at expiration, she will buy the\nstock effectively at $63.25. If assigned, the time premium of the put allows\nher to buy the stock at adiscount compared with where it is priced when the\ntrade is established, $64. The higher the time premium—or the higher the\nimplied volatility—the bigger the discount.\nThis discount, however, is contingent on the stock not moving too much.\nIf it is above $65 at expiration she won’tget assigned and therefore can\nonly profit amaximum of 1.75 per contract. If the stock is below $63.25 at\nexpiration, the time premium no longer represents adiscount, in fact, the\ntrade becomes aloser. In away, Stacie is still selling volatility.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:177", "doc_id": "4424049d1e02f922fc679aacefdd18c8d1b313665107edce273330958edeecec", "chunk_index": 0}
{"text": "Covered Call\nThe problem with selling anaked call is that it has unlimited exposure to\nupside risk. Because of this, many traders simply avoid trading naked calls.\nAmore common, and some would argue safer, method of selling calls is to\nsell them covered.\nAcovered call is when calls are sold and stock is purchased on ashare-\nfor-share basis to cover the unlimited upside risk of the call. For each call\nthat is sold, 100 shares of the underlying security are bought. Because of the\naddition of stock to this strategy, covered calls are traded with adifferent\nmotivation than naked calls.\nThere are clearly many similarities between these two strategies. The\nmain goal for both is to harvest the premium of the call. The theta for the\ncall is the same with or without the stock component. The gamma and vega\nfor the two strategies are the same as well. The only difference is the stock.\nWhen stock is added to an option position, the net delta of the position is\nthe only thing affected. Stock has adelta of one, and all its other greeks are\nzero.\nThe pivotal point for both positions is the strike price. That’sthe point the\ntrader wants the stock to be above or below at expiration. With the naked\ncall, the maximum payout is reaped if the stock is below the strike at\nexpiration, and there is unlimited risk above the strike. With the covered\ncall, the maximum payout is reaped if the stock is above the strike at\nexpiration. If the stock is below the strike at expiration, the risk is\nsubstantial—the stock can potentially go to zero.\nPutting It on\nThere are afew important considerations with the covered call, both when\nputting on, or entering, the position and when taking off, or exiting, the\ntrade. The risk/reward implications of implied volatility are important in the\ntrade-planning process. Do Iwant to get paid more to assume more\npotential risk? More speculative traders like the higher premiums. More\nconservative (investment-oriented) covered-call sellers like the low implied\nrisk of low-IV calls. Ultimately, amain focus of acovered call is the option", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:178", "doc_id": "5617dec5843008803d695cf1c3e258511260ddd09bdbb064082b308119a8e31f", "chunk_index": 0}
{"text": "premium. How fast can it go to zero without the movement hurting me? To\ndetermine this, the trader must study both theta and delta.\nThe first step in the process is determining which month and strike call to\nsell. In this example, Harley-Davidson Motor Company (HOG) is trading at\nabout $69 per share. Atrader, Bill, is neutral to slightly bullish on Harley-\nDavidson over the next three months. Exhibit 5.7 shows aselection of\navailable call options for Harley-Davidson with corresponding deltas and\nthetas.\nEXHIBIT 5.7 Harley-Davidson calls.\nIn this example, the May 70 calls have 85 days until expiration and are\n2.80 bid. If Harley-Davidson remained at $69 until May expiration, the 2.80\npremium would represent a 4 percent profit over this 85-day period (2.80 ÷\n69). That’san annualized return of about 17 percent ([0.04 / 85)] × 365).\nBill considers his alternatives. He can sell the April (57-day) 70 calls at\n2.20 or the March (22-day) 70 calls at 0.85. Since there is adifferent\nnumber of days until expiration, Bill needs to compare the trades on an\napples-to-apples basis. For this, he will look at theta and implied volatility.\nPresumably, the March call has atheta advantage over the longer-term\nchoices. The March 70 has atheta of 0.032, while the April 70’stheta is\n0.026 and the May 70’sis 0.022. Based on his assessment of theta, Bill\nwould have the inclination to sell the March. If he wants exposure for 90\ndays, when the March 70 call expires, he can roll into the April 70 call and\nthen the May 70 call (more on this in subsequent chapters). This way Bill\ncan continue to capitalize on the nonlinear rate of decay through May.\nNext, Bill studies the IV term structure for the Harley-Davidson ATMs\nand finds the March has about a 19.2 percent IV, the April has a 23.3", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:179", "doc_id": "20419362a996be0efb53f6bc40176a52e36b582fd5af3a8d13febeb9c6c509c7", "chunk_index": 0}
{"text": "percent IV, and the May has a 23 percent IV. March is the cheapest option\nby IV standards. This is not necessarily afavorable quality for ashort\ncandidate. Bill must weigh his assessment of all relevant information and\nthen decide which trade is best. With this type of astrategy, the benefits of\nthe higher theta can outweigh the disadvantages of selling the lower IV. In\nthis case, Bill may actually like selling the lower IV. He may infer that the\nmarket believes Harley-Davidson will be less volatile during this period.\nSo far, Bill has been focusing his efforts on the 70 strike calls. If he trades\nthe March 70 covered call, he will have anet delta of 0.588 per contract.\nThat’sthe negative 0.412 delta from shorting the call plus the 1.00 delta of\nthe stock. His indifference point if the trade is held until expiration is\n$70.85. The indifference point is the point at which Bill would be\nindifferent as to whether he held only the stock or the covered call. This is\nfigured by adding the strike price of $70 to the 0.85 premium. This is the\neffective sale price of the stock if the call is assigned. If Bill wants more\npotential for upside profit, he could sell ahigher strike. He would have to\nsell the April or May 75, since the March 75s are azero bid. This would\ngive him ahigher indifference point, and the upside profits would\nmaterialize quickly if HOG moved higher, since the covered-call deltas\nwould be higher with the 75 calls. The April 75 covered-call net delta is\n0.796 per contract (the stock delta of 1.00 minus the 0.204 delta of the call).\nThe May 75 covered-call delta is 0.751.\nBut Bill is neutral to only slightly bullish. In this case, he’drather have\nthe higher premium—high theta is more desirable than high delta in this\nsituation. Bill buys 1,000 shares of Harley-Davidson at $69 and sells 10\nHarley-Davidson March 70 calls at 0.85.\nBill also needs to plan his exit. To exit, he must study two things: an at-\nexpiration diagram and his greeks. Exhibit 5.8 shows the P&(L) at\nexpiration of the Harley-Davidson March 70 covered call. Exhibit 5.9\nshows the greeks.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:180", "doc_id": "87fced71bfdcac3e894b5c6151296523ef7c8afde560e3ad933b20e6a4f8e614", "chunk_index": 0}
{"text": "EXHIBIT 5.8 Harley-Davidson covered call.\nEXHIBIT 5.9 Greeks for Harley-Davidson covered call (per contract).\nDelta 0.591\nGamma−0.121\nTheta 0.032\nVega −0.066\nTaking It Off\nIf the trade works out perfectly for Bill, 22 days from now Harley-Davidson\nwill be trading right at $70. He’dprofit on both delta and theta. If the trade\nisn’texactly perfect, but still good, Harley-Davidson will be anywhere\nabove $68.15 in 22 days. It’sthe prospect that the trade may not be so good\nat March expiration that occupies Bill’sthoughts, but atrader has to hope\nfor the best and plan for the worst.\nIf it starts to trend, Bill needs to react. The consequences to the stock’strending to the upside are not quite so dire, although he might be somewhat\nfrustrated with any lost opportunity above the indifference point. It’sthe\ndownside risk that Bill will more vehemently guard against.\nFirst, the same IV/vega considerations exist as they did in the previous\nexamples. In the event the trade is closed early, IV/vega may help or hinder\nprofitability. Arise in implied volatility will likely accompany adecline in", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:181", "doc_id": "ee679c96d7624c8784844ea317662fe87b91420a815daec3e3e23ec6f9ba9261", "chunk_index": 0}
{"text": "the stock price. This can bring Bill to his stop-loss sooner. Delta versus\ntheta however, is the major consideration. He will plan his exit price in\nadvance and cover when the planned exit price is reached.\nThere are more moving parts with the covered call than anaked option. If\nBill wants to close the position early, he can leg out, meaning close only\none leg of the trade (the call or the stock) at atime. If he legs out of the\ntrade, he’slikely to close the call first. The motivation for exiting atrade\nearly is to reduce risk. Anaked call is hardly less risky than acovered call.\nAnother tactic Bill can use, and in this case will plan to use, is rolling the\ncall. When the March 70s expire, if Harley-Davidson is still in the same\nrange and his outlook is still the same, he will sell April calls to continue\nthe position. After the April options expire, he’ll plan to sell the Mays.\nWith this in mind, Bill may consider rolling into the Aprils before March\nexpiration. If it is close to expiration and Harley-Davidson is trading lower,\ntheta and delta will both have devalued the calls. At the point when options\nare close to expiration and far enough OTM to be offered close to zero, say\n0.05, the greeks and the pricing model become irrelevant. Bill must\nconsider in absolute terms if it is worth waiting until expiration to make\n0.05. If there is alot of time until expiration, the answer is likely to be no.\nThis is when Bill will be apt to roll into the Aprils. He’ll buy the March 70s\nfor anickel, adime, or maybe 0.15 and at the same time sell the Aprils at\nthe bid. This assumes he wants to continue to carry the position. If the roll\nis entered as asingle order, it is called acalendar spread or atime spread.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:182", "doc_id": "7ccbf6598ff0ddd791a48028a86c591ab263e5df37b80abacdd6ca39897b734e", "chunk_index": 0}
{"text": "Covered Put\nThe last position in the family of basic volatility-selling strategies is the\ncovered put, sometimes referred to as selling puts and stock. In acovered\nput, atrader sells both puts and stock on aone-to-one basis. The term\ncovered put is abit of amisnomer, as the strategy changes from limited risk\nto unlimited risk when short stock is added to the short put. Anaked put can\nproduce only losses until the stock goes to zero—still asubstantial loss.\nAdding short stock means that above the strike gains on the put are limited,\nwhile losses on the stock are unlimited. The covered put functions very\nmuch like anaked call. In fact, they are synthetically equal. This concept\nwill be addressed further in the next chapter.\nLet’slooks at another trader, Libby. Libby is an active trader who trades\nseveral positions at once. Libby believes the overall market is in arange\nand will continue as such over the next few weeks. She currently holds ashort stock position of 1,000 shares in Harley-Davidson. She is becoming\nmore neutral on the stock and would consider buying in her short if the\nmarket dipped. She may consider entering into acovered-put position.\nThere is one caveat: Libby is leaving for acruise in two weeks and does not\nwant to carry any positions while she is away. She decides she will sell the\ncovered put and actively manage the trade until her vacation. Libby will sell\n10 Harley-Davidson March (22-day) 70 puts at 1.85 against her short 1,000\nshares of Harley-Davidson, which is trading at $69 per share.\nShe knows that her maximum profit if the stock declines and assignment\noccurs will be $850. That’s 0.85 × $100 × 10 contracts. Win or lose, she\nwill close the position in two weeks when there are only eight days until\nexpiration. To trade this covered put she needs to watch her greeks.\nExhibit 5.10 shows the greeks for the Harley-Davidson 70-strike covered\nput.\nEXHIBIT 5.10 Greeks for Harley-Davidson covered put (per contract).\nDelta −0.419\nGamma−0.106\nTheta 0.031\nVega −0.066", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:183", "doc_id": "4e8b44ddd1e63402ead668dbd29cc09a1544d126813227b8e6247e6fdb8ab3c0", "chunk_index": 0}
{"text": "Libby is really focusing on theta. It is currently about $0.03 per day but\nwill increase if the put stays close-to-the-money. In two weeks, the time\npremium will have decayed significantly. Amove downward will help, too,\nas the −0.419 delta indicates. Exhibit 5.11 displays an array of theoretical\nvalues of the put at eight days until expiration as the stock price changes.\nEXHIBIT 5.11 HOG 70 put values at 8 days to expiry.\nAs long as Harley-Davidson stays below the strike price, Libby can look\nat her put from apremium-over-parity standpoint. Below the strike, the\nintrinsic value of the put doesn’tmatter too much, because losses on\nintrinsic value are offset by gains on the stock. For Libby, all that really\nmatters is the time value. She sold the puts at 0.85 over parity. If Harley-\nDavidson is trading at $68 with eight days to go, she can buy her puts back\nfor 0.12 over parity. That’sa 73-cent profit, or $730 on her 10 contracts.\nThis doesn’taccount for any changes in the time value that may occur as aresult of vega, but vega will be small with Harley-Davidson at $68 and\neight days to go. At this point, she would likely close down the whole\nposition—buying the puts and buying the stock—to take aprofit on aposition that worked out just about exactly as planned.\nHer risk, though, is to the upside. Abig rally in the stock can cause big\nlosses. From atheoretical standpoint, losses are potentially unlimited with\nthis type of trade. If the stock is above the strike, she needs to have amental\nstop order in mind and execute the closing order with discipline.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:184", "doc_id": "fde0b259bb5166ed99934e6c9b046dfce4d1bf54e39de26233ba2c0f9d85ad40", "chunk_index": 0}
{"text": "Put-Call Parity Essentials\nBefore the creation of the Black-Scholes model, option pricing was hardly\nan exact science. Traders had only afew mathematical tools available to\ncompare the relative prices of options. One such tool, put-call parity, stems\nfrom the fact that puts and calls on the same class sharing the same month\nand strike can have the same functionality when stock is introduced.\nFor example, traders wanting to own astock with limited risk can buy amarried put: long stock and along put on ashare-for-share basis. The\ntraders have infinite profit potential, and the risk of the position is limited\nbelow the strike price of the option. Conceptually, long calls have the same\nrisk/reward profile—unlimited profit potential and limited risk below the\nstrike. Exhibit 6.1 is an overview of the at-expiration diagrams of amarried\nput and along call.\nEXHIBIT 6.1 Long call vs. long stock + long put (married put).\nMarried puts and long calls sharing the same month and strike on the\nsame security have at-expiration diagrams with the same shape. They have\nthe same volatility value and should trade around the same implied\nvolatility (IV). Strategically, these two positions provide the same service to\natrader, but depending on margin requirements, the married put may\nrequire more capital to establish, because the trader must buy not just the\noption but also the stock.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:187", "doc_id": "105f62bc5edfa71748f653c14af014e48fb74c8106a216db3922cae6024b461b", "chunk_index": 0}
{"text": "The stock component of the married put could be purchased on margin.\nBuying stock on margin is borrowing capital to finance astock purchase.\nThis means the trader has to pay interest on these borrowed funds. Even if\nthe stock is purchased without borrowing, there is opportunity cost\nassociated with the cash used to pay for the stock. The capital is tied up. If\nthe trader wants to use funds to buy another asset, he will have to borrow\nmoney, which will incur an interest obligation. Furthermore, if the trader\ndoesn’tinvest capital in the stock, the capital will rest in an interest-bearing\naccount. The trader forgoes that interest when he buys astock. However the\ntrader finances the purchase, there is an interest cost associated with the\ntransaction.\nBoth of these positions, the long call and the married put, give atrader\nexposure to stock price advances above the strike price. The important\ndifference between the two trades is the value of the stock below the strike\nprice—the part of the trade that is not at risk in either the long call or the\nmarried put. On this portion of the invested capital, the trader pays interest\nwith the married put (whether actually or in the form of opportunity cost).\nThis interest component is apricing consideration that adds cost to the\nmarried put and not the long call.\nSo if the married put is amore expensive endeavor than the long call\nbecause of the interest paid on the investment portion that is below the\nstrike, why would anyone buy amarried put? Wouldn’ttraders instead buy\nthe less expensive—less capital intensive—long call? Given the additional\ninterest expense, they would rather buy the call. This relates to the concept\nof arbitrage. Given two effectively identical choices, rational traders will\nchoose to buy the less expensive alternative. The market as awhole would\nbuy the calls, creating demand which would cause upward price pressure on\nthe call. The price of the call would rise until its interest advantage over the\nmarried put was gone. In arobust market with many savvy traders,\narbitrage opportunities don’texist for very long.\nIt is possible to mathematically state the equilibrium point toward which\nthe market forces the prices of call and put options by use of the put-call\nparity. As shown in Chapter 2, the put-call parity states", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:188", "doc_id": "cf1b7be18cf157e2265e70a89dc9fef71d07871a9a9184c4dd6b279415932c48", "chunk_index": 0}
{"text": "Dividends\nAnother difference between call and married-put values is dividends. Acall\noption does not extend to its owner the right to receive adividend payment.\nTraders, however, who are long aput and long stock are entitled to adividend if it is the corporation’spolicy to distribute dividends to its\nshareholders.\nAn adjustment must be made to the put-call parity to account for the\npossibility of adividend payment. The equation must be adjusted to account\nfor the absence of dividends paid to call holders. For adividend-paying\nstock, the put-call parity states\nThe interest advantage and dividend disadvantage of owning acall is\nremoved from the market by arbitrageurs. Ultimately, that is what is\nexpressed in the put-call parity. It’saway to measure the point at which the\narbitrage opportunity ceases to exist. When interest and dividends are\nfactored in, along call is an equal position to along put paired with long\nstock. In options nomenclature, along put with long stock is asynthetic\nlong call. Algebraically rearranging the above equation:\nThe interest and dividend variables in this equation are often referred to\nas the basis. From this equation, other synthetic relationships can be\nalgebraically derived, like the synthetic long put.\nAsynthetic long put is created by buying acall and selling (short) stock.\nThe at-expiration diagrams in Exhibit 6.2 show identical payouts for these\ntwo trades.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:190", "doc_id": "5165cf5d5733c3e1545584675fcb0a3856ff2a2f8e840bbcfe376da30dc6aa35", "chunk_index": 0}
{"text": "EXHIBIT 6.2 Long put vs. long call + short stock.\nThe concept of synthetics can become more approachable when studied\nfrom the perspective of delta as well. Take the 50-strike put and call listed\non a $50 stock. Ageneral rule of thumb in the put-call pair is that the call\ndelta plus the put delta equals 1.00 when the signs are ignored. If the 50 put\nin this example has a −0.45 delta, the 50 call will have a 0.55 delta. By\ncombining the long call (0.55 delta) with short stock (–1.00 delta), we get asynthetic long put with a −0.45 delta, just like the actual put. The\ndirectional risk is the same for the synthetic put and the actual put.\nAsynthetic short put can be created by selling acall of the same month\nand strike and buying stock on ashare-for-share basis (i.e., acovered call).\nThis is indicated mathematically by multiplying both sides of the put-call\nparity equation by −1:\nThe at-expiration diagrams, shown in Exhibit 6.3 , are again conceptually\nthe same.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:191", "doc_id": "5add89460feaf96573d3c223c2504212c88fd7cd6b0504610e194367722cf5a4", "chunk_index": 0}
{"text": "EXHIBIT 6.3 Short put vs. short call + long stock.\nAshort (negative) put is equal to ashort (negative) call plus long stock,\nafter the basis adjustment. Consider that if the put is sold instead of buying\nstock and selling acall, the interest that would otherwise be paid on the cost\nof the stock up to the strike price is asavings to the put seller. To balance\nthe equation, the interest benefit of the short put must be added to the call\nside (or subtracted from the put side). It is the same with dividends. The\ndividend benefit of owning the stock must be subtracted from the call side\nto make it equal to the short put side (or added to the put side to make it\nequal the call side).\nThe same delta concept applies here. The short 50-strike put in our\nexample would have a 0.45 delta. The short call would have a −0.55 delta.\nBuying one hundred shares along with selling the call gives the synthetic\nshort put anet delta of 0.45 (–0.55 + 1.00).\nSimilarly, asynthetic short call can be created by selling aput and selling\n(short) one hundred shares of stock. Exhibit 6.4 shows aconceptual\noverview of these two positions at expiration.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:192", "doc_id": "72ba95efae8f9ac73ea656ffc379e3c52226a2be800686bbc4b1b7aab41d055e", "chunk_index": 0}
{"text": "Comparing Synthetic Calls and Puts\nThe common thread among the synthetic positions explained above is that,\nfor aput-call pair, long options have synthetic equivalents involving long\noptions, and short options have synthetic equivalents involving short\noptions. After accounting for the basis, the four basic synthetic option\npositions are:\nBecause acall or put position is interchangeable with its synthetic\nposition, an efficient market will ensure that the implied volatility is closely\nrelated for both. For example, if along call has an IV of 25 percent, the\ncorresponding put should have an IV of about 25 percent, because the long\nput can easily be converted to asynthetic long call and vice versa. The\ngreeks will be similar for synthetically identical positions, too. The long\noptions and their synthetic equivalents will have positive gamma and vega\nwith negative theta. The short options and their synthetics will have\nnegative gamma and vega with positive theta.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:194", "doc_id": "cb1d80b7cd2539c2eae400a55aac71c1ecea25a2dcd06bb3ebe3b700366d1c45", "chunk_index": 0}
{"text": "American-Exercise Options\nPut-call parity was designed for European-style options. The early exercise\npossibility of American-style options gums up the works abit. Because acall (put) and asynthetic call (put) are functionally the same, it is logical to\nassume that the implied volatility and the greeks for both will be exactly the\nsame. This is not necessarily true with American-style options. However,\nput-call parity may still be useful with American options when the\nlimitations of the equation are understood. With at-the-money American-\nexercise options, the differences in the greeks for aput-call pair are subtle.\nExhibit 6.5 is acomparison of the greeks for the 50-strike call and the 50-\nstrike put with the underlying at $50 and 66 days until expiration.\nEXHIBIT 6.5 Greeks for a 50-strike put-call pair on a $50 stock.\nCall Put\nDelta 0.5540.457\nGamma0.0750.078\nTheta 0.0200.013\nVega 0.0840.084\nThe examples used earlier in this chapter in describing the deltas of\nsynthetics were predicated on the rule of thumb that the absolute values of\ncall and put deltas add up to 1.00. To be abit more realistic, consider that\nbecause of American exercise, the absolute delta values of put-call pairs\ndon’talways add up to 1.00. In fact, Exhibit 6.5 shows that the call has\ncloser to a 0.554 delta. The put struck at the same price then has a 0.457\ndelta. By selling 100 shares against the long call, we can create acombined-\nposition delta (call delta plus stock delta) that is very close to the put’sdelta. The delta of this synthetic put is −0.446 (0.554 − 1.00). The delta of aput will always be similar to the delta of its corresponding synthetic put.\nThis is also true with call–synthetic-call deltas. This relationship\nmathematically is", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:195", "doc_id": "16f65c384ba4c8caacfb1cfd5dc8cf28aff855035dc25feddc3c579a03667aa4", "chunk_index": 0}
{"text": "This holds true whether the options are in-, at-, or out-of-the-money. For\nexample, with astock at $54, the 50-put would have a −0.205 delta and the\ncall would have a 0.799 delta. Selling 100 shares against the call to create\nthe synthetic put yields anet delta of −0.201.\nIf long or short stock is added to acall or put to create asynthetic, delta\nwill be the only greek affected. With that in mind, note the other greeks\ndisplayed in Exhibit 6.5 —especially theta. Proportionally, the biggest\ndifference in the table is in theta. The disparity is due in part to interest.\nWhen the effects of the interest component outweigh the effects of the\ndividend, the time value of the call can be higher than the time value of the\nput. Because the call must lose more premium than the put by expiration,\nthe theta of the call must be higher than the theta of the put.\nAmerican exercise can also cause the option prices in put-call parity to\nnot add up. Deep in-the-money (ITM) puts can trade at parity while the\ncorresponding call still has time value. The put-call equation can be\nunbalanced. The same applies to calls on dividend-paying stocks as the\ndividend date approaches. When the date is imminent, calls can trade close\nto parity while the puts still have time value. The role of dividends will be\ndiscussed further in Chapter 8.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:196", "doc_id": "385f6f8b8841d0abd3b811333ceb0f5bf9779651324e7ed8e214f2fbecfbf46b", "chunk_index": 0}
{"text": "Synthetic Stock\nNot only can synthetic calls and puts be derived by manipulation of put-call\nparity, but synthetic positions for the other security in the equation—stock\n—can be derived, as well. By isolating stock on one side of the equation,\nthe formula becomes\nAfter accounting for interest and dividends, buying acall and selling aput\nof the same strike and time to expiration creates the equivalent of along\nstock position. This is called asynthetic stock position, or acombo. After\naccounting for the basis, the equation looks conceptually like this:\nThis is easy to appreciate when put-call parity is written out as it is here.\nIt begins to make even more sense when considering at-expiration diagrams\nand the greeks.\nExhibit 6.6 illustrates along stock position compared with along call\ncombined with ashort put position.\nEXHIBIT 6.6 Long stock vs. long call + short put.\nAquick glance at these two strategies demonstrates that they are the\nsame, but think about why. Consider the synthetic stock position if both\noptions are held until expiration. The long call gives the trader the right to\nbuy the stock at the strike price. The short put gives the trader the obligation", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:197", "doc_id": "49858642ba8db13181afa7bb1f59b30113a1eb0bef480a636e143523dceccf74", "chunk_index": 0}
{"text": "to buy the stock at the same strike price. It doesn’tmatter what the strike\nprice is. As long as the strike is the same for the call and the put, the trader\nwill have along position in the underlying at the shared strike at expiration\nwhen exercise or assignment occurs.\nThe options in this example are 50-strike options. At expiration, the trader\ncan exercise the call to buy the underlying at $50 if the stock is above the\nstrike. If the underlying is below the strike at expiration, he’ll get assigned\non the put and buy the stock at $50. If the stock is bought, whether by\nexercise or assignment, the effective price of the potential stock purchase,\nhowever, is not necessarily $50.\nFor example, if the trader bought one 50-strike call at 3.50 and sold one\n50-strike put at 1.50, he will effectively purchase the underlying at $52\nupon exercise or assignment. Why? The trader paid anet of $2 to get along\nposition in the stock synthetically (3.50 of call premium debited minus 1.50\nof put premium credited). Whether the call or the put is ITM, the effective\npurchase price of the stock will always be the strike price plus or minus the\ncost of establishing the synthetic, in this case, $52.\nThe question that begs to be asked is: would the trader rather buy the\nstock or pay $2 to have the same market exposure as long stock?\nArbitrageurs in the market (with the help of the put-call parity) ensure that\nneither position—long stock or synthetic long stock—is better than the\nother.\nFor example, assume astock is trading at $51.54. With 71 days until\nexpiration, 26.35 IV, a 5 percent interest rate, and no dividends, the 50-\nstrike call is theoretically worth 3.50, and the 50-strike put is theoretically\nworth 1.50. Exhibit 6.7 charts the synthetic stock versus the actual stock\nwhen there are 71 days until expiration.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:198", "doc_id": "ad3bd58137897b90a3c2307e23f59ba52d613c2c28468e73f99746f610a96ce3", "chunk_index": 0}
{"text": "EXHIBIT 6.7 Long stock and synthetic long stock with 71 days to\nexpiration.\nLooking at this exhibit, it appears that being long the actual stock\noutperforms being long the stock synthetically. If the stock is purchased at\n$51.54, it need only rise apenny higher to profit (in the theoretical world\nwhere traders do not pay commissions on transactions). If the synthetic is\npurchased for $2, the stock needs to rise $0.46 to break even—an apparent\ndisadvantage. This figure, however, does not include interest.\nThe synthetic stock offers the same risk/reward as actually being long the\nstock. There is abenefit, from the perspective of interest, to paying only $2\nfor this exposure rather than $51.54. The interest benefit here is about\n$0.486. We can find this number by calculating the interest as we did earlier\nin the chapter. Interest, again, is computed as the strike price times the\ninterest rate times the number of days to expiration divided by the number\nof days in ayear. The formula is as follows:\nInputting the numbers from this example:\nThe $0.486 of interest is about equal to the $0.46 disparity between the\ndiagrams of the stock and the synthetic stock with 71 days until expiration.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:199", "doc_id": "cb75fe9889f9585182ae4cb7936eb51dffee43a9ea6554ad191f705238e00e2c", "chunk_index": 0}
{"text": "The difference is due mainly to rounding and the early-exercise potential of\nthe American put. In mathematical terms\nThe synthetic long stock is approximately equal to the long stock position\nwhen considering the effect of interest. The two lines in Exhibit 6.7 —\nrepresenting stock and synthetic stock—would converge with each passing\nday as the calculated interest decreases.\nThis equation works as well for asynthetic short stock position; reversing\nthe signs reveals the synthetic for short stock.\nOr, in this case,\nShorting stock at $51.54 is about equal to selling the 50 call and buying\nthe 50 put for a $2 credit based on the interest of 0.486 computed on the 50\nstrike. Again, the $0.016 disparity between the calculated interest and the\nactual difference between the synthetic value and the stock price is afunction of rounding and early exercise. More on this in the “Conversions\nand Reversals” section.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:200", "doc_id": "9f85ecaa357270fc42e5977a43c4e0e5b13d07c74f3d74ec03a1dcf180c6a266", "chunk_index": 0}
{"text": "Conversions and Reversals\nWhen calls and puts are combined to create synthetic stock, the main\ndifferences are the interest rate and dividends. This is important because the\nrisks associated with interest and dividends can be isolated, and ultimately\ntraded, when synthetic stock is combined with the underlying. There are\ntwo ways to combine synthetic stock with its underlying security: aconversion and areversal.\nConversion\nAconversion is athree-legged position in which atrader is long stock, short\nacall, and long aput. The options share the same month and strike price.\nBy most metrics, this is avery flat position. Atrader with aconversion is\nlong the stock and, at the same time, synthetically short the same stock.\nConsider this from the perspective of delta. In aconversion, the trader is\nlong 1.00 deltas (the long stock) and short very close to 1.00 deltas (the\nsynthetic short stock). Conversions have net flat deltas.\nThe following is asimple example of atypical conversion and the\ncorresponding deltas of each component.\nShort one 35-strike call:−0.63 delta\nLong one 35-strike put:−0.37 delta\nLong 100 shares: 1.00 delta\n0.00 delta\nThe short call contributes anegative delta to the position, in this case,\n−0.63. The long put also contributes anegative delta, −0.37. The combined\ndelta of the synthetic stock is −1.00 in this example, which is like being\nshort 100 shares of stock. When the third leg of the spread is added, the\nlong 100 shares, it counterbalances the synthetic. The total delta for the\nconversion is zero.\nMost of the conversion’sother greeks are pretty flat as well. Gamma,\ntheta, and vega are similar for the call and the put in the conversion,\nbecause they have the same expiration month and strike price. Because the\ntrader is selling one option and buying another—acall and aput,\nrespectively—with the same month and strike, the greeks come very close", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:202", "doc_id": "eb2380fcda9d766c27247497cc666ee6ef6c25c44668f036b714151ed0c5ac66", "chunk_index": 0}
{"text": "to offsetting each other. For all intents and purposes, the trader is out of the\nprimary risks of the position as measured by greeks when aposition is\nconverted. Let’slook at amore detailed example.\nAtrader executes the following trade (for the purposes of this example,\nwe assume the stock pays no dividend and the trade is executed at fair\nvalue):\nSell one 71-day 50 call at 3.50\nBuy one 71-day 50 put at 1.50\nBuy 100 shares at $51.54\nThe trader buys the stock at $51.54 and synthetically sells the stock at\n$52. The synthetic price is computed as −3.50 + 1.50 − 50. Therefore, the\nstock is sold synthetically at $0.46 over the actual stock price.\nExhibit 6.8 shows the analytics for the conversion.\nEXHIBIT 6.8 Conversion greeks.\nThis position has very subtle sensitivity to the greeks. The net delta for\nthe spread has avery slightly negative bias. The bias is so small it is\nnegligible to most traders, except professionals trading very large positions.\nWhy does this negative delta bias exist? Mathematically, the synthetic’sdelta can be higher with American options than with their European\ncounterparts because of the possibility of early exercise of the put. This\nanomaly becomes more tangible when we consider the unique directional\nrisk associated with this trade.\nIn this example, the stock is synthetically sold at $0.46 over the price at\nwhich the stock is bought. If the stock declines significantly in value before\nexpiration, the put will, at some point, trade at parity while the call loses all\nits time value. In this scenario, the value of the synthetic stock will be short\nat effectively the same price as the actual stock price. For example, if the\nstock declines to $35 per share then the numbers are as follows:", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:203", "doc_id": "433d904138fb4a71d03313bed5a03ed3f57435ef7eba8053c2ffd5312fa61db5", "chunk_index": 0}
{"text": "or\nWith American options, aput this far in-the-money with less than 71 days\nuntil expiry will be all intrinsic value. Interest, in this case, will not factor\ninto the put’svalue, because the put can be exercised. By exercising the put,\nboth the long stock leg and the long put leg can be closed for even money,\nleaving only the theoretically worthless call. The stock-synthetic spread is\nsold at 0.46 and essentially bought at zero when the put is exercised. If the\nput is exercised before expiration, the profit potential is 0.46 minus the\ninterest calculated between the trade date and the day the put is exercised.\nIf, however, the conversion is held until expiration, the $0.46 is negated by\nthe $0.486 of interest incurred from holding long stock over the entire 71-\nday period, hence the trader’sdesire to see the stock decline before\nexpiration, and thus the negative bias toward delta.\nThis is, incidentally, why the synthetic price (0.46 over the stock price)\ndoes not exactly equal the calculated value of the interest (0.486). The\ntrader can exercise the put early if the stock declines and capitalize on the\ndisparity between the interest calculated when the conversion was traded\nand the actual interest calculation given the shorter time frame. The model\nvalues the synthetic at alittle less than the interest value would indicate—in\nthis case $0.46 instead of $0.486.\nThe gamma of this trade is fairly negligible. The theta is slightly positive.\nRho is the figure that deserves the most attention. Rho is the change in an\noption’sprice given achange in the interest rate.\nThe −0.090 rho of the conversion indicates that if the interest rate rises\none percentage point, the position as awhole loses $0.09. Why? The\nfinancing of the position gets more expensive as the interest rate rises. The\ntrader would have to pay more in interest to carry the long stock. In this\nexample, if interest rises by one percentage point, the synthetic stock, which\nhad an effective short price of $0.46 over the price of the long stock before\nthe interest rate increase, will be $0.55 over the price of the long stock\nafterward. If, however, the interest rate declines by one percentage point,\nthe trader profits $0.09, as the synthetic is repriced by the market to $0.37\nover the stock price. The lower the interest rate, the less expensive it is to", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:204", "doc_id": "b17e8af8a57e1594151e3ab325a92c75dd9de0ee460a2bdd1717768ed13baed8", "chunk_index": 0}
{"text": "finance the long stock. This is proven mathematically by put-call parity.\nNegative rho indicates abearish position on the interest rate; the trader\nwants it to go lower. Positive rho is abullish interest rate position.\nBut aone-percentage-point change in the interest rate in one day is abig\nand uncommon change. The question is: is rho relevant? That depends on\nthe type of position and the type of trader. A 0.090 rho would lead to a\n0.0225 profit-and-loss (P&(L)) change per one lot conversion on a 25-basis-\npoint, or quarter percent, change. That’sjust $2.25 per spread. This\nincremental profit or loss, however, can be relevant to professional traders\nlike market makers. They trade very large positions with the aspiration of\nmaking small incremental profits on each trade. Amarket maker with a\n5,000-lot conversion would stand to make or lose $11,250, given aquarter-\npercentage-point change in interest rate and a 0.090 rho.\nThe Mind of a Market Maker\nMarket makers are among the only traders who can trade conversions and\nreversals profitably, because of the size of their trades and the fact that they\ncan buy the bid and sell the offer. Market makers often attempt to leg into\nand out of conversions (and reversals). Given the conversion in this\nexample, amarket maker may set out to sell calls and in turn buy stock to\nhedge the call’sdelta risk (this will be covered in Chapters 12 and 17), then\nbuy puts and the rest of the stock to create abalanced conversion: one call\nto one put to one hundred shares. The trader may try to put on the\nconversion in the previous example for atotal of $0.50 over the price of the\nlong stock instead of the $0.46 it’sworth. He would then try to leg out of\nthe trade for less, say $0.45 over the stock, with the goal of locking in a\n$0.05 profit per spread on the whole trade.\nReversal\nAreversal, or reverse conversion, is simply the opposite of the conversion:\nbuy call, sell put, and sell (short) stock. Areversal can be executed to close\naconversion, or it can be an opening transaction. Using the same stock and\noptions as in the previous example, atrader could establish areversal as\nfollows:", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:205", "doc_id": "99e82fbe57d3d24d5f0726dcd034debb49ca70d651411d100c7fbf3442c8a610", "chunk_index": 0}
{"text": "Buy one 71-day 50 call at 3.50\nSell one 71-day 50 put at 1.50\nSell 100 shares at 51.54\nThe trader establishes ashort position in the stock at $51.54 and along\nsynthetic stock position effectively at $52.00. He buys the stock\nsynthetically at $0.46 over the stock price, again assuming the trade can be\nexecuted at fair value. With the reversal, the trader has abullish position on\ninterest rates, which is indicated by apositive rho.\nIn this example, the rho for this position is 0.090. If interest rates rise one\npercentage point, the synthetic stock (which the trader is long) gains nine\ncents in value relative to the stock. The short stock rebate on the short stock\nleg earns more interest at ahigher interest rate. If rates fall one percentage\npoint, the synthetic long stock loses $0.09. The trader earns less interest\nbeing short stock given alower interest rate.\nWith the reversal, the fact that the put can be exercised early is arisk.\nSince the trader is short the put and short stock, he hopes not to get\nassigned. If he does, he misses out on the interest he planned on collecting\nwhen he put on the reversal for $0.46 over.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:206", "doc_id": "ea9ab80f71abf4e6128a736b081758259aafc4d7b41ee7a9a0a232b5aef0bc01", "chunk_index": 0}
{"text": "Pin Risk\nConversions and reversals are relatively low-risk trades. Rho and early\nexercise are relevant to market makers and other arbitrageurs, but they are\namong the lowest-risk positions they are likely to trade. There is one\nindirect risk of conversions and reversals that can be of great concern to\nmarket makers around expiration: pin risk. Pin risk is the risk of not\nknowing for certain whether an option will be assigned. To understand this\nconcept, let’srevisit the mind of amarket maker.\nRecall that market makers have two primary functions:\n1. Buy the bid or sell the offer.\n2. Manage risk.\nWhen institutional or retail traders send option orders to an exchange\n(through abroker), market makers are usually the ones with whom they\ntrade. Customers sell the bid; the market makers buy the bid. Customers\nbuy the offer; the market makers sell the offer. The first and arguably easier\nfunction of market makers is accomplished whenever amarketable order is\nsent to the exchange.\nManaging risk can get abit hairy. For example, once the market makers\nbuy April 40 calls, their first instinct is to hedge by selling stock to become\ndelta neutral. Market makers are almost always delta neutral, which\nmitigates the direction risk. The next step is to mitigate theta, gamma, and\nvega risk by selling options. The ideal options to sell are the same calls that\nwere bought—that is, get out of the trade. The next best thing is to sell the\nApril 40 puts and sell more stock. In this case, the market makers have\nestablished areversal and thereby have very little risk. If they can lock in\nthe reversal for asmall profit, they have done their job.\nWhat happens if the market makers still have the reversal in inventory at\nexpiration? If the stock is above the strike price—40, in this case—the puts\nexpire, the market makers exercise the calls, and the short stock is\nconsequently eliminated. The market makers are left with no position,\nwhich is good. They’re delta neutral. If the stock is below 40, the calls\nexpire, the puts get assigned, and the short stock is consequently eliminated.\nAgain, no position. But what if the stock is exactly at $40? Should the calls", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:207", "doc_id": "1fe68aea932bc74157e49022ed7841ad319d0d0f6b75f703fb32caf3426ea3fc", "chunk_index": 0}
{"text": "be exercised? Will the puts get assigned? If the puts are assigned, the\ntraders are left with no short stock and should let the calls expire without\nexercising so as not to have along delta position after expiration. If the puts\nare not assigned, they should exercise the calls to get delta flat. It’salso\npossible that only some of the puts will be assigned.\nBecause they don’tknow how many, if any, of the puts will be assigned,\nthe market makers have pin risk. To avoid pin risk, market makers try to\neliminate their position if they have conversions or reversals close to\nexpiration.\nBoxes and Jelly Rolls\nThere are two other uses of synthetic stock positions that form conventional\nstrategies: boxes and rolls.\nBoxes\nWhen long synthetic stock is combined with short synthetic stock on the\nsame underlying within the same expiration cycle but with adifferent strike\nprice, the resulting position is known as abox. With abox, atrader is\nsynthetically both long and short the stock. The two positions, for all intents\nand purposes, offset each other directionally. The risk of stock-price\nmovement is almost entirely avoided. Astudy of the greeks shows that the\ndelta is close to zero. Gamma, theta, vega, and rho are also negligible.\nHere’san example of a 60–70 box for April options:\nShort 1 April 60 call\nLong 1 April 60 put\nLong 1 April 70 call\nShort 1 April 70 put\nIn this example, the trader is synthetically short the 60-strike and, at the\nsame time, synthetically long the 70-strike. Exhibit 6.9 shows the greeks.\nEXHIBIT 6.9 Box greeks.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:208", "doc_id": "8e89e4f85679f6584da943f0fbd8dc74b7d65465baab46e03c250c679d626117", "chunk_index": 0}
{"text": "Aside from the risks associated with early exercise implications, this\nposition is just about totally flat. The near-1.00 delta on the long synthetic\nstock struck at 60 is offset by the near-negative-1.00 delta of the short\nsynthetic struck at 70. The tiny gammas and thetas of both combos are\nbrought closer to zero when they are spread against each another. Vega is\nzero. And the bullish interest rate sensitivity of the long combo is nearly all\noffset by the bearish interest sensitivity of the short combo. The stock can\nmove, time can pass, volatility and interest can change, and there will be\nvery little effect on the trader’s P&(L). The question is: Why would\nsomeone trade abox?\nMarket makers accumulate positions in the process of buying bids and\nselling offers. But they want to eliminate risk. Ideally, they try to be flat the\nstrike —meaning have an equal number of calls and puts at each strike\nprice, whether through aconversion or areversal. Often, they have aconversion at one strike and areversal at another. The stock positions for\nthese cancel each other out and the trader is left with only the four option\nlegs—that is, abox. They can eliminate pin risk on both strikes by trading\nthe box as asingle trade to close all four legs. Another reason for trading abox has to do with capital.\nBorrowing and Lending Money\nThe first thing to consider is how this spread is priced. Let’slook at another\nexample of abox, the October 50–60 box.\nLong 1 October 60 call\nShort 1 October 60 put\nShort 1 October 70 call\nLong 1 October 70 put", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:209", "doc_id": "2b9dd07246d25f7583e71af16352e62f7ba2dade533e14eb5767cbf30ad2e801", "chunk_index": 0}
