lity changes,
767-775
Call buying, 95-117
advanced selection criteria, 103-107
overpriced/underpriced calls, 106-107
time value premium and volatility trading, 106-107
volatilities of underlying stock, 103-106
follow-up actions, 107-117
bull spread, 110-111, 113-116, 117
calendar spread, creating, 116-117
commissions, 108
defensive action, two strategies for, 112-117
locking in profits, four strategies for, 108-111
"mental" stop to cut losses, 107
rolling down strategy, 112-116
rolling up, 109-110
frustrations, 107
mathematical calculations of volatility, applying, 47 4
option to buy, selecting, 101-103
day trading, 101-102
intermediate-term trading, 102-103
long-term trading, 103
short-term trading, 102
time horizon as criterion, 101
risk and reward, 97-101
delta, 99-101
hedge ratio, 99-101
intermediate-term call most attractive, 98
option pricing curve, 99
timing, certainty of, 98-99
simplest form of option investment, 95
strategies, other, 118-131 (see also Call buying
strategies)
why buy, 95-96
and LEAPS, 95
985
Call buying strategies, 118-131
altering ratio oflong calls to short stock, 128-131
protected short sale, 118-122
at-the-money or out-of-the-money as protection,
120
follow-up action, 122
margin requirements, 121
reverse hedge, 123-128, 130, 131
follow-up action, 126-128
limited loss potential and unlimited profit poten
tial, 123, 128
trading against the straddle, 126-127
volatile stock preferred, 126
simulated straddle, 123-128 (see also Call buying
strategies, reverse hedge)
summary, 131
"synthetic" strategies, 118
put, 118-121 (see also Call buying strategies, pro
tected short sale)
Call option price curve, 10-13
Call option strategies, 37-241 (see also under particular
heading)
bear spreads using call options, 186-190
bull spreads, 172-185
butterfly spreads, 200-209
calendar spreads, 191-199
calendar and ratio spreads, combining, 222-229
call buying, 95-117
call buying strategies, 118-131
covered call writing, 39-94
diagonalizing spread, 236-241
naked call writing, 132-145
ratio call spreads, 210-221
ratio call writing, 146-171
reverse spreads, 230-235
summary, 241
Call options:
assignment of, 7
Call writing, applying mathematical calculations of
volatility to, 4 72-4 7 4
Capitalization-weighted indices, 494-497
divisor, 494-496
float, 494-495
largest market value stocks have most weight, 496
most prevalent, 497
Cash-based futures, 653
Cash-based options, 500-506 (see also Index option
products)
European versus American exercise, 501-504
Cash-based put writing, 294-295
Cash dividend role of underlying stock as factor in
option price, 14-15
Cash settlement futures, 653
986
Chicago Board Options Exchange (CBOE), 22
structured products listed, 618
Chicago Mercantile Exchange, 507, 509, 510, 672
option quotes, 515-516
trading limits on futures options, 680
Chicago Board of Trade:
trading limits on futures contracts, 658
trading limits on futures options, 680
Classes of options, 5-6
Closing transactions, 6
Collar, 275, 840
no-cost, 278-280
Commissions, 17-18
Concepts, advanced, 846-907 (see also Advanced
concepts)
Conservative covered write, 46
Contango, 697
Conversion, 253-255, 428-430, 431-438 (see also Put
options basics and Arbitrage)
reversal, 254, 428-430, 431-438
risks in, four, 433-43 7
summary, 437-438
Convertible security, covered writing against, 88-90, 94
Covered call writing, 39-94
definition, 39
diversifying return and protection, 66-70
"combined" write, 67-69
techniques, fundamental, 66-69
techniques, other, 69-70
execution of order, 56-58
contingent order, 57
net position, establishing, 57-58
follow-up action, 70-87, 94
aggressive action if stock rises, 71, 79-81
assignment, action to avoid if time premium
disappears, 71, 86-87
expiration, at or near, 83-85
getting out, 82-83
locked-in loss, 73
protective action if stock drops, 71-79
rolling action, 71-80 (see also Rolling action)
rolling forward/down, 83-85
spread, 76
uncovered position, avoiding, 86
when to let stock be called away, 86-87
importance, 39-42
for downside protection, 39
increase in stock price, benefits of, 40-41
profit graph, 41-42
quantification, 41-42
and naked put writing, differences between,
294-295
objective, 42
Index
PERCS (Preferred Equity Redemption Cumulative
Stock), 91
philosophy, 42-45
annual returns, 47
as conservative strategy, 46-4 7
Depository Trust Corp (DTC), role of, 43
in-the-money covered writes, 43-45, 93
letter of guarantee, 43
out-of-the-money covered writes, 43-45, 93
physical location of stock, 43
total return concept, 45-47, 60-61, 93
return on investment, computing, 47-56
compound interest, 53-54
downside break-even point, 48, 49-50
in margin accounts, 50-53
price,changesin,55-56
return if exercised, 47-48
return if unchanged, 48, 49
size of position, 54-55
static return, 49
selecting position, 58-62
downside protection, 59-60
returns, projected, 59
strategy, importance of, 60-62
total return concept, 60-61
special writing situations, 87-93
against convertible security, 88-90, 94
against LEAPS, 91, 94
against warrants, 90-91
incremental return concept, 87-88, 91-93
and stock ownership, 42
summary, 93-94
and uncovered put writing strategy, similarity of,
293-294
writing against stock already owned, 62-66
caution, 65-66
Covered pit sale, 300
Covered straddle write, 302-305
Crack spread, 702-704
Credit spread, 170, 179
Cross-currency spreads, 701
Cumulative density function (CDF), 806
Customer margin method, 5
Customer margin option requirements, 667
Day trading, call buying and, 101-102
Debit spread, 170
Definitions, 3-35 (see also under particular definition or
under Options)
Delta, 848-853, 866
calculation of by Black-Scholes model, 457
excess value, 764
Index
Delta (continued)
and implied volatility, 753-754, 755-756
of LEAPS, 387-390
put delta, 389-390
option delta, 849


gin method, 5
Customer margin option requirements, 667
Day trading, call buying and, 101-102
Debit spread, 170
Definitions, 3-35 (see also under particular definition or
under Options)
Delta, 848-853, 866
calculation of by Black-Scholes model, 457
excess value, 764
Index
Delta (continued)
and implied volatility, 753-754, 755-756
of LEAPS, 387-390
put delta, 389-390
option delta, 849
position delta, 849-853
spread, 484
Delta-neutral spreads:
calendar spreads, 227-228 (see also Calendar and
ratio spreads)
effects on of implied volatility changes, 755-756
Delta-neutral trading, 167-168, 868-879
Delta of option, 99-101
of futures aption, 676-677
"Delta spread," 213, 216-217 (see also Ratio call
spread)
for ratio put spread, 361
Depository Trust Corp. (DTC), 43
Diagonal butterfly spread, 350-353 (see also Spreads
combining calls and puts)
Diagonal spread, 169, 236-241 (see also Spread,
diagonalizing)
backspreads, 240-241
bear spread, 239-240
bull spread, 177, 236-239
and LEAPS, 405-407
backspread,407-408
Dividend arbitrage, 425-428
Dividends:
influence of on option price, 14-15
and LEAPS, effect on, 371-374
put option premiums, effect of on, 248-250
from structured products, 594
Divisor, 494-496, 497-500, 568
"Dogs of the Dow" Index, 594
Dow Jones Industrial Average, 494, 499, 793
30 Industrials ($DIX), 501, 502, 582
Top 10 Yield index ($XMT), 594
Down delta concept, 100-101
Elliott Wave theory, 796
Equity-linked notes, 618
Equivalent futures position (EFP), 676-677, 853
Equivalent stock position (ESP), 162-163, 167,
853
in ratio call spreads, 220-221
of straddle, 312-313
Equivalent strategies, 943-944
"European" exercise, 501-504, 647
options, 7
Even money spread, 240
"Ever" probability calculator, 805-806
Excess value of option price, effect on of implied
volatility changes, 762-765
"greeks" to measure, 763-764
Exchange-Traded Funds (ETFs), 637-639
987
Holding Company Depository Receipts (HOLD RS),
639
iShares, 638
options on, 637
sector, 638
Standard & Poor's Depository Receipt (SPDR), 637-
638
Creation Units, 638
Exercise of cash-based options, 501-504
Exercise price, definition, 3-4
Exercising option, 6-7, 15-16
after, 17
commissions, 17-18
early, due to discount, 19-20
early, due to dividends on underlying stock, 20-22
Exotic options, 590
Expiration date, 4
standardization, 5
Exxon (XON), 567
Facilitation, 455, 482-485 (see also Mathematical
applications)
Fat tails, 790- 792, 810, 828
Financial engineers, role of in structured products, 590
Foreign currency options, 671-673
Formulae, 947-956
"Fudge factor," 731, 733
Futures, 506-512 (see also Index option products)
calculating fair value of, 533-534
factors, four, 533
T-bill rate, use of, 534
contracts, 653-660 (see also Futures and futures
options)
on physicals, 653 (see also Futures and future
options)
Futures and futures options, 652-695
futures contracts, 653-660
"cash," 653-654
cash-based/cash settlement futures, 653
delivery, 658-659
expiration dates, 656-657
first notice day, 659
futures on physicals, 653
hedging, 653-655
limits, 657-658
month symbols, 665
notice period, 659
and options, differences between, 653
988
Futures and futures options (continued)
position limits, 657
pricing, 659-660
speculating, 655-656
spot and spot price, 658
as stock with expiration date, 653
tenns, 656-657
trading hours, 657
trading limits, 657-658
units of trading, 657
futures options trading strategies, 67 4-683
delta, 676-677
equivalent futures position (EFP), 676-677
follow-up actions, 692-694
limit bid, 679
limit offered, 680
mathematical considerations, 677-679
mispricing strategies, common, 683-694 (see also
Futures and futures option, mispricing strate
gies)
price relationships, 67 4-676
summary, 694
and trading limits, 679-683
mispricing strategies, common, for futures options,
683-694
backspreading puts, 686-688
follow-up action, 692-694
implied volatility, 685
points, 687-688
ratio spreading calls, 688-689
strategies for profiting, two, 685-689
summary, 694
volatility skewing, 683, 685, 693-694
which strategy to use, 690-692
options on futures, 660-673
assignment, 673
automatic exercise, 662-663
bid-offer spread, 665
cash settlement future, 661
commissions, 665
customer margin system, 667, 671
definition, 660
description, 660-662
exercise, 673
foreign currency options, 671-673
margins, 666-671
mathematical considerations, 677-679
month symbols, 665
notice day, 661-662
Philadelphia Stock Exchange (PHUC), 671, 673,
678-679
physical currency options, 671-673
on physical futures, 661, 678-679
position limits, 666
quote symbols, 664
"round-tum" commission, 665-666
serial options, 663-666
Index
SPAN margin (Standard Portfolio Analysis of
Risk), 667-671 (see also SPAN)
striking price intervals, 662
standardization less than for equity or index options,
652
summary, 695
Futures Magazine, 661
Futures option strategies for futures spreads, 696-721
futures options, using in futures spreads, 704-720
calendar spread, 704-709
follow-up considerations, 714-719
intramarket spread strategy, 719
long combinations, 709-714
spreading futures against stock sector indices,
719-720
futures spreads, 696-704
contango, 697
crack spread, 702-704
cross-currency spreads, 701
intermarket, 700-704
intramarket, 697-700
pricing differentials, 696-697
reverse carrying charge market, 697
TED spread, 701-702, 712-714
summary, 720-721
Futures spread, futures option strategies for, 696-721
(see also Futures option strategies)
Gamma, 853-859, 867, 882
neutral spread, 882
Gamma of the gamma, 865-866, 902-905
GARCH (Generalizes Autoregressive Conditional
Heteroskedasticity), 731-732, 814, 819
General Electric (GE), 567
General Motors (GM), 567
Gold and Silver Index (XAU), 588, 719
Good-until-canceled order, 34
Government National Mortgage Association
certificates, 420
Graphs

