How to Price and Trade Options E-Book

Al Sherbin

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Bloomberg Professional
• Sprache: Englisch

Seitenzahl: 442

Veröffentlichungsjahr: 2015

Beschreibung

Select and execute the best trades--and reduce risk Rather than teaching options from a financial perspective, How to Price and Trade Options: Identify, Analyze, and Execute the Best Trade Probabilities goes back to the Nobel Prize-winning Black-Scholes model. Written by well-known options expert Al Sherbin, it looks at the basis for probability theory in option trading and explains how to put the odds in your favor when trading options. Inside, you'll discover how anyone can "operate their own casino" if they know how through proper option strategies. Plus, a supplemental website includes videos that walk you through various probability scenarios, pre-formatted spreadsheets, and code. All investors should have a portion of their portfolio set aside for option trades. Not only do options provide great opportunities for leveraged plays, they can also help you earn larger profits with a smaller amount of cash outlay. With the help of this book, traders, active investors, and self-directed investors of all stripes will learn how simple it can be to deploy probability-based trading strategies. * Teaches both defined and undefined risk strategies * Utilizes simple cost basis reduction strategies to enhance investment returns * Draws on unique research studies * Discusses volatility to include both historical (realized) and implied volatility: the interplay between the two is a key piece of information overlooked by option traders If you're a trader of any level and want to make the best trades possible, this book has you covered.

Leseprobe

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HOW TO PRICEANDTRADE OPTIONS

Identify, Analyze, andExecute the Best Trade Probabilities

Al Sherbin

Cover image: Bull Market Financial Data © iStock.com/Henrik5000; Orange Background © iStock.com/lovin-you Cover design: Wiley

Copyright © 2015 by Al Sherbin. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Sherbin, Al, 1956–     How to price and trade options : identify, analyze, and execute the best trade probabilities / Al Sherbin.              pages cm. — (Bloomberg financial series)        Includes index.        ISBN 978-1-118-87114-0 (paper/website); ISBN 978-1-118-87103-4 (ePDF); ISBN 978-1-118-87122-5 (ePub)        1. Options (Finance)   2. Investments.   I. Title.     HG6024.A3S5145 2015     332.63'2283—dc23

2014041593          

As I always teach my children, any project worth doing is worth doing well. With respect to this book, if in the end it is judged to be done well, it is only through the efforts of many whose names do not appear on the cover.

First, I would like to thank my friend and fellow author, Larry Shover, for both encouraging and inspiring me to write this book and for introducing me to Pamela Van Giessen of John Wiley & Sons and Stephen Isaacs of Bloomberg Press. Pamela, Stephen, and I conceived this book over some good coffee and excellent pastries. Stephen continued on as my support system throughout the process of writing the book, fielding (too) many confused phone calls and setting me back on the right path.

Special thanks to Judy Howarth, my developmental editor, who always had a quick, concise answer to my questions and who took a rough, raw manuscript from me and somehow returned a book.

I am quite sure this book would not have come to be without the strong, even-handed guidance I received from Kathy Graham, founder of the HQ Companies Group. Kathy's influence far exceeded this project. She was, and continues to be, a light in the storm of my career. When I am unsure of my path, I turn to her for help. Thank you for bringing me to, and through, this project.

To my many friends, colleagues, fellow traders, and students, I thank you for teaching me my trade. I find that you often learn the most valuable lessons from the most unexpected people. Only some of you fall into this category, as I knew I would learn much from those close to me. Thank you for sharing your knowledge, support, and encouragement with me even when I continued to whine that I would never get this done.

Nothing I could say would do justice to what the love and support of my family have meant to me. To my beautiful wife, Kathleen, this is every bit as much your book as mine. As always, you went through every second of sweat, pain, fears, and turmoil as I did. Only, somehow, you managed not to complain! You encouraged me, prodded me, supported me, and loved me until it was complete. To my wonderful children, Mark, Emily, Kevin, Ted, and Kerry, I know for the past many months you could see me, but, at least mentally, I was not always there. Or as one of you so tactfully put it, “Dad, the lights are on, but nobody's home!” Thank you for the love and support and the thousands of “it will be great” e-mails, texts, phone calls, and discussions.

Contents

Introduction

CHAPTER 1 Why Trade Options?

Strategic without Being Directional

A Word about Leverage

Options Are a Decaying Asset

Insurer or Insured?

Probability of Making Money

Market Efficiency

Tired, Worn-Out Metaphors

CHAPTER 2 What to Look for in a Broker

Brokerages versus Banks

Depth of a Broker’s Pockets

Trading Risk Management

Learning from Recent Events

Account Types

Commissions

Interest Rates

Stock Borrow and Loan

Trading Platforms

Conclusion

CHAPTER 3 Building the Foundation

Option Pricing Models

Option Pricing Model Inputs

Historical Data as Input into the Implied Volatility of an Underlying

Implied Volatility as a Predictor of Stock Movement and Probabilities

The Distribution Curve

Breakout Stocks

Actual versus Historical Distribution Curves

CHAPTER 4 Trade Probabilities: What to Look For

The Results

How to Calculate Option Probabilities

CHAPTER 5 Choosing Your Trades

Choosing Your Underlying

Making an Assumption

CHAPTER 6 Choosing a Strategy

Defined Risk Trades

Credit Spreads

Debit Spreads

Butterfly

Iron Condor

Calendar Spreads

Undefined Risk Trades

The Straddle

The Strangle

Short Naked Puts

Ratio Spreads and Back Spreads

What Time to Expiration Should My Trades Have?