{"text": "Atrader with this position is synthetically long the stock at $60 and short\nthe stock at $70. That sounds like $10 in the bank. The question is: How\nmuch would atrader be willing to pay for the right to $10? And for how\nmuch would someone be willing to sell it? At face value, the obvious\nanswer is that the equilibrium point is at $10, but there is one variable that\nmust be factored in: time.\nIn this example, assume that the October call has 90 days until expiration\nand the interest rate is 6 percent. Arational trader would not pay $10 today\nfor the right to have $10 90 days from now. That would effectively be like\nloaning the $10 for 90 days and not receiving interest—Alosing\nproposition! The trader on the other side of this box would be happy to\nenter into the spread for $10. He would have interest-free use of $10 for 90\ndays. That’sfree money! Certainly, there is interest associated with the cost\nof carrying the $10. In this case, the interest would be $0.15.\nThis $0.15 is discounted from the price of the $10 box. In fact, the\ncombined net value of the options composing the box should be about 9.85\n—with differences due mainly to rounding and the early exercise possibility\nfor American options.\nAtrader buying this box—that is, buying the more ITM call and more\nITM put—would expect to pay $0.15 below the difference between the\nstrike prices. Fair value for this trade is $9.85. The seller of this box—the\ntrader selling the meatier options and buying the cheaper ones—would\nconcede up to $0.15 on the credit.\nJelly Rolls\nAjelly roll, or simply aroll, is also aspread with four legs and acombination of two synthetic stock trades. In abox, the difference between\nthe synthetics is the strike price; in aroll, it’sthe contract month. Here’san\nexample:\nLong 1 April 50 call\nShort 1 April 50 put\nShort 1 May 50 call\nLong 1 May 50 put", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:210", "doc_id": "9e526c6f43e8d55ff57505187298cb2a2077fe663bbc599afe94f3c6fbaf3271", "chunk_index": 0}
{"text": "The options in this spread all share the same strike price, but they involve\ntwo different months—April and May. In this example, the trader is long\nsynthetic stock in April and short synthetic stock in May. Like the\nconversion, reversal, and box, this is amostly flat position. Delta, gamma,\ntheta, vega, and even rho have only small effects on ajelly roll, but like the\nothers, this spread serves apurpose.\nAtrader with aconversion or reversal can roll the option legs of the\nposition into amonth with alater expiration. For example, atrader with an\nApril 50 conversion in his inventory (short the 50 call, long the 50 put, long\nstock) can avoid pin risk as April expiration approaches by trading the roll\nfrom the above example. The long April 50 call and short April 50 put\ncancel out the current option portion of the conversion leaving only the\nstock. Selling the May 50 calls and buying the May 50 puts reestablishes\nthe conversion amonth farther out.\nAnother reason for trading aroll has to do with interest. The roll in this\nexample has positive exposure to rho in April and negative exposure to rho\nin May. Based on atrader’sexpectations of future changes in interest rates,\naposition can be constructed to exploit opportunities in interest.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:211", "doc_id": "b66f00f723a21c58704addd984338d416e7ab6638dc68df74037e18780f7eb3b", "chunk_index": 0}
{"text": "Rho and Interest Rates\nRho is ameasurement of the sensitivity of an option’svalue to achange in\nthe interest rate. To understand how and why the interest rate is important to\nthe value of an option, recall the formula for put-call parity stated in\nChapter 6.\nCall + Strike − Interest = Put + Stock 1\nFrom this formula, it’sclear that as the interest rate rises, put prices must\nfall and call prices must rise to keep put-call parity balanced. With alittle\nalgebra, the equation can be restated to better illustrate this concept:\nand\nIf interest rates fall,\nand\nRho helps quantify this relationship. Calls have positive rho, and puts\nhave negative rho. For example, acall with arho of +0.08 will gain $0.08\nwith each one-percentage-point rise in interest rates and fall $0.08 with\neach one-percentage-point fall in interest rates. Aput with arho of −0.08\nwill lose $0.08 with each one-point rise and gain $0.08 in value with aone-\npoint fall.\nThe effect of changes in the interest variable of put-call parity on call and\nput values is contingent on three factors: the strike price, the interest rate,\nand the number of days until expiration.\nInterest = Strike×Interest Rate×(Days to Expiration/365) 2\nInterest, for our purposes, is afunction of the strike price. The higher the\nstrike price, the greater the interest and, consequently the more changes in\nthe interest rate will affect the option. The higher the interest rate is, the\nhigher the interest variable will be. Likewise, the more time to expiration,", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:217", "doc_id": "827bdad0576c807c3465cc156c038f1ecb2b613387540788f1732d32e59ff1e4", "chunk_index": 0}
{"text": "the greater the effect of interest. Rho measures an option’ssensitivity to the\nend results of these three influences.\nTo understand how changes in interest affect option prices, consider atypical at-the-money (ATM) conversion on anon-dividend-paying stock.\nShort 1 May 50 call at 1.92\nLong 1 May 50 put at 1.63\nLong 100 shares at $50\nWith 43 days until expiration at a 5 percent interest rate, the interest on\nthe 50 strike will be about $0.29. Put-call parity ensures that this $0.29\nshows up in option prices. After rearranging the equation, we get\nIn this example, both options are exactly ATM. There is no intrinsic value.\nTherefore, the difference between the extrinsic values of the call and the put\nmust equal interest. If one option were in-the-money (ITM), the intrinsic\nvalue on the left side of the equation would be offset by the Stock − Strike\non the right side. Still, it would be the difference in the time value of the\ncall and put that equals the interest variable.\nThis is shown by the fact that the synthetic stock portion of the\nconversion is short at $50.29 (call − put + strike). This is $0.29 above the\nstock price. The synthetic stock equals the Stock + Interest, or\nCertainly, if the interest rate were higher, the interest on the synthetic\nstock would be ahigher number. At a 6 percent interest rate, the effective\nshort price of the synthetic stock would be about $50.35. The call would be\nvalued at about 1.95, and the put would be 1.60—anet of $0.35.\nAone-percentage-point rise in the interest rate causes the synthetic stock\nposition to be revalued by $0.06—a $0.03 gain in the call value and a $0.03\ndecline in the put. Therefore, by definition, the call has a +0.03 rho and the\nput has a −0.03 rho.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:218", "doc_id": "37b7005da2fb192d60c17ea35c75a4bd88c165558a4ec3cd90e458c06ed9403d", "chunk_index": 0}
{"text": "Rho and Time\nThe time component of interest has abig impact on the magnitude of an\noption’srho, because the greater the number of days until expiration, the\ngreater the interest. Long-term options will be more sensitive to changes in\nthe interest rate and, therefore, have ahigher rho.\nTake astock trading at about $120 per share. The July, October, and\nJanuary ATM calls have the following rhos with the interest rate at 5.5\npercent.\nOption Rho\nJuly (38-day) 120 calls+0.068\nOctober (130-day) 120 calls+0.226\nJanuary (221-day) 120 calls+0.385\nIf interest rates rise 25 basis points, or aquarter of apercentage point, the\nJuly calls with only 38 days until expiration will gain very little: only\n$0.017 (0.068 × 0.25). The October 120 calls with 130 days until expiration\ngain more: $0.057 (0.226 × 0.25). The January calls that have 221 days\nuntil they expire make $0.096 theoretically (0.385 × 0.25). If all else is held\nconstant, the more time to expiration, the higher the option’srho, and\ntherefore, the more interest will affect the option’svalue.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:219", "doc_id": "7f57cbcf46672fc9c7895f4325f8115add400c70d4335bb29abcabb83507be2a", "chunk_index": 0}
{"text": "LEAPS\nOptions buyers have time working against them. With each passing day,\ntheta erodes the value of their assets. Buying along-term option, or a\nLEAPS, helps combat erosion because long-term options can decay at aslower rate. In environments where there is interest rate uncertainty,\nhowever, LEAPS traders have to think about more than the rate of decay.\nConsider two traders: Jason and Susanne. Both are bullish on XYZ Corp.\n(XYZ), which is trading at $59.95 per share. Jason decides to buy a May 60\ncall at 1.60, and Susanne buys a LEAPS 60 call at 7.60. In this example,\nMay options have 44 days until expiration, and the LEAPS have 639 days.\nBoth of these trades are bullish, but the traders most likely had slightly\ndifferent ideas about time, volatility, and interest rates when they decided\nwhich option to buy. Exhibit 7.1 compares XYZ short-term at-the-money\ncalls with XYZ LEAPS ATM calls.\nEXHIBIT 7.1 XYZ short-term call vs. LEAPS call.\nTo begin with, it appears that Susanne was allowing quite abit of time for\nher forecast to be realized—almost two years. Jason, however, was looking\nfor short-term price appreciation. Concerns about time decay may have\nbeen amotivation for Susanne to choose along-term option—her theta of\n0.01 is half Jason’s, which is 0.02. With only 44 days until expiration, the\ntheta of Jason’s May call will begin to rise sharply as expiration draws near.\nBut the trade-off of lower time decay is lower gamma. At the current\nstock price, Susanne has ahigher delta. If the XYZ stock price rises $2, the\ngamma of the May call will cause Jason’sdelta to creep higher than\nSusanne’s. At $62, the delta for the May 60s would be about 0.78, whereas", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:221", "doc_id": "03ca7237f2d56977a8c16888bb0c8da8f0bd74603e54a04bc8c655b6b631e21d", "chunk_index": 0}
{"text": "the LEAPS 60 call delta is about 0.77. This disparity continues as XYZ\nmoves higher.\nPerhaps Susanne had implied volatility (IV) on her mind as well as time\ndecay. These long-term ATM LEAPS options have vegas more than three\ntimes the corresponding May’s. If IV for both the May and the LEAPS is at\nayearly low, LEAPS might be abetter buy. Aone- or two-point rise in\nvolatility if IV reverts to its normal level will benefit the LEAPS call much\nmore than the May.\nTheta, delta, gamma, and vega are typical considerations with most\ntrades. Because this option is long term, in addition to these typical\nconsiderations, Susanne needs to take agood hard look at rho. The LEAPS\nrho is significantly higher than that of its short-term counterpart. Aone-\npercentage-point change in the interest rate will change Susanne’s P&(L) by\n$0.64—that’sabout 8.5 percent of the value of her option—and she has\nnearly two years of exposure to interest rate fluctuations. Certainly, when\nthe Federal Reserve Board has great concerns about growth or inflation,\nrates can rise or fall by more than one percentage point in one year’stime.\nIt is important to understand that, like the other greeks, rho is asnapshot\nat aparticular price, volatility level, interest rate, and moment in time. If\ninterest rates were to fall by one percentage point today, it would cause\nSusanne’scall to decline in value by $0.64. If that rate drop occurred over\nthe life of the option, it would have amuch smaller effect. Why? Rate\nchanges closer to expiration have less of an effect on option values.\nAssume that on the trade date, when the LEAPS has 639 days until\nexpiration, interest rates fall by 25 basis points. The effect will be adecline\nin the value of the call of 0.16—one-fourth of the 0.638 rho. If the next rate\ncut occurs six months later, the rho of the LEAPS will be smaller, because it\nwill have less time until expiration. In this case, after six months, the rho\nwill be only 0.46. Another 25-basis-point drop will hurt the call by $0.115.\nAfter another six months, the option will have a 0.26 rho. Another quarter-\npoint cut costs Susanne only $0.065. Any subsequent rate cuts in ensuing\nmonths will have almost no effect on the now short-term option value.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:222", "doc_id": "855b864410078ecad672ab7692ae687d8c07c5f10098d94920e7c5fac2d8c25d", "chunk_index": 0}
{"text": "Pricing in Interest Rate Moves\nIn the same way that volatility can get priced in to an option’svalue, so can\nthe interest rate. When interest rates are expected to rise or fall, those\nexpectations can be reflected in the prices of options. Say current interest\nrates are at 8 percent, but the Fed has announced that the economy is\ngrowing at too fast of apace and that it may raise interest rates at the next\nFederal Open Market Committee meeting. Analysts expect more rate hikes\nto follow. The options with expiration dates falling after the date of the\nexpected rate hikes will have higher interest rates priced in. In this situation,\nthe higher interest rates in the longer-dated options will be evident when\nentering parameters into the model.\nTake options on Already Been Chewed Bubblegum Corp. (ABC). Atrader, Kyle, enters parameters into the model for ABC options and notices\nthat the prices don’tline up. To get the theoretical values of the ATM calls\nfor all the expiration months to sit in the middle of the actual market values,\nKyle may have to tinker with the interest rate inputs.\nAssume the following markets for the ATM 70-strike calls in ABC\noptions:\nCalls Puts\nAug 70 calls1.75–1.851.30–1.40\nSep 70 calls2.65–2.751.75–1.85\nDec 70 calls4.70–4.902.35–2.45\nMar 70 calls6.50–6.702.65–2.75\nABC is at $70 ashare, has a 20 percent IV in all months, and pays no\ndividend. August expiration is one month away.\nEntering the known inputs for strike price, stock price, time to expiration,\nvolatility, and dividend and using an 8 percent interest rate yields the\nfollowing theoretical values for ABC options:", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:223", "doc_id": "d7131b150d3de69893f4b4101c277fa879a021e547cf6c97894996f035fbd52b", "chunk_index": 0}
{"text": "The theoretical values, in bold type, are those that don’tline up in the\nmiddle of the call and put markets. These values are wrong. The call\ntheoretical values are too low, and the put theoretical values are too high.\nThey are the product of an interest rate that is too low being applied to the\nmodel. To generate values that are indicative of market prices, Kyle must\nchange the interest input to the pricing model to reflect the market’sexpectations of future interest rate changes.\nUsing new values for the interest rate yields the following new values:\nAfter recalculating, the theoretical values line up in the middle of the call\nand put markets. Using higher interest rates for the longer expirations raises\nthe call values and lowers the put values for these months. These interest\nrates were inferred from, or backed out of, the option-market prices by use\nof the option-pricing model. In practice, it may take some trial and error to\nfind the correct interest values to use.\nIn times of interest rate uncertainty, rho can be an important factor in\ndetermining which strategy to select. When rates are generally expected to\ncontinue to rise or fall over time, they are normally priced in to the options,\nas shown in the previous example. When there is no consensus among\nanalysts and traders, the rates that are priced in may change as economic\ndata are made available. This can cause arevision of option values. In long-\nterm options that have higher rhos, this is abona fide risk. Short-term", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:224", "doc_id": "b8046c6a75375de08b4a8fa83303e08f4d75ef5dad135eea809966663d60113c", "chunk_index": 0}
{"text": "Trading Rho\nWhile it’spossible to trade rho, most traders forgo this niche for more\ndynamic strategies with greater profitability. The effects of rho are often\novershadowed by the more profound effects of the other greeks. The\nopportunity to profit from rho is outweighed by other risks. For most\ntraders, rho is hardly ever even looked at.\nBecause LEAPS have higher rho values than corresponding short-term\noptions, it makes sense that these instruments would be appropriate for\ninterest-rate plays. But even with LEAPS, rho exposure usually pales in\ncomparison with that of delta, theta, and vega.\nIt is not uncommon for the rho of along-term option to be 5 to 8 percent\nof the option’svalue. For example, Exhibit 7.2 shows atwo-year LEAPS on\na $70 stock with the following pricing-model inputs and outputs:\nEXHIBIT 7.2 Long 70-strike LEAPS call.\nThe rho is +0.793, or about 5.8 percent of the call value. That means a 25-\nbasis-point rise in rates contributes to only a 20-cent profit on the call.\nThat’sonly about 1.5 percent of the call’svalue. On one hand, 1.5 percent is\nnot avery big profit on atrade. On the other hand, if there are more rate\nrises at following Fed meetings, the trader can expect further gains on rho.\nEven if the trader is compelled to wait until the next Fed meeting to make\nanother $0.20—or less, as rho will get smaller as time passes—from asecond 25-basis-point rate increase, other influences will diminish rho’ssignificance. If over the six-week period between Fed meetings, the", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:226", "doc_id": "3bc5c89875202fc4070706a8dd23066251865ea54b0c2653b09399c149b84745", "chunk_index": 0}
{"text": "underlying declines by just $0.60, the $0.40 that the trader hoped to make\non rho is wiped out by delta loss. With the share price $0.60 lower, the\n0.760 delta costs the trade about $0.46. Furthermore, the passing of six\nweeks (42 days) will lead to aloss of about $0.55 from time decay because\nof the −0.013 theta. There is also the risk from the fat vegas associated with\nLEAPS. A 1.5 percent drop in implied volatility completely negates any\nhopes of rho profits.\nAside from the possibility that delta, theta, and vega may get in the way\nof profits, the bid-ask spread with these long-term options tends to be wider\nthan with their short-term counterparts. If the bid-ask spread is more than\n$0.40 wide, which is often the case with LEAPS, rho profits are canceled\nout by this cost of doing business. Buying the offer and selling the bid\nnegative scalps away potential profits.\nWith LEAPS, rho is always aconcern. It will contribute to prosperity or\nperil and needs to be part of the trade plan from forecast to implementation.\nBuying or selling a LEAPS call or put, however, is not apractical way to\nspeculate on interest rates.\nTo take aposition on interest rates in the options market, risk needs to be\ndistilled down to rho. The other greeks need to be spread off. This is\naccomplished only through the conversions, reversals, and jelly rolls\ndescribed in Chapter 6. However, the bid-ask can still be ahurdle to trading\nthese strategies for non–market makers. Generally, rho is agreek that for\nmost traders is important to understand but not practical to trade.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:227", "doc_id": "304406896d36f6c24f946550699d2fda7c3ee000e241698e5ec69f8912ea9c87", "chunk_index": 0}
{"text": "CHAPTER 8\nDividends and Option Pricing\nMuch of this book studies how to break down and trade certain components\nof option prices. This chapter examines the role of dividends in the pricing\nstructure. There is no greek symbol that measures an option’ssensitivity to\nchanges in the dividend. And in most cases, dividends are not “traded” by\nmeans of options in the same way that volatility, interest, and other option\nprice influences are. Dividends do, though, affect option prices, and\ntherefore atrader’s P&(L), so they deserve attention.\nThere are some instances where dividends provide ample opportunity to\nthe option trader, and there some instances where achange in dividend\npolicy can have desirable, or undesirable, effects on the bottom line.\nDespite the fact that dividends do not technically involve greeks, they need\nto be monitored in much the same way as do delta, gamma, theta, vega, and\nrho.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:229", "doc_id": "51dda03df9d570fd6d6e9afb9e67d3b16c722e70d2e85edf7df68b3462b4e430", "chunk_index": 0}
{"text": "Dividends and Option Pricing\nThe preceding discussion demonstrated how dividends affect stock traders.\nThere’sone problem: we’re option traders! Option holders or writers do not\nreceive or pay dividends, but that doesn’tmean dividends aren’trelevant to\nthe pricing of these securities. Observe the behavior of aconversion or areversal before and after an ex-dividend date. Assuming the stock opens\nunchanged on the ex-date, the relationship of the price of the synthetic stock\nto the actual stock price will change. Let’slook at an example to explore\nwhy.\nAt the close on the day before the ex-date of astock paying a $0.25\ndividend, atrader has an at-the-money (ATM) conversion. The stock is\ntrading right at $50 per share. The 50 puts are worth 2.34, and the 50 calls\nare worth 2.48. Before the ex-date, the trader is\nLong 100 shares at $50\nLong one 50 put at 2.34\nShort one 50 call at 2.48\nHere, the trader is long the stock at $50 and short stock synthetically at\n$50.14—50 + (2.48 − 2.34). The trader is synthetically short $0.14 over the\nprice at which he is long the stock.\nAssume that the next morning the stock opens unchanged. Since this is\nthe ex-date, that means the stock opens at $49.75—$0.25 lower than the\nprevious day’sclose. The theoretical values of the options will change very\nlittle. The options will be something like 2.32 for the put and 2.46 for the\ncall.\nAfter the ex-date, the trader is\nLong 100 shares at $49.75\nLong one 50 put at 2.32\nShort one 50 call at 2.46\nEach option is two cents lower. Why? The change in the option prices is\ndue to theta. In this case, it’s $0.02 for each option. The synthetic stock is\nstill short from an effective price of $50.14. With the stock at $49.75, the", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:232", "doc_id": "0cf7bddb2b7412b6cce5d7355d86843a653d2218959255fd2e061d6b8109ae05", "chunk_index": 0}
{"text": "Dividends and Early Exercise\nAs the ex-date approaches, in-the-money (ITM) calls on equity options can\noften be found trading at parity, regardless of the dividend amount and\nregardless of how far off expiration is. This seems counterintuitive. What\nabout interest? What about dividends? Normally, these come into play in\noption valuation.\nBut option models designed for American options take the possibility of\nearly exercise into account. It is possible to exercise American-style calls\nand exchange them for the underlying stock. This would give traders, now\nstockholders, the right to the dividend—aright for which they would not be\neligible as call holders. Because of the impending dividend, the call\nbecomes an exercise just before the ex-date. For this reason, the call can\ntrade for parity before the ex-date.\nLet’slook at an example of areversal on a $70 stock that pays a $0.40\ndividend. The options in this reversal have 24 days until expiration, which\nmakes the interest on the 60 strike roughly $0.20, given a 5 percent interest\nrate. The day before the ex-date, atrader has the following position at the\nstated prices:\nShort 100 shares at $70\nLong one 60 call at 10.00\nShort one 60 put at 0.05\nTo understand how American calls work just before the ex-date, it is\nhelpful first to consider what happens if the trader holds the position until\nthe ex-date. Making the assumption that the stock is unchanged on the ex-\ndividend date, it will open at $69.60, lower by the amount of the dividend—\nin this case, $0.40. The put, being so far out-of-the-money (OTM) as to\nhave anegligible delta, will remain unchanged. But what about the call?\nWith no dividend left in the stock, the put call-parity states\nIn this case,", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:234", "doc_id": "639b4deb919d5b183163ef17024a2934dfb15cd474ce5a7a43590d3b83e66577", "chunk_index": 0}
{"text": "Before the ex-date, the model valued the call at parity. Now it values the\nsame call at $0.25 over parity (9.85 − [69.60 − 60]). Another way to look at\nthis is that the time value of the call is now made up of the interest plus the\nput premium. Either way, that’sagain of $0.25 on the call. That sounds\ngood, but because the trader is short stock, if he hasn’texercised, he will\nowe the $0.40 dividend—anet loss of $0.15. The new position will be\nShort 100 shares at $69.60\nOwe $0.40 dividend\nLong one 60 call at 9.85\nShort one 60 put at 0.05\nAt the end of the trading day before the ex-date, this trader must exercise\nthe call to capture the dividend. By doing so, he closes two legs of the trade\n—the call and the stock. The $10 call premium is forfeited, the stock that is\nshort at $70 is bought at $60 (from the call exercise) for a $10 profit. The\ntransaction leads to neither aprofit nor aloss. The purpose of exercising is\nto avoid the $0.15 loss ($0.25 gain in call time value minus the $0.40 loss in\ndividends owed).\nThe other way the trader could achieve the same ends is to sell the long\ncall and buy in the short stock. This is tactically undesirable because the\ntrader may have to sell the bid in the call and buy the offer in the stock.\nFurthermore, when legging atrade in this manner, there is the risk of\nslippage. If the call is sold first, the stock can move before the trader has achance to buy it at the necessary price. It is generally better and less risky to\nexercise the call rather than leg out of the trade.\nIn this transaction, the trader begins with afairly flat position (short\nstock/long synthetic stock) and ends with ashort put that is significantly\nout-of-the-money. For all intents and purposes, exercising the call in this\ntrade is like synthetically selling the put. But at what price? In this case, it’s\n$0.15. This again is the cost benefit of saving $0.40 by avoiding the\ndividend obligation versus the $0.25 gain in call time value. Exercising the\ncall is effectively like selling the put at 0.15 in this example. If the dividend\nis lower or the interest is higher, it may not be worth it to the trader to\nexercise the call to capture the dividend. How do traders know if their calls\nshould be exercised?", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:235", "doc_id": "140637fd11c3c2032351dee69019ff6b2d78ee87209d99f745c59e83cedf10bf", "chunk_index": 0}
{"text": "The traders must do the math before each ex-dividend date in option\nclasses they trade. The traders have to determine if the benefit from\nexercising—or the price at which the synthetic put is essentially being sold\n—is more or less than the price at which they can sell the put. The math\nused here is adopted from put-call parity:\nThis shows the case where the traders can effectively synthetically sell the\nput (by exercising) for more than the current put value. Tactically, it’sappropriate to use the bid price for the put in this calculation since that is\nthe price at which the put can be sold.\nIn this case, the traders would be inclined to not exercise. It would be\ntheoretically more beneficial to sell the put if the trader is so inclined.\nHere, the traders, from avaluation perspective, are indifferent as to whether\nor not to exercise. The question then is simply: do they want to sell the put\nat this price?\nProfessionals and big retail traders who are long (ITM) calls—whether as\npart of areversal, part of another type of spread, or because they are long\nthe calls outright—must do this math the day before each ex-dividend date\nto maximize profits and minimize losses. Not exercising, or forgetting to\nexercise, can be acostly mistake. Traders who are short ITM dividend-\npaying calls, however, can reap the benefits of those sleeping on the job. It\nworks both ways.\nTraders who are long stock and short calls at parity before the ex-date\nmay stand to benefit if some of the calls do not get assigned. Any shares of\nlong stock remaining on the ex-date will result in the traders receiving\ndividends. If the dividends that will be received are greater in value than the\ninterest that will subsequently be paid on the long stock, the traders may\nstand reap an arbitrage profit because of long call holders’ forgetting to\nexercise.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:236", "doc_id": "d15822d97c9c506b7a7a5155411f701c1cb961f196e853c4309e40bb767727ad", "chunk_index": 0}
{"text": "Dividend Plays\nThe day before an ex-dividend date in astock, option volume can be\nunusually high. Tens of thousands of contracts sometimes trade in names\nthat usually have average daily volumes of only acouple thousand. This\nspike in volume often has nothing to do with the market’sopinion on\ndirection after the dividend. The heavy trading has to do with the\nrevaluation of the relationship of exercisable options to the underlying\nexpected to occur on the ex-dividend date.\nTraders that are long ITM calls and short ITM calls at another strike just\nbefore an ex-dividend date have apotential liability and apotential benefit.\nThe potential liability is that they can forget to exercise. This is aliability\nover which the traders have complete control. The potential benefit is that\nsome of the short calls may not get assigned. If traders on the other side of\nthe short calls (the longs) forget to exercise, the traders that are short the\ncall make out by not having to pay the dividend on short stock.\nProfessionals and big retail traders who have very low transaction costs\nwill sometimes trade ITM call spreads during the afternoon before an ex-\ndividend date. This consists of buying one call and selling another call with\nadifferent strike price. Both calls in the dividend-play strategy are ITM and\nhave corresponding puts with little or no value (to be sure, the put value is\nless than the dividend minus the interest). The traders trade the spreads,\nfairly indifferent as to whether they buy or sell the spreads, in hope of\nskating—or not getting assigned—on some of their short calls. The more\nthey don’tget assigned the better.\nThis usually occurs in options that have high open interest, meaning there\nare alot of outstanding contracts already. The more contracts in existence,\nthe better the possibility of someone forgetting to exercise. The greatest\nvolume also tends to occur in the front month.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:237", "doc_id": "584de05c751ea449004810db682883e297c99639d2be986476fe881a87daf60c", "chunk_index": 0}
{"text": "Strange Deltas\nBecause American calls become an exercise possibility when the ex-date is\nimminent, the deltas can sometimes look odd. When the calls are trading at\nparity, they have a 1.00 delta. They are asubstitute for the stock. They, in\nfact, will be stock if and when they are exercised just before the ex-date.\nBut if the puts still have some residual time value, they may also have asmall delta, of 0.05 or perhaps more.\nIn this unique scenario, the delta of the synthetic can be greater than\n+1.00 or less than −1.00. It is not uncommon to see the absolute values of\nthe call and put deltas add up to 1.07 or 1.08. When the dividend comes out\nof the options model on the ex-date, synthetics go back to normal. The delta\nof the synthetic again approaches 1.00. Because of the out-of-whack deltas,\ndelta-neutral traders need to take extra caution in their analytics when ex-\ndates are near. Alittle common sense should override what the computer\nspits out.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:238", "doc_id": "e91106f9ccf0b885e7ac23682c2763fcac783af8535ba82421ba22fd912869c1", "chunk_index": 0}
{"text": "Inputting Dividend Data into the\nPricing Model\nOften dividend payments are regular and predictable. With many\ncompanies, the dividend remains constant quarter after quarter. Some\ncorporations have atrack record of incrementally increasing their dividends\nevery year. Some companies pay dividends in avery irregular fashion, by\npaying special dividends that are often announced as asurprise to investors.\nIn atruly capitalist society, there are no restrictions and no rules on when,\nwhether, or how corporations pay dividends to their shareholders.\nUnpredictability of dividends, though, can create problems in options\nvaluation.\nWhen acompany has aconstant, reasonably predictable dividend, there is\nnot alot of guesswork. Take Exelon Corp. (EXC). From November 2008 to\nthe time of this writing, Exelon has paid aregular quarterly dividend of\n$0.525. During that period, atrader has needed simply to enter 0.525 into\nthe pricing calculator for all expected future dividends to generate the\ntheoretical value. Based on recent past performance, the trader could feel\nconfident that the computed analytics were reasonably accurate. If the\ntrader believed the company would continue its current dividend policy,\nthere would be little options-related dividend risk—unless things changed.\nWhen there is uncertainty about when future dividends will be paid in\nwhat amounts, the level of dividend-related risk begins to increase. The\nmore uncertainty, the more risk. Let’sexamine an interesting case study:\nGeneral Electric (GE).\nFor along time, GE was acompany that has had ahistory of increasing\nits dividends at fairly regular intervals. In fact, there was more than a 30-\nyear stretch in which GE increased its dividend every year. During most of\nthe first decade of the 2000s, increases in GE’sdividend payments were\naround one to six cents and tended to occur toward the end of December,\nafter December expiration. The dividends were paid four times per year but\nnot exactly quarterly. For several years, the ex-dates were in February, June,\nSeptember, and December. Option traders trading GE options had apretty", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:239", "doc_id": "b03853774855a1e6097ed96c464b11848440045dee515fad693d1906a191fd85", "chunk_index": 0}
{"text": "Good and Bad Dates with Models\nUsing an incorrect date for the ex-date in option pricing can lead to\nunfavorable results. If the ex-dividend date is not known because it has yet\nto be declared, it must be estimated and adjusted as need be after it is\nformally announced. Traders note past dividend history and estimate the\nexpected dividend stream accordingly. Once the dividend is declared, the\nex-date is known and can be entered properly into the pricing model. Not\nexecuting due diligence to find correct known ex-dates can lead to trouble.\nUsing abad date in the model can yield dubious theoretical values that can\nbe misleading or worse—especially around the expiration.\nSay acall is trading at 2.30 the day before the ex-date of a $0.25\ndividend, which happens to be thirty days before expiration. The next day,\nof course, the stock may have moved higher or lower. Assume for\nillustrative purposes, to compare apples to apples as it were, that the stock is\ntrading at the same price—in this case, $76.\nIf the trader is using the correct date in the model, the option value will\nadjust to take into account the effect of the dividend expiring, or reaching\nits ex-date, when the number of days to expiration left changes from 30 to\n29. The call trading postdividend will be worth more relative to the same\nstock price. If the dividend date the trader is using in the model is wrong,\nsay one day later than it should be, the dividend will still be an input of the\ntheoretical value. The calculated value will be too low. It will be wrong.\nExhibit 8.1 compares the values of a 30-day call on the ex-date given the\nright and the wrong dividend.\nEXHIBIT 8.1 Comparison of 30-day call values", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:243", "doc_id": "02b8705a5c21267c3bf16d35d8cf06d01ee226940175153c706efa71e8307f36", "chunk_index": 0}
{"text": "At the same stock price of $76 per share, the call is worth $0.13 more\nafter the dividend is taken out of the valuation. Barring any changes in\nimplied volatility (IV) or the interest rate, the market prices of the options\nshould reflect this change. Atrader using an ex-date in the model that is\nfarther in the future than the actual ex-date will still have the dividend as\npart of the generated theoretical value. With the ex-date just one day later,\nthe call would be worth 2.27. The difference in option value is due to the\neffect of theta—in this case, $0.03.\nWith abad date, the value of 2.27 would likely be significantly below\nmarket price, causing the market value of the option to look more expensive\nthan it actually is. If the trader did not know the date was wrong, he would\nneed to raise IV to make the theoretical value match the market. This option\nhas avega of 0.08, which translates into adifference of about two IV points\nfor the theoretical values 2.43 and 2.27. The trader would perceive the call\nto be trading at an IV two points higher than the market indicates.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:244", "doc_id": "c6adfb78d4ac486a29a8218a4841fe0d6ac0ab6f90e2637c374501b7b711f505", "chunk_index": 0}
{"text": "Dividend Size\nIt’snot just the date but also the size of the dividend that matters. When\ncompanies change the amount of the dividend, options prices follow in step.\nIn 2004, when Microsoft (MSFT) paid aspecial dividend of $3 per share,\nthere were unexpected winners and losers in the Microsoft options. Traders\nwho were long calls or short puts were adversely affected by this change in\ndividend policy. Traders with short calls or long puts benefited. With long-\nterm options, even less anomalous changes in the size of the dividend can\nhave dramatic effects on options values.\nLet’sstudy an example of how an unexpected rise in the quarterly\ndividend of astock affects along call position. Extremely Yellow Zebra\nCorp. (XYZ) has been paying aquarterly dividend of $0.10. After asteady\nrise in stock price to $61 per share, XYZ declares adividend payment of\n$0.50. It is expected that the company will continue to pay $0.50 per\nquarter. Atrader, James, owns the 528-day 60-strike calls, which were\ntrading at 9.80 before the dividend increase was announced.\nExhibit 8.2 compares the values of the long-term call using a $0.10\nquarterly dividend and using a $0.50 quarterly dividend.\nEXHIBIT 8.2 Effect of change in quarterly dividend on call value.\nThis $0.40 dividend increase will have abig effect on James’scalls. With\n528 days until expiration, there will be six dividends involved. Because", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:245", "doc_id": "0f0e0fc93a738a706a23423baef137c5a8445b909ed9eb202d46ea9f4acb7a04", "chunk_index": 0}
{"text": "James is long the calls, he loses 1.52 per option. If, however, he were short\nthe calls, 1.52 would be his profit on each option.\nPut traders are affected as well. Another trader, Marty, is long the 60-\nstrike XYZ puts. Before the dividend announcement, Marty was running his\nvalues with a $0.10 dividend, giving his puts avalue of 5.42. Exhibit 8.3\ncompares the values of the puts with a $0.10 quarterly dividend and with a\n$0.50 quarterly dividend.\nEXHIBIT 8.3 Effect of change in quarterly dividend on put value.\nWhen the dividend increase is announced, Marty will benefit. His puts\nwill rise because of the higher dividend by $0.66 (all other parameters held\nconstant). His long-term puts with six quarters of future expected dividends\nwill benefit more than short-term XYZ puts of the same strike would. Of\ncourse, if he were short the puts, he would lose this amount.\nThe dividend inputs to apricing model are best guesses until the dates\nand amounts are announced by the company. How does one find dividend\ninformation? Regularly monitoring the news and press releases on the\ncompanies one trades is agood way to stay up to date on dividend\ninformation, as well as other company news. Dividend announcements are\nwidely disseminated by the major news services. Most companies also have\nan investor-relations phone number and section on their web sites where\ndividend information can be found.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:246", "doc_id": "9263da9ac47681cafed5302df8f274f4748b7e96b78fa2bf6359d586e6d720da", "chunk_index": 0}
{"text": "CHAPTER 9\nVertical Spreads\nRisk—it is the focal point around which all trading revolves. It may seem as\nif profit should be occupying this seat, as most important to trading options,\nbut without risk, there would be no profit! As traders, we must always look\nfor ways to mitigate, eliminate, preempt, and simply avoid as much risk as\npossible in our pursuit of success without diluting opportunity. Risk must be\ncontrolled. Trading vertical spreads takes us one step further in this quest.\nThe basic strategies discussed in Chapters 4 and 5 have strengths when\ncompared with pure linear trading in the equity markets. But they have\nweaknesses, too. Consider the covered call, one of the most popular option\nstrategies.\nAcovered call is best used as an augmentation to an investment plan. It\ncan be used to generate income on an investment holding, as an entrance\nstrategy into astock, or as an exit strategy out of astock. But from atrading\nperspective, one can often find better ways to trade such aforecast.\nIf the forecast on astock is neutral to moderately bullish, accepting the\nrisk of stock ownership is often unwise. There is always the chance that the\nstock could collapse. In many cases, this is an unreasonable risk to assume.\nTo some extent, we can make the same case for the long call, short put,\nnaked call, and the like. In certain scenarios, each of these basic strategies is\naccompanied with unwanted risks that serve no beneficial purpose to the\ntrader but can potentially cause harm. In many situations, avertical spread\nis abetter alternative to these basic spreads. Vertical spreads allow atrader\nto limit potential directional risk, limit theta and vega risk, free up margin,\nand generally manage capital more efficiently.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:248", "doc_id": "ace4f2026328e1a1c4ca8c490580f5f6a67959b99d4ded24878fcc0d389b04a9", "chunk_index": 0}
{"text": "Bull Call Spread\nAbull call spread is along call combined with ashort call that has ahigher\nstrike price. Both calls are on the same underlying and share the same\nexpiration month. Because the purchased call has alower strike price, it\ncosts more than the call being sold. Establishing the trade results in adebit\nto the trader’saccount. Because of this debit, it’scalled adebit spread.\nBelow is an example of abull call spread on Apple Inc. (AAPL):\nIn this example, Apple is trading around $391. With 40 days until\nFebruary expiration, the trader buys the 395–405 call spread for anet debit\nof $4.40, or $440 in actual cash. Or one could simply say the trader paid\n$4.40 for the 395–405 call.\nConsider the possible outcomes if the spread is held until expiration.\nExhibit 9.1 shows an at-expiration diagram of the bull call spread.\nEXHIBIT 9.1 AAPL bull call spread.\nBefore discussing the greeks, consider the bull call spread from an at-\nexpiration perspective. Unlike the long call, which has two possible", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:250", "doc_id": "b70f00fcf374c7746f3094c8de8f178ea4ea0b57b9aa52b031f24718969b8b60", "chunk_index": 0}
{"text": "outcomes at expiration—above or below the strike—this spread has three\npossibilities: below both strikes, between the strikes, or above both strikes.\nIn this example, if Apple is below $395 at expiration, both calls expire\nworthless. The rights and obligations of the options are gone, as is the cash\nspent on the trade. In this case, the entire debit of $4.40 is lost.\nIf Apple is between the strikes at expiration, the 405-strike call expires\nworthless. The trader is long stock at an effective price of $399.40. This is\nthe $395-strike price at which the stock would be purchased if the call is\nexercised, plus the $4.40 premium spent on the spread. The break-even\nprice of the trade is $399.40. If Apple is above $399.40 at expiration, the\ntrade is profitable; below $399.40, it is aloser. The aptly named bull call\nspread requires the stock to rise to reach its profit potential. But unlike an\noutright long call, profits are capped with the spread.\nIf Apple is above $405 at expiration, both calls are in-the-money (ITM).\nIf the 395-strike calls are exercised, the trader buys 100 shares of Apple at\n$395 and these shares, in turn, would be sold at $405 when the 405-strike\ncalls are assigned, for a $10 gain per share. Subtract from that $10 the $4.40\ndebit spent on the trade and the net profit is $5.60 per share.\nThere are some other differences between the 395–405 call spread and the\noutright purchase of the 395 call. The absolute risk is lower. To buy the\n395-strike call costs 14.60, versus 4.40 for the spread—abig difference.\nBecause the debit is lower, the margin for the spread is lower at most\noption-friendly brokers, as well.\nIf we dig alittle deeper, we find some other differences between the bull\ncall spread and the outright call. Long options are haunted by the specter of\ntime. Because the spread involves both along and ashort option, the time-\ndecay risk is lower than that associated with owning an option outright.\nImplied volatility (IV) risk is lower, too. Exhibit 9.2 compares the greeks of\nthe long 395 call with those of the 395–405 call spread.\nEXHIBIT 9.2 Apple call versus bull call spread (Apple @ $391).\n395 Call395–405 Call\nDelta 0.484 0.100\nGamma0.00970.0001\nTheta −0.208−0.014\nVega 0.513 0.020", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:251", "doc_id": "b2730f8b41b4b8451d0870cda4def940d32728a883185d15d8476f26ac1e512c", "chunk_index": 0}
{"text": "The positive deltas indicate that both positions are bullish, but the outright\ncall has ahigher delta. Some of the 395 call’sdirectional sensitivity is lost\nwhen the 405 call is sold to make aspread. The negative delta of the 405\ncall somewhat offsets the positive delta of the 395 call. The spread delta is\nonly about 20 percent of the outright call’sdelta. But for atrader wanting to\nfocus on trading direction, the smaller delta can be asmall sacrifice for the\nbenefit of significantly reduced theta and vega. Theta spread’srisk is about\n7 percent that of the outright. The spread’svega risk is also less than 4\npercent that of the outright 395 call. With the bull call spread, atrader can\nspread off much of the exposure to the unwanted risks and maintain adisproportionately higher greeks in the wanted exposure (delta).\nThese relationships change as the underlying moves higher. Remember,\nat-the-money (ATM) options have the greatest sensitivity to theta and vega.\nWith Apple sitting at around the long strike, gamma and vega have their\ngreatest positive value, and theta has its most negative value. Exhibit 9.3\nshows the spread greeks given other underlying prices.\nEXHIBIT 9.3 AAPL 395–405 bull call spread.\nAs the stock moves higher toward the 405 strike, the 395 call begins to\nmove away from being at-the-money, and the 405 call moves toward being\nat-the-money. The at-the-money is the dominant strike when it comes to the\ncharacteristics of the spread greeks. Note the greeks position when the\nunderlying is directly between the two strike prices: The long call has\nceased to be the dominant influence on these metrics. Both calls influence\nthe analytics pretty evenly. The time-decay risk has been entirely spread off.\nThe volatility risk is mostly spread off. Gamma remains aminimal concern.\nWhen the greeks of the two calls balance each other, the result is adirectional play.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:252", "doc_id": "7ff0c6a8a6e65ec93f4041a2a1bbe81dbe25dd1b141f13d27f27eb04731d3143", "chunk_index": 0}