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf


see also Futures option strategies)
Gamma, 853-859, 867, 882
neutral spread, 882
Gamma of the gamma, 865-866, 902-905
GARCH (Generalizes Autoregressive Conditional
Heteroskedasticity), 731-732, 814, 819
General Electric (GE), 567
General Motors (GM), 567
Gold and Silver Index (XAU), 588, 719
Good-until-canceled order, 34
Government National Mortgage Association
certificates, 420
Graphs, 957-960
"Greeks," 848-866 (see also Advanced concepts)
calculating, 901-902
to measure excess value, 763-764
Hedge ratio, 99-101, 457
advantages of, 482-485
delta spread, 484
neutral spread, 483-485
Hedge wrapper, 275
Hedging, futures contracts and, 653-655
Index
Historical volatility, 461, 728-731
lognormal, computation of, 461-466
Holder, 6
HOLDRS, 639
"Hooks," 449-450
Horizontal spread, 169
IBM (International Business Machines), 567
Implied volatility, 132, 248, 685, 727, 734-743 (see also
Volatility trading)
difference of, measuring, 905-907
effect of on specific option strategies, 7 49-782 (see
also Volatility, effects of)
and delta, 753-754
in trading techniques, 812-845 (see also Volatility
trading)
In-the-money:
calendar spread, 228
covered writes, 43-45, 93
definition, 7, 8
for put options, 246-247
Incremental return concept of covered writing, 91-93
(see also Covered call writing)
rolling for credit, 92
Index arbitrage, 547-556 (see also Stock index hedging
strategies)
Index calls, hedging with, 545-547
Index option products and futures, introduction to,
493-530
cash-based options, 500-506
assignment, 501
commissions, 503
European versus American exercise, 501-504
exercise, 501-504
indices underlying, 500-501
naked margin, 504-505
definition, 493
and equity options, difference between, 493
futures, 506-512
cash-based only, 506
"circuit breakers," 511
commodities contract, definition, 506
contract, terms of, 507-508
hedgers, 506-507
limits, 511
"locals," 509
maintenance margin, 509
margin, limits, and quotes, 509-510
"open outcry" method, 508-509
quotes, 511-512
speculators, 506-507
S&P 500 Index, 507-509
S&P and NYSE expiration, 510-511
989
and stock trading, differences between, 508, 512
traders, types of, 506-507
LEAPS (Long-term Equity AnticiPation Securities)
index options, 367-410, 505-506
options on index futures, 512-516
caution,516
customer margin method, 515
expiration dates, 513
option margin, 514-515
premiums, 514
quotes, 515-516
SPAN (Standard Portfolio Analysis of Risk),
514-515
terms, other, 515
put-call ratio, 520-530
figures, 524-530
interpreting, 522-523
standard options strategies using index options,
516-520
conclusion, 519-520
early assignment of cash-based options, handling,
518-519
option buying, 516-517
selling index options, 517-518
volatility skewing, 517
stock indices, 493-500
broad-based, 500, 504-505
capitalization-weighted indices, 494-497 (see also
Capitalization-weighted indices)
narrow-based, 500, 505
price-weighted indices, 500 (see also Price
weighted indices)
sector, 500
summary, 523
Index options and futures, 138, 491-721 (see also under
particular heading)
futures and futures options, 652-695
futures option strategies for futures spreads, 696-721
hedging portfolios with, 541-543
index spreading, 579-588
introduction, 493-530
mathematical considerations for index products,
641-651
products and futures, introduction to, 493-530
stock index hedging strategies, 531-578
structured products, 589-640
Index puts, hedging with, 543-545
Index spreading, 579-588
approaches,two,580-581
characteristics, 682-583
inter-index spreading, 579-587
philosophy, 579
S&P 100,583
S&P 500, 583, 584
990
Index spreading (continued)
spreads using options, 583-584
options, using in index spreads, 584-587
striking price differential, 587
volatility differential, 587
summary, 588
Value Line Index, 579, 582
Inflection points, 792-793
Insider trading, 7 45-7 46
Institutional block positioning, 482-485 (see also
Mathematical applications)
Institutional use of market basket strategies, 556
Inter-index spreading, 579-587 (see also Index
spreading)
"Interest play" strategy, 438-439
Interest rates, effects of on LEAPS, 371-37 4
Intermarket futures spreads, 700-704
Intermediate-term trading, call buying and, 102-103
Intramarket futures spreads, 697-700
iShares, 638
Japanese Nikkei 225 Index, 532, 601
Kicker, 136, 169
LEAPS (Long-term Equity AnticiPation Securities), 5,
367-410
basics, 368-369
expiration date, 368
standardization less, 368
striking price, 369
type,368
underlying stock and quote symbol, 368
and call buying, 95
definition, 367
dividends, effects of, 371-37 4
to establish collar, 279
history, 367
and implied volatility, 735, 736
index options, 505-506
interest rates, effects of, 371-372
and long-term trading, 103
options, 616-617
popularity, 367
pricing, 369-37 4
rho, 864-865
selling, 390-403
assignment, early, 401-402
covered writing, 390-396
incremental return, 391
rolling down, 394
Index
short LEAPS instead of short stock, 400-402
straddle selling, 402-403
uncovered call selling, 399-400
uncovered LEAPS, 396-399
whipsaw, 403
short-term options, three sets of comparison with,
374-375
and speculative option buying, 382-390
buying "cheap," advantages of, 385-386
delta, 387-390
less risk of time decay, 383-385
spreads using, 403-409
backspreads,407-408
bull spread using calls, 403-404
calendar spreads, 408-409
diagonal, 405-407
strategies, 375-382
buying LEAPS as initial purchase instead of buy-
ing common stock, 378-381
LEAPS instead of short stock, 382
margin, using, 380-381
protecting existing stock holdings with LEAPS
puts, 381-382
as stock substitute, 375-378
summary, 409-410
symbols, 26-27
writing against, 91, 94
"Leg" into spread, 171
out of spread, 180, 207
out of put calendar spread, 335
Letter of guarantee, 43
Limit bid, 679
Limit offered, 680
Limit order, 28, 33
"Loc


