High Performance Options Trading

Option Volatility & Pricing Strategies
By Leonard Yates

John Wiley & Sons

Copyright © 2003 Leonard Yates
All right reserved.

ISBN: 0-471-32365-9

Contents

A Note from the Author......................................................................xiii
Introduction................................................................................xv
CHAPTER 1  The Language of Options..........................................................1
The Basics..................................................................................2
Listed Options..............................................................................4
Nomenclature................................................................................6
Longs and Shorts............................................................................6
A Bit More Terminology......................................................................7
Offsetting Option Trades....................................................................10
Expiration, Exercise, and Assignment........................................................11
American versus European....................................................................11
Quotations..................................................................................12
The Special Properties of Options...........................................................14
Time........................................................................................15
Volatility..................................................................................18
How Options Respond to Changing Conditions..................................................18
The Greeks..................................................................................19
The Role of the Market Maker................................................................21
Volume and Open Interest....................................................................22
CHAPTER 2  Option Strategies................................................................25
Long Call...................................................................................26
Short Covered Call..........................................................................27
Short Naked Call............................................................................29
Long Call with Short Stock..................................................................30
Long Put....................................................................................30
Short Covered Put...........................................................................31
Short Naked Put.............................................................................32
Long Put with Long Stock....................................................................33
Equivalent Strategies.......................................................................34
Combinational Strategies....................................................................39
CHAPTER 3  Volatility.......................................................................43
Volatility Trading-Buying and Selling Volatility............................................44
Tools of the V-Trade........................................................................46
Selling High Volatility.....................................................................47
Buying Low Volatility.......................................................................50
Delta-Neutral Trading-In a Nutshell.........................................................54
Seasonal Patterns in the Grains.............................................................55
Other Commodities...........................................................................59
Volatility Skew-What Is It and How Can I Use It?............................................60
Some Words of Warning about Naked Writing...................................................64
The Relationship between Volatility and Price...............................................64
CHAPTER 4  The Option Trader's Arsenal......................................................69
Buying Nearby Options-The Swing Trader's Perfect Tool.......................................69
Debit Spreads-The Calm Approach.............................................................73
Strategies for Trending Markets.............................................................76
The Horizontal Spread-Good Strategy in a Sideways Market....................................78
Credit Spreads-Say "Don't Go There".........................................................92
Condors-Two-Winged Creatures................................................................85
The Backspread-Directional Strategy that Costs Nothing If You Are Wrong.....................88
Covered Writing-Enhancing Your Returns......................................................92
LEAPS-An Alternative to Stock...............................................................95
The Synthetic-Another Alternative to Stock..................................................98
The Butterfly Spread-When You Have a Narrow Target Range....................................100
Using the Right Option Strategy.............................................................101
CHAPTER 5  Special Situations...............................................................105
Playing Takeovers...........................................................................105
Letting the Options Market Tip You Off on Takeovers.........................................107
Covered Writing with Convertible Securities.................................................111
Investing in a Rough Market.................................................................118
CHAPTER 6  Theoretical and Practical Matters................................................127
Options Pricing Models......................................................................127
Coming Up with the Right Volatility.........................................................133
Volatility Skew.............................................................................134
What Causes Volatility Skew?................................................................136
Balancing Factors...........................................................................139
Put/Call Parity.............................................................................139
The Greeks Revisited........................................................................141
True Delta and Gamma........................................................................143
Understanding the Limitations of Your Model.................................................144
Dealing with Anomalies and Pricing Difficulties.............................................146
CHAPTER 7  Tips for Beginners...............................................................149
The Psychological Battle....................................................................154
Trading Mistakes and What I Learned.........................................................156
Some Thoughts on How Trading Fits In with Real Life.........................................158
CHAPTER 8  Encore...........................................................................161
Directional Trading Using Pattern Recognition...............................................161
Timing the Market Using the VIX.............................................................169
Why a VIX Spike Stops a Market Sell-Off.....................................................179
Starting the Business (on a Shoestring).....................................................185
Business Philosophy.........................................................................191
Glossary....................................................................................195
Index.......................................................................................213


Chapter One

The Language of Options

In the Chicago area, where I live, many people know what options are. That is because several of the world's largest options exchanges are here, and many people either work at one of the exchanges or know someone who does.

Still, more people are probably unfamiliar with options. And so it happens that when someone asks about my line of work, the discussion invariably leads to the subject of options, and I find myself having to tell them, in the briefest terms, what options are.

After a short description, I pause, and the words that often come back to me are "Well, that sounds too complicated for me." At that point, I usually hesitate to go much further, because I don't want to make them listen to what might be, to them, an arcane subject. But what I want to say, and sometimes do come right out and say, is that options are not really that complicated. Sure, there is a terminology to learn. But I like comparing options to the game of chess. Like chess, you can learn all the rules about options in just about 20 minutes. Then you're off and running.