{"text": "As AAPL continues to move closer to the 405-strike, it becomes the at-\nthe-money option, with the dominant greeks. The gamma, theta, and vega\nof the 405 call outweigh those of the ITM 395 call. Vega is more negative.\nPositive theta now benefits the trade. The net gamma of the spread has\nturned negative. Because of the negative gamma, the delta has become\nsmaller than it was when the stock was at $400. This means that the benefit\nof subsequent upward moves in the stock begins to wane. Recall that there\nis amaximum profit threshold with avertical spread. As the stock rises\nbeyond $405, negative gamma makes the delta smaller and time decay\nbecomes less beneficial. But at this point, the delta has done its work for the\ntrader who bought this spread when the stock was trading around $395. The\naverage delta on amove in the stock from $395 to $405 is about 0.10 in this\ncase.\nWhen the stock is at the 405 strike, the characteristics of the trade are\nmuch different than they are when the stock is at the 395 strike. Instead of\nneeding movement upward in the direction of the delta to combat the time\ndecay of the long calls, the position can now sit tight at the short strike and\nreap the benefits of option decay. The key with this spread, and with all\nvertical spreads, is that the stock needs to move in the direction of the delta\nto the short strike.\nStrengths and Limitations\nThere are many instances when abull call spread is superior to other bullish\nstrategies, such as along call, and there are times when it isn’t. Traders\nmust consider both price and time.\nAbull call spread will always be cheaper than the outright call purchase.\nThat’sbecause the cost of the long-call portion of the spread is partially\noffset by the premium of the higher-strike short call. Spending less for the\nsame exposure is always abetter choice, but the exposure of the vertical is\nnot exactly the same as that of the long call. The most obvious trade-off is\nthe fact that profit is limited. For smaller moves—up to the price of the\nshort strike—vertical spreads tend to be better trades than outright call\npurchases. Beyond the strike? Not so much.\nBut time is atrade-off, too. There have been countless times that Ihave\ntalked with new traders who bought acall because they thought the stock", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:253", "doc_id": "0e554719cf3b86a7f520d7137c4fd521422f57c02c3ec4a2657b3b715bb2dff6", "chunk_index": 0}
{"text": "was going up. They were right and still lost money. As the adage goes,\ntiming is everything. The more time that passes, the more advantageous the\nlower-theta vertical spread becomes. When held until expiration, avertical\nspread can be abetter trade than an outright call in terms of percentage\nprofit.\nIn the previous example, when Apple is at $391 with 40 days until\nexpiration, the 395 call is worth 14.60 and the spread is worth 4.40. If\nApple were to rise to be trading at $405 at expiration, the call rises to be\nworth 10, for aloss of 4.60 on the 14.60 debit paid. The spread also is worth\n10. It yields again of about 127 percent on the initial $4.40 per share debit.\nBut look at this same trade if the move occurs before expiration. If Apple\nrallies to $405 after only acouple weeks, the outcome is much different.\nWith four weeks still left until expiration, the 395 call is worth 19.85 with\nthe underlying at $405. That’sa 36 percent gain on the 14.60. The spread is\nworth 5.70. That’sa 30 percent gain. The vertical spread must be held until\nexpiration to reap the full benefits, which it accomplishes through erosion\nof the short option.\nThe long-call-only play (with asignificantly larger negative theta) is\npunished severely by time passing. The long call benefits more from aquick move in the underlying. And of course, if the stock were to rise to aprice greater than $405, in ashort amount of time—the best of both worlds\nfor the outright call—the outright long 395 call would be emphatically\nsuperior to the spread.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:254", "doc_id": "e5523becc4441461f7203e610fc67dc2389245e73a5b097afa45e17308539fce", "chunk_index": 0}
{"text": "Bear Call Spread\nThe next type of vertical spread is called abear call spread . Abear call\nspread is ashort call combined with along call that has ahigher strike\nprice. Both calls are on the same underlying and share the same expiration\nmonth. In this case, the call being sold is the option of higher value. This\ncall spread results in anet credit when the trade is put on and, therefore, is\ncalled acredit spread.\nThe bull call spread and the bear call spread are two sides of the same\ncoin. The difference is that with the bull call spread, one is buying the call\nspread, and with the bear call spread, one is selling the call spread. An\nexample of abear call spread can be shown using the same trade used\nearlier.\nHere we are selling one AAPL February (40-day) 395 call at 14.60 and\nbuying the 405 call at 10.20. We are selling the 395–405 call at $4.40 per\nshare, or $440.\nExhibit 9.4 is an at-expiration diagram of the trade.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:255", "doc_id": "5eb4cfe53e015e671dadec0ed2d4ca4a0f83d708660b4f4c40249740da17f16f", "chunk_index": 0}
{"text": "EXHIBIT 9.4 Apple bear call spread.\nThe same three at-expiration outcomes are possible here as with the bull\ncall spread: the stock can be above both strikes, between both strikes, or\nbelow both strikes. If the stock is below both strikes at expiration, both calls\nwill expire worthless. The rights and obligations cease to exist. In this case,\nthe entire credit of $440 is profit.\nIf AAPL is between the two strike prices at expiration, the 395-strike call\nwill be in-the-money. The short call will get assigned and result in ashort\nstock position at expiration. The break-even price falls at $399.40—the\nshort strike plus the $4.40 net premium. This is the price at which the stock\nwill effectively be sold if assignment occurs.\nIf Apple is above both strikes at expiration, it means both calls are in-the-\nmoney. Stock is sold at $395 because of assignment and bought back at\n$405 through exercise. This leads to aloss of $10 per share on the negative\nscalp. Factoring in the $4.40-per-share credit makes the net loss only $5.60\nper share with AAPL above $405 at February expiration.\nJust as the at-expiration diagram is the same but reversed, the greeks for\nthis call spread will be similar to those in the bull call spread example\nexcept for the positive and negative signs. See Exhibit 9.5 .\nEXHIBIT 9.5 Apple 395–405 bear call spread.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:256", "doc_id": "22a746c3d9fe21dc694252dab95958b303b118048da9a87890ef8db185c8c151", "chunk_index": 0}
{"text": "Acredit spread is commonly traded as an income-generating strategy. The\nidea is simple: sell the option closer-to-the-money and buy the more out-of-\nthe-money (OTM) option—that is, sell volatility—and profit from\nnonmovement (above acertain point). In this example, with Apple at $391,\naneutral to slightly bearish trader would think about selling this spread at\n4.40 in hopes that the stock will remain below $395 until expiration. The\nbest-case scenario is that the stock is below $395 at expiration and both\noptions expire, resulting in a $4.40-per-share profit.\nThe strategy profits as long as Apple is under its break-even price,\n$399.40, at expiration. But this is not so much abearish strategy as it is anonbullish strategy. The maximum gain with acredit spread is the premium\nreceived, in this case $4.40 per share. Traders who thought AAPL was\ngoing to decline sharply would short it or buy aput. If they thought it would\nrise sharply, they’duse another strategy.\nFrom agreek perspective, when the trade is executed it’svery close to its\nhighest theta price point—the 395 short strike price. This position\ntheoretically collects $0.90 aday with Apple at around $395. As time\npasses, that theta rises. The key is that the stock remains at around $395\nuntil the short option is just about worthless. The name of the game is sit\nand wait.\nAlthough the delta is negative, traders trading this spread to generate\nincome want the spread to expire worthless so they can pocket the $4.40 per\nshare. If Apple declines, profits will be made on delta, and theta profits will\nbe foregone later. All that matters is the break-even point. Essentially, the\nidea is to sell anaked call with amaximum potential loss. Sell the 395s and\nbuy the 405s for protection.\nIf the underlying decreases enough in the short term and significant\nprofits from delta materialize, it is logical to consider closing the spread\nearly. But it often makes more sense to close part of the spread. Consider", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:257", "doc_id": "6df76a7380eb3fa40c677817cdd5fb15eb8f2b0666e76727186d3bd9db1af8ad", "chunk_index": 0}
{"text": "that the 405-strike call is farther out-of-the-money and will lose its value\nbefore the 395 call.\nSay that after two weeks abig downward move occurs. Apple is trading at\n$325 ashare; the 405s are 0.05 bid at 0.10, and the 395s are 0.50 bid at\n0.55. At this point, the lion’sshare of the profits can be taken early. Atrader\ncan do so by closing only the 395 calls. Closing the 395s to eliminate the\nrisk of negative delta and gamma makes sense. But does it make sense to\nclose the 405s for 0.05? Usually not. Recouping this residual value\naccomplishes little. It makes more sense to leave them in your position in\ncase the stock rebounds. If the stock proves it can move down $70; it can\ncertainly move up $70. Because the majority of the profits were taken on\nthe 395 calls, holding on to the 405s is like getting paid to own calls. In\nscenarios where abig move occurs and most of the profits can be taken\nearly, it’soften best to hold the long calls, just in case. It’sawin-win\nsituation.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:258", "doc_id": "3a932b7b48f26692c58979f4b468e502bf1b3bade81282a6c116dd5ba4d5f746", "chunk_index": 0}
{"text": "Credit and Debit Spread Similarities\nThe credit call spread and the debit call spread appear to be exactly opposite\nin every respect. Many novice traders perceive credit spreads to be\nfundamentally different from debit spreads. That is not necessarily so.\nCloser study reveals that these two are not so different after all.\nWhat if Apple’sstock price was higher when the trade was put on? What\nif the stock was at $405? First, the spread would have had more value. The\n395 and 405 calls would both be worth more. Atrader could have sold the\nspread for a $5.65-per-share credit. The at-expiration diagram would look\nalmost the same. See Exhibit 9.6 .\nEXHIBIT 9.6 Apple bear call spread initiated with Apple at $405.\nBecause the net premium is much higher in this example, the maximum\ngain is more—it is $5.65 per share. The breakeven is $400.65. The price\npoints on the at-expiration diagram, however, have nothing to do with the\ngreeks. The analytics from Exhibit 9.5 are the same either way.\nThe motivation for atrader selling this call spread, which has both\noptions in-the-money, is different from that for the typical income\ngenerator. When the spread is sold in this context, the trader is buying\nvolatility. Long gamma, long vega, negative theta. The trader here has a", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:259", "doc_id": "3616fdf4d69aefb84da8db9632affe45e24076842327afa681725fc24acc2e92", "chunk_index": 0}
{"text": "Bear Put Spread\nThere is another way to take abearish stance with vertical spreads: the bear\nput spread. Abear put spread is along put plus ashort put that has alower\nstrike price. Both puts are on the same underlying and share the same\nexpiration month. This spread, however, is adebit spread because the more\nexpensive option is being purchased.\nImagine that astock has had agood run-up in price. The chart shows asteady march higher over the past couple of months. Astudy of technical\nanalysis, though, shows that the run-up may be pausing for breath. An\noscillator, such as slow stochastics, in combination with the relative\nstrength index (RSI), indicates that the stock is overbought. At the same\ntime, the average directional movement index (ADX) confirms that the\nuptrend is slowing.\nFor traders looking for asmall pullback, abear put spread can be an\nexcellent strategy. The goal is to see the stock drift down to the short strike.\nSo, like the other members of the vertical spread family, strike selection is\nimportant.\nLet’slook at an example of ExxonMobil (XOM). After the stock has\nrallied over atwo-month period to $80.55, atrader believes there will be ashort-term temporary pullback to $75. Instead of buying the June 80 puts\nfor 1.75, the trader can buy the 75–80 put spread of the same month for\n1.30 because the 75 put can be sold for 0.45. 1\nIn this example, the June put has 40 days until expiration. Exhibit 9.7\nillustrates the payout at expiration.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:261", "doc_id": "ebe7fcfa689cdb044efe84f970e8ad95d7b59b325a1b2951525b446331e3f9fa", "chunk_index": 0}
{"text": "EXHIBIT 9.7 ExxonMobil bear put spread.\nIf the trader is wrong and ExxonMobil is still above 80 at expiry, both\nputs expire and the 1.30 premium is lost. If ExxonMobil is between the two\nstrikes, the 80 puts are ITM, resulting in an exercise, and the 75 puts are\nOTM and expire. The net effect is short stock at an effective price of\n$78.70. The effective sale price is found by taking the price at which the\nshort stock is established when the puts are exercised—$80—minus the net\n1.30 paid for the spread. This is the spread’sbreakeven at expiration.\nIf the trader is right and ExxonMobil is below both strikes at expiration,\nboth puts are ITM, and the result is a 3.70 profit and no position. Why a\n3.70 profit? The 80 puts are exercised, making the trader short at $80, and\nthe 75 puts are assigned, so the short is bought back at $75 for apositive\nstock scalp of $5. Including the 1.30 debit for the spread in the profit and\nloss (P&(L)), the net profit is $3.70 per share when the stock is below both\nstrikes at expiration.\nThis is abearish trade. But is the bear put spread necessarily abetter trade\nthan buying an outright ATM put? No. The at-expiration diagram makes this\nclear. Profits are limited to $3.70 per share. This is an important difference.\nBut because in this particular example, the trader expects the stock to\nretrace only to around $75, the benefits of lower cost and lower theta and\nvega risk can be well worth the trade-off of limited profit. The trader’s", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:262", "doc_id": "91ea86bc06eb186abd3dde2347abc8917612ac95281610e44e4533fe9880b720", "chunk_index": 0}
{"text": "objectives are met more efficiently by buying the spread. The goal is to\nprofit from the delta move down from $80 to $75. Exhibit 9.8 shows the\ndifferences between the greeks of the outright put and the spread when the\ntrade is put on with ExxonMobil at $80.55.\nEXHIBIT 9.8 ExxonMobil put vs. bear put spread (ExxonMobil @\n$80.55).\n80 Put75–80 Put\nDelta −0.445−0.300\nGamma+0.080+0.041\nTheta −0.018−0.006\nVega +0.110+0.046\nAs in the call-spread examples discussed previously, the spread delta is\nsmaller than the outright put’s. It appears ironic that the spread with the\nsmaller delta is abetter trade in this situation, considering that the intent is\nto profit from direction. But it is the relative differences in the greeks\nbesides delta that make the spread worthwhile given the trader’sgoal.\nGamma, theta, and vega are proportionately much smaller than the delta in\nthe spread than in the outright put. While the spread’sdelta is two thirds\nthat of the put, its gamma is half, its theta one third, and its vega around 42\npercent of the put’s.\nRetracements such as the one called for by the trader in this example can\nhappen fast, sometimes over the course of aweek or two. It’snot\nnecessarily bad if this move occurs quickly. If ExxonMobil drops by $5\nright away, the short delta will make the position profitable. Exhibit 9.9\nshows how the spread position changes as the stock declines from $80 to\n$75.\nEXHIBIT 9.9 75–80 bear put spread as ExxonMobil declines.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:263", "doc_id": "0d14c73c5bb1186c5792fd28308fa2a3e4f8d10be54acd08fd31834721dc1f99", "chunk_index": 0}
{"text": "The delta of this trade remains negative throughout the stock’sdescent to\n$75. Assuming the $5 drop occurs in one day, adelta averaging around\n−0.36 means about a 1.80 profit, or $180 per spread, for the $5 move (0.36\ntimes $5 times 100). This is still afar cry from the spread’s $3.70 potential\nprofit. Although the stock is at $75, the maximum profit potential has yet to\nbe reached, and it won’tbe until expiration. How does the rest of the profit\nmaterialize? Time decay.\nThe price the trader wants the stock to reach is $75, but the assumption\nhere is that the move happens very fast. The trade went from being along-\nvolatility play—long gamma and vega—to ashort-vol play: short gamma\nand vega. The trader wanted movement when the stock was at $80 and\nwants no movement when the stock is at $75. When the trade changes\ncharacteristics by moving from one strike to another, the trader has to\nreconsider the stock’soutlook. The question is: if Ididn’thave this position\non, would Iwant it now?\nThe trader has achoice to make: take the $180 profit—which represents a\n138 percent profit on the 1.30 debit—or wait for theta to do its thing. The\ntrader looking for aretracement would likely be inclined to take aprofit on\nthe trade. Nobody ever went broke taking aprofit. But if the trader thinks\nthe stock will sit tight for the remaining time until expiration, he will be\nhappy with this income-generating position.\nAlthough the trade in the last, overly simplistic example did not reap its\nfull at-expiration potential, it was by no means abad trade. Holding the\nspread until expiration is not likely to be part of atrader’splan. Buying the\n80 put outright may be abetter play if the trader is expecting afast move. It\nwould have abigger delta than the spread. Debit and credit spreads can be\nused as either income generators or as delta plays. When they’re used as\ndelta plays, however, time must be factored in.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:264", "doc_id": "f36a85e31947fbb709600d4de565d449e23074541699475eaa708d508291110d", "chunk_index": 0}
{"text": "Bull Put Spread\nThe last of the four vertical spreads is abull put spread. Abull put spread is\nashort put with one strike and along put with alower strike. Both puts are\non the same underlying and in the same expiration cycle. Abull put spread\nis acredit spread because the more expensive option is being sold, resulting\nin anet credit when the position is established. Using the same options as in\nthe bear put example:\nWith ExxonMobil at $80.55, the June 80 puts are sold for 1.75 and the\nJune 75 puts are bought at 0.45. The trade is done for acredit of 1.30.\nExhibit 9.10 shows the payout of this spread if it is held until expiration.\nEXHIBIT 9.10 ExxonMobil bull put spread.\nThe sale of this spread generates a 1.30 net credit, which is represented by\nthe maximum profit to the right of the 80 strike. With ExxonMobil above\n$80 per share at expiration, both options expire OTM and the premium is\nall profit. Between the two strike prices, the 80 put expires in the money. If\nthe ITM put is still held at expiration, it will be assigned. Upon assignment,", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:265", "doc_id": "67a4cd8ac04316b23f799fba3e44c4c89535e7915958f2cbc5c855be9fbeecfe", "chunk_index": 0}
{"text": "the put becomes long stock, profiting with each tick higher up to $80, or\nlosing with each tick lower to $75. If the 80 put is assigned, the effective\nprice of the long stock will be $78.70. The assignment will “hit your sheets”\nas abuy at $80, but the 1.30 credit lowers the effective net cost to $78.70.\nIf the stock is below $75 at option expiration, both puts will be ITM. This\nis the worst case scenario, because the higher-struck put was sold. At\nexpiration, the 80 puts would be assigned, the 75 puts exercised. That’sanegative scalp of $5 on the resulting stock. The initial credit lessens the pain\nby 1.30. The maximum possible loss with ExxonMobil below both strikes\nat expiration is $3.70 per spread.\nThe spread in this example is the flip side of the bear put spread of the\nprevious example. Instead of buying the spread, as with the bear put, the\nspread in this case is sold.\nExhibit 9.11 shows the analytics for the bull put spread.\nEXHIBIT 9.11 Greeks for ExxonMobil 75–80 bull put spread.\nInstead of having ashort delta, as with the bear spread, the bull spread is\nlong delta. There is negative theta with positive gamma and vega as XOM\napproaches the long strike—the 75s, in this case. There is also positive theta\nwith negative gamma and vega around the short strike—the 80s.\nExhibit 9.11 shows the characteristics that define the vertical spread. If\none didn’tknow which particular options were being traded here, this could\nalmost be atable of greeks for either a 75–80 bull put spread or a 75–80\nbull call spread.\nLike the other three verticals, this spread can be adelta play or atheta\nplay. Abullish trader may sell the spread if both puts are in-the-money.\nImagine that XOM is trading at around $75. The spread will have apositive", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:266", "doc_id": "9270aa3f6688478cb51c80a25cbdd164e8263efaa74453515449d9defa64ad7e", "chunk_index": 0}
{"text": "0.364 delta, positive gamma, and negative theta. The spread as awhole is adecaying asset. It needs the underlying to rally to combat time decay.\nAbullish trader may also sell this spread if XOM is between the two\nstrikes. In this case, with XOM at, say, $77, the delta is +0.388, and all\nother greeks are negligible. At this particular price point in the underlying,\nthe trader has almost pure leveraged delta exposure. But this trade would be\npositioned for only asmall move, not much above $80. Aspeculator\nwanting to trade direction for asmall move while eliminating theta and\nvega risks achieves her objectives very well with avertical spread.\nAbullish-to-neutral trader would be inclined to sell this spread if\nExxonMobil were around $80 or higher. Day by day, the 1.30 premium\nwould start to come in. With 40 days until expiration, theta would be small,\nonly 0.004. But if the stock remained at $80, this ATM put would begin\ndecaying faster and faster. The objective of trading this spread for aneutral\ntrader is selling future realized volatility—selling gamma to earn theta. Atrader can also trade avertical spread to profit from IV.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:267", "doc_id": "f8274043f1b53f98935d123af9f343abcb76287df15b7543fbd165aa2b6bc12e", "chunk_index": 0}
{"text": "Verticals and Volatility\nThe IV component of avertical spread, although small compared with that\nof an outright call or put, is still important—especially for large traders with\nlow margin and low commissions who can capitalize on small price\nchanges efficiently. Whether it’sacall spread or aput spread, acredit\nspread or adebit spread, if the underlying is at the short option’sstrike, the\nspread will have anet negative vega. If the underlying is at the long\noption’sstrike, the spread will have positive vega. Because of this\ncharacteristic, there are three possible volatility plays with vertical spreads:\nspeculating on IV changes when the underlying remains constant, profiting\nfrom IV changes resulting from movement of the underlying, and special\nvolatility situations.\nVertical spreads offer alimited-risk way to speculate on volatility changes\nwhen the underlying remains fairly constant. But when the intent of avertical spread is to benefit from vega, one must always consider the delta\n—it’sthe bigger risk. Chapter 13 discusses ways to manage this risk by\nhedging with stock, astrategy called delta-neutral trading.\nNon-delta-neutral traders may speculate on vol with vertical spreads by\nassuming some delta risk. Traders whose forecast is vega bearish will sell\nthe option with the strike closest to where the underlying is trading—that is,\nthe ATM option—and buy an OTM strike. Traders would lean with their\ndirectional bias by choosing either acall spread or aput spread. As risk\nmanagers, the traders balance the volatility stance being taken against the\nadditional risk of delta. Again, in this scenario, delta can hurt much more\nthan help.\nIn the ExxonMobil bull put spread example, the trader would sell the 80-\nstrike put if ExxonMobil were around $80 ashare. In this case, if the stock\ndidn’tmove as time passed, theta would benefit from historical volatility\nbeing’slow—that is, from little stock movement. At first, the benefit would\nbe only 0.004 per day, speeding up as expiration nears. And if implied\nvolatility decreased, the trader would profit 0.04 for every 1 percent decline\nin IV. Small directional moves upward help alittle. But in the long run,", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:268", "doc_id": "ce42082bd37e25fa220ac0902465522a92eb396d5583ea8c487508eb50b55c3c", "chunk_index": 0}
{"text": "those profits are leveled off by the fact that theta gets smaller as the stock\nmoves higher above $80—more profit on direction, less on time.\nFor the delta player, bull call spreads and bull put spreads have apotential\nadded benefit that stems from the fact that IV tends to decrease as stocks\nrise and increase when stocks fall. This offers additional opportunity to the\nbull spread player. With the bull call spread or the bull put spread, the trader\ngains on positive delta with arally. Once the underlying comes close to the\nshort option’sstrike, vega is negative. If IV declines, as might be\nanticipated, there is afurther benefit of vega profits on top of delta profits.\nIf the underlying declines, the trader loses on delta. But the pain can\npotentially be slightly lessened by vega profits. Vega will get positive as the\nunderlying approaches the long strike, which will benefit from the firming\nof IV that often occurs when the stock drops. But this dual benefit is paid\nfor in the volatility skew. In most stocks or indexes, the lower strikes—the\nones being bought in abull spread—have higher IVs than the higher strikes,\nwhich are being sold.\nThen there are special market situations in which vertical spreads that\nbenefit from volatility changes can be traded. Traders can trade vertical\nspreads to strategically position themselves for an expected volatility\nchange. One example of such asituation is when astock is rumored to be atakeover target. Anatural instinct is to consider buying calls as an\ninexpensive speculation on ajump in price if the takeover is announced.\nUnfortunately, the IV of the call is often already bid up by others with the\nsame idea who were quicker on the draw. Buying acall spread consisting of\nalong ITM call and ashort OTM call can eliminate immediate vega risk\nand still provide wanted directional exposure.\nCertainly, with this type of trade, the trader risks being wrong in terms of\ndirection, time, and volatility. If and when atakeover bid is announced, it\nwill likely be for aspecific price. In this event, the stock price is unlikely to\nrise above the announced takeover price until either the deal is\nconsummated or asecond suitor steps in and offers ahigher price to buy the\ncompany. If the takeover is a “cash deal,” meaning the acquiring company\nis tendering cash to buy the shares, the stock will usually sit in avery tight\nrange below the takeover price for along time. In this event, implied\nvolatility will often drop to very low levels. Being short an ATM call when", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:269", "doc_id": "90d3a3711b102bb02bc22101afbbd41a17618009e1a528c7e4211bda74ec98a8", "chunk_index": 0}
{"text": "The Interrelations of Credit\nSpreads and Debit Spreads\nMany traders Iknow specialize in certain niches. Sometimes this is because\nthey find something they know well and are really good at. Sometimes it’sbecause they have become comfortable and don’thave the desire to try\nanything new. I’ve seen this strategy specialization sometimes with traders\ntrading credit spreads and debit spreads. I’ve had serial credit spread traders\ntell me credit spreads are the best trades in the world, much better than debit\nspreads. Habitual debit spread traders have likewise said their chosen\nspread is the best. But credit spreads and debit spreads are not so different.\nIn fact, one could argue that they are really the same thing.\nConventionally, credit-spread traders have the goal of generating income.\nThe short option is usually ATM or OTM. The long option is more OTM.\nThe traders profit from nonmovement via time decay. Debit-spread traders\nconventionally are delta-bet traders. They buy the ATM or just out-of-the-\nmoney option and look for movement away from or through the long strike\nto the short strike. The common themes between the two are that the\nunderlying needs to end up around the short strike price and that time has to\npass to get the most out of either spread.\nWith either spread, movement in the underlying may be required,\ndepending on the relationship of the underlying price to the strike prices of\nthe options. And certainly, with acredit spread or debit spread, if the\nunderlying is at the short strike, that option will have the most premium.\nFor the trade to reach the maximum profit, it will need to decay.\nFor many retail traders, debit spreads and credit spreads begin to look\neven more similar when margin is considered. Margin requirements can\nvary from firm to firm, but verticals in retail accounts at option-friendly\nbrokerage firms are usually margined in such away that the maximum loss\nis required to be deposited to hold the position (this assumes Regulation Tmargining). For all intents and purposes, this can turn the trader’scash\nposition from acredit into adebit. From acash perspective, all vertical\nspreads are spreads that require adebit under these margin requirements.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:271", "doc_id": "625d3ff42a0130f7530fb4b99fce91efcaf0dbd4c29a94e2614a191619fde980", "chunk_index": 0}
{"text": "Building a Box\nTwo traders, Sam and Isabel, share ajoint account. They have each been\nstudying Johnson & Johnson (JNJ), which is trading at around $63.35 per\nshare. Sam and Isabel, however, cannot agree on direction. Sam thinks\nJohnson & Johnson will rise over the next five weeks, and Isabel believes it\nwill decline during that period.\nSam decides to buy the January 62.50 −65 call spread (January has 38\ndays until expiration in this example). Sam can buy this spread for 1.28. His\nmaximum risk is 1.28. This loss occurs if Johnson & Johnson is below\n$62.50 at expiration, leaving both calls OTM. His maximum gain is 1.22,\nrealized if Johnson & Johnson is above $65 (65–62.50–1.28). With Johnson\n& Johnson at $63.35, Sam’sdelta is long 0.29 and his other greeks are\nabout flat.\nIsabel decides to buy the January 62.50–65 put spread for adebit of 1.22.\nIsabel’sbiggest potential loss is 1.22, incurred if Johnson & Johnson is\nabove $65 ashare at expiration, leaving both puts OTM. Her maximum\npossible profit is 1.28, realized if the stock is below $62.50 at option\nexpiration. With Johnson & Johnson at $63.35, Isabel has adelta that is\nshort around 0.27 and is nearly flat gamma, theta, and vega.\nCollectively, if both Sam and Isabel hold their trades until expiration, it’sazero-sum game. With Johnson & Johnson below $62.50, Sam loses his\ninvestment of 1.28, but Isabel profits. She cancels out Sam’sloss by making\n1.28. Above $65, Sam makes 1.22 while Isabel loses the same amount,\ncanceling out Sam’sgains. Between the two strikes, Sam has gains on his\n62.50 call and Isabel has gains on her 65 put. The gains on the two options\nwill total 2.50, the combined total spent on the spreads—another draw.\nEXHIBIT 9.12 Sam’slong call spread in Johnson & Johnson.\n62.50–65 Call Spread\nDelta +0.290\nGamma+0.001\nTheta −0.004\nVega +0.006", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:273", "doc_id": "ac0352ef6ac05772203699c18d451a8ea0bf78254adcf511366cf6a9d355f9d7", "chunk_index": 0}
{"text": "EXHIBIT 9.13 Isabel’slong put spread in Johnson & Johnson.\n62.50–65 Put Spread\nDelta −0.273\nGamma−0.001\nTheta +0.005\nVega −0.006\nThese two spreads were bought for acombined total of 2.50. The\ncollective position, composed of the four legs of these two spreads, forms anew strategy altogether.\nThe two traders together have created abox. This box, which is empty of\nboth profit and loss, is represented by greeks that almost entirely offset each\nother. Sam’spositive delta of 0.29 is mostly offset by Isabel’s −0.273 delta.\nGamma, theta, and vega will mostly offset each other, too.\nChapter 6 described abox as long synthetic stock combined with short\nsynthetic stock having adifferent strike price but the same expiration\nmonth. It can also be defined, however, as two vertical spreads: abull (bear)\ncall spread plus abear (bull) put spread with the same strike prices and\nexpiration month.\nThe value of abox equals the present value of the distance between the\ntwo strike prices (American-option models will also account for early\nexercise potential in the box’svalue). This 2.50 box, with 38 days until\nexpiration at a 1 percent interest rate, has less than apenny of interest\naffecting its value. Boxes with more time until expiration will have ahigher\ninterest rate component. If there was one year until expiration, the\ncombined value of the two verticals would equal 2.475. This is simply the\ndistance between the strikes minus interest (2.50–[2.50 × 0.01]).\nCredit spreads are often made up of OTM options. Traders betting against\nastock rising through acertain price tend to sell OTM call spreads. For astock at $50 per share, they might sell the 55 calls and buy the 60 calls. But\nbecause of the synthetic relationship that verticals have with one another,\nthe traders could buy an ITM put spread for the same exposure, after", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:274", "doc_id": "30f7d8be0a73b43a9aafa3d1dfb03d7c358ce87be1d001a3b18fa8a58829061c", "chunk_index": 0}
{"text": "Condors and Butterflies\nThe “wing spread” family is aset of option strategies that is very popular,\nparticularly among experienced traders. These strategies make it possible\nfor speculators to accomplish something they could not possibly do by just\ntrading stocks: They provide ameans to profit from atruly neutral market\nin asecurity. Stocks that don’tmove one iota can earn profits month after\nmonth for income-generating traders who trade these strategies.\nThese types of spreads have alot of moving parts and can be intimidating\nto newcomers. At their heart, though, they are rather straightforward break-\neven analysis trades that require little complex math to maintain. Asimple\nat-expiration diagram reveals in black and white the range in which the\nunderlying stock must remain in order to have aprofitable position.\nHowever, applying the greeks and some of the mathematics discussed in\nprevious chapters can help atrader understand these strategies on adeeper\nlevel and maximize the chance of success. This chapter will discuss condors\nand butterflies and how to put them into action most effectively.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:279", "doc_id": "e5e99286db4650639433a1d224bad64ae78f6e52fb25683333827e6a1d63d779", "chunk_index": 0}
{"text": "Condor\nAcondor is afour-legged option strategy that enables atrader to capitalize\non volatility—increased or decreased. Traders can trade long or short iron\ncondors.\nLong Condor\nLong one call (put) with strike A; short one call (put) with ahigher strike,\nB; short one call (put) at strike C, which is higher than B; and long one call\n(put) at strike D, which is higher than C. The distance between strike price\nAand Bis equal to the distance between strike Cand strike D. The options\nare all on the same security, in the same expiration cycle, and either all calls\nor all puts.\nLong Condor Example\nBuy 1 XYZ November 70 call (A)\nSell 1 XYZ November 75 call (B)\nSell 1 XYZ November 90 call (C)\nBuy 1 XYZ November 95 call (D)\nShort Condor\nShort one call (put) with strike A; long one call (put) with ahigher strike, B;\nlong one call (put) with astrike, C, that is higher than B; and short one call\n(put) with astrike, D, that is higher than C. The options must be on the\nsame security, in the same expiration cycle, and either all calls or all puts.\nThe differences in strike price between the vertical spread of strike prices Aand Band the strike prices of the vertical spread of strikes Cand Dare\nequal.\nShort Condor Example\nSell 1 XYZ November 70 call (A)\nBuy 1 XYZ November 75 call (B)\nBuy 1 XYZ November 90 call (C)\nSell 1 XYZ November 95 call (D)", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:281", "doc_id": "356b447d6f467425655aadf970d29c502ce14acdef2d8217f254e600a11a6e05", "chunk_index": 0}
{"text": "Iron Condor\nAn iron condor is similar to acondor, but with amix of both calls and puts.\nEssentially, the condor and iron condor are synthetically the same.\nShort Iron Condor\nLong one put with strike A; short one put with ahigher strike, B; short one\ncall with an even higher strike, C; and long one call with astill higher\nstrike, D. The options are on the same security and in the same expiration\ncycle. The put credit spread has the same distance between the strike prices\nas the call credit spread.\nShort Iron Condor Example\nBuy 1 XYZ November 70 put (A)\nSell 1 XYZ November 75 put (B)\nSell 1 XYZ November 90 call (C)\nBuy 1 XYZ November 95 call (D)\nLong Iron Condor\nShort one put with strike A; long one put with ahigher strike, B; long one\ncall with an even higher strike, C; and short one call with astill higher\nstrike, D. The options are on the same security and in the same expiration\ncycle. The put debit spread (strikes Aand B) has the same distance between\nthe strike prices as the call debit spread (strikes Cand D).\nLong Iron Condor Example\nSell 1 XYZ November 70 put (A)\nBuy 1 XYZ November 75 put (B)\nBuy 1 XYZ November 90 call (C)\nSell 1 XYZ November 95 call (D)", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:282", "doc_id": "c8e7a6ec392da38e39f44538fe1c5ba376a0902da9cb6a648f0263b1159f4e3e", "chunk_index": 0}
{"text": "Butterflies\nButterflies are wing spreads similar to condors, but there are only three\nstrikes involved in the trade—not four.\nLong Butterfly\nLong one call (put) with strike A; short two calls (puts) with ahigher strike,\nB; and long one call (put) with an even higher strike, C. The options are on\nthe same security, in the same expiration cycle, and are either all calls or all\nputs. The difference in price between strikes Aand Bequals that between\nstrikes Band C.\nLong Butterfly Example\nBuy 1 XYZ December 50 call (A)\nSell 2 XYZ December 60 call (B)\nBuy 1 XYZ December 70 call (C)\nShort Butterfly\nShort one call (put) with strike A; long two calls (puts) with ahigher strike,\nB; and short one call (put) with an even higher strike, C. The options are on\nthe same security, in the same expiration cycle, and are either all calls or all\nputs. The vertical spread made up of the options with strike Aand strike Bhas the same distance between the strike prices of the vertical spread made\nup of the options with strike Band strike C.\nShort Butterfly Example\nSell 1 XYZ December 50 call\nBuy 2 XYZ December 60 call\nSell 1 XYZ December 70 call", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:283", "doc_id": "9b628d86f2bed92834d161de0d8ba06f6f3c41812a45f59820b83be8a84eaa50", "chunk_index": 0}
{"text": "Iron Butterflies\nMuch like the relationship of the condor to the iron condor, abutterfly has\nits synthetic equal as well: the iron butterfly.\nShort Iron Butterfly\nLong one put with strike A; short one put with ahigher strike, B; short one\ncall with strike B; long one call with astrike higher than B, C. The options\nare on the same security and in the same expiration cycle. The distances\nbetween the strikes of the put spread and between the strikes of the call\nspread are equal.\nShort Iron Butterfly Example\nBuy 1 XYZ December 50 put (A)\nSell 1 XYZ December 60 put (B)\nSell 1 XYZ December 60 call (B)\nBuy 1 XYZ December 70 call (C)\nLong Iron Butterfly\nShort one put with strike A; long one put with ahigher strike, B; long one\ncall with strike B; short one call with astrike higher than B, C. The options\nare on the same security and in the same expiration cycle. The distances\nbetween the strikes of the put spread and between the strikes of the call\nspread are equal. The put debit spread has the same distance between the\nstrike prices as the call debit spread.\nLong Iron Butterfly Example\nSell 1 XYZ December 50 put\nBuy 1 XYZ December 60 put\nBuy 1 XYZ December 60 call\nSell 1 XYZ December 70 call\nThese spreads were defined in terms of both long and short for each\nstrategy. Whether the spread is classified as long or short depends on\nwhether it was established at acredit or adebit. Debit condors or butterflies", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:284", "doc_id": "dd2ddb9c52cb7a0b962a265ee32a8613e8c6e8fae52da17c1415cde4446b5677", "chunk_index": 0}
{"text": "are considered long spreads. And credit condors or butterflies are\nconsidered short spreads.\nThe words long and short mean little, though in terms of the spread as awhole. The important thing is which strikes have long options and which\nhave short options. Acall debit spread is synthetically equal to aput credit\nspread on the same security, with the same expiration month and strike\nprices. That means along condor is synthetically equal to ashort iron\ncondor, and along butterfly is synthetically equal to ashort iron butterfly,\nwhen the same strikes are used. Whichever position is constructed, the best-\ncase scenario is to have debit spreads expire with both options in-the-money\n(ITM) and credit spreads expire with both options out-of-the-money\n(OTM).\nMany retail traders prefer trading these spreads for the purpose of\ngenerating income. In this case, atrader would sell the guts, or middle\nstrikes, and buy the wings, or outer strikes. When atrader is short the guts,\nlow realized volatility is usually the objective. For long butterflies and short\niron butterflies, the stock needs to be right at the middle strike for the\nmaximum payout. For long condors and short iron condors, the stock needs\nto be between the short strikes at expiration for maximum payout. In both\ninstances, the wings are bought to limit potential losses of the otherwise\nnaked options.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:285", "doc_id": "74363e489aae54a2f06f15dd3a400ad9a8f5f683c5765155e7efdb0dc7fdac57", "chunk_index": 0}
{"text": "Long Butterfly Example\nAtrader, Kathleen, has been studying United Parcel Service (UPS), which\nis trading at around $70.65. She believes UPS will trade sideways until July\nexpiration. Kathleen buys the July 65–70–75 butterfly for 2.00. She\nexecutes the following legs:\nKathleen looks at her trade as two vertical spreads, the 65–70 bull (debit)\ncall spread and the 70–75 bear (credit) call spread. Intuitively, she would\nwant UPS to be at or above $70 at expiration for her bull call spread to have\nmaximum value. But she has the seemingly conflicting goal of also wanting\nUPS to be at or below $70 to get the most from her 70–75 bear call spread.\nThe ideal price for the stock to be trading at expiration in this example is\nright at $70 per share—the best of both worlds. The at-expiration diagram,\nExhibit 10.1 , shows the profit or loss of all possible outcomes at expiration.\nEXHIBIT 10.1 UPS 65–70–75 butterfly.\nIf the price of UPS shares declines below $65 at expiration, all these calls\nwill expire. The entire 2.00 spent on the trade will be lost. If UPS is above\n$65 at expiration, the 65 call will be ITM and will be exercised. The call", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:286", "doc_id": "bc3f944b9b3323b6af83a47bf3a8d3caf8cd943df6df0380c8ac55c14d13b41c", "chunk_index": 0}
{"text": "will profit like along position in 100 shares of the underlying. The\nmaximum profit is reached if UPS is at $70 at expiration. Kathleen makes a\n5.00 profit from $65 to $70 on her 65 calls. But because she paid 2.00\ninitially for the spread, her net profit at $70 is just 3.00. If UPS is above $70\nashare at expiration in this example, the two 70 calls will be assigned. The\nassignment of one call will offset the long stock acquired by the 65 calls\nbeing exercised. Assignment of the other call will create ashort position in\nthe underlying. That short position loses as UPS moves higher up to $75 ashare, eating away at the 3.00 profit. If UPS is above $75 at expiration, the\n75 call can be exercised to buy back the short stock position that resulted\nfrom the 70’sbeing assigned. The loss on the short stock between $70 and\n$75 will cost Kathleen 5.00, stripping her of her 3.00 profit and giving her anet loss of 2.00 to boot. End result? Above $75 at expiration, she has no\nposition in the underlying and loses 2.00.\nAbutterfly is abreak-even analysis trade . This name refers to the idea\nthat the most important considerations in this strategy are the breakeven\npoints. The at-expiration diagram, Exhibit 10.2 , shows the break-even\nprices for this trade.\nEXHIBIT 10.2 UPS 65–70–75 butterfly breakevens.\nIf the position is held until expiration and UPS is between $65 and $70 at\nthat time, the 65 calls are exercised, resulting in long stock. The effective\npurchase price of that stock is $67. That’sthe strike price plus the cost of", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:287", "doc_id": "f6ce572dfcc7528a8d835e576e226f51ad45bfecd23145b39d0bf874a1ec134d", "chunk_index": 0}
{"text": "the spread; that’sthe lower break-even price. The other break-even is at\n$73. The net short position of 100 shares resulting from assignment of the\n70 call loses more as the stock rises between $70 and $75. The entire 3.00\nprofit realized at the $70 share price is eroded when the stock reaches $73.\nAbove $73, the trade produces aloss.\nKathleen’strading objective is to profit from UPS trading between $67\nand $73 at expiration. The best-case scenario is that it declines only slightly\nfrom its price of $70.65 when the trade is established, to $70 per share.\nAlternatives\nKathleen had other alternative positions she could have traded to meet her\ngoals. An iron butterfly with the same strike prices would have shown about\nthe same risk/reward picture, because the two positions are synthetically\nequivalent. But there may, in some cases, be aslight advantage to trading\nthe iron butterfly over the long butterfly. The iron butterfly uses OTM put\noptions instead of ITM calls, meaning the bid-ask spreads may be tighter.\nThis means giving up less edge to the liquidity providers.\nShe could have also bought acondor or sold an iron condor. With condor-\nfamily spreads, there is alower maximum profit potential but awider range\nin which that maximum payout takes place. For example, Kathleen could\nhave executed the following legs to establish an iron condor:\nEssentially, Kathleen would be selling two credit spreads: the July 60–65\nput spread for 0.30 and the July 75–80 call spread for 0.35. Exhibit 10.3\nshows the payout at expiration of the UPS July 60–65–75–80 iron condor.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:288", "doc_id": "8cba9d201e4bca1aeacccc2c5de26cf4d2c149c3a2d300e86a30d7171d2808f5", "chunk_index": 0}