ommon stock, 378-381
LEAPS instead of short stock, 382
margin, using, 380-381
protecting existing stock holdings with LEAPS
puts, 381-382
as stock substitute, 375-378
summary, 409-410
symbols, 26-27
writing against, 91, 94
"Leg" into spread, 171
out of spread, 180, 207
out of put calendar spread, 335
Letter of guarantee, 43
Limit bid, 679
Limit offered, 680
Limit order, 28, 33
"Locals," 509
Locked-in loss, 73-76
Locking in profits, four strategies for, 108-1 11
Lognormal distribution of stock prices, 783-81 I
(See also Stock prices, distribution oO
Long-term Equity AnticiPation Securities (LEAl'Si
See also LEAPS
Long-term trading, call buying and, 103
Maintenance margin, 509
Major Market Index (XMI), 499
Market basket of stocks, 531-537 (see also Stock ind,·\
hedging strategies)
Market dynamics, nonquantifiable, as influt·11t·,· 011
market price, 15
Market-makers, 22
Market order, 32
Market not held order, 33
"Married" put and stock for tax purposC's, !J:l I
Index
Martingale strategy, 140, 145
Mathematical applications, 456-489
Black-Scholes model, 456-466 (see also
Black-Scholes model)
expected return, 466-472
calculation of, 467, 4 71
definition,466
expected profit, computation of, 468
lognormal distribution, typical, 469
Simpson's Rule, 471
Trapezoidal Rule, 471
facilitation (institutional block positioning), 482-485
delta spread, 484
follow-up action, computer as aid in, 485-488
implementation, 488-489
neutral spread, 483-485
hedge ratio, 482-485 (see also Mathematical applica
tions, facilitation [institutional block position
ing])
strategy decisions, applying calculations to, 4 72-482
calendar spreads, 479-480
call buying, 474
call writing, 472-474
profitability, 474-475
put buying, 478-479
put option, pricing, 477-478
ratio strategies, 480-482
risk, 4 75-4 77
theoretical value of spread, using, 480
summary, 489
Mathematical applications for index options, 644-651
Black model, 647-648, 651
Black-Scholes model, 644-645, 646, 651
cash-based, 644-646
deltas, 648
European exercise, 647
follow-up action, 648-651
for inter-index spreads, 648-649
"sliding scale," 649-650
futures, 644
options, 647-648
implied dividend, 646
Mathematical concepts, advanced, 901-907
Mathematical considerations for index products, 641-651
Mathematical models:
for index products, 641-651
arbitrage, 641-644 (see also Arbitrage)
graph, three-dimensional, 651
mathematical applications, 644-651 (see also
Mathematical applications)
summary, 651
for pricing options, 14
Mayhew, Dr. Stewart, 806
Mergers, risk arbitrage and, 445-450
Monte Carlo analysis, 806
simulation, 807-809, 828
991
Morgan Stanley High-Tech index ($MSH), 639, 788
Naked call writing, 132-145
high risk strategy, 135-136
"kicker," 136
marked to market daily, 136
implied volatility, 132
investment required, 134-137
margin requirements, 134-137
not same as short sale of underlying stock, 133-134
risk and reward, 138-145
Martingale strategy, 140, 145
rolling for credits, 140-144
time value as misnomer, 144
selling naked options, philosophy of, 137-138
index options, 138
summary, 144-145
uncovered (naked) call option, 133-134
Naked put write, evaluating, 296-298
Narrow-based indices, 500
NASDAQ:
Index ($NDX), 501
-100 (NDX), 588
tracking stock (QQQ), 638,639
Neutral calendar spread, 192-194
Neutrality:
effects of implied volatility changes on, 755-756
in options positions, 846-84 7
New York Stock Exchange:
"circuit breaker," 562
expiration, 510-511
Index,497,500,532
limits on index futures traded, 511
POT system, 555-556
Nikkei 225 Index, 532, 601
No-cost collars, 278-280
Notice period, 659, 661-662
OEX, 497, 500-501
Oil and Gas Index (XOI), 588, 719
Open interest, 6
"Open outcry" method of trading futures, 508-509
Opening transactions, 6
Option markets, 22
board broker system, 22
Chicago Board Options Exchange (CBOE), 22
Web site, 23
market-makers, 22
Option Price Reporting Authority (OPRA), 368
Option pricing curve, 99
992
Option purchase and spread, combining, 339-341 (see
also Spreads combining calls and puts)
Options:
arbitrageurs, role of, 19-21
risk arbitrage, 21
assignment, 7, 16-17
anticipating, 18-22 (see also Assignment)
margin requirements, 15-17
classes and series, 5-6
closing transaction, 6
commissions, 17-18
definition, 3-4
as derivative security, 4
"European" exercise options, 7
exercising, 6-7, 15-16
after, 17
early, due to discount, 19-20
early, due to dividends on underlying stock, 20-22
premature, 19-22
holder, 6
in-the-money, 7, 8
LEAPS, 5
symbols, 26-27
markets, 22 (see also Option markets)
open interest, 6
opening transaction, 6
option price and stock price, relationship of, 7-9
order entry, 32-34
good-until-canceled order, 34
information, 32
limit order, 33
market order, 32
market not held order, 33
stop-limit order, 33-34
stop order, 33
out-of-the-money, 7
parity, 8-9
premature exercise, 19-22 (see also Options, exercis
ing)
premium, 7-8
price, factors influencing, 9-15 (see also Price of
option)
profits and profit graphs, 34-35
specifications, four, 4
standardization, 4-5
expiration dates, 5
striking price, 5
symbology, 23-27
CBOE's Web site, 23
expiration month code, 23
LEAPS, 26-27
option base symbol, 23
stock splits, 27
striking price code, 24-25
summary, 27
wraps, 25-26
time value premium, 7-8, 11
trading details, 27-32
limit order, 28
one-day settlement cycle, 28
position limit and exercise limit, 31-32
rotation, 28
value, 4
as "wasting" asset, 4
writer, 6
Index
Options to buy, selecting, 101-103 (see also Call buying)
Options Clearing Corp. (OCC), 6, 15-16, 673
Options on futures, 660-673 (see also Futures and
futures options)
Options and Treasury bills, buying, 413-421
advantages, 413, 421
annualized risk, 416-418
excessive risk, avoiding, 420-421
how strategy works, 413-421
risk adjustment, 418-420
risk level, kee


asset, 4
writer, 6
Index
Options to buy, selecting, 101-103 (see also Call buying)
Options Clearing Corp. (OCC), 6, 15-16, 673
Options on futures, 660-673 (see also Futures and
futures options)
Options and Treasury bills, buying, 413-421
advantages, 413, 421
annualized risk, 416-418
excessive risk, avoiding, 420-421
how strategy works, 413-421
risk adjustment, 418-420
risk level, keeping even, 415-416
summary, 421
synthetic convertible bond, 414
Order entry for options, 32-34 (see also Options)
Original Issue Discount (OID), 592-593
Out-of-the-money:
call spread, 222-225
covered writes, 43-45, 93
definition, 7
for put options, 246-247
Outright option purchases and sales, effect of, on
implied volatility changes on, 757-762
Pairs trading, 454-455
Parity, 8-9
Percentile of implied volatility approach, 814-818
composite implied volatility reading, 815
historical and implied volatility, comparing, 817-818
PERCS (Preferred Equity Redemption Cumulative
Stock), 91, 619-637
call feature, 620-622
redemption price, 622
sliding scale, 620-621
covered call write, equivalent to, 622-623
definition, 619
life span, 619
owning as equivalent to sale of naked put, 626
price behavior, 623-625
strategies, 625-636
delta of imbedded call, using, 630-631
hedging PERCS with common stock, 631-6:32
issue price, determining, 633-634
Index
PERCS (Preferred Equity Redemption Cumulative
' Stock) (continued)
pricing, 634-636
protecting PERCS with listed options, 625-626
redemption feature, removing, 626-627
redemption price, changing, 627-629
rolling down/up, 628-629
selling call against long PERCS as ratio write,
629-631
selling short, 632-633
summary, 636-637
Phantom interest, 592
Philadelphia Stock Exchange (PHLX), 671, 673,
678-679
Portfolio hedge, 539-541
Portfolio insurance, 563-564
Position delta, 162-163, 167
Position limit rule, 253
Position vega, 757
POT system of NYSE, 555-556
Premium, 7-8
time value, 7-8
Price of option, factors influencing, 9-15
cash dividend rate of underlying stock, 14-15
dividends and lower call option price, 14-15
call option price curve, 10-13
market dynamics, nonquantitative, 15
risk-free interest rate, 14
striking price of option, 9-10
time remaining until expiration, 11-13
time value premium decay, 13-14
underlying stock, price of, 9-10
volatility of underlying stock, 13-14
Price-weighted indices, 497-500
computing, 497-498
divisor, 497-500
Dow Jones indices, 499
each stock with equal number of shares, 497, 499
Major Market Index (XMI), 499
Probability calculator, 798-799, 824, 827-829
Probability of stock price movement, 798-809 (see also
Stock prices)
Profits, locking in, four strategies for, 108-111
Program trading, 537-547 (see also Stock index
hedging)
Protected short sale, 118-121, 270 (see also Call buying
strategies)
Protective collar, 275
no-cost, 278-280
and splitting strikes, 328
Put, sale of, 291-301
buying stock below its market price, 299-300
caution, 299-300
covered put, 300
follow-up action, 295-296
naked put write, evaluating, 296-298
ratio put writing, 300-301
uncovered, 292-295
cash-based put writing, 294-295
993
covered call writing, similarity to, 293-294
naked put writing, differences between, 294-295
Put arbitrage, 445 (see also Arbitrage)
Put bear spreads, effects on of implied volatility
changes, 777-778
Put buying:
in conjunction with call purchases, 281-291
mathematical calculations of volatility, applying to,
478-479
straddle buying, 282-288
equivalences, 283-284
follow-up action, 285-288
reverse hedge, equivalent to, 283
reverse hedge with puts, 284
selecting, 285
strangle, buying, 288-291
trading against straddle, 287
Put buying in conjunction with common stock owner
ship, 271-280
as protection for covered call writer, 275-278
bull spread as equivalent, 278
long-term effects, 277-278
protective collar, 275, 278-280
rolling down, 276
no-cost collars, 278-280
lower strikes as partial covered write, 279-280
synthetic long call, 271
tax considerations, 275
which put to buy, 273-274
equivalent strategies, 27 4
slightly out-of-the-money put preferable, 27 4
Put option:
effects on of implied volatility changes, 765-766
pricing, applying mathematical calculations of
volatility to, 4 77-4 78
Put option basics, 245-255
assignment, 250-253
anticipating, 251-252
and dividend payment dates, 252
position limits, 253
conversion, 253-255
no risk, 254
reversal. 254
dividends, effect of on premiums, 248-250
exercise, 250-253
in-the-money, 246-247
out-of-the-money, 246-247
pricing, 247-248, 249
implied volatility, 248
994
Put option basics (continued)
strategies, 245-247
time value premium, 246-247
Put option buying, 256-270
as alternative to short sale of stock, 256-258
purpose, 256
equivalent positions, 270
protected short sale, 270
follow-up action, 262-266
call option, 264
listed call, buying, 263
profits, five tactics for locking in, 262-266
loss-limiting actions, 267-270
calendar spread strategy, 269-270
"rolling-up" strategy, 267-269
margin account required, 269
ranking prospective purchases, 261-262
selection of which put to buy, 258-261
delta, 260-261
in-the-money puts, concentrating on, 259
Put option strategies, 243-410 (see also under particular
heading)
basics, 245-255
buying, 256-270
call and put strategies, similarities between, 244
LEAPS, 367-410
listed put options newer than listed call options, 244
put, sale of, 292-301
put buying in conjunction with call purchases,
281-291
put buying in conjunction with common stock own-
ership, 271-280
put spreads, basic, 329-335
ratio spreads using puts, 358-366
spreads combining calls and puts, 336-357
straddle, sale of, 302-320
summary, 366
synthetic stock positions created by puts and calls,
321-328
Put options, assignment of, 7
Put spreads, basic, 329-335
bear spread, 329-332
advantage over call bear spread, 330-332
as