Admittedly, some practice is needed to become successful. Options have a number of strategies to become familiar with, but hardly as many as chess! Anyone with average intelligence can learn all about options in a short time.

Also, it's easy to set up an account and begin trading options. Almost every brokerage that allows you to trade stocks also allows you to trade stock or index options. And almost every brokerage that allows you to trade futures also allows you to trade futures-based options. Establishing an options trading account just requires a little extra paperwork, including signing a statement that you have read and understood the options prospectus and are prepared to assume the risks involved.

Options are fascinating to trade, and they have some unique qualities as a trading vehicle. There are many strategies, some involving the use of two or more options in combination, or the use of options along with a position in the underlying security or futures contract, that have extraordinary risk/reward characteristics.

However, options trading is not for everyone. While there are some conservative options trading strategies, there are some risky strategies as well, where your capital can be lost very quickly. It is up to the individual, after learning about options, to decide whether he or she has the tempera-ment for it.

THE BASICS

Suppose you agree to sell something. And suppose you and the other party have agreed on a price and a time to complete the sale. In such a case, you have what is called, in the realm of finance, a forward contract.

However, if you agree to let someone have the privilege of buying something from you at a stated price and for a limited time, if and when the other party decides to do so, you have sold an option.

The holder of the option possesses the right, but not an obligation, to buy something at a stated price for a limited time. The party who sold the option is obligated to deliver the goods if the options holder decides to exercise his option.

The asset that would be delivered is called the underlying asset, or just the underlying. The price agreed to is called the strike price or exercise price of the option.

For example, let's say I have a piece of real estate worth $100,000. I could agree to let someone have an option to buy the property from me for, say, exactly $100,000 at any time during the next two years. The option's strike price is therefore $100,000, the underlying is the property itself, and the expiration date is two years from today.

Now, why would I enter into such an agreement? After all, if the property increases in value over the next two years, that appreciation would be lost to me because I have agreed to sell the property for $100,000. Furthermore, I am locked into owning the property, and may not sell it to anyone for the next two years-because if the option holder decides to exercise, I am obligated to deliver the property. So why should I put myself in such a constrained position?

First, for the money I receive. An option has value and won't be granted without compensation. I may need to receive, for example, $15,000 for this particular option. The $15,000 (should the option buyer agree to that amount) would be mine to keep, regardless of the outcome (whether or not the buyer decides to exercise his option). The price paid for an option is usually referred to as the premium.

The second reason for me to do this is that I may be unwilling, or unable, to sell the property at this time. Under those circumstances, I might be happy to at least receive $15,000 immediately, especially if I do not believe that the house is likely to appreciate more than $15,000 over the next two years.

What happens at the end of the two-year period, as we approach the expiration date of the option? If it turns out that the property appreciates less than $15,000, then I'm better off for having sold the option. If the property appreciates exactly $15,000 during the next two years, I end up with the same outcome as if I had not sold the option. And if the property appreciates more than $15,000, then I may regret having sold the option.

Why might someone want to buy an option? For one thing, leverage. In this example, for just $15,000, an option buyer can have control over a $100,000 asset. Without incurring the hassle of ownership, he has the right to own the property anytime simply by submitting an exercise notice and paying the agreed $100,000. Suppose, during the next two years, he pursues his plans for the property, and those plans don't come together the way he hoped. He now has greater flexibility in getting out because, in fact, he never got in; he never bought the property. He can simply let his option expire.

Also, the option buyer may believe that the property will appreciate more than $15,000 during the next two years. If it does, he could exercise his option and then sell the property for more than $115,000.

Another reason to buy an option, rather than the asset itself, is the limited risk. Although real estate doesn't often drop in price, if the value of this property, for whatever reason, were to fall below $100,000, the option holder is not likely to exercise. Why should he pay $100,000 for something that could be bought, on the open market, for less than $100,000? And if the value of the property were to fall to less than $85,000, the option buyer would be happy that his loss is limited to the $15,000 he paid for the option, rather than having bought the property and now seeing a loss of more than $15,000.

Does the strike price of an option have to be precisely equal to the property's current fair value? Of course not. I could have written (sold) my option at a strike price of, say $110,000, $10,000 above the current fair value. Such an option wouldn't be worth as much, however, and I probably would not get $15,000 for it. When an option's strike price is above the underlying's current market value, the option is said to be "out of the money." (More on this later. As we will see, I might prefer selling an out-of-the-money option because it gives my asset room to appreciate.)

Does this option have to end either in exercise or by letting it expire? No, there is a third possible outcome. If the two parties are willing and can agree on a price, the option seller may buy back his option, effectively canceling it out.

Again, to open an option position the buyer (holder) pays the seller (writer) an agreed amount (premium) for the option. This premium is the writer's to keep, regardless of the outcome.

Table 1.1 summarizes the possible closing option transactions.

Note the use of a new term-assigned. When an option holder exercises, an option writer is assigned, meaning he is being called upon to ful-fill his obligation.