{"text": "EXHIBIT 10.3 UPS 60–65–75–80 iron condor.\nAlthough the forecast and trading objectives may be similar to those for\nthe butterfly, the payout diagram reveals some important differences. First,\nthe maximum loss is significantly higher with acondor or iron condor. In\nthis case, the maximum loss is 4.35. This unfortunate situation would occur\nif UPS were to drop to below $60 or rise above $80 by expiration. Below\n$60, the call spread expires, netting 0.35. But the put spread is ITM.\nKathleen would lose anet of 4.70 on the put spread. The gain on the call\nspread combined with the loss on the put spread makes the trade aloser of\n4.35 if the stock is below $60 at expiration. Above $80, the put spread is\nworthless, earning 0.30, but the call spread is aloser by 4.65. The gain on\nthe put spread plus the loss on the call spread is anet loser of 4.35. Between\n$65 and $75, all options expire and the 0.65 credit is all profit.\nSo far, this looks like apretty lousy alternative to the butterfly. You can\nlose 4.35 but only make 0.65! Could there be any good reason for making\nthis trade? Maybe. The difference is wiggle room. The breakevens are 2.65\nwider in each direction with the iron condor. Exhibit 10.4 shows these\nprices on the graph.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:289", "doc_id": "f9f3fcc602c5edb97e2d87b61c942ac5c4a6bba3d24a337d4dcc5bfc160abe39", "chunk_index": 0}
{"text": "Keys to Success\nNo matter which trade is more suitable to Kathleen’srisk tolerance, the\noverall concept is the same: profit from little directional movement. Before\nKathleen found astock on which to trade her spread, she will have sifted\nthrough myriad stocks to find those that she expects to trade in arange. She\nhas afew tools in her trading toolbox to help her find good butterfly and\ncondor candidates.\nFirst, Kathleen can use technical analysis as aguide. This is arather\nstraightforward litmus test: does the stock chart show atrending, volatile\nstock or aflat, nonvolatile stock? For the condor, aquick glance at the past\nfew months will reveal whether the stock traded between $65 and $75. If it\ndid, it might be agood iron condor candidate. Although this very simplistic\napproach is often enough for many traders, those who like lots of graphs\nand numbers can use their favorite analyses to confirm that the stock is\ntrading in arange. Drawing trendlines can help traders to visualize the\nchannel in which astock has been trading. Knowing support and resistance\nis also beneficial. The average directional movement index (ADX) or\nmoving average converging/diverging (MACD) indicator can help to show\nif there is atrend present. If there is, the stock may not be agood candidate.\nSecond, Kathleen can use fundamentals. Kathleen wants stocks with\nnothing on their agendas. She wants to avoid stocks that have pending\nevents that could cause their share price to move too much. Events to avoid\nare earnings releases and other major announcements that could have an\nimpact on the stock price. For example, adrug stock that has been trading\nin arange because it is awaiting Food and Drug Administration (FDA)\napproval, which is expected to occur over the next month, is not agood\ncandidate for this sort of trade.\nThe last thing to consider is whether the numbers make sense. Kathleen’siron condor risks 4.35 to make 0.65. Whether this sounds like agood trade\ndepends on Kathleen’srisk tolerance and the general environment of UPS,\nthe industry, and the market as awhole. In some environments, the\n0.65/4.35 payout-to-risk ratio makes alot of sense. For other people, other\nstocks, and other environments, it doesn’t.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:291", "doc_id": "d4ab5a8c172037f7040ac1f633e1f53796444ed1ee27f9c608dc4f8b3f6cdbff", "chunk_index": 0}
{"text": "Greeks and Wing Spreads\nMuch of this chapter has been spent on how wing spreads perform if held\nuntil expiration, and little has been said of option greeks and their role in\nwing spreads. Greeks do come into play with butterflies and condors but not\nnecessarily the same way they do with other types of option trades.\nThe vegas on these types of spreads are smaller than they are on many\nother types of strategies. For atypical nonprofessional trader, it’shard to\ntrade implied volatility with condors or butterflies. The collective\ncommissions on the four legs, as well as margin and capital considerations,\nput these out of reach for active trading. Professional traders and retail\ntraders subject to portfolio margining are better equipped for volatility\ntrading with these spreads.\nThe true strength of wing spreads, however, is in looking at them as\nbreak-even analysis trades much like vertical spreads. The trade is awinner\nif it is on the correct side of the break-even price. Wing spreads, however,\nare acombination of two vertical spreads, so there are two break-even\nprices. One of the verticals is guaranteed to be awinner. The stock can be\neither higher or lower at expiration—not both. In some cases, both verticals\ncan be winners.\nConsider an iron condor. Instead of reaping one premium from selling one\nOTM call credit spread, iron condor sellers double dip by additionally\nselling an OTM put credit spread. They collect adouble credit, but only one\nof the credit spreads can be aloser at expiration. The trader, however, does\nhave to worry about both directions independently.\nThere are two ways for greeks and volatility analysis to help traders trade\nwing spreads. One of them involves using delta and theta as tools to trade adirectional spread. The other uses implied volatility in strike selection\ndecisions.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:292", "doc_id": "51e822b78a6dfe55c7fc2bec8727156c201933307ee3918bab49cc4e6a6be105", "chunk_index": 0}
{"text": "Directional Butterflies\nTrading abutterfly can be an excellent way to establish alow-cost,\nrelatively low-risk directional trade when atrader has aspecific price target\nin mind. For example, atrader, Ross, has been studying Walgreen Co.\n(WAG) and believes it will rise from its current level of $33.50 to $36 per\nshare over the next month. Ross buys abutterfly consisting of all OTM\nJanuary calls with 31 days until expiration.\nHe executes the following legs:\nAs adirectional trade alternative, Ross could have bought just the January\n35 call for 1.15. As acheaper alternative, he could have also bought the 35–\n36 bull call spread for 0.35. In fact, Ross actually does buy the 35–36\nspread, but he also sells the January 36–37 call spread at 0.25 to reduce the\ncost of the bull call spread, investing only adime. The benefit of lower cost,\nhowever, comes with trade-offs. Exhibit 10.5 compares the bull call spread\nwith abullish butterfly.\nEXHIBIT 10.5 Bull call spread vs. bull butterfly (Walgreen Co. at $33.50).", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:293", "doc_id": "f36ba4cfc7aea3e4c1f4db59628e82d5e507be52e13540e6d30f1669837f64f4", "chunk_index": 0}
{"text": "The butterfly has lower nominal risk—only 0.10 compared with 0.35 for\nthe call spread. The maximum reward is higher in nominal terms, too—0.90\nversus 0.65. The trade-off is what is given up. With both strategies, the goal\nis to have Walgreen Co. at $36 around expiration. But the bull call spread\nhas more room for error to the upside. If the stock trades alot higher than\nexpected, the butterfly can end up being alosing trade.\nGiven Ross’sexpectations in this example, this might be arisk he is\nwilling to take. He doesn’texpect Walgreen Co. to close right at $36 on the\nexpiration date. It could happen, but it’sunlikely. However, he’dhave to be\nwildly wrong to have the trade be aloser on the upside. It would be amuch\nlarger move than expected for the stock to rise significantly above $36. If\nRoss strongly believes Walgreen Co. can be around $36 at expiration, the\ncost benefit of 0.10 vs. 0.35 may offset the upside risk above $37. As ageneral rule, directional butterflies work well in trending, low-volatility\nstocks.\nWhen Ross monitors his butterfly, he will want to see the greeks for this\nposition as well. Exhibit 10.6 shows the trade’sanalytics with Walgreen Co.\nat $33.50.\nEXHIBIT 10.6 Walgreen Co. 35–36–37 butterfly greeks (stock at $33.50,\n31 days to expiration).\nDelta +0.008\nGamma−0.004\nTheta +0.001\nVega −0.001\nWhen the trade is first put on, the delta is small—only +0.008. Gamma is\nslightly negative and theta is very slightly positive. This is important\ninformation if Walgreen Co.’sascent happens sooner than Ross planned.\nThe trade will show just asmall profit if the stock jumps to $36 per share\nright away. Ross’stheoretical gain will be almost unnoticeable. At $36 per\nshare, the position will have its highest theta, which will increase as\nexpiration approaches. Ross will have to wait for time to pass to see the\ntrade reach its full potential.\nThis example shows the interrelation between delta and theta. We know\nfrom an at-expiration analysis that if Walgreen Co. moves from $33.50 to\n$36, the butterfly’sprofit will be 0.90 (the spread of $1 minus the 0.10", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:294", "doc_id": "a346b04dd0cf0d5a2fcad825386fb9eade1163286bcee9fa7070e9ea110c475b", "chunk_index": 0}
{"text": "Three Looks at the Condor\nStrike selection is essential for asuccessful condor. If strikes are too close\ntogether or two far apart, the trade can become much less attractive.\nStrikes Too Close\nThe QQQs are options on the ETFs that track the Nasdaq 100 (QQQ). They\nhave strikes in $1 increments, giving traders alot to choose from. With\nQQQ trading at around $55.95, consider the 54–55–57–58 iron condor. In\nthis example, with 31 days until expiration, the following legs can be\nexecuted:\nIn this trade, the maximum profit is 0.63. The maximum risk is 0.37. This\nisn’tabad profit-to-loss ratio. The break-even price on the downside is\n$54.37 and on the upside is $57.63. That’sa $3.26 range—atight space for\namover like the QQQ to occupy in amonth. The ETF can drop about only\n2.8 percent or rise 3 percent before the trade becomes aloser. No one needs\nany fancy math to show that this is likely alosing proposition in the long\nrun. While choosing closer strikes can lead to higher premiums, the range\ncan be so constricting that it asphyxiates the possibility of profit.\nStrikes Too Far\nStrikes too far apart can make for impractical trades as well. Exhibit 10.7\nshows an options chain for the Dow Jones Industrial Average Index (DJX).\nThese prices are from around 2007 when implied volatility (IV) was\nhistorically low, making the OTM options fairly low priced. In this\nexample, DJX is around $135.20 and there are 51 days until expiration.\nEXHIBIT 10.7 Options chain for DJIA.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:297", "doc_id": "f64c1f4c1b752befbfd8172a2af57c63e4724255747f02e3f7e53d1129a460b7", "chunk_index": 0}
{"text": "This would be agreat trade if it weren’tfor the prices one would have to\naccept to put it on. First, the 120 puts are offered at 0.25 and the 123 puts\nare 0.25 bid. This means that the put spread would be sold at zero! The\nmaximum risk is 3.00, and the maximum gain is zero. Not areally good\nrisk/reward. The 142–145 call spread isn’tmuch better: it can be sold for adime.\nAt the time, again alow-volatility period, many traders probably felt it\nwas unlikely that the DJX will rise 5 percent in a 51-day period. Some\ntraders may have considered trading asimilarly priced iron condor (though\nof course they’dhave to require some small credit for the risk). Alittle over\nayear later the DJX was trading around 50 percent lower. Traders must\nalways be vigilant of the possibility of volatility, even unexpected volatility\nand structure their risk/reward accordingly. Most traders would say the\nrisk/reward of this trade isn’tworth it. Strikes too far apart have agreater\nchance of success, but the payoff just isn’tthere.\nStrikes with High Probabilities of Success\nSo how does atrader find the happy medium of strikes close enough\ntogether to provide rich premiums but far enough apart to have agood\nchance of success? Certainly, there is something to be said for looking at\nthe prices at which atrade can be done and having asubjective feel for\nwhether the underlying is likely to move outside the range of the break-\neven prices. Alittle math, however, can help quantify this likelihood and aid\nin the decision-making process.\nRecall that IV is read by many traders to be the market’sconsensus\nestimate of future realized volatility in terms of annualized standard\ndeviation. While that is amouthful to say—or in this case, rather, an eyeful\nto read—when broken down it is not quite as intimidating as it sounds.\nConsider asimplified example in which an underlying security is trading at\n$100 ashare and the implied volatility of the at-the-money (ATM) options\nis 10 percent. That means, from astatistical perspective, that if the expected\nreturn for the stock is unchanged, the one-year standard deviations are at\n$90 and $110. 1 In this case, there is about a 68 percent chance of the stock\ntrading between $90 and $110 one year from now. IV then is useful\ninformation to atrader who wants to quantify the chances of an iron", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:299", "doc_id": "7e695a58f90ec85aa5969db6f692744f4d78f108ec9540a48ef83fd913227b0b", "chunk_index": 0}
{"text": "condor’sexpiring profitable, but there are afew adjustments that need to be\nmade.\nFirst, because with an iron condor the idea is to profit from net short\noption premium, it usually makes more sense to sell shorter-term options to\nprofit from higher rates of time decay. This entails trading condors\ncomposed of one- or two-month options. The IV needs to be deannualized\nand converted to represent the standard deviation of the underlying at\nexpiration.\nThe first step is to compute the one-day standard deviation. This is found\nby dividing the implied volatility by the square root of the number of\ntrading days in ayear, then multiplying by the square root of the number of\ntrading days until expiration. The result is the standard deviation (σ) at the\ntime of expiration stated as apercent. Next, multiply that percentage by the\nprice of the underlying to get the standard deviation in absolute terms.\nThe formula 2 for calculating the shorter-term standard deviation is as\nfollows:\nThis value will be added to or subtracted from the price of the underlying\nto get the price points at which the approximate standard deviations fall.\nConsider an example using options on the Standard & Poor’s 500 Index\n(SPX). With 50 days until expiration, the SPX is at 1241 and the implied\nvolatility is 23.2 percent. To find strike prices that are one standard\ndeviation away from the current index price, we need to enter the values\ninto the equation. We first need to know how many actual trading days are\nin the 50-day period. There are 35 business days during this particular 50-\nday period (there is one holiday and seven weekend days). We now have all\nthe data we need to calculate which strikes to sell.\nThe lower standard deviation is 1134.55 (1241 − 106.45) and the upper is\n1347.45 (1241 + 106.45). This means there would be about a 68 percent\nchance of SPX ending up between 1134.55 and 1347.45 at expiration. In\nthis example, to have about atwo-thirds chance of success, one would sell\nthe 1135 puts and the 1350 calls as part of the iron condor.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:300", "doc_id": "b6bcff395c0ea53b5c7a6a154f47d8ff244cff4e124810dd54e51221de5e6d88", "chunk_index": 0}
{"text": "Being Selective\nThere is about atwo-thirds chance of the underlying staying between the\nupper and lower standard deviation points and about aone-third chance it\nwon’t. Reasonably good odds. But the maximum loss of an iron condor will\nbe more than the maximum profit potential. In fact, the max-profit-to-max-\nloss ratio is usually less than 1 to 3. For every $1 that can be made, often $4\nor $5 will be at risk.\nThe pricing model determines fair value of an option based on the implied\nvolatility set by the market. Again, many traders consider IV to be the\nmarket’sconsensus estimate of future realized volatility. Assuming the\nmarket is generally right and options are efficiently priced, in the long run,\nfuture stock volatility should be about the same as the implied volatility\nfrom options prices. That means that if all of your options trades are\nexecuted at fair value, you are likely to break even in the long run. The\ncaveat is that whether the options market is efficient or not, retail or\ninstitutional traders cannot generally execute trades at fair value. They have\nto sell the bid (sell below theoretical value) and buy the offer (buy above\ntheoretical value). This gives the trade astatistical disadvantage, called\ngiving up the edge, from an expected return perspective.\nEven though you are more likely to win than to lose with each individual\ntrade when strikes are sold at the one-standard-deviation point, the edge\ngiven up to the market in conjunction with the higher price tag on losers\nmakes the trade astatistical loser in the long run. While this means for\ncertain that the non-market-making trader is at aconstant disadvantage,\ntrading condors and butterflies is no different from any other strategy.\nGiving up the edge is the plight of retail and institutional traders. To profit\nin the long run, atrader needs to beat the market, which requires careful\nplanning, selectivity, and risk management.\nSavvy traders trade iron condors with strikes one standard deviation away\nfrom the current stock price only when they think there is more than atwo-\nthirds chance of market neutrality. In other words, if you think the market\nwill be less volatile than the prices in the options market imply, sell the iron\ncondor or trade another such premium-selling strategy. As discussed above,\nthis opinion should reflect sound judgment based on some combination of", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:301", "doc_id": "ec09851e45db29a1d0e0fbfc907b86593088a3c1f05db8d5a2c69d67b30adb67", "chunk_index": 0}
{"text": "technical analysis, fundamental analysis, volatility analysis, feel, and\nsubjectivity.\nA Safe Landing for an Iron Condor\nAlthough traders can’tcontrol what the market does, they can control how\nthey react to the market. Assume atrader has done due diligence in studying\nastock and feels it is aqualified candidate for aneutral strategy. With the\nstock at $90, a 16.5 percent implied volatility, and 41 days until expiration,\nthe standard deviation is about 5. The trader sells the following iron condor:\nWith the stock at $90, directly between the two short strikes, the trade is\ndirection neutral. The maximum profit is equal to the total premium taken\nin, which in this case is $800. The maximum loss is $4,200. There is about\natwo-thirds chance of retaining the $800 at expiration.\nAfter one week, the overall market begins trending higher on unexpected\nbullish economic news. This stock follows suit and is now trading at $93,\nand concern is mounting that the rally will continue. The value of the spread\nnow is about 1.10 per contract (we ignore slippage from trading on the bid-\nask spreads of the four legs of the spread). This means the trade has lost\n$300 because it would cost $1,100 to buy back what the trader sold for atotal of $800.\nOne strategy for managing this trade looking forward is inaction. The\nphilosophy is that sometimes these trades just don’twork out and you take\nyour lumps. The philosophy is that the winners should outweigh the losers\nover the long term. For some of the more talented and successful traders\nwith aproven track record, this may be aviable strategy, but there are more\nactive options as well. Atrader can either close the spread or adjust it.\nThe two sets of data that must be considered in this decision are the prices\nof the individual options and the greeks for the trade. Exhibit 10.8 shows\nthe new data with the stock at $93.\nEXHIBIT 10.8 Greeks for iron condor with stock at $93.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:302", "doc_id": "8554aa163cdc78c63279706271d975bc8e816667cbf301bfda938fec9ce91611", "chunk_index": 0}
{"text": "The trade is no longer neutral, as it was when the underlying was at $90.\nIt now has adelta of −2.54, which is like being short 254 shares of the\nunderlying. Although the more time that passes the better—as indicated by\nthe +0.230 theta—delta is of the utmost concern. The trader has now found\nhimself short amarket that he thinks may rally.\nClosing the entire position is one alternative. To be sure, if you don’thave\nan opinion on the underlying, you shouldn’thave aposition. It’slike\nmaking abet on asporting event when you don’treally know who you\nthink will win. The spread can also be dismantled piecemeal. First, the 85\nputs are valued at $0.07 each. Buying these back is ano-brainer. In the\nevent the stock does retrace, why have the positive delta of that leg working\nagainst you when you can eliminate the risk inexpensively now?\nThe 80 puts are worthless, offered at 0.05, presumably. There is no point\nin trying to sell these. If the market does turn around, they may benefit,\nresulting in an unexpected profit.\nThe 80 and 85 puts are the least of his worries, though. The concern is acontinuing rally. Clearly, the greater risk is in the 95–100 call spread.\nClosing the call spread for aloss eliminates the possibility of future losses\nand may be awise choice, especially if there is great uncertainty. Taking asmall loss now of only around $300 is abetter trade than risking atotal loss\nof $4,200 when you think there is astrong chance of that total loss\noccurring.\nBut if the trader is not merely concerned that the stock will rally but truly\nbelieves that there is agood chance it will, the most logical action is to\nposition himself for that expected move. Although there are many ways to\naccomplish this, the simplest way is to buy to close the 95 calls to eliminate\nthe position at that strike. This eliminates the short delta from the 95 calls,", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:303", "doc_id": "1a1dca2a21f29fb55e7a87c5fa09856911204953a2adab7ac576f1768df82658", "chunk_index": 0}
{"text": "The Retail Trader versus the Pro\nIron condors are very popular trades among retail traders. These days one\ncan hardly go to acocktail party and mention the word options without\nhearing someone tell astory about an iron condor on which he’smade abundle of money trading. Strangely, no one ever tells stories about trades in\nwhich he has lost abundle of money.\nTwo of the strengths of this strategy that attract retail traders are its\nlimited risk and high probability of success. Another draw of this type of\nstrategy is that the iron condor and the other wing spreads offer something\ntruly unique to the retail trader: away to profit from stocks that don’tmove.\nIn the stock-trading world, the only thing that can be traded is direction—\nthat is, delta. The iron condor is an approachable way for anonprofessional\nto dabble in nonlinear trading. The iron condor does agood job in\neliminating delta—unless, of course, the stock moves and gamma kicks in.\nIt is efficient in helping income-generating retail traders accomplish their\ngoals. And when aloss occurs, although it can be bigger than the potential\nprofits, it is finite.\nBut professional option traders, who have access to lots of capital and\nhave very low commissions and margin requirements, tend to focus their\nefforts in other directions: they tend to trade volatility. Although iron\ncondors are well equipped for profiting from theta when the stock\ncooperates, it is also possible to trade implied volatility with this strategy.\nThe examples of iron condors, condors, iron butterflies, and butterflies\npresented in this chapter so far have for the most part been from the\nperspective of the neutral trader: selling the guts and buying the wings. Atrader focusing on vega in any of these strategies may do just the opposite\n—buy the guts and sell the wings—depending on whether the trader is\nbullish or bearish on volatility.\nSay atrader, Joe, had abullish outlook on volatility in Salesforce.com\n(CRM). Joe could sell the following condor 100 times.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:305", "doc_id": "288988471f34119216a352c8b73b858c265985221f00641c918b24c50a830b67", "chunk_index": 0}
{"text": "In this example, February is 59 days from expiration. Exhibit 10.10 shows\nthe analytics for this trade with CRM at $104.32.\nEXHIBIT 10.10 Salesforce.com condor ( Salesforce.com at $104.32).\nAs expected with the underlying centered between the two middle strikes,\ndelta and gamma are about flat. As Salesforce.com moves higher or lower,\nthough, gamma and, consequently, delta will change. As the stock moves\ncloser to either of the long strikes, gamma will become more positive,\ncausing the delta to change favorably for Joe. Theta, however, is working\nagainst him with Salesforce.com at $104.32, costing $150 aday. In this\ninstance, movement is good. Joe benefits from increased realized volatility.\nThe best-case scenario would be if Salesforce.com moves through either of\nthe long strikes to, or through, either of the short strikes.\nThe prime objective in this example, though, is to profit from arise in IV.\nThe position has apositive vega. The position makes or loses $400 with\nevery point change in implied volatility. Because of the proportion of theta\nrisk to vega risk, this should be ashort-term play.\nIf Joe were looking for asmall rise in IV, say five points, the move would\nhave to happen within 13 calendar days, given the vega and theta figures.\nThe vega gain on arise of five vol points would be $2,000, and the theta\nloss over 13 calendar days would be $1,950. If there were stock movement\nassociated with the IV increase, that delta/gamma gain would offset some of\nthe havoc that theta wreaked on the option premiums. However, if Joe\ntraded astrategy like acondor as avol play, he would likely expect abigger", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:306", "doc_id": "2dbab39192f5f0328625f877037ece96f2257df10b3096713d4948e864b724c4", "chunk_index": 0}
{"text": "Buying the Calendar\nThe calendar spread and all its variations are commonly associated with\nincome-generating spreads. Using calendar spreads as income generators is\npopular among retail and professional traders alike. The process involves\nbuying alonger-term at-the-money option and selling ashorter-term at-the-\nmoney (ATM) option. The options must be either both calls or both puts.\nBecause this transaction results in anet debit—the longer-term option being\npurchased has ahigher premium than the shorter-term option being sold—\nthis is referred to as buying the calendar.\nThe main intent of buying acalendar spread for income is to profit from\nthe positive net theta of the position. Because the shorter-term ATM option\ndecays at afaster rate than the longer-term ATM option, the net theta is\npositive. As for most income spreads, the ideal outcome occurs when the\nunderlying is at the short strike (in this case, shared strike) when the\nshorter-term option expires. At this strike price, the long option has its\nhighest value, while the short option expires without the trader’sgetting\nassigned. As long as the underlying remains close to the strike price, the\nvalue of the spread rises as time passes, because the short option decreases\nin value faster than the long option.\nFor example, atrader, Richard, watches Bed Bath & Beyond Inc. (BBBY)\non aregular basis. Richard believes that Bed Bath & Beyond will trade in arange around $57.50 ashare (where it is trading now) over the next month.\nRichard buys the January–February 57.50 call calendar for 0.80. Assuming\nJanuary has 25 days until expiration and February has 53 days, Richard will\nexecute the following trade:\nRichard’sbest-case scenario occurs when the January calls expire at\nexpiration and the February calls retain much of their value.\nIf Richard created an at-expiration P&(L) diagram for his position, he’dhave trouble because of the staggered expiration months. Ageneral\nrepresentation would look something like Exhibit 11.1 .", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:311", "doc_id": "304cfeab3e68f4ffcffa824e6f7cf172580541ff700baf4e0de2dbd359f4a35e", "chunk_index": 0}
{"text": "EXHIBIT 11.1 Bed Bath & Beyond January–February 57.50 calendar.\nThe only point on the diagram that is drawn with definitive accuracy is\nthe maximum loss to the downside at expiration of the January call. The\nmaximum loss if Bed Bath & Beyond falls low enough is 0.80—the debit\npaid for the spread. If Bed Bath & Beyond is below $57.50 at January\nexpiration, the January 57.50 call expires worthless, and the February 57.50\ncall may or may not have residual value. If Bed Bath & Beyond declines\nenough, the February 57.50 call can lose all of its value, even with residual\ntime until expiration. If the stock falls enough, the entire 0.80 debit would\nbe aloss.\nIf Bed Bath & Beyond is above $57.50 at January expiration, the January\n57.50 call will be trading at parity. It will be anegative-100-delta option,\nimitating short stock. If Bed Bath & Beyond is trading high enough, the\nFebruary 57.50 call will become apositive-100-delta option trading at\nparity plus the interest calculated on the strike. The February deep-in-the-\nmoney option would imitate long stock. At a 2 percent interest rate, interest\non the 57.50 strike is about 0.17. Therefore, Richard would essentially have\nashort stock position from $57.50 from the January 57.50 call and would\nbe essentially long stock from $57.50 plus 0.28 from the February call. The\nmaximum loss to the upside is about 0.63 (0.80 − 0.17).\nThe maximum loss if Bed Bath & Beyond is trading over $57.50 at\nexpiration is only an estimate that assumes there is no time value and that", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:312", "doc_id": "c0a582b24e92e8d17c775754f1f56a062e7aef441f8a1a73d3c06cc8827fc573", "chunk_index": 0}
{"text": "interest and dividends remain constant. Ultimately, the maximum loss will\nbe 0.80, the premium paid, if there is no time value or carry considerations.\nThe maximum profit is gained if Bed Bath & Beyond is at $57.50 at\nexpiration. At this price, the February 57.50 call is worth the most it can be\nworth without having the January 57.50 call assigned and creating negative\ndeltas to the upside. But how much precisely is the maximum profit?\nRichard would have to know what the February 57.50 call would be worth\nwith Bed Bath & Beyond stock trading at $57.50 at February expiration\nbefore he can know the maximum profit potential. Although Richard can’tknow for sure at what price the calls will be trading, he can use apricing\nmodel to estimate the call’svalue. Exhibit 11.2 shows analytics at January\nexpiration.\nEXHIBIT 11.2 Bed Bath & Beyond January–February 57.50 call calendar\ngreeks at January expiration.\nWith an unchanged implied volatility of 23 percent, an interest rate of two\npercent, and no dividend payable before February expiration, the February\n57.50 calls would be valued at 1.53 at January expiration. In this best-case\nscenario, therefore, the spread would go from 0.80, where Richard\npurchased it, to 1.53, for again of 91 percent. At January expiration, with\nBed Bath & Beyond at $57.50, the January call would expire; thus, the\nspread is composed of just the February 57.50 call.\nLet’snow go back in time and see how Richard figured this trade. Exhibit\n11.3 shows the position when the trade is established.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:313", "doc_id": "21e294afb33e4665290807d8be1a9f0df510c510336204504a72b2d53a17d6f0", "chunk_index": 0}
{"text": "EXHIBIT 11.3 Bed Bath & Beyond January–February 57.50 call calendar.\nAsmall and steady rise in the stock price with enough time to collect\ntheta is the recipe for success in this trade. As time passes, delta will flatten\nout if Bed Bath & Beyond is still right at-the-money. The delta of the\nJanuary call that Richard is short will move closer to exactly −0.50. The\nFebruary call delta moves toward exactly +0.50.\nGamma and theta will both rise if Bed Bath & Beyond stays around the\nstrike. As expiration approaches, there is greater risk if there is movement\nand greater reward if there is not.\nVega is positive because the long-term option with the higher vega is the\nlong leg of the spread. When trading calendars for income, implied\nvolatility (IV) must be considered as apossible threat. Because it is\nRichard’sobjective to profit from Bed Bath & Beyond being at $57.50 at\nexpiration, he will try to avoid vega risk by checking that the implied\nvolatility of the February call is in the lower third of the 12-month range.\nHe will also determine if there are any impending events that could cause\nIV to change. The less likely IV is to drop, the better.\nIf there is an increase in IV, that may benefit the profitability of the trade.\nBut arise in IV is not really adesired outcome for two reasons. First, arise\nin IV is often more pronounced in the front month than in the months\nfarther out. If this happens, Richard can lose more on the short call than he\nmakes on the long call. Second, arise in IV can indicate anxiety and\ntherefore agreater possibility for movement in the underlying stock.\nRichard doesn’twant IV to rock the boat. “Buy low, stay low” is his credo.\nRho is positive also. Arise in interest rates benefits the position because\nthe long-term call is helped by the rise more than the short call is hurt. With", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:314", "doc_id": "d6fe17ae66b77f1cc2d9eb921324cd8d267ea95b32553cd34a7aa539c279f9cf", "chunk_index": 0}
{"text": "only aone-month difference between the two options, rho is very small.\nOverall, rho is inconsequential to this trade.\nThere is something curious to note about this trade: the gamma and the\nvega. Calendar spreads are the one type of trade where gamma can be\nnegative while vega is positive, and vice versa. While it appears—at least\non the surface—that Richard wants higher IV, he certainly wants low\nrealized volatility.\nBed Bath & Beyond January–February 57.50 Put\nCalendar\nRichard’sposition would be similar if he traded the January–February 57.50\nput calendar rather than the call calendar. Exhibit 11.4 shows the put\ncalendar.\nEXHIBIT 11.4 Bed Bath & Beyond January–February 57.50 put calendar.\nThe premium paid for the put spread is 0.75. Ahuge move in either\ndirection means aloss. It is about the same gamma/theta trade as the 57.50\ncall calendar. At expiration, with Bed Bath & Beyond at $57.50 and IV\nunchanged, the value of the February put would be 1.45—a 93 percent gain.\nThe position is almost exactly the same as the call calendar. The biggest\ndifference is that the rho is negative, but that is immaterial to the trade. As\nwith the call spread, being short the front-month option means negative\ngamma and positive theta; being long the back month means positive vega.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:315", "doc_id": "f9fd646f3e800c4c3c69efeccbaf3239a55248d6473c83c30be13c10242c0898", "chunk_index": 0}
{"text": "Managing an Income-Generating\nCalendar\nLet’ssay that instead of trading aone-lot calendar, Richard trades it 20\ntimes. His trade in this case is\nHis total cash outlay is $1,600 ($80 times 20). The greeks for this trade,\nlisted in Exhibit 11.5 , are also 20 times the size of those in Exhibit 11.3 .\nEXHIBIT 11.5 20-Lot Bed Bath & Beyond January–February 57.50 call\ncalendar.\nNote that Richard has a +0.18 delta. This means he’slong the equivalent\nof about 18 shares of stock—still pretty flat. Agamma of −0.72 means that\nif Bed Bath & Beyond moves $1 higher, his delta will be starting to get\nshort; and if it moves $1 lower he will be longer, long 90 deltas.\nRichard can use the greeks to get afeel for how much the stock can move\nbefore negative gamma causes aloss. If Bed Bath & Beyond starts trending\nin either direction, Richard may need to react. His plan is to cover his deltas\nto continue the position.\nSay that after one week Bed Bath & Beyond has dropped $1 to $56.50.\nRichard will have collected seven days of theta, which will have increased\nslightly from $18 per day to $20 per day. His average theta during that time\nis about $19, so Richard’sprofit attributed to theta is about $133.\nWith abig-enough move in either direction, Richard’sdelta will start\nworking against him. Since he started with adelta of +0.18 on this 20-lot", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:316", "doc_id": "2af328abec37e5b1e1dc774bce812165073a1ac99cc014aebc529659a22e4be1", "chunk_index": 0}
{"text": "spread and agamma of −0.72, one might think that his delta would increase\nto 0.90 with Bed Bath & Beyond adollar lower (18 − [−0.072 × 1.00]). But\nbecause aweek has passed, his delta would actually get somewhat more\npositive. The shorter-term call’sdelta will get smaller (closer to zero) at afaster rate compared to the longer-term call because it has less time to\nexpiration. Thus, the positive delta of the long-term option begins to\noutweigh the negative delta of the short-term option as time passes.\nIn this scenario, Richard would have almost broken even because what\nwould be lost on stock price movement, is made up for by theta gains.\nRichard can sell about 100 shares of Bed Bath & Beyond to eliminate his\nimmediate directional risk and stem further delta losses. The good news is\nthat if Bed Bath & Beyond declines more after this hedge, the profit from\nthe short stock offsets losses from the long delta. The bad news is that if\nBBBY rebounds, losses from the short stock offset gains from the long\ndelta.\nAfter Richard’shedge trade is executed, his delta would be zero. His\nother greeks remain unchanged. The idea is that if Bed Bath & Beyond\nstays at its new price level of $56.50, he reaps the benefits of theta\nincreasing with time from $18 per day. Richard is accepting the new price\nlevel and any profits or losses that have occurred so far. He simply adjusts\nhis directional exposure to azero delta.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:317", "doc_id": "af22aa69a8c9167ceabc200a22a37e44cd12db00aa755d3c37b79b42e926145f", "chunk_index": 0}
{"text": "Rolling and Earning a “Free” Call\nMany traders who trade income-generating strategies are conservative.\nThey are happy to sell low IV for the benefits afforded by low realized\nvolatility. This is the problem-avoidance philosophy of trading. Due to risk\naversion, it’scommon to trade calendar spreads by buying the two-month\noption and selling the one-month option. This can allow traders to avoid\nbuying the calendar in earnings months, and it also means ashorter time\nhorizon, signifying less time for something unwanted to happen.\nBut there’sanother school of thought among time-spread traders. There\nare some traders who prefer to buy alonger-term option—six months to ayear—while selling aone-month option. Why? Because month after month,\nthe trader can roll the short option to the next month. This is asimple tactic\nthat is used by market makers and other professional traders as well as\nsavvy retail traders. Here’show it works.\nXYZ stock is trading at $60 per share. Atrader has aneutral outlook over\nthe next six months and decides to buy acalendar. Assuming that July has\n29 days until expiration and December has 180, the trader will take the\nfollowing position:\nThe initial debit here is 2.55. The goal is basically the same as for any\ntime spread: collect theta without negative gamma spoiling the party. There\nis another goal in these trades as well: to roll the spread.\nAt the end of month one, if the best-case scenario occurs and XYZ is\nsitting at $60 at July expiration, the July 60 call expires. The December 60\ncall will then be worth 3.60, assuming all else is held constant. The positive\ntheta of the short July call gives full benefits as the option goes from 1.45 to\nzero. The lower negative theta of the December call doesn’tbite into profits\nquite as much as the theta of ashort-term call would.\nThe profit after month one is 1.05. Profit is derived from the December\ncall, worth 3.60 at July expiry, minus the 2.55 initial spread debit. This\nworks out to about a 41 percent return. The profit is hardly as good as it", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:318", "doc_id": "50f45bb982f4fd735043e45763ec918d7ad6ca0eb141c5e8a265b1f53b97c4cd", "chunk_index": 0}
{"text": "would have been if ashort-term, less expensive August 60 call were the\nlong leg of this spread.\nRolling the Spread\nThe July–December spread is different from short-term spreads, however.\nWhen the Julys expire, the August options will have 29 days until\nexpiration. If volatility is still the same, XYZ is still at $60, and the trader’sforecast is still neutral, the 29-day August 60 calls can be sold for 1.45. The\ntrader can either wait until the Monday after July expiration and then sell\nthe August 60s, or when the Julys are offered at 0.05 or 0.10, he can buy the\nJulys and sell the Augusts as aspread. In either case, it is called rolling the\nspread. When the August expires, he can sell the Septembers, and so on.\nThe goal is to get acredit month after month. At some point, the\naggregate credit from the call sales each month is greater than the price\ninitially paid for the long leg of the spread, thus eliminating the original net\ndebit. Exhibit 11.6 shows how the monthly credits from selling the one-\nmonth calls aggregate over time.\nEXHIBIT 11.6 A “free” call.\nAfter July has expired, 1.45 of premium is earned. After August\nexpiration, the aggregate increases to 2.90. When the September calls,\nwhich have 36 days until expiration, are sold, another 1.60 is added to the\ntotal premium collected. Over three months—assuming the stock price,\nvolatility, and the other inputs don’tchange—this trader collects atotal of\n4.50. That’s 0.50 more than the price originally paid for the December 60\ncall leg of the spread.\nAt this point, he effectively owns the December call for free. Of course,\nthis call isn’treally free; it’searned. It’spaid for with risk and maybe afew\nsleepless nights. At this point, even if the stock and, consequently, the", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:319", "doc_id": "35c5b22c19e4b23667328dce783c84052b386e606b077639a7d651f3d512251e", "chunk_index": 0}
{"text": "December call go to zero, the position is still aprofitable trade because of\nthe continued month-to-month rolling. This is now ano-lose situation.\nWhen the long call of the spread has been paid for by rolling, there are\nthree choices moving forward: sell it, hold it, or continue writing calls\nagainst it. If the trader’sopinion calls for the stock to decline, it’slogical to\nsell the December call and take the residual value as profit. In this case,\nover three months the trade will have produced 4.50 in premium from the\nsale of three consecutive one-month calls, which is more than the initial\npurchase price of the December call. At September expiration, the premium\nthat will be received for selling the December call is all profit, plus 0.50,\nwhich is the aggregate premium minus the initial cost of the December call.\nIf the outlook is for the underlying to rise, it makes sense to hold the call.\nAny appreciation in the value of the call resulting from delta gains as the\nunderlying moves higher is good—$0.50 plus whatever the call can be sold\nfor.\nIf the forecast is for XYZ to remain neutral, it’slogical to continue selling\nthe one-month call. Because the December call has been financed by the\naggregate short call premiums already, additional premiums earned by\nwriting calls are profit with “free” protection. As long as the short is closed\nat its expiration, the risk of loss is eliminated.\nThis is the general nature of rolling calls in acalendar spread. It’sabeautiful plan when it works! The problem is that it is incredibly unlikely\nthat the stock will stay right at $60 per share for five months. It’salmost\ninevitable that it will move at some point. It’slike agame of Russian\nroulette. At some point it’sgoing to be alosing proposition—you just don’tknow when. The benefit of rolling is that if the trade works out for afew\nmonths in arow, the long call is paid for and the risk of loss is covered by\naggregate profits.\nIf we step outside this best-case theoretical world and consider what is\nreally happening on aday-to-day basis, we can gain insight on how to\nmanage this type of trade when things go wrong. Effectively, along\ncalendar is atypical gamma/theta trade. Negative gamma hurts. Positive\ntheta helps.\nIf we knew which way the stock was going, we would simply buy or sell\nstock to adjust to get long or short deltas. But, unfortunately, we don’t. Our", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:320", "doc_id": "05a4f1b5b20fe5fd5bb54a35338ee60d0ef9cf163b4c3a5f71aed29b163d4263", "chunk_index": 0}
{"text": "Selling the Front, Buying the Back\nIf for aparticular stock, the February ATM calls are trading at 50 volatility\nand the May ATM calls are trading at 35 volatility, avol-calendar trader\nwould buy the Mays and sell the Februarys. Sounds simple, right? The devil\nis in the details. We’ll look at an example and then discuss some common\npitfalls with vol-trading calendars.\nGeorge has been studying the implied volatility of a $164.15 stock.\nGeorge notices that front-month volatility has been higher than that of the\nother months for acouple of weeks. There is nothing in the news to indicate\nimmediate risk of extraordinary movement occurring in this example.\nGeorge sees that he can sell the 22-day July 165 calls at a 45 percent IV\nand buy the 85-day September 165 calls at a 38 percent IV. George would\nlike to buy the calendar spread, because he believes the July ATM volatility\nwill drop down to around 38, where the September is trading. If he puts on\nthis trade, he will establish the following position:\nWhat are George’srisks? Because he would be selling the short-term\nATM option, negative gamma could be aproblem. The greeks for this trade,\nshown in Exhibit 11.7 , confirm this. The negative gamma means each\ndollar of stock price movement causes an adverse change of about 0.09 to\ndelta. The spread’sdelta becomes shorter when the stock rises and longer\nwhen the stock falls. Because the position’sdelta is long 0.369 from the\nstart, some price appreciation may be welcomed in the short term. The stock\nadvance will yield profits but at adiminishing rate, as negative gamma\nreduces the delta.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:323", "doc_id": "f3f889491722a5f223343565b0b8d9df3c513af374fe551a9b97f623600e0324", "chunk_index": 0}