buying in conjunction with common stock own-
ership, 271-280
put spreads, basic, 329-335
ratio spreads using puts, 358-366
spreads combining calls and puts, 336-357
straddle, sale of, 302-320
summary, 366
synthetic stock positions created by puts and calls,
321-328
Put options, assignment of, 7
Put spreads, basic, 329-335
bear spread, 329-332
advantage over call bear spread, 330-332
as debit spread, 329
bull spread, 332-333
as credit spread, 332
formulae, 333
risk limited, 333
calendar spread, 333-335
bearish, 334-335
neutral, 334
option spreads, three simplest forms of, 329
Index
Qualified covered calls, 961-962
Ratio calendar combination, 364-366 (see also Ratio
spreads using puts)
Ratio calendar spread, 222-225 (see also Calendar and
ratio spreads)
Ratio call spreads, 210-221
and calendar spreads, combining, 222-229 (see also
Calendar and ratio spreads)
combination of bull spread and naked call write, 212
definition, 210
follow-up action, 217-221
delta, adjusting with, 219-221
equivalent stock position (ESP), using, 220-221
profits, taking, 221
ratio, reducing, 218-218
philosophies, three differing, 213-217
altering ratio, 215-216
as ratio write, 213-214
"delta spread," 213, 216-217
for credits, 213, 214-215
preferred over ratio writes, 211-212
ratio write, similarity to, 210
dissimilarity, 210-211
summary, 221
Ratio call write equivalent to naked straddle write, 306
Ratio call writing, 146-171
call spread strategies, introduction to, 168-171
credit/debit spread, 170
diagonal spread, 169
horizontal spread, 169
kicker, 169
"leg" into spread, 171
long/short side, 170
splitting quote, 171
spread, definition, 168
spread order, 169-171
vertical spread, 169
combination of covered call writing and naked call
writing, 146, 150
definition, 146
delta-neutral trading, 167-168
follow-up action, 158-168
altering ration of covered write, 160
closing out write, 166-167
delta, adjusting with, 160-163
equivalent stock position (ESP), 162-163, 167
position delta, 162-163, 167
rolling up/down as defensive action, 160
stop orders, using as defensive strategy, 163-166
"telescoping" action points, 166-167
investment required, 150-151
and ratio call spreads, similarity to, 210
Index
Ratio call writing (continued)
dissimilarity, 210-211
ratio write, 146-149
objections, two, 148-149
probability curve for stock movement, 149
profit range, 14 7
ratio spread as, 213-214 (see also Ratio call
spreads)
and reverse hedge (simulated straddle), similarity of,
154
risk, two-sided, 146
selection criteria, 151-155
break-even points of position, 151-152
neutral ratio, 152-154
volatile stocks preferred, 152
summary, 168
not suitable for all investors, 168
variable, 155-157
trapezoidal hedge, 155, 156, 157
Ratio put spread, 358-361 (see also Ratio spreads)
calendar spread, 361-364
Ratio put writing, 300-301
Ratio spreads, effects on of implied volatility changes,
780-781
Ratio spreads using puts, 358-366
ratio calendar combination, 364-366
ratio put spread, 358-361
deltas, 361
follow-up action, 360-361
limited upside risk, large downside risk, 358, 359
ratio put calendar spread, 361-364
and naked options, 362-363
Ratio strategies, applying mathematical calculations of
volatility to, 480-482
Regression analysis, 566
Reversals, 254-255, 428-430, 431-438 (see also
Arbitrage)
risks in, four, 433-437
Reverse calendar spread, 230-232 (see also Reverse
spreads)
selling, 833-834
Reverse carrying charge market, 697
Reverse conversion, 428-430, 431-438
risks in, four, 433-437
Reverse hedge 123-128, 130, 131 (see also Call buying
strategies)
ratio writing, similarity to, 154-155
straddle buying, equivalent to, 283
Reverse ratio spread (backspread), 232-235 (see also
Reverse spreads)
Reverse spreads, 230-235
backspread, 232-235 (see also Reverse spreads,
reverse ratio spread)
reverse calendar spread, 230-232
margin requirements onerous, 230, 231-232
used infrequently, 230
reverse ratio spread (backspread), 232-235
and delta-neutral spread, 234-235
early exercise, possibility of, 235
established for credits, 233
investment small, 233-234
limited risk, 233
volatile stocks preferable, 235
Rho, 864-865
for LEAPS or warrants, 873
Risk arbitrage, 21, 426-427, 445-454 (see also
Arbitrage)
"hooks," 449-450
limits on merger, 448-450
mergers, 445-448
tender offers, 451-454
Risk-free interest rate, 14
Rolling action, 71-80, 94, 158-160
alternative, 76-77
debit incurred in roll-up, 80-81
different expiration series, using, 78-79
partial, 77
Rolling for credits, 140-144
Martingale strategy, 140, 145
Rolling down strategy, 112-116, 628-629
LEAPS, 394
and protective put, 276
Rolling forward/down, 83-85
Rolling up, 109-110, 267-269, 628-629
"Round-tum" commission, 665-666
Rubenstein, Professor Mark, 797
Russell 2000 Growth Fund, 638, 788
Russell 2000 Value Fund, 638, 788
S&P: see also Standard & Poor
Scientific American, 796
Sector, 500
Semiconductor Index ($SOX), 588, 6,39
HOLDRS, 639
Serial options, 663-666
Series of options, ,5-6
Short-sale rule, 923-924
Short tendering, 453
Short-term trading, call buying and, 102
Sigma, 783-786
Simpson's Rule, 471
Simulated straddle, 123-128 (see also Call buying
strategies)
ratio writing, similarity to, 154-155
SIS (Stock Index return Security), 596-601
cash value formula, 596-597
imbedded call, 597-598
issued in 1993 and matured in 2000, 596
995
996
SIS (Stock Index return Security) (continued)
track record, 598, 599
trading at discount to cash value, 598-600
trading at discount to guarantee price, 600-601
60/40 rule, 919-920
SPAN (Standard Portfolio Analysis of Risk), 514-515,
667-671
advantages,667
example, 668, 669, 670
how it works, 667-671
maintenance margin, 667
purpose, 667
risk array, 667, 668, 669
Speculating in futures contracts, 655-656
Splitting quote, 171
Splitting strikes, 325-328 (see also Synthetic s