LISTED OPTIONS

In the example above, an option was transacted between two individuals. Its strike price and duration were created by agreement between the two parties to meet their specific needs. Its price was also reached by negotiation. The underlying asset was a specific and unique piece of property. Options that are tailored to a specific situation, with the terms negotiated, are often called over-the-counter (OTC) options. As you can imagine, this process is cumbersome, and finding a willing counter-party usually involves a third party. That's why these types of options are done primarily by large institutions.

In contrast, individuals are more likely to trade listed options. These are standardized contracts traded on exchanges and available on many stocks, indexes, bond futures, commodity futures, and currency futures. There are even options on interest rates, inflation rates, and the weather.

With listed options, you do not need to worry about the trustworthiness of the other party to the transaction. A single clearing agency, such as the Options Clearing Corporation, stands in the middle of every trade, guaranteeing the transaction to both the buyer and the seller.

If an option holder exercises his option, the clearing corporation assigns any party holding a short position on a random, arbitrary basis. An option buyer never finds out, nor does he care, who sold the option to him. An option seller never finds out, nor does he care, who bought the option from him.

Listed options have many attractive features. For one thing, several strike prices are usually available at regular price intervals. Also, several different durations (expiration dates) are usually available, following a set pattern. In stocks, for example, one set of options expires in 30 days or less, another set of options expires in approximately 31 to 60 days, another set expires in approximately 3 to 6 months, and so on, going out as far as 2 years or more.

Each listed option is standardized for the same quantity of the underlying asset. In the United States, for example, one stock option is based on 100 shares of an underlying stock, and one futures option is based on one futures contract. By standardizing options contracts, the exchanges make them appealing to large groups of investors, which results in heavy trading and a liquid market.

As the markets are constantly moving, options prices are continuously quoted and changing. Market makers at the options exchanges are always publicly posting prices at which they are willing to buy and sell each option. They stand ready to take the other side of your trade, and thus make a market in the options they are responsible for. This allows an option holder to sell his option(s) at any time, and an option writer may buy to close his position at any time.

In the real estate example discussed previously, it is very possible, even likely, that the option holder will exercise his option prior to expiration. In contrast, the vast majority of listed option buyers never exercise them; they simply sell them back on the open market. Many of these people are speculators who only expect to hold their option for a short time. Once the underlying makes a move in the expected direction (or perhaps a move in the wrong direction) they sell. In a sense, options are like hot potatoes being tossed around among speculators. This accounts for quite a bit of the options trading volume.

Another big source of trading volume is institutional trading. Institutions may use options to hedge large positions, or simply trade large positions for speculation.

So far we have only talked about options to buy. Options to buy something at a stated price for a limited time are call options. There is another type of option: an option to sell something. While these options can be a bit more difficult to conceptualize, options to sell something at a stated price for a limited time are put options.

NOMENCLATURE

An option is identified by stating its underlying asset, the expiration month, the strike price, and the type (call or put), usually in that order. For example,

Motorola April 20 calls

would define an option expiring in April of this year. If the option expires more than a year from now, one might need to include a year indication of some kind, as in the following example.

Motorola April04 20 calls

In this example, "04" means the year 2004.

Also important is the way options prices translate into dollar amounts. Most stock options have a multiplier of 100, based on the fact that one option is for 100 shares of stock. So if you were to buy one option at a price of 2.20, for example, you would pay $220. Most index options also have a multiplier of 100. Multipliers for futures-based options vary from 50 to 500 or so.

LONGS AND SHORTS

Most investors are familiar with being long, whether they realize it or not. When you own something, you are said to have a long position in it. When you are long in the market, it means you hope to make a profit from a rising market.

Going short means to sell something, without first owning it, to profit from a falling market. The concept of going short can be confusing at first. How can you sell something you don't own? In securities, going short involves borrowing the securities (usually from your broker) to sell. Later, to close the position, you buy, giving the shares back to your broker. With instruments such as futures and options, it's much easier. You're entering into an agreement to buy or sell-that's all. It is a contract with rights and obligations like any other contract. The only difference is that with futures and options, you may get out of the contract at any time by placing an order that cancels your position before the obligations come due.

However, the concepts of long and short are a bit more involved when working with options. When you buy an option, you are long the option. With a call option, you stand to benefit from the underlying going up, so you can be considered to be, in a general sense, long the underlying as well. However, when you buy a put option, you stand to benefit from the underlying going down, so you can be considered to be, in a general sense, short the underlying. Table 1.2 summarizes the four possible scenarios.

A BIT MORE TERMINOLOGY

Now just a bit more terminology, and then we can look at why options are such an interesting trading vehicle.

It is very important that the options trader be familiar with the terms and concepts. In this section, the examples refer to stock options. However, the same terms and concepts apply to all asset types.

The value of an option is comprised of two components: intrinsic value and time value. You'll never see these two components quoted separately.

Continues...


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