{"text": "EXHIBIT 11.7 10-lot July–September 165 call calendar.\nBut just looking at the net position greeks doesn’ttell the whole story. It\nis important to appreciate the fact that long calendar spreads such as this\nhave long vegas. In this case, the vega is +1.522. But what does this number\nreally mean? This vega figure means that if IV rises or falls in both the July\nand the September calls by the same amount, the spread makes or loses\n$152 per vol point.\nGeorge’splan, however, is to see the July’svolatility decline to converge\nwith the September’s. He hopes the volatilities of the two months will move\nindependently of each other. To better gauge his risk, he needs to look at the\nvega of each option. With the stock at $164.15 the vegas are as follows:\nIf George is right and July volatility declines 8 points, from 46 to 38, he\nwill make $1,283 ($1.604 × 100 × 8).\nThere are acouple of things that can go awry. First, instead of the\nvolatilities converging, they can diverge further. Implied volatility is aslave\nto the whims of the market. If the July IV continues to rise while the\nSeptember IV stays the same, George loses $160 per vol point.\nThe second thing that can go wrong is the September IV declining along\nwith the July IV. This can lead George into trouble, too. It depends the\nextent to which the September volatility declines. In this example, the vega\nof the September leg is about twice that of the July leg. That means that if\nthe July volatility loses eight points while the September volatility declines\nfour points, profits from the July calls will be negated by losses from the\nSeptember calls. If the September volatility falls even more, the trade is aloser.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:324", "doc_id": "f72ab0c0db0770cb15e2f6617f76627e4c902c6b2f462fc23554dfbc44459a2e", "chunk_index": 0}
{"text": "IV is acommon cause of time-spread failure for market makers. When iin the front month rises, the volatility of the back-months sometimes does\nas well. When this happens, it’soften because market makers who sold\nfront-month options to retail or institutional buyers buy the back-month\noptions to hedge their short-gamma risk. If the market maker buys enough\nback-month options, he or she will accumulate positive vega. But when the\nmarket sells the front-month volatility back to the market makers, the back\nmonths drop, too, because market makers no longer need the back months\nfor ahedge.\nTraders should study historical implied volatility to avoid this pitfall. As\nis always the case with long vega strategies, there is arisk of adecline in\nIV. Buying long-term options with implied volatility in the lower third of\nthe 12-month IV range helps improve the chances of success, since the\nvolatility being bought is historically cheap.\nThis can be tricky, however. If atrader looks back on achart of IV for an\noption class and sees that over the past six months it has ranged between 20\nand 30 but nine months ago it spiked up to, say, 55, there must be areason.\nThis solitary spike could be just an anomaly. To eliminate the noise from\nvolatility charts, it helps to filter the data. News stories from that time\nperiod and historical stock charts will usually tell the story of why volatility\nspiked. Often, it is aone-time event that led to the spike. Is it reasonable to\ninclude this unique situation when trying to get afeel for the typical range\nof implied volatility? Usually not. This is ajudgment call that needs to be\nmade on acase-by-case basis. The ultimate objective of this exercise is to\ndetermine: “Is volatility cheap or expensive?”", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:325", "doc_id": "64e770baa9edaf891085d3d88d8d879c8c457eec8d8cadacacb7fedf51fbff61", "chunk_index": 0}
{"text": "Buying the Front, Selling the Back\nAll trading is based on the principle of “buy low, sell high”—even volatility\ntrading. With time spreads, we can do both at once, but we are not limited\nto selling the front and buying the back. When short-term options are\ntrading at alower IV than long-term ones, there may be an opportunity to\nsell the calendar. If the IV of the front month is 17 and the back-month IV is\n25, for example, it could be awise trade to buy the front and sell the back.\nBut selling time spreads in this manner comes with its own unique set of\nrisks.\nFirst, ashort calendar’sgreeks are the opposite of those of along\ncalendar. This trade has negative theta with positive gamma. Asideways\nmarket hurts this position as negative theta does its damage. Each day of\ncarrying the position is paid for with time decay.\nThe short calendar is also ashort-vega trade. At face value, this implies\nthat adrop in IV leads to profit and that the higher the IV sold in the back\nmonth, the better. As with buying acalendar, there are some caveats to this\nlogic.\nIf there is an across-the-board decline in IV, the net short vega will lead to\naprofit. But an across-the-board drop in volatility, in this case, is probably\nnot arealistic expectation. The front month tends to be more sensitive to\nvolatility. It is acommon occurrence for the front month to be “cheap”\nwhile the back month is “expensive.”\nThe volatilities of the different months can move independently, as they\ncan when one buys atime spread. There are acouple of scenarios that might\nlead to the back-month volatility’sbeing higher than the front month. One is\nhigh complacency in the short term. When the market collectively sells\noptions in expectation of lackluster trading, it generally prefers to sell the\nshort-term options. Why? Higher theta. Because the trade has less time until\nexpiration, the trade has ashorter period of risk. Because of this, selling\npressure can push down IV in the front-month options more than in the\nback. Again, the front month is more sensitive to changes in implied\nvolatility.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:326", "doc_id": "59201a6d4047e0090e6a49b49374639c9e9ba0ff2a6a02037c5b5941f7ebc72a", "chunk_index": 0}
{"text": "Because volatility has peaks and troughs, this can be asmart time to sell acalendar. The focus here is in seeing the “cheap” front month rise back up\nto normal levels, not so much in seeing the “expensive” back month fall.\nThis trade is certainly not without risk. If the market doesn’tmove, the\nnegative theta of the short calendar leads to aslow, painful death for\ncalendar sellers.\nAnother scenario in which the back-month volatility can trade higher than\nthe front is when the market expects higher movement after the expiration\nof the short-term option but before the expiration of the long-term option.\nSituations such as the expectation of the resolution of alawsuit, aproduct\nannouncement, or some other one-time event down the road are\nopportunities for the market to expect such movement. This strategy\nfocuses on the back-month vol coming back down to normal levels, not on\nthe front-month vol rising. This can be amore speculative situation for avolatility trade, and more can go wrong.\nThe biggest volatility risk in selling atime spread is that what goes up can\ncontinue to go up. The volatility disparity here is created by hedgers and\nspeculators favoring long-term options, hence pushing up the volatility, in\nanticipation of abig future stock move. As the likely date of the anticipated\nevent draws near, more buyers can be attracted to the market, driving up IV\neven further. Realized volatility can remain low as investors and traders lie\nin wait. This scenario is doubly dangerous when volatility rises and the\nstock doesn’tmove. Atrader can lose on negative theta and lose on negative\nvega.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:327", "doc_id": "021be0dc82e8774f9be39dc3572418f6d340444f67a37532ed24364f31eed9fb", "chunk_index": 0}
{"text": "A Directional Approach\nCalendar spreads are often purchased when the outlook for the underlying is\nneutral. Sell the short-term ATM option; buy the long-term ATM option;\ncollect theta. But with negative gamma, these trades are never really\nneutral. The delta is constantly changing, becoming more positive or\nnegative. It’slike arubber band: at times being stretched in either direction\nbut always demanding apull back to the strike. When the strike price being\ntraded is not ATM, calendar spreads can be strategically traded as\ndirectional plays.\nBuying acalendar, whether using calls or puts, where the strike price is\nabove the current stock price is abullish strategy. With calls, the positive\ndelta of the long-term out-of-the-money (OTM) call will be greater than the\nnegative delta of the short-term OTM call. For puts, the positive delta of the\nshort-term in-the-money (ITM) put will be greater than the negative delta of\nthe long-term ITM put.\nJust the opposite applies if the strike price is below the current stock\nprice. The negative delta of the short-term ITM call is greater than the\npositive delta of the long-term ITM call. The negative delta of the long-term\nOTM put is greater than the positive delta of the short-term OTM put.\nWhen the position starts out with either apositive or negative delta,\nmovement in the direction of the delta is necessary for the trade to be\nprofitable. Negative gamma is also an important strategic consideration.\nStock-price movement is needed, but not too much.\nBuying calendar spreads is like playing outfield in abaseball game. To\ncatch afly ball, an outfielder must focus on both distance and timing. He\nmust gauge how far the ball will be hit and how long it will take to get\nthere. With calendars, the distance is the strike price—that’swhere the stock\nneeds to be—and the time is the expiration day of the short month’soption:\nthat’swhen it needs to be at the target price.\nFor example, with Wal-Mart (WMT) at $48.50, atrader, Pete, is looking\nfor arise to about $50 over the next five or six weeks. Pete buys the\nAugust–September call calendar. In this example, August has 39 days until\nexpiration and September has 74 days.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:328", "doc_id": "2773ed5f416fb31e9563262a212c64aea1ffc7983ee48ec910ad066330f8135c", "chunk_index": 0}
{"text": "Exactly what does 50 cents buy Pete? The stock price sitting below the\nstrike price means anet positive delta. This long time spread also has\npositive theta and vega. Gamma is negative. Exhibit 11.8 shows the\nspecifics.\nEXHIBIT 11.8 10-lot Wal-Mart August–September 50 call calendar.\nThe delta of this trade, while positive, is relatively small with 39 days left\nuntil August expiration. It’snot rational to expect aquick profit if the stock\nadvances faster than expected. But ultimately, arise in stock price is the\ngoal. In this example, Wal-Mart needs to rise to $50, and timing is\neverything. It needs to be at that price in 39 days. In the interim, amove too\nbig and too fast in either direction hurts the trade because of negative\ngamma. Starting with Wal-Mart at $48.50, delta/gamma problems are worse\nto the downside. Exhibit 11.9 shows the effects of stock price on delta,\ngamma, and theta.\nEXHIBIT 11.9 Stock price movement and greeks.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:329", "doc_id": "119c60f6a4ab2f64b7e2cb4cf1cb52c75101801a38035ddfc8f4506a8e49520f", "chunk_index": 0}
{"text": "The In-or-Out Crowd\nPete could just as well have traded the Aug–Sep 50 put calendar in this\nsituation. If he’dbeen bearish, he could have traded either the Aug–Sep 45\ncall spread or the Aug–Sep 45 put spread. Whether bullish or bearish, as\nmentioned earlier, the call calendar and the put calendar both function about\nthe same. When deciding which to use, the important consideration is that\none of them will be in-the-money and the other will be OTM. Whether you\nhave an ITM spread or an OTM spread has potential implications for the\nsuccess of the trade.\nThe bid-ask spreads tend to be wider for higher-delta, ITM options.\nBecause of this, it can be more expensive to enter into an ITM calendar.\nWhy? Trading options with wider markets requires conceding more edge.\nTake the following options series:\nBy buying the May 50 calls at 3.20, atrader gives up 0.10 of theoretical\nedge (3.20 is 0.10 higher than the theoretical value). Buying the put at 1.00\nmeans buying only 0.05 over theoretical.\nBecause acalendar is atwo-legged spread, the double edge given up by\ntrading the wider markets of two in-the-money options can make the out-of-\nthe-money spread amore attractive trade. The issue of wider markets is\ncompounded when rolling the spread. Giving up anickel or adime each\nmonth can add up, especially on nominally low-priced spreads. It can cut\ninto ahigh percentage of profits.\nEarly assignment can complicate ITM calendars made up of American\noptions, as dividends and interest can come into play. The short leg of the\nspread could get assigned before the expiration date as traders exercise calls\nto capture the dividend. Short ITM puts may get assigned early because of\ninterest.\nAlthough assignment is an undesirable outcome for most calendar spread\ntraders, getting assigned on the short leg of the calendar spread may not\nnecessarily create asignificantly different trade. If along put calendar, for", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:331", "doc_id": "9580cfe4c5874d215410e39e61215340d29fd97523f3b9601c94585b75a607d3", "chunk_index": 0}
{"text": "Double Calendars\nDefinition : Adouble calendar spread is the execution of two calendar\nspreads that have the same months in common but have two different strike\nprices.\nExample\nSell 1 XYZ February 70 call\nBuy 1 XYZ March 70 call\nSell 1 XYZ February 75 call\nBuy 1 XYZ March 75 call\nDouble calendars can be traded for many reasons. They can be vega\nplays. If there is avolatility-time skew, adouble calendar is away to take aposition without concentrating delta or gamma/theta risk at asingle strike.\nThis spread can also be agamma/theta play. In that case, there are two\nstrikes, so there are two potential focal points to gravitate to (in the case of\nalong double calendar) or avoid (in the case of ashort double calendar).\nSelling the two back-month strikes and buying the front-month strikes\nleads to negative theta and positive gamma. The positive gamma creates\nfavorable deltas when the underlying moves. Positive or negative deltas can\nbe covered by trading the underlying stock. With positive gamma, profits\ncan be racked up by buying the underlying to cover short deltas and\nsubsequently selling the underlying to cover long deltas.\nBuying the two back-month strikes and selling the front-month strikes\ncreates negative gamma and positive theta, just as in aconventional\ncalendar. But the underlying stock has two target price points to shoot for at\nexpiration to achieve the maximum payout.\nOften double calendars are traded as IV plays. Many times when they are\ntraded as IV plays, traders trade the lower-strike spread as aput calendar\nand the higher-strike spread acall calendar. In that case, the spread is\nsometimes referred to as astrangle swap . Strangles are discussed in\nChapter 15.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:333", "doc_id": "637309e2021a03b89c2139ba9506916c0440c31326ab3e5b77aba4529e3206a4", "chunk_index": 0}
{"text": "Two Courses of Action\nAlthough there may be many motivations for trading adouble calendar,\nthere are only two courses of action: buy it or sell it. While, for example,\nthe trader’sgoal may be to capture theta, buying adouble calendar comes\nwith the baggage of the other greeks. Fully understanding the\ninterrelationship of the greeks is essential to success. Option traders must\ntake aholistic view of their positions.\nLet’slook at an example of buying adouble calendar. In this example,\nMinnesota Mining & Manufacturing (MMM) has been trading in arange\nbetween about $85 and $97 per share. The current price of Minnesota\nMining & Manufacturing is $87.90. Economic data indicate no specific\nreasons to anticipate that Minnesota Mining & Manufacturing will deviate\nfrom its recent range over the next month—that is, there is nothing in the\nnews, no earnings anticipated, and the overall market is stable. August IV is\nhigher than October IV by one volatility point, and October implied\nvolatility is in line with 30-day historical volatility. There are 38 days until\nAugust expiration, and 101 days until October expiration.\nThe Aug–Oct 85–90 double calendar can be traded at the following\nprices:\nMuch like atraditional calendar spread, the price points cannot be\ndefinitively plotted on a P&(L) diagram. What is known for certain is that at\nAugust expiration, the maximum loss is $3,200. While it’scomforting to\nknow that there is limited loss, losing the entire premium that was paid for\nthe spread is an outcome most traders would like to avoid. We also know\nthe maximum gains occur at the strike prices; but not exactly what the\nmaximum profit can be. Exhibit 11.10 provides an alternative picture of the\nposition that is useful in managing the trade on aday-to-day basis.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:334", "doc_id": "76941dd47cb7ae205f8481b8d9844638e31ee01dc350563e10b93682fe535efb", "chunk_index": 0}
{"text": "EXHIBIT 11.10 10-lot Minnesota Mining & Manufacturing Aug–Oct 85–\n90 double call calendar.\nThese numbers are agood representation of the position’srisk. Knowing\nthat long calendars and long double calendars have maximum losses at the\nexpiration of the short-term option equal to the net premiums paid, the max\nloss in this example is 3.20. Break-even prices are not relevant to this\nposition because they cannot be determined with any certainty. What is\nimportant is to get afeel for how much movement can hurt the position.\nTo make $19 aday in theta, a −0.468 gamma must be accepted. In the\nlong run, $1 of movement is irrelevant. In fact, some movement is favorable\nbecause the ideal point for MMM to be at, at August expiration is either $85\nor $90. So while small moves are acceptable, big moves are of concern. The\nnegative gamma is an illustration of this warning.\nThe other risk besides direction is vega. Apositive 1.471 vega means the\ncalendar makes or loses about $147 with each one-point across-the-board\nchange in implied volatility. Implied volatility is arisk in all calendar\ntrades. Volatility was one of the criteria studied when considering this trade.\nRecall that the August IV was one point higher than the October and that\nthe October IV was in line with the 30-day historical volatility at inception\nof the trade.\nConsidering the volatility data is part of the due diligence when\nconsidering acalendar or adouble calendar. First, the (slightly) more\nexpensive options (August) are being sold, and the cheaper ones are being\nbought (October). Astudy of the company reveals no news to lead one to\nbelieve that Minnesota Mining & Manufacturing should move at ahigher\nrealized volatility than it currently is in this example. Therefore, the front", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:335", "doc_id": "ec5f5426c81cbf9ea9676f1cc4f0966f71232e3b759c2ddd7cf9b0f3a018d3a8", "chunk_index": 0}
{"text": "Diagonals\nDefinition : Adiagonal spread is an option strategy that involves buying one\noption and selling another option with adifferent strike price and with adifferent expiration date. Diagonals are another strategy in the time spread\nfamily.\nDiagonals enable atrader to exploit opportunities similar to those\nexploited by acalendar spread, but because the options in adiagonal spread\nhave two different strike prices, the trade is more focused on delta. The\nname diagonal comes from the fact that the spread is acombination of ahorizontal spread (two different months) and avertical spread (two different\nstrikes).\nSay it’s 22 days until January expiration and 50 days until February\nexpiration. Apple Inc. (AAPL) is trading at $405.10. Apple has been in an\nuptrend heading toward the peak of its six-month range, which is around\n$420. Atrader, John, believes that it will continue to rise and hit $420 again\nby February expiration. Historical volatility is 28 percent. The February 400\ncalls are offered at a 32 implied volatility and the January 420 calls are bid\non a 29 implied volatility. John executes the following diagonal:\nExhibit 11.11 shows the analytics for this trade.\nEXHIBIT 11.11 Apple January–February 400–420 call diagonal.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:337", "doc_id": "3d0a511b241081d11e2afc7b2da8dc9d6a2c2ae1f5ebb2e098e8178e90d812fb", "chunk_index": 0}
{"text": "From the presented data, is this agood trade? The answer to this question\nis contingent on whether the position John is taking is congruent with his\nview of direction and volatility and what the market tells him about these\nelements.\nJohn is bullish up to August expiration, and the stock in this example is in\nan uptrend. Any rationale for bullishness may come from technical or\nfundamental analysis, but techniques for picking direction, for the most\npart, are beyond the scope of this book. Buying the lower strike in the\nFebruary option gives this trade amore positive delta than astraight\ncalendar spread would have. The trader’sdelta is 0.255, or the equivalent of\nabout 25.5 shares of Apple. This reflects the trader’sdirectional view.\nThe volatility is not as easy to decipher. Aspecific volatility forecast was\nnot stated above, but there are afew relevant bits of information that should\nbe considered, whether or not the trader has aspecific view on future\nvolatility. First, the historical volatility is 28 percent. That’slower than\neither the January or the February calls. That’snot ideal. In aperfect world,\nit’sbetter to buy below historical and sell above. To that point, the February\noption that John is buying has ahigher volatility than the January he is\nselling. Not so good either. Are these volatility observations deal breakers?", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:338", "doc_id": "8789a63a293a395072f909608bb5897621a8e405659d1a9c1f53c2aa6d2c28d1", "chunk_index": 0}
{"text": "A Good Ex-Skews\nIt’simportant to take skew into consideration. Because the January calls\nhave ahigher strike price than the February calls, it’slogical for them to\ntrade at alower implied volatility. Is this enough to justify the possibility of\nselling the lower volatility? Consider first that there is some margin for\nerror. The bid-ask spreads of each of the options has avolatility disparity. In\nthis case, both the January and February calls are 10 cents wide. That means\nwith a January vega of 0.34 the bid-ask is about 0.29 vol points wide. The\nFebruarys have a 0.57 vega. They are about 0.18 vol points wide. That\naccounts for some of the disparity. Natural vertical skew accounts for the\nrest of the difference, which is acceptable as long as the skew is not\nabnormally pronounced.\nAs for other volatility considerations, this diagonal has the rather\nunorthodox juxtaposition of positive vega and negative gamma seen with\nother time spreads. The trader is looking for amove upward, but not abig\none. As the stock rises and Apple moves closer to the 420 strike, the\npositive delta will shrink and the negative gamma will increase. In order to\ncontinue to enjoy profits as the stock rises, John may have to buy shares of\nApple to keep his positive delta. The risk here is that if he buys stock and\nApple retraces, he may end up negative scalping stock. In other words, he\nmay sell it back at alower price than he bought it. Using stock to adjust the\ndelta in anegative-gamma play can be risky business. Gamma scalping is\naddressed further in Chapter 13.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:339", "doc_id": "505542869f7e153613e607e0e063bb515e84e650a37888ac815a3222c4153189", "chunk_index": 0}
{"text": "Making the Most of Your Options\nThe trader from the previous example had atime-spread alternative to the\ndiagonal: John could have simply bought atraditional time spread at the\n420 strike. Recall that calendars reap the maximum reward when they are at\nthe shared strike price at expiration of the short-term option. Why would he\nchoose one over the other?\nThe diagonal in that example uses alower-strike call in the February than\nastraight 420 calendar spread and therefore has ahigher delta, but it costs\nmore. Gamma, theta, and vega may be slightly lower with the in-the-money\ncall, depending on how far from the strike price the ITM call is and how\nmuch time until expiration it has. These, however, are less relevant\ndifferences.\nThe delta of the February 400 call is about 0.57. The February 420 call,\nhowever, has only a 0.39 delta. The 0.18 delta difference between the calls\nmeans the position delta of the time spread will be only about 0.07 instead\nof about 0.25 of the diagonal—abig difference. But the trade-off for lower\ndelta is that the February 420 call can be bought for 12.15. That means alower debit paid—that means less at risk. Conversely, though there is\ngreater risk with the diagonal, the bigger delta provides abigger payoff if\nthe trader is right.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:340", "doc_id": "93320660db2a4835c33a1c98a148d501bed804bf2e3e63074e2253aca449ce1f", "chunk_index": 0}
{"text": "Double Diagonals\nAdouble diagonal spread is the simultaneous trading of two diagonal\nspreads: one call spread and one put spread. The distance between the\nstrikes is the same in both diagonals, and both have the same two expiration\nmonths. Usually, the two long-term options are more out-of-the-money than\nthe two shorter-term options. For example\nBuy 1 XYZ May 70 put\nSell 1 XYZ March 75 put\nSell 1 XYZ March 85 call\nBuy 1 XYZ May 90 call\nLike many option strategies, the double diagonal can be looked at from anumber of angles. Certainly, this is atrade composed of two diagonal\nspreads—the March–May 70–75 put and the March–May 85–90 call. It is\nalso two strangles—buying the May 70–90 strangle and selling the March\n75–85 strangle. One insightful way to look at this spread is as an iron\ncondor in which the guts are March options and the wings are May options.\nTrading adouble diagonal like this one, rather than atypically positioned\niron condor, can offer afew advantages. The first advantage, of course, is\ntheta. Selling short-term options and buying long-term options helps the\ntrader reap higher rates of decay. Theta is the raison d’être of the iron\ncondor. Asecond advantage is rolling. If the underlying asset stays in arange for along period of time, the short strangle can be rolled month after\nmonth. There may, in some cases, also be volatility-term-structure\ndiscrepancies on which to capitalize.\nAtrader, Paul, is studying JPMorgan (JPM). The current stock price is\n$49.85. In this example, JPMorgan has been trading in apretty tight range\nover the past few months. Paul believes it will continue to do so over the\nnext month. Paul considers the following trade:", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:341", "doc_id": "8c64a964ebd3be32382c3e8729b3230d1a1c8c324f4bab68c7a169e7a9cd8a46", "chunk_index": 0}
{"text": "Paul considers volatility. In this example, the JPMorgan ATM call, the\nAugust 50 (which is not shown here), is trading at 22.9 percent implied\nvolatility. This is in line with the 20-day historical volatility, which is 23\npercent. The August IV appears to be reasonably in line with the September\nvolatility, after accounting for vertical skew. The IV of the August 52.50\ncalls is 1.5 points above that of the September 55 calls and the August 47.50\nput IV is 1.6 points below the September 45 put IV. It appears that neither\nmonth’svolatility is cheap or expensive.\nExhibit 11.12 shows the trade’sgreeks.\nEXHIBIT 11.12 10-lot JPMorgan August–September 45–47.50–52.50–55\ndouble diagonal.\nThe analytics of this trade are similar to those of an iron condor.\nImmediate directional risk is almost nonexistent, as indicated by the delta.\nBut gamma and theta are high, even higher than they would be if this were\nastraight September iron condor, although not as high as if this were an\nAugust iron condor.\nVega is positive. Surely, if this were an August or a September iron\ncondor, vega would be negative. In this example, Paul is indifferent as to\nwhether vega is positive or negative because IV is fairly priced in terms of\nhistorical volatility and term structure. In fact, to play it close to the vest,\nPaul probably wants the smallest vega possible, in case of an IV move.\nWhy take on the risk?\nThe motivation for Paul’sdouble diagonal was purely theta. The\nvolatilities were all in line. And this one-month spread can’tbe rolled. If\nPaul were interested in rolling, he could have purchased longer-term", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:342", "doc_id": "51a3b10dfdd56a6a6cb130a5179f548bdb5069afcc27fe5b700937096ddeb295", "chunk_index": 0}
{"text": "Direction Neutral versus Direction\nIndifferent\nIn the world of nonlinear trading, there are two possible nondirectional\nviews of the underlying asset: direction neutral and direction indifferent.\nDirection neutral means the trader believes the stock will not trend either\nhigher or lower. The trader is neutral in his or her assessment of the future\ndirection of the asset. Short iron condors, long time spreads, and out-of-the-\nmoney (OTM) credit spreads are examples of direction-neutral strategies.\nThese strategies generally have deltas close to zero. Because of negative\ngamma, movement is the bane of the direction-neutral trade.\nDirection indifferent means the trader may desire movement in the\nunderlying but is indifferent as to whether that movement is up or down.\nSome direction-indifferent trades are almost completely insulated from\ndirectional movement, with afocus on interest or dividends instead.\nExamples of these types of trades are conversions, reversals, and boxes,\nwhich are described in Chapter 6, as well as dividend plays, which are\ndescribed in Chapter 8.\nOther direction-indifferent strategies are long option strategies that have\npositive gamma. In these trades, the focus is on movement, but the direction\nof that movement is irrelevant. These are plays that are bullish on realized\nvolatility. Yet other direction-indifferent strategies are volatility plays from\nthe perspective of IV. These are trades in which the trader’sintent is to take\nabullish or bearish position in IV.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:349", "doc_id": "d4d500b7ac0e12c8d4763ea15670e37b54a99da6a034df7f50793ee4cc025166", "chunk_index": 0}
{"text": "Delta Neutral\nTo be truly direction neutral or direction indifferent means to have adelta\nequal to zero. In other words, there are no immediate gains if the underlying\nmoves incrementally higher or lower. This zero-delta method of trading is\ncalled delta-neutral trading .\nAdelta-neutral position can be created from any option position simply\nby trading stock to flatten out the delta. Avery basic example of adelta-\nneutral trade is along at-the-money (ATM) call with short stock.\nConsider atrade in which we buy 20 ATM calls that have a 50 delta and\nsell stock on adelta-neutral ratio.\nBuy 20 50-delta calls (long 1,000 deltas)\nShort 1,000 shares (short 1,000 deltas)\nIn this position, we are long 1,000 deltas from the calls (20 × 50) and\nshort 1,000 deltas from the short sale of stock. The net delta of the position\nis zero. Therefore, the immediate directional exposure has been eliminated\nfrom the trade. But intuitively, there are other opportunities for profit or loss\nwith this trade.\nThe addition of short stock to the calls will affect only the delta, not the\nother greeks. The long calls have positive gamma, negative theta, and\npositive vega. Exhibit 12.1 is asimplified representation of the greeks for\nthis trade.\nEXHIBIT 12.1 20-lot delta-neutral long call.\nWith delta not an immediate concern, the focus here is on gamma, theta,\nand vega. The +1.15 vega indicates that each one-point change in IV makes\nor loses $115 for this trade. Yet there is more to the volatility story. Each\nday that passes costs the trader $50 in time decay. Holding the position for", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:350", "doc_id": "dc937783f1b93d7d13389a5ee91d0fba0532d71544d3a81d7176885d077ba83d", "chunk_index": 0}
{"text": "an extended period of time can produce aloser even if IV rises. Gamma is\npotentially connected to the success of this trade, too. If the underlying\nmoves in either direction, profit from deltas created by positive gamma may\noffset the losses from theta. In fact, abig enough move in either direction\ncan produce aprofitable trade, regardless of what happens to IV.\nImagine, for amoment, that this trade is held until expiration. If the stock\nis below the strike price at this point, the calls expire. The resulting position\nis short 1,000 shares of stock. If the stock is above the strike price at\nexpiration, the calls can be exercised, creating 2,000 shares of long stock.\nBecause the trade is already short 1,000 shares, the resulting net position is\nlong 1,000 shares (2,000 − 1,000). Clearly, the more the underlying stock\nmoves in either direction the greater the profit potential. The underlying has\nto move far enough above or below the strike price to allow the beneficial\ngains from buying or selling stock to cover the option premium lost from\ntime decay. If the trade is held until expiration, the underlying needs to\nmove far enough to cover the entire premium spent on the calls.\nThe solid lines forming a Vin Exhibit 12.2 conceptually illustrate the\nprofit or loss for this delta-neutral long call at expiration.\nEXHIBIT 12.2 Profit-and-loss diagram for delta-neutral long-call trade.\nBecause of gamma, some deltas will be created by movement of the\nunderlying before expiration. Gamma may lead to this being aprofitable", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:351", "doc_id": "1acd7fe2b870c77fdf62636250404bc8f5f2098b300a3600fe58da672d44719d", "chunk_index": 0}
{"text": "Why Trade Delta Neutral?\nAfew years ago, Iwas teaching aclass on option trading. Before the\nseminar began, Iwas talking with one of the students in attendance. Iasked\nhim what he hoped to learn in the class. He said that he was really\ninterested in learning how to trade delta neutral. When Iasked him why he\nwas interested in that specific area of trading, he replied, “Ihear that’swhere all the big money is made!”\nThis observation, right or wrong, probably stems from the fact that in the\npast most of the trading in this esoteric discipline has been executed by\nprofessional traders. There are two primary reasons why the pros have\ndominated this strategy: high commissions and high margin requirements\nfor retail traders. Recently, these two reasons have all but evaporated.\nFirst, the ultracompetitive world of online brokers has driven\ncommissions for retail traders down to, in some cases, what some market\nmakers pay. Second, the oppressive margin requirements that retail option\ntraders were subjected to until 2007 have given way to portfolio margining.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:353", "doc_id": "ba975aee101e611a1db10d218938e2f6fabfed4ee661dfe348fbd5c445ee3dd1", "chunk_index": 0}
{"text": "Portfolio Margining\nCustomer portfolio margining is amethod of calculating customer margin\nin which the margin requirement is based on the “up and down risk” of the\nportfolio. Before the advent of portfolio margining, retail traders were\nsubject to strategy-based margining, also called Reg. Tmargining, which in\nmany cases required asignificantly higher amount of capital to carry aposition than portfolio margining does.\nWith portfolio margining, highly correlated securities can be offset\nagainst each other for purposes of calculating margin. For example, SPX\noptions and SPY options—both option classes based on the Standard &\nPoor’s 500 Index—can be considered together in the margin calculation. Abearish position in one and abullish position in the other may partially\noffset the overall risk of the portfolio and therefore can help to reduce the\noverall margin requirement.\nWith portfolio margining, many strategies are margined in such away\nthat, from the point of view of this author, they are subject to amuch more\nlogical means of risk assessment. Strategy-based margining required traders\nof some strategies, like aprotective put, to deposit significantly more\ncapital than one could possibly lose by holding the position. The old rules\nrequire aminimum margin of 50 percent of the stock’svalue and up to 100\npercent of the put premium. Aportfolio-margined protective put may\nrequire only afraction of what it would with strategy-based margining.\nEven though Reg. Tmargining is antiquated and sometimes unreasonable,\nmany traders must still abide by these constraints. Not all traders meet the\neligibility requirements to qualify for portfolio-based margining. There is aminimum account balance for retail traders to be eligible for this treatment.\nAbroker may also require other criteria to be met for the trader to benefit\nfrom this special margining. Ultimately, portfolio margining allows retail\ntraders to be margined similarly to professional traders.\nThere are some traders, both professional and otherwise, who indeed have\nmade “big money,” as the student in my class said, trading delta neutral.\nBut, to be sure, there are successful and unsuccessful traders in many areas", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:354", "doc_id": "fac2e662377761384f476ab3ff9249095336f6d564dc38f502705b8a14897c8c", "chunk_index": 0}
{"text": "Trading Implied Volatility\nWith atypical option, the sensitivity of delta overshadows that of vega. To\ntry and profit from arise or fall in IV, one has to trade delta neutral to\neliminate immediate directional sensitivity. There are many strategies that\ncan be traded as delta-neutral IV strategies simply by adding stock.\nThroughout this chapter, Iwill continue using asingle option leg with\nstock, since it provides asimple yet practical example. It’simportant to note\nthat delta-neutral trading does not refer to aspecific strategy; it refers to the\nfact that the trader is indifferent to direction. Direction isn’tbeing traded,\nvolatility is.\nVolatility trading is fundamentally different from other types of trading.\nWhile stocks can rise to infinity or decline to zero, volatility can’t. Implied\nvolatility, in some situations, can rise to lofty levels of 100, 200, or even\nhigher. But in the long-run, these high levels are not sustainable for most\nstocks. Furthermore, an IV of zero means that the options have no extrinsic\nvalue at all. Now that we have established that the thresholds of volatility\nare not as high as infinity and not as low as zero, where exactly are they?\nThe limits to how high or low IV can go are not lines in the sand. They are\nmore like tides that ebb and flow, but normally come up only so far onto the\nbeach.\nThe volatility of an individual stock tends to trade within arange that can\nbe unique to that particular stock. This can be observed by studying achart\nof recent volatility. When IV deviates from the range, it is typical for it to\nreturn to the range. This is called reversion to the mean , which was\ndiscussed in Chapter 3. IV can get stretched in either direction like arubber\nband but then tends to snap back to its original shape.\nThere are many examples of situations where reversion to the mean enters\ninto trading. In some, volatility temporarily dips below the typical range,\nand in some, it rises beyond the recent range. One of the most common\nexamples is the rush and the crush.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:356", "doc_id": "e06c2ce5aa1b8543f40217ddf9fef71213632a303068ec7bf3f54a9be9e4d375", "chunk_index": 0}
{"text": "The Rush and the Crush\nIn this situation, volatility rises before and falls after awidely anticipated\nnews announcement, of earnings, for instance, or of a Food and Drug\nAdministration (FDA) approval. In this situation, option buyers rush in and\nbid up IV. The more uncertainty—the more demand for insurance—the\nhigher vol rises. When the event finally occurs and the move takes place or\ndoesn’t, volatility gets crushed. The crush occurs when volatility falls very\nsharply—sometimes 10 points, 20 points, or more—in minutes. Traders\nwith large vega positions appreciate the appropriateness of the term crush\nall too well. Volatility traders also affectionately refer to this sudden drop in\nIV by saying that volatility has gotten “whacked.”\nIn order to have afeel for whether implied volatility is high or low for aparticular stock, you need to know where it’sbeen. It’shelpful to have an\nidea of where realized volatility is and has been, too. To be sure, one\nanalysis cannot be entirely separate from the other. Studying both implied\nand realized volatility and how they relate is essential to seeing the big\npicture.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:357", "doc_id": "ce5369ded76688abfcedc5513d42bd8239c7a71b16e57cdb709a372e69a6129e", "chunk_index": 0}
{"text": "Volatility Selling\nSusie Seller, avolatility trader, studies semiconductor stocks. Exhibit 12.3\nshows the volatilities of a $50 chip stock. The circled area shows what\nhappened before and after second-quarter earnings were reported in July.\nThe black line is the IV, and the gray is the 30-day historical.\nEXHIBIT 12.3 Chip stock volatility before and after earnings reports.\nSource : Chart courtesy of iVolatility.com\nIn mid-July, Susie did some digging to learn that earnings were to be\nannounced on July 24, after the close. She was careful to observe the classic\nrush and crush that occurred to varying degrees around the last three\nearnings announcements, in October, January, and April. In each case, IV\nfirmed up before earnings only to get crushed after the report. In mid-to-late\nJuly, she watched as IV climbed to the mid-30s (the rush) just before\nearnings. As the stock lay in wait for the report, trading came to aproverbial screeching halt, sending realized volatility lower, to about 13\npercent. Susie waited for the end of the day just before the report to make\nher move. Before the closing bell, the stock was at $50. Susie sold 20 one-\nmonth 50-strike calls at 2.10 (a 35 volatility) and bought 1,100 shares of the\nunderlying stock at $50 to become delta neutral.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:359", "doc_id": "141ffcb04192eacb7c97ae1fbaa8f0326cbf4cbb70f9b3a1bb2b10e54b79b8c5", "chunk_index": 0}
{"text": "Exhibit 12.4 shows Susie’sposition.\nEXHIBIT 12.4 Delta-neutral short ATM call, long stock position.\nHer delta was just about flat. The delta for the 50 calls was 0.54 per\ncontract. Selling a 20-lot creates 10.80 short deltas for her overall position.\nAfter buying 1,100 shares, she was left long 0.20 deltas, about the\nequivalence of being long 20 shares. Where did her risk lie? Her biggest\nconcern was negative gamma. Without even seeing achart of the stock’sprice, we can see from the volatility chart that this stock can have big\nmoves on earnings. In October, earnings caused amore than 10-point jump\nin realized volatility, to its highest level during the year shown. Whether the\nstock rose or fell is irrelevant. Either event means risk for apremium seller.\nThe positive theta looks good on the surface, but in fact, theta provided\nSusie with no significant benefit. Her plan was “in and out and nobody gets\nhurt.” She got into the trade right before the earnings announcement and out\nas soon as implied volatility dropped off. Ideally, she’dlike to hold these\ntypes of trades for less than aday. The true prize is vega.\nSusie was looking for about a 10-point drop in IV, which this option class\nhad following the October and January earnings reports. April had abig\ndrop in IV, as well, of about eight or nine points. Ultimately, what Susie is\nlooking for is reversion to the mean.\nShe gauges the normal level of volatility by observing where it is before\nand after the surges caused by earnings. From early November to mid- to\nlate- December, the stock’s IV bounced around the 25 percent level. In the\nmonth of February, the IV was around 25. After the drop-off following\nApril earnings and through much of May, the IV was closer to 20 percent.\nIn June, IV was just above 25. Susie surmised from this chart that when no", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:360", "doc_id": "da3d68883be8a02484ca3f19a506fc77d2b59a0835bd10fe05dd4bfdf6cd6b6f", "chunk_index": 0}
{"text": "earnings event is pending, this stock’soptions typically trade at about a 25\npercent IV. Therefore, anticipating a 10-point decline from 35 was\nreasonable, given the information available. If Susie gets it right, she stands\nto make $1,150 from vega (10 points × 1.15 vegas × 100).\nAs we can see from the right side of the volatility chart in Exhibit 12.3 ,\nSusie did get it right. IV collapsed the next morning by just more than ten\npoints. But she didn’tmake $1,150; she made less. Why? Realized volatility\n(gamma). The jump in realized volatility shown on the graph is afunction\nof the fact that the stock rallied $2 the day after earnings. Negative gamma\ncontributed to negative deltas in the face of arallying market. This negative\ndelta affected some of Susie’spotential vega profits.\nSo what was Susie’sprofit? On this trade she made $800. The next\nmorning at the open, she bought back the 50-strike calls at 2.80 (25 IV) and\nsold the stock at $52. To compute her actual profit, she compared the prices\nof the spread when entering the trade with the prices of the spread when\nexiting. Exhibit 12.5 shows the breakdown of the trade.\nEXHIBIT 12.5 Profit breakdown of delta-neutral trade.\nAfter closing the trade, Susie knew for sure what she made or lost. But\nthere are many times when atrader will hold adelta-neutral position for an\nextended period of time. If Susie hadn’tclosed her trade, she would have\nlooked at her marks to see her P&(L) at that point in time. Marks are the\nprices at which the securities are trading in the actual market, either in real\ntime or at end of day. With most online brokers’ trading platforms or\noptions-trading software, real-time prices are updated dynamically and\nalways at their fingertips. The profit or loss is, then, calculated\nautomatically by comparing the actual prices of the opening transaction\nwith the current marks.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:361", "doc_id": "c5a9056cefb825450a49f12b7edc9fd2f9e299d94ba2a6cc0c0b1867893cb6e8", "chunk_index": 0}
{"text": "What Susie will want to know is why she made $800. Why not more?\nWhy not less, for that matter? When trading delta neutral, especially with\nmore complex trades involving multiple legs, amanual computation of each\nleg of the spread can be tedious. And to be sure, just looking at the profit or\nloss on each leg doesn’tprovide an explanation.\nSusie can see where her profits or losses came from by considering the\nprofit or loss for each influence contributing to the option’svalue. Exhibit\n12.6 shows the breakdown.\nEXHIBIT 12.6 Profit breakdown by greek.\nDelta\nSusie started out long 0.20 deltas. A $2 rise in the stock price yielded a $40\nprofit attributable to that initial delta.\nGamma\nAs the stock rose, the negative delta of the position increased as aresult of\nnegative gamma. The delta of the stock remained the same, but the negative\ndelta of the 50 call grew by the amount of the gamma. Deriving an exact\nP&(L) attributable to gamma is difficult because gamma is adynamic\nmetric: as the stock price changes, so can the gamma. This calculation\nassumes that gamma remains constant. Therefore, the gamma calculation\nhere provides only an estimate.\nThe initial position gamma of −1.6 means the delta decreases by 3.2 with\na $2 rise in the stock (–1.60 times the $2 rise in the stock price). Susie, then,\nwould multiply −3.2 by $2 to find the loss on −3.2 deltas over a $2 rise. But\nshe wasn’tshort 3.2 deltas for the whole $2. She started out with zero deltas\nattributable to gamma and ended up being 3.2 shorter from gamma over that\n$2 move. Therefore, if she assumes her negative delta from gamma grew\nsteadily from 0 to −3.2, she can estimate her average delta loss over that\nmove by dividing by 2.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:362", "doc_id": "59fe7b627bb63595bd7142725aab39466b71a1a90f4cf0c3d9e22c0928ed5411", "chunk_index": 0}