to cash value, 598-600
trading at discount to guarantee price, 600-601
60/40 rule, 919-920
SPAN (Standard Portfolio Analysis of Risk), 514-515,
667-671
advantages,667
example, 668, 669, 670
how it works, 667-671
maintenance margin, 667
purpose, 667
risk array, 667, 668, 669
Speculating in futures contracts, 655-656
Splitting quote, 171
Splitting strikes, 325-328 (see also Synthetic stock
positions)
Spot/spot price for futures contracts, 658
Spread, diagonalizing, 236-241
advantage,236,241
backspreads,240-241
even-money spread, 240
bear spread, 239-240
bull spread, 236-239
often improvement over normal bull spread, 239
definition, 236
for any type of spread, 241
Spreads, 76, 168-171 (see also under particular head)
backspread,232-235
diagonal, 240-241
bear, using call options, 186-190
bull, 110-111, 113-116, 117, 172-185
butterfly, 200-209
calendar, 116-117, 191-199
categories, three, 169
definition, 168
diagonal, 169, 236-241 (see also Spreads,
diagonalizing)
even money, 240
horizontal, 169
using LEAPS, 403-409 (see also LEAPS)
"leg" into, 171
out of, 180, 207
out-of-the-money call spread, 222-225
ratio call, 210-221
reverse, 230-235
reverse calendar, 230-232
reverse ratio, 232-235
unequal tax treatment on, 929-930
vertical, 169
Spread order, 169-171
Spreads combining calls and puts, 336-357
butterfly spread, 336-338
arbitrageur, role of, 338
box spread, 338
commissions high, 338
Index
equivalent of completely protected straddle write,
338
establishing, four ways for, 336-338
striking prices, three, 336
calendar combination, 345-348, 353-354, 356-357
superior to calendar straddle, 349-350
calendar straddle, 348-350, 354, 356-357
as neutral strategy, 349
criteria for, three, 354
inferior to calendar combination, 349-350
diagonal butterfly spread, 350-353, 354-355, 356-357
criteria, four, 355
legging out, 351-352
follow-up action for bull or bear spreads, 341-344
option purchase and spread, combining, 339-341
bearish scenario, 341, 342
bullish scenario, 339-340, 342
selecting, 353-356
criteria, five, 353-354
summary, 356-357
Standard Portfolio Analysis of Risk (SPAN), 514-515
Standard & Poor (S&P):
Depository Receipt (SPDR), 637-638
expiration, 510-511
100 Index (OEX), 497, 500-501, 582-583
400 Index, 497
500 Futures, 532
500 Index (SPX), 497, 502, 507, 583, 584
Standard & Poor's Stock/Bond Guide, 88
Stock:
buying below its market price, 299-300
underlying, price of as related to option price, 9-10
Stock index hedging strategies, 531-578
follow-up strategies, 557-559
rolling to another month, 557-559
impact on stock market, 561-565
"circuit breaker" of NYSE, 562
at expiration, 564-565
before expiration, 561-563
portfolio insurance, 563-564
regulatory bodies, concern of, 562
trading ban, 562
index, simulating, 566-574
hedge, monitoring, 572-573
high-capitalization stocks, using, 566-571
largest-capitalization stocks, four, 567
options instead of futures, using, 573-57 4
regression analysis, 566
tracking error risk, 571-572
index arbitrage, 547-556
commissions, 552-554
computerized method of order entry, 555-556
Index
Stock index hedging strategies (continued)
hedging price-weighted index, 547,548
how many shares to buy, 547-552
institutional strategies, 556
POT system of NYSE, 555-556
profitability, 552-554
trade execution, 554-556
market baskets, 531-537
dividends, inverse correlation of to premium
value, 534-537
execution risk, 560
futures fair value, 533-534
risk, 560-561
tracking error, 538,561, 571-572
"mini-index," creating, 566-574 (see also Stock index
hedging strategies, index, simulating)
program trading, 537-547
adjusted volatility, 539
arbitrage approach, 537
hedging with index calls, 545-547
hedging with index puts, 543-545
hedging portfolios with index options, 541-543
market risk, removing, 538
portfolio hedge, 539-541
tracking error, 538, 561, 571-572
volatility versus Beta, 538-539
summary, 577-578
tracking error, trading, 57 4-577
collateral requirements, 577
Stock indices, 493-500
Stock options:
basic properties of, 1-35
definitions, 3-35
definition, 3-35
Stock price and option price, relationship between,
7-9
Stock prices, distribution of, 783-811
distribution, 789-795
"big" picture, 790
fat tails, 790-792, 810
inflection points, 792-793
normal, 780-795
risk of too conservative estimate of stock price
movement, 796
summary, 796-797
Elliott Wave theory, 796
expected return, 809-810
lognormal distribution, 783-789
options, pricing of, 798
probability of stock price movement, 798-809
Brownian motion, 806
calculation mechanisms, 803-805
cumulative density function (CDF), 806
delta, 805
"ever" probability calculator, 805-806
Monte Carlo analysis, 806, 807-809
probability calculator, 798-799
summary, 810-811
volatility, prediction of, 799-803
sigma, 783-784
volatility buyer's rule, 787-789
volatility, misconceptions about, 783-787
standard deviations, 783-786
what this means for option traders, 795-796
Stock splits, symbols for, 27
997
Stock trading and futures trading, difference between,
508,512
Stop order, 33
Stop-limit order, 33-34
Straddle:
buying, 282-288 (see also Put buying)
equivalent stock position follow-up, 312-313
follow-up action, 308-312
"legging out," 310
risk large, 308, 314
rolling up/down, 310
in volatility trading, 824, 825, 829
sale of, 302-320
covered, 302-305
uncovered, 305-307
selecting write, 307-308
selling, LEAPS and, 402-403
starting out with protection in place, 313-314
strangle (combination) writing, 315-320
credits, using, 320
definition, 315
deltas, 318-319
excess trading, avoiding, 319-320
margin requirements, 317-318
Straddle calendar spread, 348-350 (see also Spreads
combining calls and puts)
Straddle/strangle buying and selling, effects on of
implied volatility changes, 766-767
Strangle, 281
buying, 288-291
definition, 315
in volatility tr