{"text": "The Imprecision of Estimation\nIt is important to notice that the P&(L) found by adding up the P&(L)’sfrom the greeks is slightly different from the actual P&(L). There are acouple of reasons for this. First, the change in delta resulting from gamma is\nonly an estimate, because gamma changes as the stock price changes. For\nsmall moves in the underlying, the gamma change is less significant, but for\nlarger moves, the rate of change of the gamma can be bigger, and it can be\nnonlinear. For example, as an option moves from being at-the-money\n(ATM) to being out-of-the-money (OTM), its gamma decreases. But as the\noption becomes more OTM, its gamma decreases at aslower rate.\nAnother reason that the P&(L) from the greeks is different from the actual\nP&(L) is that the greeks are derived from the option-pricing model and are\ntherefore theoretical values and do not include slippage.\nFurthermore, the volatility input in this example is rounded abit for\nsimplicity. For example, avolatility of 25 actually yielded atheoretical\nvalue of 2.796, while the call was bought at 2.80. Because some options\ntrade at minimum price increments of anickel, and none trade in fractions\nof apenny, IV is often rounded.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:365", "doc_id": "fef5af94d898f75b08c097b168bc9c97e1035dbbec0dfe528879af99a5a75671", "chunk_index": 0}
{"text": "Volatility Buying\nThis same earnings event could have been played entirely differently. Adifferent trader, Bobby Buyer, studied the same volatility chart as Susie. It\nis shown again here as Exhibit 12.7 . Bobby also thought there would be arush and crush of IV, but he decided to take adifferent approach.\nEXHIBIT 12.7 Chip stock volatility before and after earnings reports.\nSource : Chart courtesy of iVolatility.com\nAbout an hour before the close of business on July 21, just three days\nbefore earnings announcements, Bobby saw that he could buy volatility at\n30 percent. In Bobby’sopinion, volatility seemed cheap with earnings so\nclose. He believed that IV could rise at least five points over the next three\ndays. Note that we have the benefit of 20/20 hindsight in the example.\nNear the end of the trading day, the stock was at $49.70. Bobby bought 20\n33-day 50-strike calls at 1.75 (30 volatility) and sold short 1,000 shares of\nthe underlying stock at $49.70 to become delta neutral. Exhibit 12.8 shows\nBobby’sposition.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:367", "doc_id": "cb631ea1caedcfa7946d1f1e8e3177380874aedad046a610344d358343c0caae", "chunk_index": 0}
{"text": "EXHIBIT 12.8 Delta-neutral long call, short stock position.\nWith the stock at $49.70, the calls had +0.51 delta per contract, or +10.2\nfor the 20-lot. The short sale of 1,000 shares got Bobby as close to delta-\nneutral as possible without trading an odd lot in the stock. The net position\ndelta was +0.20, or about the equivalent of being long 20 shares of stock.\nBobby’sobjective in this case is to profit from an increase in implied\nvolatility leading up to earnings.\nWhile Susie was looking for reversion to the mean, Bobby hoped for afurther divergence. For Bobby, positive gamma looked like agood thing on\nthe surface. However, his plan was to close the position just before earnings\nwere released—before the vol crush and before the potential stock-price\nmove. With realized volatility already starting to drop off at the time the\ntrade was put on, gamma offered little promise of gain.\nAs fate would have it, IV did indeed increase. At the end of the day before\nthe July earnings report, IV was trading at 35 percent. Bobby closed his\ntrade by selling his 20-lot of the 50 calls at 2.10 and buying his 1,000 shares\nof stock back at $50. Exhibit 12.9 shows the P&(L) for each leg of the\nspread.\nEXHIBIT 12.9 Profit breakdown.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:368", "doc_id": "afcec3c75786522c7d391c9ec1d47395887236852166e311aee1760407d66d99", "chunk_index": 0}
{"text": "The calls earned Bobby atotal of $700, while the stock lost $300. Of\ncourse, with this type of trade, it is not relevant which leg was awinner and\nwhich aloser. All that matters is the bottom line. The net P&(L) on the trade\nwas again of $400. The gain in this case was mostly aproduct of IV’srising. Exhibit 12.10 shows the P&(L) per greek.\nEXHIBIT 12.10 Profit breakdown by greek.\nDelta\nThe position began long 0.20 deltas. The 0.30-point rise earned Bobby a\n0.06 point gain in delta per contract.\nGamma\nBobby had an initial gamma of +1.8. We will use 1.8 for estimating the P&\n(L) in this example, assuming gamma remained constant. A 0.30 rise in the\nstock price multiplied by the 1.8 gamma means that with the stock at $50,\nBobby was long an additional 0.54 deltas. We can estimate that over the\ncourse of the 0.30 rise in the stock price, Bobby was long an average of\n0.27 (0.54 ÷ 2). His P&(L) due to gamma, therefore, is again of about 0.08\n(0.27 × 0.30).\nTheta\nBobby held this trade for three days. His total theta cost him 1.92 or $192.\nVega\nThe biggest contribution to Bobby’sprofit on this trade was made by the\nspike in IV. He bought 30 volatility and sold 35 volatility. His 1.20 position\nvega earned him 6.00, or $600.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:369", "doc_id": "74cb280f1d55aa73eb88e73a8cc24ba9fd89e0df8fde1b7b96ed396da1aed74d", "chunk_index": 0}
{"text": "Trading Realized Volatility\nSo far, we’ve discussed many option strategies in which realized volatility\nis an important component of the trade. And while the management of these\npositions has been the focus of much of the discussion, the ultimate gain or\nloss for many of these strategies has been from movement in asingle\ndirection. For example, with along call, the higher the stock rallies the\nbetter.\nBut increases or decreases in realized volatility do not necessarily have an\nexclusive relationship with direction. Recall that realized volatility is the\nannualized standard deviation of daily price movements. Take two similarly\npriced stocks that have had anet price change of zero over aone-month\nperiod. Stock Ahad small daily price changes during that period, rising\n$0.10 one day and falling $0.10 the next. Stock Bwent up or down by $5\neach day for amonth. In this rather extreme example, Stock Bwas much\nmore volatile than Stock A, regardless of the fact that the net price change\nfor the period for both stocks was zero.\nAstock’svolatility—either high or low volatility—can be capitalized on\nby trading options delta neutral. Simply put, traders buy options delta\nneutral when they believe astock will have more movement and sell\noptions delta neutral when they believe astock will move less.\nDelta-neutral option sellers profit from low volatility through theta. Every\nday that passes in which the loss from delta/gamma movement is less than\nthe gain from theta is awinning day. Traders can adjust their deltas by\nhedging. Delta-neutral option buyers exploit volatility opportunities through\natrading technique called gamma scalping.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:373", "doc_id": "cd80089b583de3fe630b33ea62f51c48e9a955fc5169432463bf3a17df71fd67", "chunk_index": 0}
{"text": "Gamma Scalping\nIntraday trading is seldom entirely in one direction. Astock may close\nhigher or lower, even sharply higher or lower, on the day, but during the day\nthere is usually not asteady incremental rise or fall in the stock price. Atypical intraday stock chart has peaks and troughs all day long. Delta-\nneutral traders who have gamma don’tremain delta neutral as the\nunderlying price changes, which inevitably it will. Delta-neutral trading is\nkind of amisnomer.\nIn fact, it is gamma trading in which delta-neutral traders engage. For\nlong-gamma traders, the position delta gets more positive as the underlying\nmoves higher and more negative as the underlying moves lower. An upward\nmove in the underlying increases positive deltas, resulting in exponentially\nincreasing profits. But if the underlying price begins to retrace downward,\nthe gain from deltas can be erased as quickly as it was racked up.\nTo lock in delta gains, atrader can adjust the position to delta neutral\nagain by selling short stock to cover long deltas. If the stock price declines\nafter this adjustment, losses are curtailed thanks to the short stock. In fact,\nthe delta will become negative as the underlying price falls, leading to\ngrowing profits. To lock in profits again, the trader buys stock to cover\nshort deltas to once again become delta neutral.\nThe net effect is astock scalp. Positive gamma causes the delta-neutral\ntrader to sell stock when the price rises and buy when the stock falls. This\nadds up to atrue, realized profit. So positive gamma is amoney-making\nmachine, right? Not so fast. As in any business, the profits must be great\nenough to cover expenses. Theta is the daily cost of running this gamma-\nscalping business.\nFor example, atrader, Harry, notices that the intraday price swings in aparticular stock have been increasing. He takes abullish position in realized\nvolatility by buying 20 off the 40-strike calls, which have a 50 delta, and\nselling stock on adelta-neutral ratio.\nBuy 20 40-strike calls (50 delta) (long 1,000 deltas)\nShort 1,000 shares at $40 (short 1,000 deltas)", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:374", "doc_id": "aa0815ea21a21cabe4c6cb780c0cad1372b3865af32f81ca66da45f2a6c2f803", "chunk_index": 0}
{"text": "The immediate delta of this trade is flat, but as the stock moves up or\ndown, that will change, presenting gamma-scalping opportunities. Gamma\nscalping is the objective here. The position greeks in Exhibit 13.1 show the\nrelationship of the two forces involved in this trade: gamma and theta.\nEXHIBIT 13.1 Greeks for 20-lot delta-neutral long call.\nThe relationship of gamma to theta in this sort of trade is paramount to its\nsuccess. Gamma-scalping plays are not buy-and-hold strategies. This is\nactive trading. These spreads need to be monitored intraday to take\nadvantage of small moves in the underlying security. Harry will sell stock\nwhen the underlying rises and buy it when the underlying falls, taking aprofit with each stock trade. The goal for each day that passes is to profit\nenough from positive gamma to cover the day’stheta. But that’snot always\nas easy as it sounds. Let’sstudy what happens the first seven days after this\nhypothetical trade is executed. For the purposes of this example, we assume\nthat gamma remains constant and that the trader is content trading odd lots\nof stock.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:375", "doc_id": "8e01c0a16de1c97ea16d0e32c0732f2bd97b558bd8217116ec68ec6d8e4101e6", "chunk_index": 0}
{"text": "Day One\nThe first day proves to be fairly volatile. The stock rallies from $40 to $42\nearly in the day. This creates apositive position delta of 5.60, or the\nequivalent of being long about 560 shares. At $42, Harry covers the\nposition delta by selling 560 shares of the underlying stock to become delta\nneutral again.\nLater in the day, the market reverses, and the stock drops back down to\n$40 ashare. At this point, the position is short 5.60 deltas. Harry again\nadjusts the position, buying 560 shares to get flat. The stock then closes\nright at $40.\nThe net result of these two stock transactions is again of $1,070. How?\nThe gamma scalp minus the theta, as shown below.\nThe volatility of day one led to it being aprofitable day. Harry scalped 560\nshares for a $2 profit, resulting from volatility in the stock. If the stock\nhadn’tmoved as much, the delta would have been smaller, and the dollar\namount scalped would have been smaller, leading to an exponentially\nsmaller profit. If there had been more volatility, profits would have been\nexponentially larger. It would have led to abigger bite being taken out of\nthe market.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:376", "doc_id": "12e794daf0d65b4e9c3fbc73cfb84885054bd3ea98efffb8d01c3413aad0b947", "chunk_index": 0}
{"text": "Day Three\nOn this day, the market trends. First, the stock rises $0.50, at which point\nHarry sells 140 shares of stock at $40.50 to lock in gains from his delta and\nto get flat. However, the market continues to rally. At $41 ashare, Harry is\nlong another 1.40 deltas and so sells another 140 shares. The rally\ncontinues, and at $41.50 he sells another 140 shares to cover the delta.\nFinally, at the end of the day, the stock closes at $42 ashare. Harry sells afinal 140 shares to get flat.\nThere was not any literal scalping of stock today. It was all selling.\nNonetheless, gamma trading led to aprofitable day.\nAs the stock rose from $40 to $40.50, 140 deltas were created from\npositive gamma. Because the delta was zero at $40 and 140 at $40.50, the\nestimated average delta is found by dividing 140 in half. This estimated\naverage delta multiplied by the $0.50 gain on the stock equals a $35 profit.\nThe delta was zero after the adjustment made at $40.50, when 140 shares\nwere sold. When the stock reached $41, another $35 was reaped from the\naverage delta of 70 over the $0.50 move. This process was repeated every\ntime the stock rose $0.50 and the delta was covered.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:378", "doc_id": "b2c3e1dda01d1ef7344a8866c59814fb68e46d91f336a75c1fb23d5732221fb2", "chunk_index": 0}
{"text": "Art and Science\nAlthough this was avery simplified example, it was typical of how aprofitable week of gamma scalping plays out. This stock had apretty\nvolatile week, and overall the week was awinner: there were four losing\ndays and three winners. The number of losing days includes the weekends.\nWeekends and holidays are big hurdles for long-gamma traders because of\nthe theta loss. The biggest contribution to this being awinning week was\nmade by the gap open on day four. Part of the reason was the sheer\nmagnitude of the move, and part was the fact that the deltas weren’tcovered\ntoo soon, as they had been on day three.\nIn aperfect world, along-gamma trader will always buy the low of the\nday and sell the high of the day when covering deltas. This, unfortunately,\nseldom happens. Long-gamma traders are very often wrong when trading\nstock to cover deltas.\nBeing wrong can be okay on occasion. In fact, it can even be rewarding.\nDay three was profitable despite the fact that 140 shares were sold at\n$40.50, $41, and $41.50. The stock closed at $42; the first three stock trades\nwere losers. Harry sold stock at alower price than the close. But the\nposition still made money because of his positive gamma. To be sure, Harry\nwould like to have sold all 560 shares at $42 at the end of the day. The day’sprofits would have been significantly higher.\nThe problem is that no one knows where the stock will move next. On\nday three, if the stock had topped out at $40.50 and Harry did not sell stock\nbecause he thought it would continue higher, he would have missed an\nopportunity. Gamma scalping is not an exact science. The art is to pick\nspots that capture the biggest moves possible without missing opportunities.\nThere are many methods traders have used to decide where to cover\ndeltas when gamma scalping: the daily standard deviation, afixed\npercentage of the stock price, afixed nominal value, covering at acertain\ntime of day, “market feel.” No system appears to be absolutely better than\nanother. This is where it gets personal. Finding what works for you, and\nwhat works for the individual stocks you trade, is the art of this science.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:382", "doc_id": "cfcfd6eae05737562355f0b90fbc8485120add7d4d79c5efde6e0e3d2e8be540", "chunk_index": 0}
{"text": "Gamma, Theta, and Volatility\nClearly, more volatile stocks are more profitable for gamma scalping, right?\nWell . . . maybe. Recall that the higher the implied volatility, the lower the\ngamma and the higher the theta of at-the-money (ATM) options. In many\ncases, the more volatile astock, the higher the implied volatility (IV). That\nmeans that avolatile stock might have to move more for atrader to scalp\nenough stock to cover the higher theta.\nLet’slook at the gamma-theta relationship from another perspective. In\nthis example, for 0.50 of theta, Harry could buy 2.80 gamma. This\nrelationship is based on an assumed 25 percent implied volatility. If IV were\n50 percent, theta for this 20 lot would be higher, and the gamma would be\nlower. At avolatility of 50, Harry could buy 1.40 gammas for 0.90 of theta.\nThe gamma is more expensive from atheta perspective, but if the stock’sstatistical volatility is significantly higher, it may be worth it.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:383", "doc_id": "6e1c38215fabf577b976baa3ea4b3c867782783e9fbb728208c670cbf635db13", "chunk_index": 0}
{"text": "Gamma Hedging\nKnowing that the gamma and theta figures of Exhibit 13.1 are derived from\na 25 percent volatility assumption offers abenchmark with which to gauge\nthe potential profitability of gamma trading the options. If the stock’sstandard deviation is below 25 percent, it will be difficult to make money\nbeing long gamma. If it is above 25 percent, the play becomes easier to\ntrade. There is more scalping opportunity, there are more opportunities for\nbig moves, and there are more likely to be gaps in either direction. The 25\npercent volatility input not only determines the option’stheoretical value\nbut also helps determine the ratio of gamma to theta.\nA 25 percent or higher realized volatility in this case does not guarantee\nthe trade’ssuccess or failure, however. Much of the success of the trade has\nto do with how well the trader scalps stock. Covering deltas too soon leads\nto reduced profitability. Covering too late can lead to missed opportunities.\nTrading stock well is also important to gamma sellers with the opposite\ntrade: sell calls and buy stock delta neutral. In this example, atrader will\nsell 20 ATM calls and buy stock on adelta-neutral ratio.\nThis is abearish position in realized volatility. It is the opposite of the\ntrade in the last example. Consider again that 25 percent IV is the\nbenchmark by which to gauge potential profitability. Here, if the stock’svolatility is below 25, the chances of having aprofitable trade are increased.\nAbove 25 is abit more challenging.\nIn this simplified example, adifferent trader, Mary, plays the role of\ngamma seller. Over the same seven-day period as before, instead of buying\ncalls, Mary sold a 20 lot. Exhibit 13.2 shows the analytics for the trade. For\nthe purposes of this example, we assume that gamma remains constant and\nthe trader is content trading odd lots of stock.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:384", "doc_id": "122d1aedf1f0118df31f952d43322a47a26421846870ea55058d79c0601976f6", "chunk_index": 0}
{"text": "Day One\nThis was one of the volatile days. The stock rallied from $40 to $42 early in\nthe day and had fallen back down to $40 by the end of the day. Big moves\nlike this are hard to trade as ashort-gamma trader. As the stock rose to $42,\nthe negative delta would have been increasing. That means losses were\nadding up at an increasing rate. The only way to have stopped the\nhemorrhaging of money as the stock continued to rise would have been to\nbuy stock. Of course, if Mary buys stock and the stock then declines, she\nhas aloser.\nLet’sassume the best-case scenario. When the stock reached $42 and she\nhad a −560 delta, Mary correctly felt the market was overbought and would\nretrace. Sometimes, the best trades are the ones you don’tmake. On this\nday, Mary traded no stock. When the stock reached $40 ashare at the end of\nthe day, she was back to being delta neutral. Theta makes her awinner\ntoday.\nBecause of the way Mary handled her trade, the volatility of day one was\nnot necessarily an impediment to it being profitable. Again, the assumption\nis that Mary made the right call not to negative scalp the stock. Mary could\nhave decided to hedge her negative gamma when the stock reach $42 and\nthe position delta was at −$560 by buying stock and then selling it at $40.\nThere are anumber of techniques for hedging deltas resulting from\nnegative gamma. The objective of hedging deltas is to avoid losses from the\nstock trending in one direction and creating increasingly adverse deltas but\nnot to overtrade stock and negative scalp.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:386", "doc_id": "ce0370bd6976c9bc946c428c04e82b134d34c5c0c973421f59d225ab8d4763ea", "chunk_index": 0}
{"text": "Day Three\nDay three saw the stock price trending. It slowly drifted up $2. There would\nhave been some judgment calls throughout this day. Again, delta-neutral\ntrades are for active traders. Prepare to watch the market much of the day if\nimplementing this kind of strategy.\nWhen the stock was at $41 ashare, Mary decided to guard against further\nadvances in stock price and hedged her delta. At that point, the position\nwould have had a −2.80 delta. She bought 280 shares at $41.\nAs the day progressed, the market proved Mary to be right. The stock rose\nto $42 giving the position adelta of −2.80 again. She covered her deltas at\nthe end of the day by buying another 280 shares.\nCovering the negative deltas to get flat at $41 proved to be asmart move\ntoday. It curtailed an exponentially growing delta and let Mary take asmaller loss at $41 and get afresh start. While the day was aloser, it would\nhave been $280 worse if she had not purchased stock at $41 before the run-\nup to $42. This is evidenced by the fact that she made a $280 profit on the\n280 shares of stock bought at $41, since the stock closed at $42.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:388", "doc_id": "af72c036e04f6b5043fdbff02dfd986dd65a78ebae33697c0e2807e92b51bbc4", "chunk_index": 0}
{"text": "Day Four\nDay four offered arather unpleasant surprise. This was the day that the\nstock gapped open $4 lower. This is the kind of day short-gamma traders\ndread. There is, of course, no right way to react to this situation. The stock\ncan recover, heading higher; it can continue lower; or it can have adead-cat\nbounce, remaining where it is after the fall.\nStaring at aquite contrary delta of 11.20, Mary was forced to take action\nby selling stock. But how much stock was the responsible amount to sell for\napure short-gamma trader not interested in trading direction? Selling 1,120\nshares would bring the position back to being delta neutral, but the only\nway the trade would stay delta neutral would be if the stock stayed right\nwhere it was.\nHedging is always adifficult call for short-gamma traders. Long-gamma\ntraders are taking aprofit on deltas with every stock trade that covers their\ndeltas. Short-gamma traders are always taking aloss on delta. In this case,\nMary decided to cover half her deltas by selling 560 shares. The other 560\ndeltas represent aloss, too; it’sjust not locked in.\nHere, Mary made the conscious decision not to go home flat. On the one\nhand, she was accepting the risk of the stock continuing its decline. On the\nother hand, if she had covered the whole delta, she would have been\naccepting the risk of the stock moving in either direction. Mary felt the\nstock would regain some of its losses. She decided to lead the stock alittle,\ngoing into the weekend with apositive delta bias.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:389", "doc_id": "ff2a04b26d0c2579ea5c59f4ae0250965d78a246d1f90bc112014c252ed8642c", "chunk_index": 0}
{"text": "Day Seven\nThis was the quiet day of the week, and awelcome respite. On this day, the\nstock rose just $0.25. The rise in price helped abit. Mary was still long 560\ndeltas from Friday. Negative gamma took only asmall bite out of her profit.\nThe P&(L) can be broken down into the profit attributable to the starting\ndelta of the trade, the estimated loss from gamma, and the gain from theta.\nMary ends these seven days of trading worse off than she started. What\nwent wrong? The bottom line is that she sold volatility on an asset that\nproved to be volatile. A $4 drop in price of a $42 dollar stock was abig\nmove. This stock certainly moved at more than 25 percent volatility. Day\nfour alone made this trade alosing proposition.\nCould Mary have done anything better? Yes. In aperfect world, she\nwould not have covered her negative deltas on day 3 by buying 280 shares\nat $41 and another 280 at $42. Had she not, this wouldn’thave been such abad week. With the stock ending at $38.25, she lost $1,050 on the 280\nshares she bought at $42 ($3.75 times 280) and lost $770 on the 280 shares\nbought at $41 ($2.75 times 280). Then again, if the stock had continued\nhigher, rising beyond $42, those would have been good buys.\nMary can’tbeat herself up too much for protecting herself in away that\nmade sense at the time. The stock’s $2 rally is more to blame than the fact\nthat she hedged her deltas. That’sthe risk of selling volatility: the stock may\nprove to be volatile. If the stock had not made such amove, she wouldn’thave faced the dilemma of whether or not to hedge.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:391", "doc_id": "39f370eb49a1d054c09585b9bc8abca0e7df3b73738e9ca3accf28fc72720044", "chunk_index": 0}
{"text": "Conclusions\nThe same stock during the same week was used in both examples. These\ntwo traders started out with equal and opposite positions. They might as\nwell have made the trade with each other. And although in this case the vol\nbuyer (Harry) had apretty good week and the vol seller (Mary) had anot-\nso-good week, it’simportant to notice that the dollar value of the vol\nbuyer’sprofit was not the same as the dollar value of the vol seller’sloss.\nWhy? Because each trader hedged his or her position differently. Option\ntrading is not azero-sum game.\nOption-selling delta-neutral strategies work well in low-volatility\nenvironments. Small moves are acceptable. It’sthe big moves that can blow\nyou out of the water.\nLike long-gamma traders, short-gamma traders have many techniques for\ncovering deltas when the stock moves. It is common to cover partial deltas,\nas Mary did on day four of the last example. Conversely, if astock is\nexpected to continue along its trajectory up or down, traders will sometimes\noverhedge by buying more deltas (stock) than they are short or selling more\nthan they are long, in anticipation of continued price rises. Daily standard\ndeviation derived from implied volatility is acommon measure used by\nshort-gamma players to calculate price points at which to enter hedges.\nMarket feel and other indicators are also used by experienced traders when\ndeciding when and how to hedge. Each trader must find what works best for\nhim or her.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:392", "doc_id": "07c7119c0f0a2127638a17f5ca8690bef17ccf615344fdfdb85a8173e999e086", "chunk_index": 0}
{"text": "Smileys and Frowns\nThe trade examples in this chapter have all involved just two components:\ncalls and stock. We will explore delta-neutral strategies in other chapters\nthat involve more moving parts. Regardless of the specific makeup of the\nposition, the P&(L) of each individual leg is not of concern. It is the\nprofitability of the position as awhole that matters. For example, after avolatile move in astock occurs, apositive-gamma trader like Harry doesn’tcare whether the calls or the stock made the profit on the move. The trader\nwould monitor the net delta that was produced—positive or negative—and\ncover accordingly. The process is the same for anegative-gamma trader. In\neither case, it is gamma and delta that need to be monitored closely.\nGamma can make or break atrade. P&(L) diagrams are helpful tools that\noffer avisual representation of the effect of gamma on aposition. Many\noption-trading software applications offer P&(L) graphing applications to\nstudy the payoff of aposition with the days to expiration as an adjustable\nvariable to study the same trade over time.\nP&(L) diagrams for these delta-neutral positions before the options’\nexpiration generally take one of two shapes: asmiley or afrown. The shape\nof the graph depends on whether the position gamma is positive or negative.\nExhibit 13.3 shows atypical positive-gamma trade.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:393", "doc_id": "a868751726372c04ffb7883848c729be63692da1b93cb35d6207d60ce8c15787", "chunk_index": 0}
{"text": "EXHIBIT 13.4 The effect of time on P&(L).\nAs time passes, the reduction in profit is reflected by the center point of\nthe graph dipping farther into negative territory. That is the effect of time\ndecay. The long options will have lost value at that future date with the\nstock still at the same price (all other factors held constant). Still, amove in\neither direction can lead to aprofitable position. Ultimately, at expiration,\nthe payoff takes on arigid kinked shape.\nIn the delta-neutral long call examples used in this chapter the position\nbecomes net long stock if the calls are in-the-money at expiration or net\nshort stock if they are out-of-the-money and only the short stock remains.\nVolatility, as well, would move the payoff line vertically. As IV increases,\nthe options become worth more at each stock price, and as IV falls, they are\nworth less, assuming all other factors are held constant.\nAdelta-neutral short-gamma play would have a P&(L) diagram quite the\nopposite of the smiley-faced long-gamma graph. Exhibit 13.5 shows what is\ncalled the short-gamma frown.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:395", "doc_id": "456206172170e0d9f357c8dcccac61692923d5aed0f683f490ee02612bf6c33d", "chunk_index": 0}
{"text": "Adecrease in value of the options from time decay causes an increase in\nprofitability. This profit potential pinnacles at the center (strike) price at\nexpiration. Rising IV will cause adecline in profitability at each stock price\npoint. Declining IV will raise the payout on the Yaxis as profitability\nincreases at each price point.\nSmileys and frowns are amere graphical representation of the technique\ndiscussed in this chapter: buying and selling realized volatility. These P&\n(L) diagrams are limited, because they show the payout only of stock-price\nmovement. The profitability of direction-indifferent and direction-neutral\ntrading is also influenced by time and implied volatility. These actively\ntraded strategies are best evaluated on agamma-theta basis. Long-gamma\ntraders strive each day to scalp enough to cover the day’stheta, while short-\ngamma traders hope to keep the loss due to adverse movement in the\nunderlying lower than the daily profit from theta.\nThe strategies in this chapter are the same ones traded in Chapter 12. The\nonly difference is the philosophy. Ultimately, both types of volatility are\nbeing traded using these and other option strategies. Implied and realized\nvolatility go hand in hand.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:397", "doc_id": "3aa298139a6cec3abc370e47f679be2e40bac4b30dd5fad15dcb4c1337124c51", "chunk_index": 0}
{"text": "CHAPTER 14\nStudying Volatility Charts\nImplied and realized volatility are both important to option traders. But\nequally important is to understand how the two interact. This relationship is\nbest studied by means of avolatility chart. Volatility charts are invaluable\ntools for volatility traders (and all option traders for that matter) in many\nways.\nFirst, volatility charts show where implied volatility (IV) is now\ncompared with where it’sbeen in the past. This helps atrader gauge\nwhether IV is relatively high or relatively low. Vol charts do the same for\nrealized volatility. The realized volatility line on the chart answers three\nquestions:\nHave the past 30 days been more or less volatile for the stock than\nusual?\nWhat is atypical range for the stock’svolatility?\nHow much volatility did the underlying historically experience in the\npast around specific recurring events?\nWhen IV lines and realized volatility lines are plotted on the same chart,\nthe divergences and convergences of the two spell out the whole volatility\nstory for those who know how to read it.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:398", "doc_id": "cfedb5e21c2a0b50e1f5289c7baa6909a76771adc180032a6702e6d12a195c66", "chunk_index": 0}
{"text": "1. Realized Volatility Rises, Implied\nVolatility Rises\nThe first volatility chart pattern is that in which both IV and realized\nvolatility rise. In general, this kind of volatility chart can line up three ways:\nimplied can rise more than realized volatility; realized can rise more than\nimplied; or they can both rise by about the same amount. The chart below\nshows implied volatility rising at afaster rate than realized vol. The general\ntheme in this case is that the stock’sprice movement has been getting more\nvolatile, and the option prices imply even higher volatility in the future.\nThis specific type of volatility chart pattern is commonly seen in active\nstocks with alot of news. Stocks du jour, like some Internet stocks during\nthe tech bubble of the late 1990s, story stocks like Apple (AAPL) around\nthe release of the iPhone in 2007, have rising volatilities, with the IV\noutpacing the realized volatility. Sometimes individual stocks and even\nbroad market indexes and exchange-traded funds (ETFs) see this pattern,\nwhen the market is declining rapidly, like in the summer of 2011.\nAdelta-neutral long-volatility position bought at the beginning of May,\naccording to Exhibit 14.1 , would likely have produced awinner. IV took\noff, and there were sure to be plenty of opportunities to profit from gamma\nwith realized volatility gaining strength through June and July.\nEXHIBIT 14.1 Realized volatility rises, implied volatility rises.\nSource : Chart courtesy of iVolatility.com", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:400", "doc_id": "afa801e302960c9041a0a018355ed6302432dc3ee48d32868ef1ffd0e0551be3", "chunk_index": 0}
{"text": "Looking at the right side of the chart, in late July, with IV at around 50\npercent and realized vol at around 35 percent, and without the benefit of\nknowing what the future will bring, it’sharder to make acall on how to\ntrade the volatility. The IV signals that the market is pricing ahigher future\nlevel of stock volatility into the options. If the market is right, gamma will\nbe good to have. But is the price right? If realized volatility does indeed\ncatch up to implied volatility—that is, if the lines converge at 50 or realized\nvolatility rises above IV—atrader will have agood shot at covering theta.\nIf it doesn’t, gamma will be very expensive in terms of theta, meaning it\nwill be hard to cover the daily theta by scalping gamma intraday.\nThe question is: why is IV so much higher than realized? If important\nnews is expected to be released in the near future, it may be perfectly\nreasonable for the IV to be higher, even significantly higher, than the\nstock’srealized volatility. One big move in the stock can produce anice\nprofit, as long as theta doesn’thave time to work its mischief. But if there is\nno news in the pipeline, there may be some irrational exuberance—in the\nwords of ex-Fed chairman Alan Greenspan—of option buyers rushing to\nacquire gamma that is overvalued in terms of theta.\nIn fact, alack of expectation of news could indicate apotential bearish\nvolatility play: sell volatility with the intent of profiting from daily theta\nand adecline in IV. This type of play, however, is not for the fainthearted.\nNo one can predict the future. But one thing you can be sure of with this", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:401", "doc_id": "013467eaba7642fa2efc1ba2b89ecdc044da08086f159bf704c71aeadf5b0f0b", "chunk_index": 0}
{"text": "trade: you’re in for awild ride. The lines on this chart scream volatility.\nThis means that negative-gamma traders had better be good and had better\nbe right!\nIn this situation, hedgers and speculators in the market are buying option\nvolatility of 50 percent, while the stock is moving at 35 percent volatility.\nTraders putting on adelta-neutral volatility-selling strategy are taking the\nstance that this stock will not continue increasing in volatility as indicated\nby option prices; specifically, it will move at less than 50 percent volatility\n—hopefully alot less. They are taking the stance that the market’sexpectations are wrong.\nInstead of realized and implied volatility both trending higher, sometimes\nthere is asharp jump in one or the other. When this happens, it could be an\nindication of aspecific event that has occurred (realized volatility) or news\nsuddenly released of an expected event yet to come (implied volatility). Asharp temporary increase in IV is called aspike, because of its pointy shape\non the chart. Aone-day surge in realized volatility, on the other hand, is not\nso much avolatility spike as it is arealized volatility mesa. Realized\nvolatility mesas are shown in Exhibit 14.2 .\nEXHIBIT 14.2 Volatility mesas.\nSource : Chart courtesy of iVolatility.com\nThe patterns formed by the gray line in the circled areas of the chart\nshown below are the result of typical one-day surges in realized volatility.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:402", "doc_id": "d39d3eed44384567e75eb3d6157aac626faaebca3329ef33cf8197077515b9c2", "chunk_index": 0}
{"text": "2. Realized Volatility Rises, Implied\nVolatility Remains Constant\nThis chart pattern can develop from afew different market conditions. One\nscenario is aone-time unanticipated move in the underlying that is not\nexpected to affect future volatility. Once the news is priced into the stock,\nthere is no point in hedgers’ buying options for protection or speculators’\nbuying options for aleveraged bet. What has happened has happened.\nThere are other conditions that can cause this type of pattern to\nmaterialize. In Exhibit 14.3 , the IV was trading around 25 for several\nmonths, while the realized volatility was lagging. With hindsight, it makes\nperfect sense that something had to give—either IV needed to fall to meet\nrealized, or realized would rise to meet market expectations. Here, indeed,\nthe latter materialized as realized volatility had asteady rise to and through\nthe 25 level in May. Implied, however remained constant.\nEXHIBIT 14.3 Realized volatility rises, implied volatility remains\nconstant.\nSource : Chart courtesy of iVolatility.com\nTraders who were long volatility going into the May realized-vol rise\nprobably reaped some gamma benefits. But those who got in “too early,”\nbuying in January or February, would have suffered too great of theta losses\nbefore gaining any significant profits from gamma. Time decay (theta) can\ninflict aslow, painful death on an option buyer. By studying this chart in\nhindsight, it is clear that options were priced too high for agamma scalper\nto have afighting chance of covering the daily theta before the rise in May.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:404", "doc_id": "9d41a37017feab7f2dde667ad7bf3ba5e947cf3a2f8ada2dfc6294d7f112c6e1", "chunk_index": 0}
{"text": "3. Realized Volatility Rises, Implied\nVolatility Falls\nThis chart pattern can manifest itself in different ways. In this scenario, the\nstock is becoming more volatile, and options are becoming cheaper. This\nmay seem an unusual occurrence, but as we can see in Exhibit 14.4 ,\nvolatility sometimes plays out this way. This chart shows two different\nexamples of realized vol rising while IV falls.\nEXHIBIT 14.4 Realized volatility rises, implied volatility falls.\nSource : Chart courtesy of iVolatility.com\nThe first example, toward the left-hand side of the chart, shows realized\nvolatility trending higher while IV is trending lower. Although\nfundamentals can often provide logical reasons for these volatility changes,\nsometimes they just can’t. Both implied and realized volatility are\nultimately afunction of the market. There is anormal oscillation to both of\nthese figures. When there is no reason to be found for avolatility change, it\nmight be an opportunity. The potential inefficiency of volatility pricing in\nthe options market sometimes creates divergences such as this one that vol\ntraders scour the market in search of.\nIn this first example, after at least three months of IV’strading marginally\nhigher than realized volatility, the two lines converge and then cross. The", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:406", "doc_id": "6346d0a23c05836ab4e51992b9f9c29ae7310a829ed5deba113ec9844fce6cf8", "chunk_index": 0}
{"text": "point at which these lines meet is an indication that IV may be beginning to\nget cheap.\nFirst, it’sapotentially beneficial opportunity to buy alower volatility than\nthat at which the stock is actually moving. The gamma/theta ratio would be\nfavorable to gamma scalpers in this case, because the lower cost of options\ncompared with stock fluctuations could lead to gamma profits. Second, with\nIV at 35 at the first crossover on this chart, IV is dipping down into the\nlower part of its four-month range. One can make the case that it is getting\ncheaper from ahistorical IV standpoint. There is arguably an edge from the\nperspective of IV to realized volatility and IV to historical IV. This is an\nexample of buying value in the context of volatility.\nFurthermore, if the actual stock volatility is rising, it’sreasonable to\nbelieve that IV may rise, too. In hindsight we see that this did indeed occur\nin Exhibit 14.4 , despite the fact that realized volatility declined.\nThe example circled on the right-hand side of the chart shows IV\ndeclining sharply while realized volatility rises sharply. This is an example\nof the typical volatility crush as aresult of an earnings report. This would\nprobably have been agood trade for long volatility traders—even those\nbuying at the top. Atrader buying options delta neutral the day before\nearnings are announced in this example would likely lose about 10 points of\nvega but would have agood chance to more than make up for that loss on\npositive gamma. Realized volatility nearly doubled, from around 28 percent\nto about 53 percent, in asingle day.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:407", "doc_id": "a66ce7ab867149040189bb383e3795b3143b096fb735a120ab3ae7133066bab8", "chunk_index": 0}
{"text": "4. Realized Volatility Remains Constant,\nImplied Volatility Rises\nExhibit 14.5 shows that the stock is moving at about the same volatility\nfrom the beginning of June to the end of July. But during that time, option\npremiums are rising to higher levels. This is an atypical chart pattern. If this\nwas aperiod leading up to an anticipated event, like earnings, one would\nanticipate realized volatility falling as the market entered await-and-see\nmode. But, instead, statistical volatility stays the same. This chart pattern\nmay indicate apotential volatility-selling opportunity. If there is no news or\nreason for IV to have risen, it may simply be high tide in the normal ebb\nand flow of volatility.\nEXHIBIT 14.5 Realized volatility remains constant, implied volatility\nrises.\nSource : Chart courtesy of iVolatility.com\nIn this example, the historical volatility oscillates between 20 and 24 for\nnearly two months (the beginning of June through the end of July) as IV\nrises from 24 to over 30. The stock price is less volatile than option prices\nindicate. If there is no news to be dug up on the stock to lead one to believe\nthere is avalid reason for the IV’strading at such alevel, this could be an\nopportunity to sell IV 5 to 10 points higher than the stock volatility. The", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:408", "doc_id": "e8c96f5eedf1cf9045199bc74df646c15c13c43f760cc404422918a90e2c1897", "chunk_index": 0}
{"text": "5. Realized Volatility Remains Constant,\nImplied Volatility Remains Constant\nThis volatility chart pattern shown in Exhibit 14.6 is typical of aboring,\nrun-of-the-mill stock with nothing happening in the news. But in this case,\nno news might be good news.\nEXHIBIT 14.6 Realized volatility remains constant, implied volatility\nremains constant.\nSource : Chart courtesy of iVolatility.com\nAgain, the gray is realized volatility and the black line is IV.\nIt’scommon for IV to trade slightly above or below realized volatility for\nextended periods of time in certain assets. In this example, the IV has traded\nin the high teens from late January to late July. During that same time,\nrealized volatility has been in the low teens.\nThis is aprime environment for option sellers. From agamma/theta\nstandpoint, the odds favor short-volatility traders. The gamma/theta ratio\nprovides an edge, setting the stage for theta profits to outweigh negative-\ngamma scalping. Selling calls and buying stock delta neutral would be atrade to look at in this situation. But even more basic strategies, such as\ntime spreads and iron condors, are appropriate to consider.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:410", "doc_id": "071de91811f3786797910fa9004c56e9eba4ce6c5878545111d42e4cb9bc2e22", "chunk_index": 0}
{"text": "6. Realized Volatility Remains Constant,\nImplied Volatility Falls\nExhibit 14.7 shows two classic implied-realized convergences. From mid-\nSeptember to early November, realized volatility stayed between 22 and 25.\nIn mid-October the implied was around 33. Within the span of afew days,\nthe implied vol collapsed to converge with the realized at about 22.\nEXHIBIT 14.7 Realized volatility remains constant, implied volatility falls.\nSource : Chart courtesy of iVolatility.com\nThere can be many catalysts for such adrop in IV, but there is truly only\none reason: arbitrage. Although it is common for asmall difference between\nimplied and realized volatility—1 to 3 points—to exist even for extended\nperiods, bigger disparities, like the 7- to 10-point difference here cannot\nexist for that long without good reason.\nIf, for example, IV always trades significantly above the realized\nvolatility of aparticular underlying, all rational market participants will sell\noptions because they have agamma/theta edge. This, in turn, forces options\nprices lower until volatility prices come into line and the arbitrage\nopportunity no longer exists.\nIn Exhibit 14.7 , from mid-March to mid-May asimilar convergence took\nplace but over alonger period of time. These situations are often the result", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:412", "doc_id": "728223bd5052b37760c23e6f3667cc50a0d40d59a09d52587c54677bbdac5d51", "chunk_index": 0}
{"text": "7. Realized Volatility Falls, Implied\nVolatility Rises\nThis setup shown in Exhibit 14.8 should now be etched into the souls of\nanyone who has been reading up to this point. It is, of course, the picture of\nthe classic IV rush that is often seen in stocks around earnings time. The\nmore uncertain the earnings, the more pronounced this divergence can be.\nEXHIBIT 14.8 Realized volatility falls, implied volatility rises.\nSource : Chart courtesy of iVolatility.com\nAnother classic vol divergence in which IV rises and realized vol falls\noccurs in adrug or biotech company when a Food and Drug Administration\n(FDA) decision on one of the company’snew drugs is imminent. This is\nespecially true of smaller firms without big portfolios of drugs. These\ndivergences can produce ahuge implied–realized disparity of, in some\ncases, literally hundreds of volatility points leading up to the\nannouncement.\nAlthough rising IV accompanied by falling realized volatility can be one\nof the most predictable patterns in trading, it is ironically one of the most\ndifficult to trade. When the anticipated news breaks, the stock can and often\nwill make abig directional move, and in that case, IV can and likely will\nget crushed. Vega and gamma work against each other in these situations, as", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:414", "doc_id": "79ed3d126a6d3a3f0a152fe3427c43a4638551523da2d3b19cc5c46df2d1ac9d", "chunk_index": 0}
{"text": "8. Realized Volatility Falls, Implied\nVolatility Remains Constant\nThis volatility shift can be marked by avolatility convergence, divergence,\nor crossover. Exhibit 14.9 shows the realized volatility falling from around\n30 percent to about 23 percent while IV hovers around 25. The crossover\nhere occurs around the middle of February.\nEXHIBIT 14.9 Realized volatility falls, implied volatility remains constant.\nSource : Chart courtesy of iVolatility.com\nThe relative size of this volatility change makes the interpretation of the\nchart difficult. The last half of September saw around a 15 percent decline\nin realized volatility. The middle of October saw aone-day jump in realized\nof about 15 points. Historical volatility has had several dynamic moves that\nwere larger and more abrupt than the seven-point decline over this six-week\nperiod. This smaller move in realized volatility is not necessarily an\nindication of avolatility event. It could reflect some complacency in the\nmarket. It could indicate aslow period with less trading, or it could simply\nbe anatural contraction in the ebb and flow of volatility causing the\ncalculation of recent stock-price fluctuations to wane.\nWhat is important in this interpretation is how the options market is\nreacting to the change in the volatility of the stock—where the rubber hits", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:416", "doc_id": "0aeb0d6577d4fa07d2093de57ab6426b1c1b2771471a3c4968d398a253074374", "chunk_index": 0}
{"text": "the road. The market’sapparent assessment of future volatility is unchanged\nduring this period. When IV rises or falls, vol traders must look to the\nunderlying stock for areason. The options market reacts to stock volatility,\nnot the other way around.\nFinding fundamental or technical reasons for surges in volatility is easier\nthan finding specific reasons for adecline in volatility. When volatility falls,\nit is usually the result of alack of news, leading to less price action. In this\nexample, probably nothing happened in the market. Consequently, the stock\nvolatility drifted lower. But it fell below the lowest IV level seen for the six-\nmonth period leading up to the crossover. It was probably hard to take aconfident stance in volatility immediately following the crossover. It is\ndifficult to justify selling volatility when the implied is so cheap compared\nwith its historic levels. And it can be hard to justify buying volatility when\nthe options are priced above the stock volatility.\nThe two-week period before the realized line moved beneath the implied\nline deserves closer study. With the IV four or five points lower than the\nrealized volatility in late January, traders may have been tempted to buy\nvolatility. In hindsight, this trade might have been profitable, but there was\nsurely no guarantee of this. Success would have been greatly contingent on\nhow the traders managed their deltas, and how well they adapted as realized\nvolatility fell.\nDuring the first half of this period, the stock volatility remained above\nimplied. For an experienced delta-neutral trader, scalping gamma was likely\neasy money. With the oscillations in stock price, the biggest gamma-\nscalping risk would have been to cover too soon and miss out on\nopportunities to take bigger profits.\nUsing the one-day standard deviation based on IV (described in Chapter\n3) might have produced early covering for long-gamma traders. Why?\nBecause in late January, the standard deviation derived from IV was lower\nthan the actual standard deviation of the stock being traded. In the latter half\nof the period being studied, the end of February on this chart, using the one-\nday standard deviation based on IV would have produced scalping that was\ntoo late. This would have led to many missed opportunities.\nTraders entering hedges at regular nominal intervals—every $0.50, for\nexample—would probably have needed to decrease the interval as volatility", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:417", "doc_id": "cbb96fb7c088d4729fc0c500101f444150b5b523cdcfbb6c456a71d0d592bbb1", "chunk_index": 0}
{"text": "9. Realized Volatility Falls, Implied\nVolatility Falls\nThis final volatility-chart permutation incorporates afall of both realized\nand IV. The chart in Exhibit 14.10 clearly represents the slow culmination\nof ahighly volatile period. This setup often coincides with news of some\nscary event’sbeing resolved—alaw suit settled, unpopular upper\nmanagement leaving, rumors found to be false, ahappy ending to political\nissues domestically or abroad, for example. After asharp sell-off in IV,\nfrom 75 to 55, in late October, marking the end of aperiod of great\nuncertainty, the stock volatility began asteady decline, from the low 50s to\nbelow 25. IV fell as well, although it remained abit higher for several\nmonths.\nEXHIBIT 14.10 Realized volatility falls, implied volatility falls.\nSource : Chart courtesy of iVolatility.com\nIn some situations where an extended period of extreme volatility appears\nto be coming to an end, there can be some predictability in how IV will\nreact. To be sure, no one knows what the future holds, but when volatility\nstarts to wane because aspecific issue that was causing gyrations in the\nstock price is resolved, it is common, and intuitive, for IV to fall with the\nstock volatility. This is another type of example of reversion to the mean.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:419", "doc_id": "88bf2c6364eca94e587a7e365628b970c3cf58e3d8bbeb45bcc5618040f6773e", "chunk_index": 0}
{"text": "The Basic Long Straddle\nThe long straddle is an option strategy to use when atrader is looking for abig move in astock but is uncertain which direction it will move.\nTechnically, the Commodity Channel Index (CCI), Bollinger bands, or\npennants are some examples of indicators which might signal the possibility\nof abreakout. Or fundamental data might call for arevaluation of the stock\nbased on an impending catalyst. In either case, along straddle, is away for\ntraders to position themselves for the expected move, without regard to\ndirection. In this example, we’ll study ahypothetical $70 stock poised for abreakout. We’ll buy the one-month 70 straddle for 4.25.\nExhibit 15.1 shows the payout of the straddle at expiration.\nEXHIBIT 15.1 At-expiration diagram for along straddle.\nAt expiration, with the stock at $70, neither the call nor the put is in-the-\nmoney. The straddle expires worthless, leaving aloss of 4.25 in its wake\nfrom erosion. If, however, the stock is above or below $70, either the call or\nthe put will have at least some value. The farther the stock price moves", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:425", "doc_id": "e473d2bb5801cd2bf544877dcf38dc839fffe38307e5445e03db10619267251a", "chunk_index": 0}
{"text": "from the strike price in either direction, the higher the net value of the\noptions.\nAbove $70, the call has value. If the underlying is at $74.25 at expiration,\nthe put will expire worthless, but the call will be worth 4.25—the price\ninitially paid for the straddle. Above this break-even price, the trade is awinner, and the higher, the better. Below $70, the put has value. If the\nunderlying is at $65.75 at expiration, the call expires, and the put is worth\n4.25. Below this breakeven, the straddle is awinner, and the lower, the\nbetter.\nWhy It Works\nIn this basic example, if the underlying is beyond either of the break-even\npoints at expiration, the trade is awinner. The key to understanding this is\nthe fact that at expiration, the loss on one option is limited—it can only fall\nto zero—but the profit potential on the other can be unlimited.\nIn practice, most active traders will not hold astraddle until expiration.\nEven if the trade is not held to term, however, movement is still beneficial\n—in fact, it is more beneficial, because time decay will not have depleted\nall the extrinsic value of the options. Movement benefits the long straddle\nbecause of positive gamma. But movement is arace against the clock—arace against theta. Theta is the cost of trading the long straddle. Only pay it\nfor as long as necessary. When the stock’svolatility appears poised to ebb,\nexit the trade.\nExhibit 15.2 shows the P&(L) of the straddle both at expiration and at the\ntime the trade was made.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:426", "doc_id": "5aa61ee57e191afc1341342c49c9355a2135e91a5119e49d30bcfa8c449f3d42", "chunk_index": 0}
{"text": "EXHIBIT 15.2 Long straddle P&(L) at initiation and expiration.\nBecause this is ashort-term at-the-money (ATM) straddle, we will\nassume for simplicity that it has adelta of zero. 1 When the trade is\nconsummated, movement can only help, as indicated by the dotted line on\nthe exhibit. This is the classic graphic representation of positive gamma—\nthe smiley face. When the stock moves higher, the call gains value at an\nincreasing rate while the put loses value at adecreasing rate. When the\nstock moves lower, the put gains at an increasing rate while the call loses at\nadecreasing rate. This is positive gamma.\nThis still may not be an entirely fair representation of how profits are\nearned. The underlying is not required to move continuously in one\ndirection for traders to reap gamma profits. As described in Chapter 13,\ntraders can scalp gamma by buying and selling stock to offset long or short\ndeltas created by movement in the underlying. When traders scalp gamma,\nthey lock in profits as the stock price oscillates.\nThe potential for gamma scalping is an important motivation for straddle\nbuyers. Gamma scalping astraddle gives traders the chance to profit from astock that has dynamic price swings. It should be second nature to volatility\ntraders to understand that theta is the trade-off of gamma scalping.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:427", "doc_id": "54a6fbc65288d9b925e40b677ac925a6c60aa41a6b739378c98478181842e4c7", "chunk_index": 0}
{"text": "The Big V\nGamma and theta are not alone in the straddle buyer’sthoughts. Vega is amajor consideration for astraddle buyer, as well. In astraddle, there are two\nlong options of the same strike, which means double the vega risk of asingle-leg trade at that strike. With no short options in this spread, the\nimplied-volatility exposure is concentrated. For example, if the call has avega of 0.05, the put’svega at that same strike will also be about 0.05. This\nmeans that buying one straddle gives the trader exposure of around 10 cents\nper implied volatility (IV) point. If IV rises by one point, the trader makes\n$10 per one-lot straddle, $20 for two points, and so on. If IV falls one point,\nthe trader loses $10 per straddle, $20 for two points, and so on. Traders who\nwant maximum positive exposure to volatility find it in long straddles.\nThis strategy is aprime example of the marriage of implied and realized\nvolatility. Traders who buy straddles because they are bullish on realized\nvolatility will also have bullish positions in implied volatility—like it or\nnot. With this in mind, traders must take care to buy gamma via astraddle\nthat it is not too expensive in terms of the implied volatility. Awinning\ngamma trade can quickly become aloser because of implied volatility.\nLikewise, traders buying straddles to speculate on an increase in implied\nvolatility must take the theta risk of the trade very seriously. Time can eat\naway all atrade’svega profits and more. Realized and implied exposure go\nhand in hand.\nThe relationship between gamma and vega depends on, among other\nthings, the time to expiration. Traders have some control over the amount of\ngamma relative to the amount of vega by choosing which expiration month\nto trade. The shorter the time until expiration, the higher the gammas and\nthe lower the vegas of ATM options. Gamma traders may be better served\nby buying short-term contracts that coincide with the period of perceived\nhigh stock volatility.\nIf the intent of the straddle is to profit from vega, the choice of the month\nto trade depends on which month’svolatility is perceived to be too high or\ntoo low. If, for example, the front-month IV looks low compared with\nhistorical IV, current and historical realized volatility, and the expected\nfuture volatility, but the back months’ IVs are higher and more in line with\nthese other metrics, there would be no point in buying the back-month", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:428", "doc_id": "ce65182209997603219824ad3c4d4c0040ab82bff100aab9bf92121041e262bd", "chunk_index": 0}
{"text": "Trading the Long Straddle\nOption trading is all about optimizing the statistical chances of success. Along-straddle trade makes the most sense if traders think they can make\nmoney on both implied volatility and gamma. Many traders make the\nmistake of buying astraddle just before earnings are announced because\nthey anticipate abig move in the stock. Of course, stock-price action is only\nhalf the story. The option premium can be extraordinarily expensive just\nbefore earnings, because the stock move is priced into the options. This is\nbuying after the rush and before the crush. Although some traders are\nsuccessful specializing in trading earnings, this is ahard way to make\nmoney.\nIdeally, the best time to buy volatility is before the move is priced in—\nthat is, before everyone else does. This is conceptually the same as buying astock in anticipation of bullish news. Once news comes out, the stock\nrallies, and it is often too late to participate in profits. The goal is to get in at\nthe beginning of the trend, not the end—the same goal as in trading\nvolatility.\nAs in analyzing astock, fundamental and technical tools exist for\nanalyzing volatility—namely, news and volatility charts. For fundamentals,\nbuy the rumor, sell the news applies to the rush and crush of implied\nvolatility. Previous chapters discussed fundamental events that affect\nvolatility; be prepared to act fast when volatility-changing situations present\nthemselves. With charts, the elementary concept of buy low, sell high is\nobvious, yet profound. Review Chapter 14 for guidance on reading\nvolatility charts.\nWith all trading, getting in is easy. It’smanaging the position, deciding\nwhen to hedge and when to get out that is the tricky part. This is especially\ntrue with the long straddle. Straddles are intended to be actively managed.\nInstead of waiting for abig linear move to evolve over time, traders can\ntake profits intermittently through gamma scalping. Furthermore, they hold\nthe trade only as long as gamma scalping appears to be apromising\nopportunity.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:430", "doc_id": "490b37fe79305e5d474dadee163d2de24267cb837e40254a1322d9749a888e46", "chunk_index": 0}
{"text": "Legging Out\nThere are many ways to exiting astraddle. In the right circumstances,\nlegging out is the preferred method. Instead of buying and selling stock to\nlock in profits and maintain delta neutrality, traders can reduce their\npositions by selling off some of the calls or puts that are part of the straddle.\nIn this technique, when the underlying rises, traders sell as many calls as\nneeded to reduce the delta to zero. As the underlying falls, they sell enough\nputs to reduce their position to zero delta. As the stock oscillates, they\nwhittle away at the position with each hedging transaction. This serves the\ndual purpose of taking profits and reducing risk.\nAtrader, Susan, has been studying Acme Brokerage Co. (ABC). Susan\nhas noticed that brokerage stocks have been fairly volatile in recent past.\nExhibit 15.3 shows an analysis of Acme’svolatility over the past 30 days.\nEXHIBIT 15.3 Acme Brokerage Co. volatility.\nStock Price Realized VolatilityFront-Month Implied Volatility\n30-day high $78.6630-day high 47%30-day high 55%\n30-day low $66.9430-day low 36%30-day low 34%\nCurrent px $74.80Current vol 36%Current vol 36%\nDuring this period, Acme stock ranged more than $11 in price. In this\nexample, Acme’svolatility is afunction of interest rate concerns and other\nmacroeconomic issues affecting the brokerage industry as awhole. As the\nstock price begins to level off in the latter half of the 30-day period, realized\nvolatility begins to ebb. The front month’s IV recedes toward recent lows as\nwell. At this point, both realized and implied volatility converge at 36\npercent. Although volatility is at its low for the past month, it is still\nrelatively high for abrokerage stock under normal market conditions.\nSusan does not believe that the volatility plaguing this stock is over. She\nbelieves that an upcoming scheduled Federal Reserve Board announcement\nwill lead to more volatility. She perceives this to be avolatility-buying\nopportunity. Effectively, she wants to buy volatility on the dip. Susan pays\n5.75 for 20 July 75-strike straddles.\nExhibit 15.4 shows the analytics of this trade with four weeks until\nexpiration.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:431", "doc_id": "5e7afdd548df443d6deed9487f3de5b47e1eaae8810cd57b0b446397b3cc067d", "chunk_index": 0}
{"text": "EXHIBIT 15.4 Analytics for long 20 Acme Brokerage Co. 75-strike\nstraddles.\nAs with any trade, the risk is that the trader is wrong. The risk here is\nindicated by the −2.07 theta and the +3.35 vega. Susan has to scalp an\naverage of at least $207 aday just to break even against the time decay. And\nif IV continues to ebb down to alower, more historically normal, level, she\nneeds to scalp even more to make up for vega losses.\nEffectively, Susan wants both realized and implied volatility to rise. She\npaid 36 volatility for the straddle. She wants to be able to sell the options at\nahigher vol than 36. In the interim, she needs to cover her decay just to\nbreak even. But in this case, she thinks the stock will be volatile enough to\ncover decay and then some. If Acme moves at avolatility greater than 36,\nher chances of scalping profitably are more favorable than if it moves at\nless than 36 vol. The following is one possible scenario of what might have\nhappened over two weeks after the trade was made.\nWeek One\nDuring the first week, the stock’svolatility tapered off abit more, but\nimplied volatility stayed firm. After some oscillation, the realized volatility\nended the week at 34 percent while IV remained at 36 percent. Susan was\nable to scalp stock reasonably well, although she still didn’tcover her seven\ndays of theta. Her stock buys and sells netted again of $1,100. By the end\nof week one, the straddle was 5.10 bid. If she had sold the straddle at the\nmarket, she would have ended up losing $200.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:432", "doc_id": "04c08cffe1f384f7e4d3b2b8abaeb69fdd64d89c07e3e6a7e6a9ea69c1fa70e2", "chunk_index": 0}
{"text": "Susan decided to hold her position. Toward the end of week two, there\nwould be the Federal Open Market Committee (FOMC) meeting.\nWeek Two\nThe beginning of the week saw IV rise as the event drew near. By the close\non Tuesday, implied volatility for the straddle was 40 percent. But realized\nvolatility continued its decline, which meant Susan was not able to scalp to\ncover the theta of Saturday, Sunday, Monday, and Tuesday. But, the straddle\nwas now 5.20 bid, 0.10 higher than it had been on previous Friday. The\nrising IV made up for most of the theta loss. At this point, Susan could have\nsold her straddle to scratch her trade. She would have lost $1,100 on the\nstraddle [(5.20 − 5.75) × 20] but made $1,100 by scalping gamma in the\nfirst week. Susan decided to wait and see what the Fed chairman had to say.\nBy week’send, the trade had proved to be profitable. After the FOMC\nmeeting, the stock shot up more than $4 and just as quickly fell. It\ncontinued to bounce around abit for the rest of the week. Susan was able to\nlock in $5,200 from stock scalps. After much gyration over this two-week\nperiod, the price of Acme stock incidentally returned to around the same\nprice it had been at when Susan bought her straddle: $74.50. As might have\nbeen expected after the announcement, implied volatility softened. By\nFriday, IV had fallen to 30. Realized volatility was sharply higher as aresult\nof the big moves during the week that were factored into the 30-day\ncalculation.\nWith seven more days of decay and alower implied volatility, the straddle\nwas 3.50 bid at midafternoon on Friday. Susan sold her 20-lot to close the\nposition. Her profit for week two was $2,000.\nWhat went into Susan’sdecision to close her position? Susan had two\nobjectives: to profit from arise in implied volatility and to profit from arise", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:433", "doc_id": "132bd2fd2f2cd0195af0184636f7e2d462205423f9a1db34e1c53d5bcca7d657", "chunk_index": 0}
{"text": "in realized volatility. The rise in IV did indeed occur, but not immediately.\nBy Tuesday of the second week, vega profits were overshadowed by theta\nlosses.\nGamma was the saving grace with this trade. The bulk of the gain\noccurred in week two when the Fed announcement was made. Once that\nevent passed, the prospects for covering theta looked less attractive. They\nwere further dimmed by the sharp drop in implied volatility from 40 to 30.\nIn this hypothetical scenario, the trade ended up profitable. This is not\nalways the case. Here the profit was chiefly produced by one or two high-\nvolatility days. Had the stock not been unusually volatile during this time,\nthe trade would have been acertain loser. Even though implied volatility\nhad risen four points by Tuesday of the second week, the trade did not yield\naprofit. The time decay of holding two options can make long straddles atough strategy to trade.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:434", "doc_id": "638067b01455526c80d3dc0bd8789bff7d9a3b46896c28517785ad69c3f39471", "chunk_index": 0}
{"text": "Short Straddle\nDefinition : Selling one call and one put in the same option class, in the\nsame expiration cycle, and with the same strike price.\nJust as buying astraddle is apure way to buy volatility, selling astraddle\nis away to short it. When atrader’sforecast calls for lower implied and\nrealized volatility, astraddle generates the highest returns of all volatility-\nselling strategies. Of course, with high reward necessarily comes high risk.\nAshort straddle is one of the riskiest positions to trade.\nLet’slook at aone-month 70-strike straddle sold at 4.25.\nThe risk is easily represented graphically by means of a P&(L) diagram.\nExhibit 15.5 shows the risk and reward of this short straddle.\nEXHIBIT 15.5 Short straddle P&(L) at initiation and expiration.\nIf the straddle is held until expiration and the underlying is trading below\nthe strike price, the short put is in-the-money (ITM). The lower the stock,\nthe greater the loss on the +1.00 delta from the put. The trade as awhole", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:435", "doc_id": "da0ee80e83258dc56ac123be899705716b874ae5f08107bd8013f281ee3b6ecf", "chunk_index": 0}
{"text": "will be aloser if the underlying is below the lower of the two break-even\npoints—in this case $65.75. This point is found by subtracting the premium\nreceived from the strike. Before expiration, negative gamma adversely\naffects profits as the underlying falls. The lower the underlying is trading\nbelow the strike price, the greater the drain on P&(L) due to the positive\ndelta of the short put.\nIt is the same proposition if the underlying is above $70 at expiration. But\nin this case, it is the short call that would be in-the-money. The higher the\nunderlying price, the more the −1.00 delta adversely impacts P&(L). If at\nexpiration the underlying is above the higher breakeven, which in this case\nis $74.25 (the strike plus the premium), the trade is aloser. The higher the\nunderlying, the worse off the trade. Before expiration, negative gamma\ncreates negative deltas as the underlying climbs above the strike, eating\naway at the potential profit, which is the net premium received.\nThe best-case scenario is that the underlying is right at $70 at the closing\nbell on expiration Friday. In this situation, neither option is ITM, meaning\nthat the 4.25 premium is all profit. In reaping the maximum profit, both\ntime and price play roles. If the position is closed before expiration, implied\nvolatility enters into the picture as well.\nIt’simportant to note that just because neither option is ITM if the\nunderlying is right at $70 at expiration, it doesn’tmean with certainty that\nneither option will be assigned. Sometimes options that are ATM or even\nout-of-the-money (OTM) get assigned. This can lead to apleasant or\nunpleasant surprise the Monday morning following expiration. The risk of\nnot knowing whether or not you will be assigned—that is, whether or not\nyou have aposition in the underlying security—is arisk to be avoided. It is\nthe goal of every trader to remove unnecessary risk from the equation.\nBuying the call and the put for 0.05 or 0.10 to close the position is asmall\nprice to pay when one considers the possibility of waking up Monday\nmorning to find aloss of hundreds of dollars per contract because aposition\nyou didn’teven know you owned had moved against you. Most traders\navoid this risk, referred to as pin risk, by closing short options before\nexpiration.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:436", "doc_id": "b40a3c1edfedfdc252826af10cb73b765e486842262d3aed28ca56ab79a0d60c", "chunk_index": 0}
{"text": "Trading the Short Straddle\nAshort straddle is atrade for highly speculative traders who think asecurity\nwill trade within adefined range and that implied volatility is too high.\nWhile along straddle needs to be actively traded, ashort straddle needs to\nbe actively monitored to guard against negative gamma. As adverse deltas\nget bigger because of stock price movement, traders have to be on alert,\nready to neutralize directional risk by offsetting the delta with stock or by\nlegging out of the options. To be sure, with ashort straddle, every stock\ntrade locks in aloss with the intent of stemming future losses. The ideal\nsituation is that the straddle is held until expiration and expires with the\nunderlying right at $70 with no negative-gamma scalping.\nShort-straddle traders must take alonger-term view of their positions than\nlong-straddle traders. Often with short straddles, it is ultimately time that\nprovides the payout. While long straddle traders would be inclined to watch\ngamma and theta very closely to see how much movement is required to\ncover each day’serosion, short straddlers are more inclined to focus on the\nat-expiration diagram so as not to lose sight of the end game.\nThere are some situations that are exceptions to this long-term focus. For\nexample, when implied volatility gets to be extremely high for aparticular\noption class relative to both the underlying stock’svolatility and the\nhistorical implied volatility, one may want to sell astraddle to profit from afall in IV. This can lead to leveraged short-term profits if implied volatility\ndoes, indeed, decline.\nBecause of the fact that there are two short options involved, these\nstraddles administer aconcentrated dose of negative vega. For those willing\nto bet big on adecline in implied volatility, ashort straddle is an eager\ncroupier. These trades are delta neutral and double the vega of asingle-leg\ntrade. But they’re double the gamma, too. As with the long straddle,\nrealized and implied volatility levels are both important to watch.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:438", "doc_id": "6c5db5ea1554f598e5f28e87866394376f6cc4bd4c65cb26e12a139f6a4c0dc7", "chunk_index": 0}
{"text": "Short-Straddle Example\nFor this example, atrader, John, has been watching Federal XYZ Corp.\n(XYZ) for ayear. During the 12 months that John has followed XYZ, its\nfront-month implied volatility has typically traded at around 20 percent, and\nits realized volatility has fluctuated between 15 and 20 percent. The past 30\ndays, however, have been abit more volatile. Exhibit 15.6 shows XYZ’srecent volatility.\nEXHIBIT 15.6 XYZ volatility.\nStock Price Realized VolatilityFront-Month Implied Volatility\n30-day high $111.7130-day high 26%30-day high 30%\n30-day low $102.0530-day low 21%30-day low 24%\nCurrent px $104.75Current vol 22%Current vol 26%\nThe stock volatility has begun to ease, trading now at a 22 volatility\ncompared with the 30-day high of 26, but still not down to the usual 15-to-\n20 range. The stock, in this scenario, has traded in achannel. It currently\nlies in the lower half of its recent range. Although the current front-month\nimplied volatility is in the lower half of its 30-day range, it’shistorically\nhigh compared with the 20 percent level that John has been used to seeing,\nand it’sstill four points above the realized volatility. John believes that the\nconditions that led to the recent surge in volatility are no longer present. His\nforecast is for the stock volatility to continue to ease and for implied\nvolatility to continue its downtrend as well and revert to its long-term mean\nover the next week or two. John sells 10 September 105 straddles at 5.40.\nExhibit 15.7 shows the greeks for this trade.\nEXHIBIT 15.7 Greeks for short XYZ straddle.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:439", "doc_id": "1b2cc88d87396b7ac3726be1489d4bc3e338cdf606da7d0a0fcf8439da6baf39", "chunk_index": 0}
{"text": "The goal here is for implied volatility to fall to around 20. If it does, John\nmakes $1,254 (6 vol points × 2.09 vega). He also thinks theta gains will\noutpace gamma losses. The following is atwo-week examination of one\npossible outcome for John’strade.\nWeek One\nThe first week in this example was aprofitable one, but it came with\nchallenges. John paid for his winnings with afew sleepless nights. On the\nMonday following his entry into the trade, the stock rose to $106. While\nJohn collected aweekend’sworth of time decay, the $1.25 jump in stock\nprice ate into some of those profits and naturally made him uneasy about\nthe future.\nAt this point, John was sitting on aprofit, but his position delta began to\ngrow negative, to around −1.22 [(–1.18 × 1.25) + 0.26]. For a $104.75\nstock, amove of $1.25—or just over 1 percent—is not out of the ordinary,\nbut it put John on his guard. He decided to wait and see what happened\nbefore hedging.\nThe following day, the rally continued. The stock was at $107.30 by\nnoon. His delta was around −3. In the face of an increasingly negative delta,\nJohn weighed his alternatives: He could buy back some of his calls to offset\nhis delta, which would have the added benefit of reducing his gamma as\nwell. He could buy stock to flatten out. Lastly, he could simply do nothing\nand wait. John felt the stock was overbought and might retrace. He also still\nbelieved volatility would fall. He decided to be patient and enter astop\norder to buy all of his deltas at $107.50 in case the stock continued trending\nup. The XYZ shares closed at $107.45 that day.\nThis time inaction proved to be the best action. The stock did retrace.\nWeek one ended with Federal XYZ back down around $105.50. The IV of\nthe straddle was at 23. The straddle finished up week one offered at $4.10.\nWeek Two\nThe future was looking bright at the start of week two until Wednesday.\nWednesday morning saw XYZ gap open to $109. When you have ashort\nstraddle, a $3.50 gap move in the underlying tends to instantly give you a", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:440", "doc_id": "5f3046177e81597ee66037312039ad6936e0ff9b746b11f13cb7cbee23e1bb23", "chunk_index": 0}
{"text": "sinking feeling in the pit of your stomach. But the damage was truly not that\nbad. The offer in the straddle was 4.75, so the position was still awinner if\nJohn bought it back at this point.\nGamma/delta hurt. Theta helped. Acharacteristic that enters into this\ntrade is volatility’schanging as aresult of movement in the stock price.\nDespite the fact that the stock gapped $3.50 higher, implied volatility fell by\n1 percent, to 22. This volatility reaction to the underlying’srise in price is\nvery common in many equity and index options. John decided to close the\ntrade. Nobody ever went broke taking aprofit.\nThe trade in this example was profitable. Of course, this will not always\nbe the case. Sometimes short straddles will be losers—sometimes big ones.\nBig moves and rising implied volatility can be perilous to short straddles\nand their writers. If the XYZ stock in the previous example had gapped up\nto $115—which is not an unreasonable possibility—John’strade would\nhave been ugly.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:441", "doc_id": "47bb44f6bf09d5e23d821f6f5ad053e9859c0b67f538a53685f1c1cc8605623b", "chunk_index": 0}
{"text": "Synthetic Straddles\nStraddles are the pet strategy of certain professional traders who specialize\nin trading volatility. In fact, in the mind of many of these traders, astraddle\nis all there is. Any single-legged trade can be turned into astraddle\nsynthetically simply by adding stock.\nChapter 6 discussed put-call parity and showed that, for all intents and\npurposes, aput is acall and acall is aput. For the most part, the greeks of\nthe options in the put-call pair are essentially the same. The delta is the only\nreal difference. And, of course, that can be easily corrected. As amatter of\nperspective, one can make the case that buying two calls is essentially the\nsame as buying acall and aput, once stock enters into the equation.\nTake anon-dividend-paying stock trading at $40 ashare. With 60 days\nuntil expiration, a 25 volatility, and a 4 percent interest rate, the greeks of\nthe 40-strike calls and puts of the straddle are as follows:\nEssentially, the same position can be created by buying one leg of the\nspread synthetically. For example, in addition to buying one 40 call, another\n40 call can be purchased along with shorting 100 shares of stock to create a\n40 put synthetically.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:442", "doc_id": "d15dc88c8470c54a1df2903dac0f43045cc0136dc0a359bcdb713d527013c1d9", "chunk_index": 0}
{"text": "Combined, the long call and the synthetic long put (long call plus short\nstock) creates asynthetic straddle. Along synthetic straddle could have\nsimilarly been constructed with along put and along synthetic call (long\nput plus long stock). Furthermore, ashort synthetic straddle could be\ncreated by selling an option with its synthetic pair.\nNotice the similarities between the greeks of the two positions. The\nsynthetic straddle functions about the same as aconventional straddle.\nBecause the delta and gamma are nearly the same, the up-and-down risk is\nnearly the same. Time and volatility likewise affect the two trades about the\nsame. The only real difference is that the synthetic straddle might require abit more cash up front, because it requires buying or shorting the stock. In\npractice, straddles will typically be traded in accounts with retail portfolio\nmargining or professional margin requirements (which can be similar to\nretail portfolio margining). So the cost of the long stock or margin for short\nstock is comparatively small.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:443", "doc_id": "7291536c0aabb422ecb06dddce0b4e43be5b3deee479381ee1b34e84dd27825a", "chunk_index": 0}
{"text": "Long Strangle\nDefinition : Buying one call and one put in the same option class, in the\nsame expiration cycle, but with different strike prices. Typical long\nstrangles involve an OTM call and an OTM put. Astrangle in which an\nITM call and an ITM put are purchased is called along guts strangle.\nAlong strangle is similar to along straddle in many ways. They both\nrequire buying acall and aput on the same class in the same expiration\nmonth. They are both buying volatility. There are, however, some functional\ndifferences. These differences stem from the fact that the options have\ndifferent strike prices.\nBecause there is distance between the strike prices, from an at-expiration\nperspective, the underlying must move more for the trade to show aprofit.\nExhibit 15.8 illustrates the payout of options as part of along strangle on\na $70 stock. The graph is much like that of Exhibit 15.1 , which shows the\npayout of along straddle. But the net cost here is only 1.00, compared with\n4.25 for the straddle with the same time and volatility inputs. The cost is\nlower because this trade consists of OTM options instead of ATM options.\nThe breakdown is as follows:", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:444", "doc_id": "a808ff7f7871a66e2532f116149f26cdb97f5c192fb1c4faf5fe84f5dfbc556c", "chunk_index": 0}
{"text": "EXHIBIT 15.8 Long strangle at-expiration diagram.\nThe underlying has abit farther to go by expiration for the trade to have\nvalue. If the underlying is above $75 at expiration, the call is ITM and has\nvalue. If the underlying is below $65 at expiration, the put is ITM and has\nvalue. If the underlying is between the two strike prices at expiration both\noptions expire and the 1.00 premium is lost.\nAn important difference between astraddle and astrangle is that if astrangle is held until expiration, its break-even points are farther apart than\nthose of acomparable straddle. The 70-strike straddle in Exhibit 15.1 had alower breakeven of $65.75 and an upper break-even of $74.25. The\ncomparable strangle in this example has break-even prices of $64 and $76.\nBut what if the strangle is not held until expiration? Then the trade’sgreeks must be analyzed. Intuitively, two OTM options (or ITM ones, for\nthat matter) will have lower gamma, theta, and vega than two comparable\nATM options. This has atwo-handed implication when comparing straddles\nand strangles.\nOn the one hand, from arealized volatility perspective, lower gamma\nmeans the underlying must move more than it would have to for astraddle\nto produce the same dollar gain per spread, even intraday. But on the other\nhand, lower theta means the underlying doesn’thave to move as much to\ncover decay. Alower nominal profit but ahigher percentage profit is\ngenerally reaped by strangles as compared with straddles.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:445", "doc_id": "e2f2d527d10b01d0df51794ff9e2c608a0fd39a7dccc0dfde641f6f832993926", "chunk_index": 0}
{"text": "Long-Strangle Example\nLet’sreturn to Susan, who earlier in this chapter bought astraddle on Acme\nBrokerage Co. (ABC). Acme currently trades at $74.80 ashare with current\nrealized volatility at 36 percent. The stock’svolatility range for the past\nmonth was between 36 and 47. The implied volatility of the four-week\noptions is 36 percent. The range over the past month for the IV of the front\nmonth has been between 34 and 55.\nAs in the long-straddle example earlier in this chapter, there is agreat deal\nof uncertainty in brokerage stocks revolving around interest rates, credit-\ndefault problems, and other economic issues. An FOMC meeting is\nexpected in about one week’stime about whose possible actions analysts’\nestimates vary greatly, from acut of 50 basis points to no cut at all. Add apending earnings release to the docket, and Susan thinks Acme may move\nquite abit.\nIn this case, however, instead of buying the 75-strike straddle, Susan pays\n2.35 for 20 one-month 70–80 strangles. Exhibit 15.9 compares the greeks of\nthe long ATM straddle with those of the long strangle.\nEXHIBIT 15.9 Long straddle versus long strangle.\nThe cost of the strangle, at 2.35, is about 40 percent of the cost of the\nstraddle. Of course, with two long options in each trade, both have positive\ngamma and vega and negative theta, but the exposure to each metric is less\nwith the strangle. Assuming the same stock-price action, astrangle would", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:447", "doc_id": "22317d0dd8cb74ea2ee019f3cc80afa7e8ea78db9ff9473ad1f0c47125268e84", "chunk_index": 0}
{"text": "enjoy profits from movement and losses from lack of movement that were\nsimilar to those of astraddle—just nominally less extreme.\nFor example, if Acme stock rallies $5, from $74.80 to $79.80, the gamma\nof the 75 straddle will grow the delta favorably, generating again of 1.50,\nor about 25 percent. The 70–80 strangle will make 1.15 from the curvature\nof the delta–almost a 50 percent gain.\nWith the straddle and especially the strangle, there is one more detail to\nfactor in when considering potential P&L: IV changes due to stock price\nmovement. IV is likely to fall as the stock rallies and rise as the stock\ndeclines. The profits of both the long straddle and the long strangle would\nlikely be adversely affected by IV changes as the stock rose toward $79.80.\nAnd because the stock would be moving away from the straddle strike and\ntoward one of the strangle strikes, the vegas would tend to become more\nsimilar for the two trades. The straddle in this example would have avega\nof 2.66, while the strangle’svega would be 2.67 with the underlying at\n$79.80 per share.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:448", "doc_id": "0ff01b3755e1fa6186a05f510481442f54881b4e472ee439cec979e441c3284d", "chunk_index": 0}
{"text": "Short Strangle\nDefinition : Selling one call and one put in the same option class, in the\nsame expiration cycle, but with different strike prices. Typically, an OTM\ncall and an OTM put are sold. Astrangle in which an ITM call and an ITM\nput are sold is called ashort guts strangle.\nAshort strangle is avolatility-selling strategy, like the short straddle. But\nwith the short strangle, the strikes are farther apart, leaving more room for\nerror. With these types of strategies, movement is the enemy. Wiggle room\nis the important difference between the short-strangle and short-straddle\nstrategies. Of course, the trade-off for ahigher chance of success is lower\noption premium.\nExhibit 15.10 shows the at-expiration diagram of ashort strangle sold at\n1.00, using the same options as in the diagram for the long strangle.\nEXHIBIT 15.10 Short strangle at-expiration diagram.\nNote that if the underlying is between the two strike prices, the maximum\ngain of 1.00 is harvested. With the stock below $65 at expiration, the short\nput is ITM, with a +1.00 delta. If the stock price is below the lower\nbreakeven of $64 (the put strike minus the premium), the trade is aloser.\nThe lower the stock, the bigger the loss. If the underlying is above $75, the", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:449", "doc_id": "45d543d10256825eb8277a6e87368f4636bbe9b38a20bf267e0100a6c648198b", "chunk_index": 0}
{"text": "short call is ITM, with a −1.00 delta. If the stock is above the upper\nbreakeven of $76 (the call strike plus the premium), the trade is aloser. The\nhigher the stock, the bigger the loss.\nIntuitively, the signs of the greeks of this strangle should be similar to\nthose of ashort straddle—negative gamma and vega, positive theta. That\nmeans that increased realized volatility hurts. Rising IV hurts. And time\nheals all wounds—unless, of course, the wounds caused by gamma are\ngreater than the net premium received.\nThis brings us to an important philosophical perspective that emphasizes\nthe differences between long straddles and strangles and their short\ncounterparts. Losses from rising vega are temporary; the time value of all\noptions will be zero at expiration. But gamma losses can be permanent and\nprofound. These short strategies have limited profit potential and unlimited\nloss potential. Although short-term profits (or losses) can result from IV\nchanges, the real goal here is to capture theta.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:450", "doc_id": "ee1adb8820059f7bb2be50124297c628bfe6f3ff782c9ab221a1bf816464452a", "chunk_index": 0}
{"text": "Short-Strangle Example\nLet’srevisit John, a Federal XYZ (XYZ) trader. XYZ is at $104.75 in this\nexample, with an implied volatility of 26 percent and astock volatility of\n22. Both implied and realized volatility are higher than has been typical\nduring the past twelve months. John wants to sell volatility. In this example,\nhe believes the stock price will remain in afairly tight range, causing\nrealized volatility to revert to its normal level, in this case between 15 and\n20 percent.\nHe does everything possible to ensure success. This includes scanning the\nnews headlines on XYZ and its financials for areason not to sell volatility.\nPlaying devil’sadvocate with oneself can uncover unforeseen yet valid\nreasons to avoid making bad trades. John also notes the recent price range,\nwhich has been between $111.71 and $102.05 over the past month. Once\nJohn commits to an outlook on the stock, he wants to set himself up for\nmaximum gain if he’sright and, for that matter, to maximize his chances of\nbeing right. In this case, he decides to sell astrangle to give himself as\nmuch margin for error as possible. He sells 10 three-week 100–110\nstrangles at 1.80.\nExhibit 15.11 compares the greeks of this strangle with those of the 105\nstraddle.\nEXHIBIT 15.11 Short straddle vs. short strangle.\nAs expected, the strangle’sgreeks are comparable to the straddle’sbut of\nless magnitude. If John’sintention were to capture adrop in IV, he’dbe", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:451", "doc_id": "8a03581019454b22dbab0508abac914e19c07d45eb0f9f8bb8a663f3b76fb0a3", "chunk_index": 0}
{"text": "better off selling the bigger vega of the straddle. Here, though, he wants to\nsee the premium at zero at expiration, so the strangle serves his purposes\nbetter. What he is most concerned about are the breakevens—in this case,\n98.20 and 111.8. The straddle has closer break-even points, of $99.60 and\n$110.40.\nDespite the fact that in this case, John is not really trading the greeks or\nIV per se, they still play an important role in his trade. First, he can use\ntheta to plan the best strangle to trade. In this case, he sells the three-week\nstrangle because it has the highest theta of the available months. The second\nmonth strangle has a −0.71 theta, and the third month has a −0.58 theta.\nWith strangles, because the options are OTM, this disparity in theta among\nthe tradable months may not always be the case. But for this trade, if he is\nstill bearish on realized volatility after expiration, John can sell the next\nmonth when these options expire.\nCertainly, he will monitor his risk by watching delta and gamma. These\nare his best measures of directional exposure. He will consider implied\nvolatility in the decision-making process, too. An implied volatility\nsignificantly higher than the realized volatility can be ared flag that the\nmarket expects something to happen, but there’sabigger payoff if there is\nno significant volatility. An IV significantly lower than the realized can\nindicate the risk of selling options too cheaply: the premium received is not\nhigh enough, based on how much the stock has been moving. Ideally, the\nIV should be above the realized volatility by between 2 and 20 percent,\nperhaps more for highly speculative traders.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:452", "doc_id": "d44d2eaf8d86fb630930cd9d80224682d7b123131e82ed6e004a5dd2ee07f352", "chunk_index": 0}
{"text": "Backspreads\nDefinition : An option strategy consisting of more long options than short\noptions having the same expiration month. Typically, the trader is long calls\n(or puts) in one series of options and short afewer number of calls (or puts)\nin another series with the same expiration month in the same option class.\nSome traders, such as market makers, refer generically to any delta-neutral\nlong-gamma position as abackspread.\nShades of Gray\nIn its simplest form, trading abackspread is trading aone-by-two call or put\nspread and holding it until expiration in hopes that the underlying stock’sprice will make abig move, particularly in the more favorable direction.\nBut holding abackspread to expiration as described has its challenges. Let’slook at ahypothetical example of abackspread held to term and its at-\nexpiration diagram.\nWith the stock at $71 and one month until March expiration:\nIn this example, there is acredit of 3.20 from the sale of the 70 call and adebit of 1.10 for each of the two 75 calls. This yields atotal net credit of\n1.00 (3.20 − 1.10 − 1.10). Let’sconsider how this trade performs if it is held\nuntil expiration.\nIf the stock falls below $70 at expiration, all the calls expire and the 1.00\ncredit is all profit. If the stock is between $70 and $75 at expiration, the 70\ncall is in-the-money (ITM) and the −1.00 delta starts racking up losses\nabove the breakeven of $71 (the strike plus the credit). At $75 ashare this\ntrade suffers its maximum potential loss of $4. If the stock is above $75 at\nexpiration, the 75 calls are ITM. The net delta of +1.00, resulting from the\n+2.00 deltas of the 75 calls along with the −1.00 delta of the 70 call, makes\nmoney as the stock rises. To the upside, the trade is profitable once the\nstock is at ahigh enough price for the gain on the two 75 calls to make up", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:458", "doc_id": "0f8ce8ec1590f13305d44adc67512a449b53a2615493498e8e1f49baa3f55b77", "chunk_index": 0}