14
strangle (combination) writing, 315-320
credits, using, 320
definition, 315
deltas, 318-319
excess trading, avoiding, 319-320
margin requirements, 317-318
Straddle calendar spread, 348-350 (see also Spreads
combining calls and puts)
Straddle/strangle buying and selling, effects on of
implied volatility changes, 766-767
Strangle, 281
buying, 288-291
definition, 315
in volatility trading, 824, 825, 828-829
strangle (combination) writing, 315-320 (see also
Straddle)
Strategy, best, 932-937
investor as dominant force in determining strategy,
938
market attitude and equivalent positions, 932-934
mathematical ranking, 936-937
strategies to be avoided, 933
summary, 937
volatility trading, 932-933
Strategy summary, 943-944
998
Striking price:
as factor influencing price, 9-10
code, 24-25
definition, 3, 4
fractional, 29
standardization, 5
Structured products, 589-640
adjustment factor, 602-604
cost, measuring, 605-607, 608
break-even final index value, 604-605
exotic options, 590
imbedded call, computing value of when underlying
is trading at discount, 602
income, products designed to provide, 618-639
covered write of call option, resembling, 619
Creation Units, 638
Diamonds, 638
Exchange-Traded Funds (ETFs), 637-639 (see
also Exchange-Traded Funds)
HOLDRS, 639
iShares, 638
NASDAQ-100 tracking stock (QQQ), 638, 639
options on ETFs, 639
PERCS (Preferred Equity Redemption
Cumulative Stock (PERCS), 619-637 (see also
PERCS)
Russell 2000 Value Fund and 2000 Growth Fund,
638
more appeal for investors than for traders, 589
"riskless" ownership of stock or index, 590-618
annual adjustment factor, 594
bull spread, 608-612
cash value, 593-594
constructs, other, 607-613
dividends, 594
equity-linked notes, 618
financial engineers, role of in structured products,
590,607
imbedded call option, cost of, 594-595
income tax consequences, 592-593
LEAPS options, 616-617
list, 618
multiple expiration dates, 613
multiplier, 614
option strategies involving structured products,
613-618
Original Issue Discount (OID), 592-593
phantom interest, 592
price behavior p1ior to maturity, 595-596
SIS (Stock Index return Security), 596-601 (see
also SIS)
strike price, 592, 615-618
structure, 590-593
when underlying index drops, 617
Index
summary, 640
Suitability of strategy for individual investor, 3
Swiss franc contract for foreign currency options, 672
Symbology, options, 23-27 (see also Options)
Synthetic convertible bond, 441 (see also Options and
Treasury bills)
Synthetic long call, 271
Synthetic long stock, 321-323
Synthetic stock positions created by puts and calls, 321-
328
splitting strikes, 325-328
bearishly oriented, 327-328
bullishly oriented, 325-327
protective collar, 328
summary, 328
synthetic long stock, 321-323
synthetic short sale, 323-325
leverage, 324
"Synthetic" strategies, 118
put, 118-121
Tau, 859-862
Tax considerations, put purchase, 275
Taxes, 908-931
assignment, 914-920
applicable stock price (ASP), 917
qualified covered call, 917-920, 961-962
"too-deeply-in-the-money" definition, 916
equity options, strategies for, 925-930
deferring put holder's short-term gain, 928
deferring short-term call gain, three tactics for,
928
difficulty of deferring gains from writing, 928-929
spreads, unequal tax treatment on, 929-930
exercise, 913-914
history, 908-909
"married" put and stock, 924
"new" stock, delivering to avoid large long-term gain,
920-921
"versus purchase" notation 921
option as capital asset, 908
problems, special, 922-925 (see also under particular
problem heading)
profit strategies and tax strategies, separating, 931
protecting long-term gain/avoiding long-term loss,
924-925
put assignment, 921-922
put exercise, 921
short sale rule, 923-925
summary, 925, 930-931
tax treatment, basic, 910-913
call buyer, 910-911
call writer, 910, 911-912
Index
Taxes (continued)
put buyer, 910
put writer, 910, 912
60/40 rule, 912-913
wash sale rule, 922-923
TED spread, 701-702, 712-714
carrying cost, 702
Tender offers, risk arbitrage and, 451-454
partial, 454
short tendering, 453
two-tier offers, 454
Theta, 862-864, 866
position theta, 877
Time spread, 191-199 (see also Calendar spread)
. Time value premium, 7-8, 11, 762-765
and volatility trading, 106-107
decay, 13-14
for put options, 246-247
"greeks" to measure, 763
Total return concept of covered writing, 45-47, 60-61,
93
Tracking error:
risk, index hedging and, 538,561, 571-572
trading, 574-577
Trading against the straddle strategy, 126-127, 287
Trading options, details of, 27-32 (see also Options)
Trapezoidal hedge, 155, 156, 157
Trapezoidal Rule, 471
Treasury bills, 413-421 (see also Options and
Treasury bills)
Uncovered call writing, 132-145 (see also Naked call
writing)
call option, 133-134
Uncovered straddle write equivalent to ratio call write,
306
Underlying security, definition, 3
Underlying stock, price of as factor influencing option
price, 9-10
Up delta concept, 100-101
"Using box stock," 432
Value Line Index, 532, 579, 582
Vega of option, 749-753, 860-862 (see also Volatility,
effects of)
and excess value, 764
option or position vega, 757,862
Vertical put spreads, effect on of implied volatility,
775-777
Vertical spread, 169, 186
Volatility, effect of on popular strategies, 7 49-782
backspreads, 781-782
calendar spreads, 778-780
call bull spreads, 767-775
vega of option, 768
implied volatility, effect of, 749-782
and delta, 753-754
neutrality, effects on, 755-756
outright option purchases and sales, 757-762
position vega, 757
put bear spreads, 777-778
put option, 765-766
ratio spreads, 780-781
straddle/strangle buying and selling'. 766-767
summary, 782
999
time value premium, 762-765
delta, 764
factors, five, 762-763
"greeks" to measure, 763-764
vega, 7 49-753
and excess value, 764
definition, 7 49-750
vertical put spreads, 775-777
Volatility, measu


option purchases and sales, 757-762
position vega, 757
put bear spreads, 777-778
put option, 765-766
ratio spreads, 780-781
straddle/strangle buying and selling'. 766-767
summary, 782
999
time value premium, 762-765
delta, 764
factors, five, 762-763
"greeks" to measure, 763-764
vega, 7 49-753
and excess value, 764
definition, 7 49-750
vertical put spreads, 775-777
Volatility, measuring and trading, 723-931 (see also
under particular heading)
advanced concepts, 846-907
basics of volatility trading, 727-7 48
definition, 859-860
most important concept in option trading, 724
stock prices, distribution of, 783-811
taxes, 908-931
volatility, effect of on popular strategies, 7 49-782
volatility trading techniques, 812-845
why trade "the market," 724-726
Volatility, misconceptions about, 783-787
buyer's rule, 787-789
Volatility, prediction of, 799-803
Volatility backspread, 827, 834-836, 841
margin, 836
not for LEAPS options, 835
Volatility in Black-Scholes model, 460
historical, 461-466 (see also Historical volatility)
Volatility Index ($VIX), 738, 761, 785-786
Volatility of stocks, 538-539
adjusted, 539
of underlying stock:
as factor in option price, 13-14
call option rankings and, 103-106
Volatility skew, 517, 683, 685, 693-694, 813
trading, 837-844 (see also Volatility trading)
Volatility trading, basics of, 727-7 48
definitions, 728-731
historical volatility, 728-731
implied volatility, 727, 732-743
GARCH (Generalized Autoregressive Conditional
Heteroskedasticity), 731-732
1000
Volatility trading, basics of (continued)
"fudge factor," 731, 733
implied volatility, 727, 732-743
as predictor of actual volatility, 737-7 43
LEAPS, 735, 736
percentile, 734-735
range, 735-737
time left in option, 736-737
Volatility Index ($VIX), 738
moving averages, 732
summary, 748
trading, 7 43-7 44
why volatility reaches extremes, 7 44-7 48
bear market in underlying stock, 746-747
cheap options, 747-748
illiquid options, 745-746
insider trading, 7 45
sellers of volatility, danger for, 7 48
supply and demand of public, 747
Volatility trading techniques, 812-845
as art and science, 812
summary, 844-845
trading volatility prediction, 814-837
backspreads, 827, 834-836 (see also Volatility
trading techniques, volatility backspread)
calendar spread, selling, 833
composite implied volatility reading, 815
histogram, construction of, 831-832
historical volatility, comparing current and past,
821-824
implied and historical volatility, comparing, 817-
818
percentile of implied volatility approach, 814-817
probability calculator, 824, 827-829
reverse calendar spread, 833-834
selecting strategy to use, 824-826
selling volatility, 826-827, 833-836
stock price history, using, 829-832
summary, 836-837
volatility chart, reading, 818-821
when volatility is out of line, determining,
814
volatility backspread, 827, 834-836, 841
margin, 836
not for LEAPS options, 835
volatility skew, trading, 837-844
collar, 840
Index
differing implied volatilities on same underlying
security, 837-838
forward/positive volatility skew, 843
reverse/negative volatility skew, 839-840
summary, 844
wrong predictions, two ways for, 813
volatility skew, 813
Warrants:
covered writing against, 90-91
rho, 872-873
Wash sale rule, 922-923
Whipsaw, 403
Wrap symbols, 25-26
Writer, definition, 6
XMI (Major Market Index), 499
Index 1001
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Technical Analysis
of Stock Trends
Eleventh Edition

Technical Analysis
of Stock Trends
Eleventh Edition
Robert D. Edwards
John Magee
W. H. C. Bassetti
A PRODUCTIVITY PRESS BOOK
Routledge
Taylor & Francis Group
711 Third Avenue, New York, NY 10017
© 2019 by Taylor & Francis Group, LLC
Productivity Press is an imprint of Taylor & Francis Group, an Informa business
No claim to original U.S. Government works
Printed on acid-free paper
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Library of Congress Cataloguing-in-Publication Data
Names: Edwards, Robert D. (Robert Davis), 1893- author. | Magee, John, 1901-
author. | Bassetti, W. H. C., author.
Title: Technical analysis of stock trends / Robert D. Edwards, John Magee,
W.H.C. Bassetti.
Description: Eleventh Edition. | New York : CRC Press, [2018] | Revised
edition of the authors’ Technical analysis of stock trends, c2013. |
Includes bibliographical references and index.
Identifiers: LCCN 2018010151 | ISBN 9781138069411 (hardback : alk. paper)
Subjects: LCSH: Investment analysis. | Stock exchanges--United States. |
Securities--United States.
Classification: LCC HG4521 .E38 2018 | DDC 332.63/20420973--dc23
LC record available at https://lccn.loc.gov/2018010151
Visit the Taylor & Francis Web site at
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and the Productivity Press site at
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Figure 0.1 DOW 25000! What a birthday present for the 11th edition! The Dow continues to set records since March of 2009, as vividly illustrated
by this chart.

vii
Contents
Preface to the eleventh edition ....................................................................................................xv
Preface to the tenth edition ....................................................................................................... xvii
Preface to the ninth edition ....................................................................................................... xxi
Preface to the eighth edition ..................................................................................................... xxv
In memoriam ............................................................................................................................ xxxv
Preface to the seventh edition ..............................................................................................xxxvii
Preface to the fifth edition .......................................................................................................... xli
Preface to the fourth edition .....................................................................................................xliii
Preface to the second edition ..................................................................................................... xlv
Foreword ....................................................................................................................................xlvii
Part I: Technical theory
Chapter 1 The technical approach to trading and investing ..............................................3
Definition of technical analysis .....................................................................................................4
Chapter 2 Charts .........................................................................................................................7
Different types of scales .................................................................................................................8
Chapter 3 The Dow Theory.....................................................................................................11
The Dow Averages ........................................................................................................................12
Basic tenets .....................................................................................................................................12
Tide, wave, and ripple .............................................................................................................. 14
Major trend phases ................................................................................................................... 14
Principle of confirmation ........................................................................................................ 16
Chapter 4 The Dow Theory’s defects ...

eBooks\Technical Analysis of Stock Trends 11thed\original\Technical Analysis of Stock Trends.pdf


...................................................................................... 14
Major trend phases ................................................................................................................... 14
Principle of confirmation ........................................................................................................ 16
Chapter 4 The Dow Theory’s defects ....................................................................................21
The Dow Theory is too late ......................................................................................................... 21
The Dow Theory is not infallible ................................................................................................23
The Dow Theory frequently leaves the investor in doubt .................................................23
The Dow Theory does not help the Intermediate Trend investor .....................................23
The Dow Theory in the 20th and 21st centuries .......................................................................26
Chapter 5 Replacing Dow Theory with John Magee’s Basing points Procedure ........31
The fractal nature of the market ................................................................................................. 31
viii Contents
Chapter 6 Important Reversal Patterns ................................................................................41
Important Reversal Patterns ........................................................................................................42
Time required to reverse a trend ................................................................................................42
The Head-and-Shoulders Top Formation ..................................................................................44
Volume is important .....................................................................................................................44
Breaking the neckline ...................................................................................................................47
Variations in Head-and-Shoulders Tops ....................................................................................49
Price action following confirmation: the measuring formula ................................................ 52
Relation of Head-and-Shoulders to Dow Theory .....................................................................55
Chapter 7 Important Reversal Patterns: continued ............................................................57
Head-and-Shoulders (EN: or Kilroy) Bottoms ..........................................................................57
Multiple Head-and-Shoulders Patterns .....................................................................................59
Tendency to symmetry ................................................................................................................. 61
A leisurely pattern ........................................................................................................................65
Rounding Tops and Bottoms .......................................................................................................66
How Rounding Turns affect trading activity ........................................................................... 70
The Dormant Bottom variation ...................................................................................................73
Volume pattern at Tops ................................................................................................................ 74
Chapter 8 Important Reversal Patterns: the Triangles ......................................................77
Symmetrical Triangles..................................................................................................................79
Some cautions about Symmetrical Triangles ............................................................................82
How prices break out of a Symmetrical Triangle .....................................................................88
A typical Triangle development .................................................................................................90
Reversal or Consolidation ............................................................................................................94
The Right-Angle Triangles ...........................................................................................................97
A planned distribution .................................................................................................................98
Descending Triangles ...................................................................................................................98
Volume characteristics same as the Symmetrical type ...........................................................99
Measuring implications of Triangles ....................................................................................... 100
Triangles on weekly and monthly charts ................................................................................ 100
Other Triangular formations ..................................................................................................... 100
Chapter 9 More important Reversal Patterns ...................................................................103
The Rectangles, Double and Triple Tops ................................................................................. 103
Pool operations ............................................................................................................................ 105
Relation of rectangle to Dow Line ............................................................................................ 112
Rectangles from Right-Angle Triangles ................................................................................... 113
Double and Triple Tops and Bottoms .....................................


.................................................................. 105
Relation of rectangle to Dow Line ............................................................................................ 112
Rectangles from Right-Angle Triangles ................................................................................... 113
Double and Triple Tops and Bottoms ....................................................................................... 113
Distinguishing characteristics .................................................................................................. 115
Double Bottoms ........................................................................................................................... 118
Triple Tops and Bottoms ............................................................................................................ 118
Chapter 10 Other Reversal phenomena ................................................................................121
The Broadening Formations ...................................................................................................... 121
Volume during Broadening Formations ..................................................................................122
A typical example ....................................................................................................................... 128
ixContents
The Orthodox Broadening Top ................................................................................................. 130
Why no Broadening Bottoms?................................................................................................... 135
Right-Angled Broadening Formations ..................................................................................... 135
The Diamond ............................................................................................................................... 137
Wedge Formations ...................................................................................................................... 139
The Falling Wedge ...................................................................................................................... 142
Wedges on weekly and monthly charts................................................................................... 143
Rising Wedges common in Bear Market Rallies .................................................................... 144
The One-Day Reversal ................................................................................................................ 144
The Selling Climax ..................................................................................................................... 145
Short-term phenomena of potential importance .................................................................... 147
Spikes ............................................................................................................................................ 147
Runaway Days ............................................................................................................................. 148
Key Reversal Days....................................................................................................................... 148
Chapter 11 Consolidation Formations ..................................................................................151
Flags and Pennants ..................................................................................................................... 151
The Pennant: a pointed Flag ...................................................................................................... 153
The measuring formula ............................................................................................................. 154
Reliability of Flags and Pennants ............................................................................................. 156
Where they may be expected .................................................................................................... 157
Flag pictures on weekly and monthly charts ......................................................................... 158
Rectangular Consolidations: an early phase phenomenon .................................................. 159
Head-and-Shoulders Consolidations ....................................................................................... 160
Scallops: repeated Saucers ......................................................................................................... 162
Modern versus old-style markets ............................................................................................. 168
Chapter 12 Gaps ........................................................................................................................171
Which gaps are significant? ....................................................................................................... 171
Closing the gap ............................................................................................................................ 171
Ex-dividend gaps......................................................................................................................... 174
The common or area gap ....................................................................................................... 175
Breakaway gaps ...................................................................................................................... 177
Continuation or runaway gaps and the measuring rule .................................................. 182
Two or more runaway gaps .................................................................................................. 184
Exhaustion gaps ..................................................................................................................... 185
The Island Reversal ..........................................................................


................................... 182
Two or more runaway gaps .................................................................................................. 184
Exhaustion gaps ..................................................................................................................... 185
The Island Reversal ..................................................................................................................... 186
Gaps in the Averages .................................................................................................................. 187
Chapter 13 Support and Resistance .......................................................................................189
Normal trend development ....................................................................................................... 190
The explanation ........................................................................................................................... 191
Estimating Support–Resistance potential ............................................................................... 193
Locating precise levels ............................................................................................................... 196
Significance of Support failure .................................................................................................. 197
Popular misconceptions ............................................................................................................. 198
The round figures .......................................................................................................................200
Repeating historical levels .........................................................................................................200
x Contents
Pattern Resistance ....................................................................................................................... 202
Volume on breaks through Support .........................................................................................205
Support and Resistance in the Averages .................................................................................206
Chapter 14 Trendlines and Channels ...................................................................................207
The Trendline............................................................................................................................... 207
How Trendlines are drawn ........................................................................................................209
Arithmetic versus logarithmic scale ........................................................................................ 211
Tests of authority ......................................................................................................................... 216
Validity of penetration ...............................................................................................................220
Amendment of Trendlines .........................................................................................................222
Double Trendlines and trend ranges .......................................................................................222
Trend Channels ...........................................................................................................................223
Experimental Lines ..................................................................................................................... 224
Consequences of Trendline penetration: Throwbacks .......................................................... 224
Intermediate Downtrends .........................................................................................................225
Corrective trends: the Fan Principle .........................................................................................226
Chapter 15 Major Trendlines ..................................................................................................229
Major Downtrends ...................................................................................................................... 242
Major Trend Channels ................................................................................................................ 242
Trendlines in the Averages ........................................................................................................ 243
Trading the Averages in the 21st century ................................................................................244
Chapter 16 Technical analysis of commodity charts .........................................................245
Technical analysis of commodity charts, part 2: a 21st-century perspective ..................... 249
Rocket scientists .......................................................................................................................... 249
Turtles? ..........................................................................................................................................250
The application of Edwards and Magee’s methods to 21st-century futures markets ....... 252
Stops .........................................................................................................................................258
A variety of methods ..................................................................................................................259
Everything you need to know as a chart analyst trading futures .......................................259
Chapter 17 A summary and concluding comments ...........................................................261
Technical analysis and technology in the 21st century: the computer and the
internet: tools of the investment/information revolution .....................................................265
The importance of computer technology ................................................................


hapter 17 A summary and concluding comments ...........................................................261
Technical analysis and technology in the 21st century: the computer and the
internet: tools of the investment/information revolution .....................................................265
The importance of computer technology ................................................................................ 267
Summary 1 ..............................................................................................................................268
Other technological developments of importance to the technical Magee analyst
and all investors
 ..........................................................................................................................268
The Internet: the eighth wonder of the modern world (EN9: Appendix B,
Resources, for the ninth edition has been enormously expanded and is of
paramount importance to modern investors.)
 ...................................................................268
Marking-to-market ................................................................................................................. 269
Separating the wheat from the chaff ................................................................................... 270
Chaff ......................................................................................................................................... 270
Summary 2 .............................................................................................................................. 270
Advancements in investment technology, part 1: developments in finance theory
and practice
 .................................................................................................................................. 271
xiContents
Options .................................................................................................................................... 271
Quantitative analysis .............................................................................................................272
Options pricing models and their importance .................................................................. 273
Futures on indexes ................................................................................................................. 273
Options on futures and indexes ........................................................................................... 274
Modern Portfolio Theory ...................................................................................................... 275
The wonders and joys of investment technology .............................................................. 275
Advancements in investment technology, part 2: futures and options on futures on
the Dow–Jones Industrial Index at the CBOT ......................................................................... 275
Investment and hedging strategies using the CBOT® DJIASM futures contract ............ 276
Settlement of futures contracts............................................................................................. 276
Marking-to-market ................................................................................................................. 276
Fungibility ............................................................................................................................... 276
Differences between cash and futures ................................................................................277
Dow Index futures .................................................................................................................277
Using stock index futures to control exposure to the market .........................................277
Investment uses of Dow Index futures ............................................................................... 279
Situation 1: Portfolio protection ....................................................................................... 279
Situation 2: Increasing exposure with futures ..............................................................280
Situation 3: Using bond and index futures for asset allocation ..................................280
Perspective............................................................................................................................... 282
Options on Dow Index futures ............................................................................................ 282
Option premiums ...................................................................................................................283
Volatility ..................................................................................................................................283
Exercising the option .............................................................................................................284
Using futures options to participate in market movements ............................................284
Profits in rising markets ........................................................................................................284
Exploiting market reversals ..................................................................................................285
Using puts to protect profits in an appreciated portfolio .................................................285
Situation 1 ...........................................................................................................................285
Improving portfolio yields ....................................................................................................286
Situation 2 ...........................................................................................................................286
Using option spreads in high- or low-volatility markets .................................................286
Situation 3 ...............................................