{"text": "for the loss on the 70 call. In this case, the breakeven is $79 (the $4\nmaximum potential loss plus the strike price of 75).\nWhile it’sgood to understand this at-expiration view of this trade, this\ndiagram is abit misleading. What does the trader of this spread want to\nhave happen? If the trader is bearish, he could find abetter way to trade his\nview than this, which limits his gains to 1.00—he could buy aput. If the\ntrader believes the stock will make avolatile move in either direction, the\nbackspread offers adecidedly limited opportunity to the downside. Astraddle or strangle might be abetter choice. And if the trader is bullish, he\nwould have to be very bullish for this trade to make sense. The underlying\nneeds to rise above $79 just to break even. If instead he just bought 2 of the\n75 calls for 1.10, the maximum risk would be 2.20 instead of 4, the\nbreakeven would be $77.20 instead of $79, and profits at expiration would\nrack up twice as fast above the breakeven, since the trader is net long two\ncalls instead of one. Why would atrader ever choose to trade abackspread?\nEXHIBIT 16.1 Backspread at expiration.\nThe backspread is acomplex spread that can be fully appreciated only\nwhen one has athorough knowledge of options. Instead of waiting patiently\nuntil expiration, an experienced backspreader is more likely to gamma scalp\nintermittent opportunities. This requires trading alarge enough position to\nmake scalping worthwhile. It also requires appropriate margining (either\nprofessional-level margin requirements or retail portfolio margining). For", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:459", "doc_id": "888acbfeecf38f10044eef817d643c804eba646bf9335e7176402adbd66f944f", "chunk_index": 0}
{"text": "example, this 1:2 contract backspread has adelta of −0.02 and agamma of\n+0.05. Fewer than 10 deltas could be scalped if the stock moves up and\ndown by one point. It becomes amore practical trade as the position size\nincreases. Of course, more practical doesn’tnecessarily guarantee it will be\nmore profitable. The market must cooperate!\nBackspread Example\nLet’ssay a 20:40 contract backspread is traded. (Note : In trader lingo this is\nstill called aone-by-two; it is just traded 20 times.) The spread price is still\n1.00 credit per contract; in this case, that’s $2,000. But with this type of\ntrade, the spread price is not the best measure of risk or reward, as it is with\nsome other kinds of spreads. Risk and reward are best measured by delta,\ngamma, theta, and vega. Exhibit 16.2 shows this trade’sgreeks.\nEXHIBIT 16.2 Greeks for 20:40 backspread with the underlying at $71.\nBackspreads are volatility plays. This spread has a +1.07 vega with the\nstock at $71. It is, therefore, abullish implied volatility (IV) play. The IV of\nthe long calls, the 75s, is 30 percent, and that of the 70s is 32 percent. Much\nas with any other volatility trade, traders would compare current implied\nvolatility with realized volatility and the implied volatility of recent past\nand consider any catalysts that might affect stock volatility. The objective is\nto buy an IV that is lower than the expected future stock volatility, based on\nall available data. The focus of traders of this backspread is not the dollar\ncredit earned. They are more interested in buying a 30 volatility—that’sthe\nfocus.\nBut the 75 calls’ IV is not the only volatility figure to consider. The short\noptions, the 70s, have implied volatility of 32 percent. Because of their", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:460", "doc_id": "032c9875455e0a1cc32a0ba2aa9b4de969b60ed578a4612c9ee1ea14c413a648", "chunk_index": 0}
{"text": "lower strike, the IV is naturally higher for the 70 calls. This is vertical skew\nand is described in Chapter 3. The phenomenon of lower strikes in the same\noption class and with the same expiration month having higher IV is very\ncommon, although it is not always the case.\nBackspreads usually involve trading vertical skew. In this spread, traders\nare buying a 30 volatility and selling a 32 volatility. In trading the skew, the\ntraders are capturing two volatility points of what some traders would call\nedge by buying the lower volatility and selling the higher.\nBased on the greeks in Exhibit 16.2 , the goal of this trade appears fairly\nstraightforward: to profit from gamma scalping and rising IV. But, sadly,\nwhat appears to be straightforward is not. Exhibit 16.3 shows the greeks of\nthis trade at various underlying stock prices.\nEXHIBIT 16.3 70–75 backspread greeks at various stock prices.\nNotice how the greeks change with the stock price. As the stock price\nmoves lower through the short strike, the 70 strike calls become the more\nrelevant options, outweighing the influence of the 75s. Gamma and vega\nbecome negative, and theta becomes positive. If the stock price falls low\nenough, this backspread becomes avery different position than it was with\nthe stock price at $71. Instead of profiting from higher implied and realized\nvolatility, the spread needs alower level of both to profit.\nThis has important implications. First, gamma traders must approach the\nbackspread alittle differently than they would most spreads. The\nbackspread traders must keep in mind the dynamic greeks of the position.\nWith atrade like along straddle, in which there are no short options, traders\nscalping gamma simply buy to cover short deltas as the stock falls and sell\nto cover long deltas as the stock rises. The only risks are that the stock may\nnot move enough to cover theta or that the traders may cover deltas too\nsoon to maximize profits.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:461", "doc_id": "9d57e21a9b5c53e246cb5b2d9a1163ee4eab2a6f693f6feee90a42914ff38dee", "chunk_index": 0}
{"text": "With the backspread, the changing gamma adds one more element of risk.\nIn this example, buying stock to flatten out delta as the stock falls can\nsometimes be apremature move. Traders who buy stock may end up with\nmore long deltas than they bargained for if the stock falls into negative-\ngamma territory.\nExhibit 16.3 shows that with the stock at $68, the delta for this trade is\n−2.50. If the traders buy 250 shares at $68, they will be delta neutral. If the\nstock subsequently falls to $62 ashare, instead of being short 1.46 deltas, as\nthe figure indicates, they will be long 1.04 because of the 250 shares they\nbought. These long deltas start to hurt as the stock continues lower.\nBackspreaders must therefore anticipate stock movements to avoid\noverhedging. The traders in this example may decide to lean short if the\nstock shows signs of weakness.\nLeaning short means that if the delta is −2.50 at $68 ashare, the traders\nmay decide to underhedge by buying just 100 or 200 shares. If the stock\ncontinues to fall and negative gamma kicks in, this gives the traders some\ncushion to the downside. The short delta of the position moves closer to\nbeing flat as the stock falls. Because there is along strike and ashort strike\nin this delta-neutral position, trading ratio spreads is like trading along and\nashort volatility position at the same time. Trading backspreads is not an\nexact science. The stock has just as good achance of rising as it does of\nfalling, and if it does rise and the traders have underhedged at $68, they will\nnot participate in all the gains they would have if they had fully hedged by\nbuying 250 shares of stock. If trading were easy, everyone would do it!\nBackspreaders must also be conscious of the volatility of each leg of the\nspread. There is an inherent advantage in this example to buying the lower\nvolatility of the 75 calls and selling the higher volatility of the 70 calls. But\nthere is also implied risk. Equity prices and IV tend to have an inverse\nrelationship. When stock prices fall—especially if the drop happens quickly\n—IV will often rise. When stock prices rise, IV often falls.\nIn this backspread example, as the stock price falls to or through the short\nstrike, vega becomes negative in the face of apotentially rising IV. As the\nstock price rises into positive vega turf, there is the risk of IV’sdeclining. Adynamic volatility forecast should be part of abackspread-trading plan. One\nof the volatility questions traders face in this example is whether the two-", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:462", "doc_id": "d063d6cdce83de8ec743c1fe509f4fb09c66d294ee9d4b5eeb5458c3fe75d6f9", "chunk_index": 0}
{"text": "Ratio Vertical Spreads\nDefinition : An option strategy consisting of more short options than long\noptions having the same expiration month. Typically, the trader is short calls\n(or puts) in one series of options and long afewer number of calls (or puts)\nin another series in the same expiration month on the same option class.\nAratio vertical spread, like abackspread, involves options struck at two\ndifferent prices—one long strike and one short. That means that it is avolatility strategy that may be long or short gamma or vega depending on\nwhere the underlying price is at the time. The ratio vertical spread is\neffectively the opposite of abackspread. Let’sstudy aratio vertical using\nthe same options as those used in the backspread example.\nWith the stock at $71 and one month until March expiration:\nIn this case, we are buying one ITM call and selling two OTM calls. The\nrelationship of the stock price to the strike price is not relevant to whether\nthis spread is considered aratio vertical spread. Certainly, all these options\ncould be ITM or OTM at the time the trade is initiated. It is also not\nimportant whether the trade is done for adebit or acredit. If the stock price,\ntime to expiration, volatility, or number of contracts in the ratio were\ndifferent, this could just as easily been acredit ratio vertical.\nExhibit 16.4 illustrates the payout of this strategy if both legs of the 1:2\ncontract are still open at expiration.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:464", "doc_id": "890bb643e124ffb25e87cd8819aa54fcc67661bd41a1151cea2875aefd96268d", "chunk_index": 0}
{"text": "EXHIBIT 16.4 Short ratio spread at expiration.\nThis strategy is amirror image of the backspread discussed previously in\nthis chapter. With limited risk to the downside, the maximum loss to the\ntrade is the initial debit of 1 if the stock is below $70 at expiration and all\nthe calls expire. There is amaximum profit potential of 4 if the stock is at\nthe short strike at expiration. There is unlimited loss potential, since ashort\nnet delta is created on the upside, as one short 75 call is covered by the long\n70 call, and one is naked. The breakevens are at $71 and $79.\nLow Volatility\nWith the stock at $71, gamma and vega are both negative. Just as the\nbackspread was along volatility play at this underlying price, this ratio\nvertical is ashort-vol play here. As in trading ashort straddle, the name of\nthe game is low volatility—meaning both implied and realized.\nThis strategy may require some gamma hedging. But as with other short\nvolatility delta-neutral trades, the fewer the negative scalps, the greater the\npotential profit. Delta covering should be implemented in situations where\nit looks as if the stock will trend deep into negative-gamma territory.\nMurphy’s Law of trading dictates that delta covering will likely be wrong at\nleast as often as it is right.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:465", "doc_id": "d77ba882519612332801f4ad1f77aa3623511c61d184348dd42f7b736c2025a0", "chunk_index": 0}
{"text": "Ratio Vertical Example\nLet’sexamine atrade of 20 contracts by 40 contracts. Exhibit 16.5 shows\nthe greeks for this ratio vertical.\nEXHIBIT 16.5 Short ratio vertical spread greeks.\nBefore we get down to the nitty-gritty of the mechanics and management\nof this trade—the how—let’sfirst look at the motivations for putting the\ntrade on—the why. For the cost of 1.00 per spread, this trader gets aleveraged position if the stock rises moderately. The profits max out with\nthe stock at the short-strike target price—$75—at expiration.\nAnother possible profit engine is IV. Because of negative vega, there is\nthe chance of taking aquick profit if IV falls in the interim. But short-term\nlosses are possible, too. IV can rise, or negative gamma can hurt the trader.\nUltimately, having naked calls makes this trade not very bullish. Abig\nmove north can really hurt.\nBasically, this is adelta-neutral-type short-volatility play that wins the\nmost if the stock is at $75 at expiration. One would think about making this\ntrade if the mechanics fit the forecast. If this trader were amore bullish than\nindicated by the profit and loss diagram, amore-balanced bull call spread\nwould be abetter strategy, eliminating the unlimited upside risk. If upside\nrisk were acceptable, this trader could get more aggressive by trading the\nspread one-by-three. That would result in acredit of 0.05 per spread. There\nwould then be no ultimate risk below $70 but rather a 0.05 gain. With\ndouble the naked calls, however, there would be double punishment if the\nstock rallied strongly beyond the upside breakeven.\nUltimately, mastering options is not about mastering specific strategies.\nIt’sabout having athorough enough understanding of the instrument to be", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:466", "doc_id": "867abc4de6ec015c983e1e30940b4f476b9aee42a49dfd936972f6584529f670", "chunk_index": 0}
{"text": "flexible enough to tailor aposition around aforecast. It’sabout minimizing\nthe unwanted risks and optimizing exposure to the intended risks. Still,\nthere always exists atrade-off in that where there is the potential for profit,\nthere is the possibility of loss—you can always be wrong.\nRecalling the at-expiration diagram and examining the greeks, the best-\ncase scenario is intuitive: the stock at $75 at expiration. The biggest theta\nwould be right at that strike. But that strike price is also the center of the\nbiggest negative gamma. It is important to guard against upward movement\ninto negative delta territory, as well as movement lower where the position\nhas aslightly positive delta. Exhibit 16.6 shows what happens to the greeks\nof this trade as the stock price moves.\nEXHIBIT 16.6 Ratio vertical spread at various prices for the underlying.\nAs the stock begins to rise from $71 ashare, negative deltas grow fast in\nthe short term. Careful trend monitoring is necessary to guard against arally. The key, however, is not in knowing what will happen but in skillfully\nhedging against the unknown. The talented option trader is adisciplined\nrisk manager, not aclairvoyant.\nOne of the risks that the trader willingly accepted when placing this trade\nwas short gamma. But when the stock moves and deltas are created,\ndecisions have to be made. Did the catalyst(s)—if any—that contributed to\nthe rise in stock price change the outlook for volatility? If not, the decision\nis simply whether or not to hedge by buying stock. However, if it appears\nthat volatility is on the rise, it is not just adelta decision. Atrader may\nconsider buying some of the short options back to reduce volatility\nexposure.\nIn this example, if the stock rises and it’sfeared that volatility may\nincrease, agood choice may be to buy back some of the short 75-strike\ncalls. This has the advantage of reducing delta (buy enough deltas to flatten", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:467", "doc_id": "19b143d3177f1110517777f1d87c735419dfabc5d5a4ec0639a6bba86312cd2a", "chunk_index": 0}
{"text": "How Market Makers Manage\nDelta-Neutral Positions\nWhile market makers are not position traders per se, they are expert\nposition managers. For the most part, market makers make their living by\nbuying the bid and selling the offer. In general, they don’tact; they react.\nMost of their trades are initiated by taking the other side of what other\npeople want to do and then managing the risk of the positions they\naccumulate.\nThe business of amarket maker is much like that of acasino. Acasino\ntakes the other side of people’sbets and, in the long run, has astatistical\n(theoretical) edge. For market makers, because theoretical value resides in\nthe middle of the bid and the ask, these accommodating trades lead to atheoretical profit—that is, the market maker buys below theoretical value\nand sells above. Actual profit—cold, hard cash you can take to the bank—\nis, however, dependent on sound management of the positions that are\naccumulated.\nMy career as amarket maker was on the floor of the Chicago Board\nOptions Exchange (CBOE) from 1998 to 2005. Because, over all, the trades\nImade had atheoretical edge, Ihoped to trade as many contracts as\npossible on my markets without getting too long or too short in any option\nseries or any of my greeks.\nAs aresult of reacting to order flow, market makers can accumulate alarge number of open option series for each class they trade, resulting in asingle position. For example, Exhibit 16.7 shows aposition Ihad in Ford\nMotor Co. (F) options as amarket maker.\nEXHIBIT 16.7 Market-maker position in Ford Motor Co. options.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:469", "doc_id": "bbc031fff35ec84bcfd264931f7fa169bfd625aabba1a9399fec9480df85b6c4", "chunk_index": 0}
{"text": "options to me at prices Iwanted to buy them—my bid—and buying options\nfrom me at prices Iwanted to sell them—my offer. Upon making an option\ntrade, Ineeded to hedge directional risk immediately. Iusually did so by\noffsetting my option trades by taking the opposite delta position in the stock\n—especially on big-delta trades. Through this process of providing liquidity\nto the market, Ibuilt up option-centric risk.\nTo manage this risk Ineeded to watch my other greeks. To be sure, trying\nto draw a P&Ldiagram of this position would be afruitless endeavor.\nExhibit 16.8 shows the risk of this trade in its most distilled form.\nEXHIBIT 16.8 Analytics for market-maker position in Ford Motor Co.\n(stock at $15.72).\nDelta +1,075\nGamma−10,191\nTheta +1,708\nVega +7,171\nRho −33,137\nThe +1,075 delta shows comparatively small directional risk relative to\nthe −10,191 gamma. Much of the daily task of position management would\nbe to carefully guard against movement by delta hedging when necessary to\nearn the $1,708 per day theta.\nMuch of the negative gamma/positive theta comes from the combined\n1,006 short January 15 calls and puts. (Note that because this position is\ntraded delta neutral, the net long or short options at each strike is what\nmatters, not whether the options are calls or puts. Remember that in delta-\nneutral trading, aput is acall, and acall is aput.) The positive vega stems\nfrom the fact that the position is long 1,927 January 2003 20-strike options.\nAlthough this position has alot going on, it can be broken down many\nways. Having long LEAPS options and short front-month options gives this\nposition the feel of atime spread. One way to think of where most of the\ngamma risk is coming from is to bear in mind that the 15 strike is\nsynthetically short 503 straddles (1,006 options ÷ two). But this position\noverall is not like astraddle. There are more strikes involved—alot more.\nThere is more short gamma to the downside if the price of Ford falls toward\n$12.50. To the upside, the 17.50 strike is long acombined total of 439\noptions. Looking at just the 15 and 17.50 strikes, we can see something that", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:472", "doc_id": "9efc3cbe7cc2dcef4c70c4b537941397fc5381e244f7931251ed3b622e151109", "chunk_index": 0}
{"text": "Trading Flat\nMost market makers like to trade flat—that is, profit from the bid-ask\nspread and strive to lower exposure to direction, time, volatility, and interest\nas much as possible. But market makers are at the mercy of customer\norders, or paper, as it’sknown in the industry. If someone sells, say, the\nMarch 75 calls to amarket maker at the bid, the best-case scenario is that\nmoments later someone else buys the same number of the same calls—the\nMarch 75s, in this case—from that same market maker at the offer. This is\nlocking in aprofit.\nUnfortunately, this scenario seldom plays out this way. In my seven years\nas amarket maker, Ican count on one hand the number of times the option\ngods smiled upon me in such away as to allow me to immediately scalp an\noption. Sometimes, the same option will not trade again for aweek or\nlonger. Very low-volume options trade “by appointment only.” Amarket\nmaker trading illiquid options may hold the position until it expires, having\nno chance to get out at areasonable price, often taking aloss on the trade.\nMore typically, if amarket maker buys an option, he must sell adifferent\noption to lessen the overall position risk. The skills these traders master are\nto lower bids and offers on options when they are long gamma and/or vega\nand to raise bids and offers on options when they are short gamma and/or\nvega. This raising and lowering of markets is done to manage risk.\nEffectively, this is your standard high school economics supply-and-\ndemand curves in living color. When the market demands (buys) all the\noptions that are supplied (offered) at acertain price, the price rises. When\nthe market supplies (sells) all the options demanded (bid) at aprice level,\nthe price falls. The catalyst of supply and demand is the market maker and\nhis risk tolerance. But instead of the supply and demand for individual\noptions, it is supply and demand for gamma, theta, and vega. This is trading\noption greeks.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:475", "doc_id": "abcb68de79f4ac914e7fda70819b1c716a3a34baf60bddf457c73b822e4539c8", "chunk_index": 0}
{"text": "Hedging the Risk\nDelta is the easiest risk for floor traders to eliminate quickly. It becomes\nsecond nature for veteran floor traders to immediately hedge nearly every\ntrade with the underlying. Remember, these liquidity providers are in the\nbusiness of buying option bids and selling option offers, not speculating on\ndirection.\nThe next hurdle is to trade out of the option-centric risk. This means that\nif the market maker is long gamma, he needs to sell options; if he’sshort\ngamma, he needs to buy some. Same with theta and vega. Market makers\nmove their bids and offers to avoid being saddled with too much gamma,\ntheta, and vega risk. Experienced floor traders are good at managing option\nrisk by not biting off more than they can chew. They strive to never buy or\nsell more options than they can spread off by selling or buying other\noptions. This breed of trader specializes in trading the spread and managing\nrisk, not in predicting the future. They’re market makers, not market takers.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:476", "doc_id": "214bc407beddd4bb7bcd39c4ee0954a77cedff602239780c426e58e08fdccbaf", "chunk_index": 0}
{"text": "Trading Skew\nThere are some trading strategies for which market makers have anatural\npropensity that stems from their daily activity of maintaining their\npositions. While money managers who manage equity funds get to know\nthe fundamentals of the stocks they trade very well, options market makers\nknow the volatility of the option classes they trade. When they adjust their\nmarkets in reacting to order flow, it’s, mechanically, implied volatility that\nthey are raising or lowering to change theoretical values. They watch this\nfigure very carefully and trade its subtle changes.\nAcharacteristic of options that many market makers and some other\nactive professional traders observe and trade is the volatility skew. Savvy\ntraders watch the implied volatility of the strikes above the at-the-money\n(ATM)—referred to as calls , for simplicity—compared with the strikes\nbelow the ATM, referred to as puts . In most stocks, there typically exists a\n“normal” volatility skew inherent to options on that stock. When this skew\ngets out of line, there may be an opportunity.\nSay for aparticular option class, the call that is 10 percent OTM typically\ntrades about four volatility points lower than the put that is 10 percent\nOTM. For example, for a $50 stock, the 55 calls are trading at a 21 IV and\nthe 45 puts are trading at a 25 volatility. If the 45 puts become bid higher,\nsay, nine points above where the calls are offered—for instance, the puts are\nbid at 32 volatility bid while the calls are offered at 23 vol—atrader can\nspeculate on the skew reverting back to its normal relationship by selling\nthe puts, buying the calls, and hedging the delta by selling the right amount\nof stock.\nThis position—long acall, short aput with adifferent strike, and short\nstock on adelta-neutral ratio—is called arisk reversal. The motive for risk\nreversals is to capture vega as the skew realigns itself. But there are many\nrisk factors that require careful attention.\nFirst, as in other positions consisting of both long and short strikes, the\ngamma, theta, and vega of the position will vary from positive to negative\ndepending on the price of the underlying. Risk-reversal traders must be", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:477", "doc_id": "7ace96f28691222fbc445d79789d08f052c79306d8c61f7ac5b431f9b2895caf", "chunk_index": 0}
{"text": "When Delta Neutral Isn’t Direction\nIndifferent\nMany dynamic-volatility option positions, such as the risk reversal, have\nvega risk from potential IV changes resulting from the stock’smoving. This\nis indirectly adirectional risk. While having adelta-neutral position hedges\nagainst the rather straightforward directional risk of the position delta, this\nhidden risk of stock movement is left unhedged. In some circumstances, adelta-lean can help abate some of the vega risk of stock-price movement.\nSay an option position has fairly flat greeks at the current stock price. Say\nthat given the way this particular position is set up, if the stock rises, the\nposition is still fairly flat, but if the stock falls, short lower-strike options\nwill lead to negative gamma and vega. One way to partially hedge this\nposition is to lean short deltas—that is, instead of maintaining atotally flat\ndelta, have aslightly short delta. That way, if the stock falls, the trade\nprofits some on the short stock to partially offset some of the anticipated\nvega losses. The trade-off of this hedge is that if the stock rises, the trade\nloses on the short delta.\nDelta leans are more of an art than ascience and should be used as ahedge only by experienced vol traders. They should be one part of awell-\norchestrated plan to trade the delta, gamma, theta, and vega of aposition.\nAnd, to be sure, adelta lean should be entered into amodel for simulation\npurposes before executing the trade to study the up-and-down risk of the\nposition. If the lean reduces the overall risk of the position, it should be\nimplemented. But if it creates asituation where there is an anticipated loss\nif the stock moves in either direction and there is little hope of profiting\nfrom the other greeks, the lean is not the answer—closing the position is.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:479", "doc_id": "85b52d09853d9eb1db9b737c9d5300ba48a894cd50371acf7680e29d86b0d4d0", "chunk_index": 0}
{"text": "Managing Multiple-Class Risk\nMost traders hold option positions in more than one option class. As an\naside, Irecommend doing so, capital and experience permitting. In my\nexperience, having positions in multiple classes psychologically allows for\nacertain level of detachment from each individual position. Most traders\ncan make better decisions if they don’thave all their eggs in one basket.\nBut holding aportfolio of option positions requires one more layer of risk\nmanagement. The trader is concerned about the delta, gamma, theta, vega,\nand rho not only of each individual option class but also of the portfolio as awhole. The trader’sportfolio is actually one big position with alot of\nmoving parts. To keep it running like awell-oiled machine requires\nmonitoring and maintaining each part to make sure they are working\ntogether. To have the individual trades work in harmony with one another, it\nis important to keep awell-balanced series of strategies.\nOption trading requires diversification, just like conventional linear stock\ntrading or investing. Diversification of the option portfolio is easily\nmeasured by studying the portfolio greeks. By looking at the net greeks of\nthe portfolio, the trader can get some idea of exposure to overall risk in\nterms of delta, gamma, theta, vega, and rho.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:480", "doc_id": "134273e549d6621fea47451a87e6f0892d93cbc4a4901e471f69a60cd31b6422", "chunk_index": 0}
{"text": "CHAPTER 17\nPutting the Greeks into Action\nThis book was intended to arm the reader with the knowledge of the greeks\nneeded to make better trading decisions. As the preface stated, this book is\nnot so much ahow-to guide as ahow-come tutorial. It is step one in athree-\nstep learning process:\nStep One: Study . First, aspiring option traders must learn as much as\npossible from books such as this one and from other sources, such as\narticles, both in print and online, and from classes both in person and\nonline. After completing this book, the reader should have asolid base\nof knowledge of the greeks.\nStep Two: Paper Trade . Atruly deep understanding requires practice,\npractice, and more practice! Fortunately, much of this practice can be\ndone without having real money on the line. Paper trading—or\nsimulated trading—in which one trades real markets but with fake\nmoney is step two in the learning process. Ihighly recommend paper\ntrading to kick the tires on various types of strategies and to see how\nthey might work differently in reality than you thought they would in\ntheory.\nStep Three: Showtime ! Even the most comprehensive academic study\nor windfall success with paper profits doesn’tgive one atrue feel for\nhow options work in the real world. There are some lessons that must\nbe learned from the black and the blue. When there’sreal money on the\nline, you will trade differently—at least in the beginning. It’shuman\nnature to be cautious with wealth. This is not abad thing. But emotions\nshould not override sound judgment. Start small—one or two lots per\ntrade—until you can make rational decisions based on what you have\nlearned, keeping emotions in check.\nThis simple three-step process can take years of diligent work to get it\nright. But relax. Getting rich quick is truly apoor motivation for trading\noptions. Option trading is abeautiful thing! It’sabout winning. It’sabout", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:481", "doc_id": "82cba9b98499f6304405c14e42876c64cbcf44e9a0a734fb9f15eee4d44a6a23", "chunk_index": 0}
{"text": "Example 1\nImagine atrader, Arlo, is studying the following chart of Agilent\nTechnologies Inc. (A). See Exhibit 17.1 .\nEXHIBIT 17.1 Agilent Technologies Inc. daily candles.\nSource : Chart courtesy of Livevol® Pro ( www.livevol.com )\nThe stock has been in an uptrend for six weeks or so. Close-to-close\nvolatility hasn’tincreased much. But intraday volatility has increased\ngreatly as indicated by the larger candles over the past 10 or so trading\nsessions. Earnings is coming up in aweek in this example, however implied\nvolatility has not risen much. It is still “cheap” relative to historical\nvolatility and past implied volatility. Arlo is bullish. But how does he play\nit? He needs to use what he knows about the greeks to guide his decision.\nArlo doesn’twant to hold the trade through earnings, so it will be ashort-\nterm trade. Thus, theta is not much of aconcern. The low-priced volatility\nguides his strategy selection in terms of vega. Arlo certainly wouldn’twant\nashort-vega trade. Not with the prospect of implied volatility potential\nrising going into earnings. In fact, he’dactually want abig positive vega\nposition. That rules out anaked/cash-secured put, put credit spread and the\nlikes.\nHe can probably rule out vertical spreads all together. He doesn’tneed to\nspread off theta. He doesn’twant to spread off vega. Positive gamma is\nattractive for this sort of trade. He wouldn’twant to spread that off either.\nPlus, the inherent time component of spreads won’twork well here. As\ndiscussed in Chapter 9, the bulk of vertical spreads profits (or losses) take\ntime to come to fruition. The deltas of acall spread are smaller than an\noutright call. Profits would come from both delta and theta, if the stock rises\nto the short strike and positive theta kicks in.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:485", "doc_id": "a3921cbe2df6019e9114dc25ac70bc06332c94dca08ef9ff338012fc9879fe15", "chunk_index": 0}
{"text": "Example 2\nAtrader, Luke, is studying the following chart for United States Steel Corp.\n(X). See Exhibit 17.2 .\nEXHIBIT 17.2 United States Steel Corp. daily candles.\nSource : Chart courtesy of Livevol® Pro ( www.livevol.com )\nThis stock is in asteady uptrend, which Luke thinks will continue.\nEarnings are out and there are no other expected volatility events on the\nhorizon. Luke thinks that over the next few weeks, United States Steel can\ngo from its current price of around $31 ashare to about $34. Volatility is\nmidpriced in this example—not cheap, not expensive.\nThis scenario is different than the previous one. Luke plans to potentially\nhold this trade for afew weeks. So, for Luke, theta is an important concern.\nHe cares somewhat about volatility, too. He doesn’tnecessarily want to be\nlong it in case it falls; he doesn’twant to be short it in case it rises. He’dlike to spread it off; the lower the vega, the better (positive or negative).\nLuke really just wants delta play that he can hold for afew weeks without\nall the other greeks getting in the way.\nFor this trade, Luke would likely want to trade adebit call spread with the\nlong call somewhat ITM and the short call at the $34 strike. This way, Luke\ncan start off with nearly no theta or vega. He’ll retain some delta, which\nwill enable the spread to profit if United States Steel rises and as it\napproaches the 34 strike, positive theta will kick in.\nThis spread is superior to apure long call because of its optimized greeks.\nIt’ssuperior to an OTM bull put spread in its vega position and will likely\nproduce ahigher profit with the strikes structured as such too, as it would\nhave abigger delta.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:487", "doc_id": "c802a1a6451e0e5a40d17295c87d7fc472bdf0c51c9cde9fdd1d0b3ce926fb42", "chunk_index": 0}
{"text": "Managing Trades\nOnce the trade is on, the greeks come in handy for trade management. The\nmost important rule of trading is Know Thy Risk . Knowing your risk means\nknowing the influences that expose your position to profit or peril in both\nabsolute and incremental terms. At-expiration diagrams reveal, in no\nuncertain terms, what the bottom-line risk points are when the option\nexpires. These tools are especially helpful with simple short-option\nstrategies and some long-option strategies. Then traders need the greeks.\nAfter all, that’swhat greeks are: measurements of option risk. The greeks\ngive insight into atrade’sexposure to the other pricing factors. Traders must\nknow the greeks of every trade they make. And they must always know the\nnet-portfolio greeks at all times. These pricing factors ultimately determine\nthe success or failure of each trade, each portfolio, and eventually each\ntrader.\nFurthermore, always—and Ido mean always—traders must know their up\nand down risk, that is, the directional risk of the market moving up or down\ncertain benchmark intervals. By definition, moves of three standard\ndeviations or more are very infrequent. But they happen. In this business\nanything can happen. Take the “flash crash of 2010 in which the Dow Jones\nIndustrial Average plunged more than 1,000 points in “aflash.” In my\ntrading career, I’ve seen some surprises. Traders have to plan for the worst.\nIt’snot too hard to tell your significant other, “Sorry I’mlate, but Ihit\nunexpected traffic. Ijust couldn’tplan for it.” But to say, “Sorry, Ilost our\nlife savings, and the kids’ college fund, and our house because the market\nmade an unexpected move. Icouldn’tplan for it,” won’tgo over so well.\nThe fact is, you can plan for it. And as an option trader, you have to. The\nbottom line is, expect the unexpected because the unexpected will\nsometimes happen. Traders must use the greeks and up and down risk,\ninstead of relying on other common indicators, such as the HAPI.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:489", "doc_id": "bf7b36333646c1a56fb2bc0b785032bf15f2e5e46b14387715593b7f1349883a", "chunk_index": 0}
{"text": "The HAPI: The Hope and Pray\nIndex\nSo you bought acall spread. At the opening bell the next morning, you find\nthat the market for the underlying has moved lower—alot lower. You have\naloss on your hands. What do you do? Keep apositive attitude? Wear your\nlucky shirt? Pray to the options gods? When traders finds themselves\nhoping and praying—Iswear I’ll never do that again if Ican just get out of\nthis position!—it is probably time for them to take their losses and move on\nto the next trade. The Hope and Pray Index is acontraindicator. Typically,\nthe higher it is, the worse the trade.\nThere are two numbers atrader can control: the entry price and the exit\nprice. All of the other flashing green and red numbers on the screen are out\nof the trader’scontrol. Savvy traders observe what the market does and\nmake decisions on whether and when to enter aposition and when to exit.\nTraders who think about their positions in terms of probability make better\ndecisions at both of these critical moments.\nIn entering atrade, traders must consider their forecast, their assessment\nof the statistical likelihood of success, the potential payout and loss, and\ntheir own tolerance for risk. Having considered these criteria helps the\ntraders stay the course and avoid knee-jerk reactions when the market\nmoves in the wrong direction. Trading is easy when positions make money.\nIt is how traders deal with adverse positions that separates good traders\nfrom bad.\nGood traders are good at losing money. They take losses quickly and let\nprofits run. Accepting, before entering the trade, the statistical nature of\ntrading can help traders trade their positions with less emotion. It then\nbecomes amatter of competent management of those positions based on\ntheir knowledge of the factors affecting option values: the greeks. Learning\nto think in terms of probability is among the most difficult challenges for anew options trader.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:490", "doc_id": "1e4ba1576935c48c7f424c4595949d6c4976741c2f2297a1915302b25b69c76c", "chunk_index": 0}
{"text": "Adjusting\nSometimes the position atrader starts off with is not the position he or she\nshould have at present. Sometimes positions need to be changed, or\nadjusted, to reflect current market conditions. Adjusting is very important to\noption traders. To be good at adjusting, traders need to use the greeks.\nImagine atrader makes the following trade in Halliburton Company\n(HAL) when the stock is trading $36.85.\nSell 10 February 35–36–38–39 iron condors at 0.45\nFebruary has 10 days until expiration in this example. The greeks for this\ntrade are as follows:\nDelta: −6.80\nGamma: −119.20\nTheta: +21.90\nVega: −12.82\nThe trader has aneutral outlook, which can be inferred by the near-flat\ndelta. But what if the underlying stock begins to rise? Gamma starts kicking\nin. The trader can end up with ashort-biased delta that loses exponentially\nif the stock continues to climb. If Halliburton rises (or falls for that matter)\nthe trader needs to recalibrate his outlook. Surely, if the trader becomes\nbullish based on recent market activity, he’dwant to close the trade. If the\ntrader is bearish, he’dprobably let the negative delta go in hopes of making\nback what was lost from negative gamma. But what if the trader is still\nneutral?\nAneutral trader needs aposition that has greeks which reflect that\noutlook. The trader would want to get delta back towards zero. Further,\ndepending on how much the stock rises, theta could start to lose its benefit.\nIf Halliburton approaches one of the long strikes, theta could move toward\nzero, negating the benefit of this sort of trade all together. If after the stock\nrises, the trader is still neutral at the new underlying price level, he’dlikely\nadjust to get delta and theta back to desired territory.\nAcommon adjustment in this scenario is to roll the call-credit-spread legs\nof the iron condor up to higher strikes. The trader would buy ten 38 calls", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:492", "doc_id": "c535a8310a431e3c5515676f7057d8a170431373f5f58a1a532df4262f616603", "chunk_index": 0}
{"text": "and sell ten 39 calls to close the credit spread. Then the trader would buy 10\nof the 39 calls as sell 10 of the 40 calls to establish an adjusted position that\nis short a 10 lot of the February 35–36–39–40 iron condor.\nThis, of course, is just one possible adjustment atrader can make. But the\ncommon theme among all adjustments is that the trader’sgreeks must\nreflect the trader’soutlook. The position greeks best describe what the\nposition is—that is, how it profits or loses. When the market changes it\naffects the dynamic greeks of aposition. If the market changes enough to\nmake atrader’sposition greeks no longer represent his outlook, the trader\nmust adjust the position (adjust the greeks) to put it back in line with\nexpectations.\nIn option trading there are an infinite number of uses for the greeks. From\nfinding trades, to planning execution, to managing and adjusting them, to\nplanning exits; the greeks are truly atrader’sbest resource. They help\ntraders see potential and actual position risk. They help traders project\npotential and actual trade profitability too. Without the greeks, atrader is at\nadisadvantage in every aspect of option trading. Use the greeks on each\nand every trade, and exploit trades to their greatest potential.\nIwish you good luck !\nFor me, trading option greeks has been alabor of love through the good\ntrades and the bad. To succeed in the long run at greeks trading—or any\nendeavor, for that matter—requires enjoying the process. Trading option\ngreeks can be both challenging and rewarding. And remember, although\noption trading is highly statistical and intellectual in nature, alittle luck\nnever hurt! That said, good luck trading!", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:493", "doc_id": "38686c8e2c064555c02d93c4d34793e3ae6a132d412cc1075fb1793b12b04f51", "chunk_index": 0}
{"text": "long OTM\nselling\nCash settlement Chicago Board Options Exchange (CBOE) Volatility\nIndex®\nCondors\niron\nlong\nshort\nlong\nshort\nstrikes\nsafe landing selectiveness too close\ntoo far\nwith high probability of success\nContractual rights and obligations open interest and volume opening and\nclosing Options Clearing Corporation (OCC) standardized contracts\nexercise style expiration month option series, option class, and contract size\noption type\npremium\nquantity\nstrike price\nCredit call spread Debit call spread Delta\ndynamic inputs effect of stock price on effect of time on effect of\nvolatility on moneyness and Delta-neutral trading art and science\ndirection neutral vs. direction indifferent gamma, theta, and volatility\ngamma scalping implied volatility, trading selling\nportfolio margining realized volatility, trading reasons for\nsmileys and frowns Diagonal spreads double\nDividends\nbasics\nand early exercise dividend plays strange deltas\nand option pricing pricing model, inputting data into dates, good and bad\ndividend size", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:497", "doc_id": "df9072ef9ea0a421fe97397bbfe3e7e97780afe00f3406505047c6dedb8d6f3d", "chunk_index": 0}
{"text": "Estimation, imprecision of European-exercise options Exchange-traded\nfund (ETF) options Exercise style Expected volatility CBOE Volatility\nIndex®\nimplied\nstock\nExpiration month Ford Motor Company Fundamental analysis Gamma\ndynamic\nscalping\nGreeks\nadjusting\ndefined\ndelta\ndynamic inputs effect of stock price on effect of time on effect of\nvolatility on moneyness and\ngamma\ndynamic\nHAPI: Hope and Pray Index managing trades online, caveats with regard\nto price vs. value rho\ncounterintuitive results effect of time on put-call parity\nstrategies, choosing between theta\neffect of moneyness and stock price on effects of volatility and time\non positive or negative taking the day out\ntrading\nvega\neffect of implied volatility on effect of moneyness on effect of time\non implied volatility (IV) and\nwhere to find Greenspan, Alan HOLDR options\nImplied volatility (IV) trading\nselling\nand vega\nIn-the-money (ITM) Index options\nInterest, open Interest rate moves, pricing in Intrinsic value Jelly rolls\nLong-Term Equity AnticiPation Securities® (LEAPS®) Open interest\nOption, definition of Option class", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:498", "doc_id": "6fcd4562bc473cbde032079991f4878b35f084ba55a11bc270a4f4689afeb0a7", "chunk_index": 0}
{"text": "Option prices, measuring incremental changes in factors affecting Option\nseries\nOptions Clearing Corporation (OCC) Out-of-the-money (OTM) Parity,\ndefinition of Pin risk\nborrowing and lending money boxes\njelly rolls\nPremium\nPrice discovery Price vs. value Pricing model, inputting data into dates,\ngood and bad dividend size “The Pricing of Options and Corporate\nLiabilities” (Black & Scholes) Put-call parity American exercise options\nessentials\ndividends\nsynthetic calls and puts, comparing\nsynthetic stock strategies\ntheoretical value and interest rate Puts\nbuying\ncash-secured long ATM\nmarried\nselling\nRatio spreads and complex spreads delta-neutral positions, management\nby market makers through longs to shorts risk, hedging trading flat\nmultiple-class risk ratio spreads backspreads\nvertical\nskew, trading Realized volatility trading\nReversion to the mean Rho\ncounterintuitive results effect of time on and interest rates in planning\ntrades interest rate moves, pricing in LEAPS\nput-call parity and time\ntrading\nRisk and opportunity, option-specific finding the right risk long ATM call\ndelta\ngamma\nrho\ntheta", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:499", "doc_id": "1193f61f1906411a7d66d01e4ffb2d4f2ef929dcbf8c2c3753d2ae6b3c9be3fc", "chunk_index": 0}
{"text": "and volatility Volatility\nbuying and selling teenie buyers teenie sellers\ncalculating data direction neutral, direction biased, and direction\nindifferent expected\nCBOE Volatility Index®\nimplied\nstock\nhistorical (HV) standard deviation\nimplied (IV) and direction HV-IV divergence inertia\nrelationship of HV and IV\nselling\nsupply and demand\nrealized\ntrading\nskew\nterm structure vertical\nvertical spreads and Volatility charts, studying patterns\nimplied and realized volatility rise realized volatility falls, implied\nvolatility falls realized volatility falls, implied volatility remains\nconstant realized volatility falls, implied volatility rises realized\nvolatility remains constant, implied volatility falls realized volatility\nremains constant, implied volatility remains constant realized\nvolatility remains constant, implied volatility rises realized volatility\nrises, implied volatility falls realized volatility rises, implied\nvolatility remains constant\nVolatility-selling strategies profit potential covered call covered put\ngamma-theta relationship greeks and income generation naked\ncall\nshort naked puts similarities Would I Do It Now? Rule", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:502", "doc_id": "eb9f723f135a7716de259001d879b99f8d463bf7b80794aaafa7cd1d2d9bdbc5", "chunk_index": 0}