.........................................................................................286
Situation 2 ...........................................................................................................................286
Using option spreads in high- or low-volatility markets .................................................286
Situation 3 ...........................................................................................................................286
Situation 4 ........................................................................................................................... 287
Perspective............................................................................................................................... 287
Recommended further study .................................................................................................... 287
Part II: Trading tactics
Chapter 18 The tactical problem ............................................................................................293
Strategy and tactics for the long-term investor—What’s a speculator? What’s an
investor? ........................................................................................................................................ 297
One definition of the long-term investor .................................................................................299
The strategy of the long-term investor .....................................................................................299
Rhythmic investing ....................................................................................................................300
Summary ......................................................................................................................................302
xii Contents
Chapter 19 The all-important details ....................................................................................303
The simplest and most direct way to use a computer for charting analysis ......................304
Summary ......................................................................................................................................305
Chapter 20 The kind of stocks we want: the speculator’s viewpoint .............................307
The kind of stocks we want: the long-term investor’s viewpoint ........................................ 310
Changing opinions about conservative investing ............................................................. 310
The kinds of stocks long-term investors want: the long-term investor’s viewpoint ......... 311
Construction of the Index Shares and similar instruments ................................................. 311
An outline of instruments available for trading and investing ...................................... 312
The importance of these instruments: diversification, dampened risks, tax, and
technical regularity ..................................................................................................................... 313
Summary ...................................................................................................................................... 313
Chapter 21 Selection of stocks to chart .................................................................................315
Chapter 22 Selection of stocks to chart: continued ............................................................319
Chapter 23 Choosing and managing high-risk stocks: tulip stocks, Internet
sector, and speculative frenzies ........................................................................325
Managing tulipomanias and Internet frenzies and…Bitcoin ............................................... 326
Detailed techniques for management of the runaway issues .............................................. 328
Hope springs eternal and there is one born every second ................................................... 332
Chapter 24 The probable moves of your stocks ..................................................................341
Chapter 25 Two touchy questions ..........................................................................................345
The use of margin .......................................................................................................................345
Short selling .................................................................................................................................346
Chapter 26 Round lots or odd lots?........................................................................................351
Chapter 27 Stop orders .............................................................................................................353
The progressive stop ...................................................................................................................355
Stop systems and methods ........................................................................................................ 357
A brief survey of stop methods .................................................................................................358
Some other stop methods ..........................................................................................................358
Average True Range ...............................................................................................................358
Parabolic stop and reverse ....................................................................................................359
Target stops .............................................................................................................................359
A natural method used by the Turtles ..................................................................................... 359
Chapter 28 What is a Bottom and what is a Top? ...............................................................361
Basing Points ......................................................


.......................................................................................359
A natural method used by the Turtles ..................................................................................... 359
Chapter 28 What is a Bottom and what is a Top? ...............................................................361
Basing Points ................................................................................................................................ 362
Basing Points: a case analyzed ..................................................................................................364
The Basing Points paradigm......................................................................................................365
Key to Figure 28.2 analysis ...................................................................................................366
A narrative of the events in the chart....................................................................................... 367
xiiiContents
The complete Basing Points Procedure: taking into consideration the setting of
Basing Points on both wave lows and new highs ..................................................................368
The complete Basing Points procedure .................................................................................... 369
Two charts giving a long-view perspective on the complete (Variant 2) procedure ......... 370
The representative case fully analyzed using wave lows and new highs .......................... 370
A narrative of the events in the chart....................................................................................... 371
Chapter 29 Trendlines in action .............................................................................................373
Buying stock, “going long” ........................................................................................................ 375
Liquidating, or selling a long position ..................................................................................... 378
Selling stock short ....................................................................................................................... 379
Covering short sales.................................................................................................................... 379
Additional suggestions ..............................................................................................................380
General outline of policy for trading in the Major Trend .....................................................380
Chapter 30 Use of Support and Resistance ..........................................................................383
Chapter 31 Not all in one basket ............................................................................................389
EN: diversification and costs .....................................................................................................390
Chapter 32 Measuring implications in technical chart patterns .....................................391
Chapter 33 Tactical review of chart action ...........................................................................393
The Dow Theory ......................................................................................................................... 393
Head-and-Shoulders Top ...........................................................................................................400
Head-and-Shoulders Bottom ..................................................................................................... 401
Complex or multiple Head-and-Shoulders .............................................................................403
Rounding Tops and Bottoms .....................................................................................................403
Symmetrical Triangles................................................................................................................406
Right-Angle Triangles.................................................................................................................408
Broadening Tops..........................................................................................................................408
Rectangles ....................................................................................................................................408
Double Tops and Bottoms ..........................................................................................................409
Right-Angled Broadening Formations .....................................................................................409
The Diamond ...............................................................................................................................409
Wedges ..........................................................................................................................................409
One-Day Reversals ...................................................................................................................... 410
Flags and Pennants ..................................................................................................................... 410
Gaps .............................................................................................................................................. 411
Support and Resistance .............................................................................................................. 414
Trendlines..................................................................................................................................... 414
Chapter 34 A quick summation of tactical methods ..........................................................417
Get out of present commitments .............................................................................................. 417
Make new commitments ............................................


......................................................................................... 414
Chapter 34 A quick summation of tactical methods ..........................................................417
Get out of present commitments .............................................................................................. 417
Make new commitments ............................................................................................................ 418
Chapter 35 Effect of technical trading on market action ..................................................419
xiv Contents
Chapter 36 Automated trendline: the Moving Average ....................................................421
Sensitizing Moving Averages ....................................................................................................422
Crossovers and penetrations .....................................................................................................422
The PENTAD Moving Average system from Formula Research ......................................... 424
Chapter 37 The same old patterns .........................................................................................427
Not all the same ...........................................................................................................................428
Chapter 38 Balanced and diversified ....................................................................................481
September 28, 1985: an oversold market ..................................................................................486
Chapter 39 Trial and error .......................................................................................................487
Chapter 40 How much capital to use in trading .................................................................489
Chapter 41 Application of capital in practice ......................................................................491
Put and call options .................................................................................................................... 493
Chapter 42 Portfolio risk management .................................................................................495
Overtrading: a paradox .............................................................................................................. 496
Risk of a single stock .................................................................................................................. 498
Risk of a portfolio ........................................................................................................................499
EN9: Risk and trend ....................................................................................................................499
Value-at-Risk procedure .............................................................................................................499
Pragmatic Portfolio Theory (and practice) ..............................................................................500
Pragmatic portfolio risk measurement ....................................................................................500
Determining the risk of one stock .......................................................................................500
Determining the risk for a portfolio .................................................................................... 501
Measuring maximum drawdown (maximum retracement) ................................................502
Pragmatic portfolio analysis: measuring the risk ..................................................................502
Portfolio Ordinary or Operational Risk ..............................................................................502
Portfolio risk over time ..........................................................................................................503
Portfolio extraordinary or catastrophic risk .......................................................................503
Controlling the Risk ...................................................................................................................503
Summary of Risk and Money Management Procedures ......................................................503
Infinitely more sophisticated risk and money management procedures—Ralph
Vince and optimal f ....................................................................................................................504
Chapter 43 Stick to your guns ................................................................................................505
Appendix A: The Dow Theory in practice ..............................................................................507
Appendix B: Resources .............................................................................................................. 523
Appendix C: Technical Analysis: beyond Edwards & Magee .............................................. 537
List of Illustrations and Text Diagrams ...................................................................................565
Alphabetic Index of Stock Charts ............................................................................................. 579
Glossary ........................................................................................................................................ 595
Bibliography ................................................................................................................................. 621
Index ............................................................................................................................................. 623
xv
Preface to the eleventh edition
Beyond Edwards & Magee
I would be remiss if I did not note the passing of two important figures in the discipline
of technical analysis—Richard Arms Jr. and Professor Hank Pruden of Golden Gate
University. Well liked and admired they leave large gaps in the community. The article
here b