Trading Earnings Announcements

CHAPTER 7 Exiting Trades

The Variables

The Kelly Criterion

Morning Routine

To Log Your Trades or Not to Log Your Trades

CHAPTER 8 Executing Your Trades

Order Types

CHAPTER 9 Portfolio Management

Two Types of Risk

The Goal: Diversification—Minimizing Unique Risk

The Methods: Correlation and Number of Positions

Identifying and Mitigating Systematic Risk

Trade Sizing

Early Exercise

Conclusion

About the Website

About the Author

Index

EULA

List of Tables

Chapter 1

Table 1.1

Chapter 4

Table 4.1

Table 4.2

Table 4.3

Chapter 7

Table 7.1

Chapter 9

Table 9.1

Table 9.2

Table 9.3

List of Illustrations

Chapter 3

Figure 3.1

Normal Distribution

Figure 3.2

Lognormal Distribution

Figure 3.3

Skewed Lognormal Distribution

Figure 3.4

Kurtosis

Figure 3.5

QQQ Option Chain

Figure 3.6

QQQ Smirk

Figure 3.7

Smile

Figure 3.8

BXM versus SPX Chart

Figure 3.9

GME Option Chain

Figure 3.10

Volatility Smile

Figure 3.11

Smirk

Figure 3.12

Forward Skew

Figure 3.13

Stock Price Rising with IV Falling

Figure 3.14

Stock Price Rising with IV Rising

Figure 3.15

Option Chain with Normal Skew

Figure 3.16

Option Chain with Inverted Skew

Figure 3.17

Distribution Curve with Varying IV

Figure 3.18

SPX Five-Year Eztrade Graph

Figure 3.19

GMCR Eztrade Graph

Chapter 4

Figure 4.1

Normal Distribution Showing 90 Percent

Chapter 6

Figure 6.1

Effect of Volatility on the Butterfly

Figure 6.2

Calendar Profit and Loss

Figure 6.3

Distribution Curve

Figure 6.4

Decay Curve with Various Deltas

Figure 6.5

GMCR Chart of Calendar IVs One Month before Earnings

Figure 6.6

GMCR Chart of Calendar IVs Day before Earnings

Chapter 8

Figure 8.1

Apple Trade Grid

Chapter 9

Figure 9.1

Asymptotic Chart of Risk

Figure 9.2

KCJ versus SPX

Figure 9.3

SPY Options Chain Showing Early Exercise

Guide

Cover

Table of Contents

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Introduction

Options are one of the most powerful money making asset classes ever devised. Yet they were not devised as a money making tool. Rather, their “purpose for being” is to limit portfolio risk. Whether you are talking about a portfolio of one stock, a hundred stocks, stocks mixed with commodities, or a myriad of other combinations, options can be used to either enhance your portfolio’s return on capital, take advantage of leverage to enhance yield, or limit your risk by exchanging a bit of profit potential for the “insurance” a long option provides. But if you are looking to buy an option to limit your risk, someone has to be on the other side of the trade. In years past, the other side of the trade was usually taken by professional options traders. The professional options trader was a mythical creature who made thousands of dollars every day by “picking the pocket” of the poor individual investor. I want to emphasize the word mythical. The professional options trader was merely someone who understood that options trading is nothing more than an exercise in simple probability theory. And this probability theory is easy enough to learn; with a bit of time and effort, most people can master it and use it for their own benefit. Furthermore, today options markets are, for the most part, so efficient that you can trade either side of a narrowly quoted market. Thus, there is no one out there picking anyone’s pockets. Options provide the fairest, most level playing field one can hope for.

When most investors hear the words options trading, they think “too much risk,” they think “calculus … too complex,” they think “too time-consuming,” and they think “the professionals will clean my clock.” However, none of these thoughts are accurate. I am not purporting that options trading is easy and that anyone can do it. In fact, I am purporting only half of that statement! If you are a motivated learner, trading options is not that difficult to learn. Though it is not easy, virtually anyone can learn to trade options with a little effort. Let’s illustrate my point by addressing each of the foregoing excuses individually.

If options trading has a bad rap, it got it as a result of the Crash of 1987. In fact, that single event has, to date, changed the way people price options. (More on that in a later chapter.) During the crash, there were stories of traders losing everything as a result of being short “naked puts.” Does that mean there is truth to the statement that options are too risky? Let me answer that question with a question. Most people are comfortable owning stocks. Which trade carries more risk, owning 100 shares of XYZ stock or being short an XYZ put (which commands 100 shares of stock)? Would you be surprised to know that owning stock is actually riskier? And would you be surprised to know that you have better odds of making money being short an out of the money put than being long stock? The difference in the odds can be considerable and quite surprising to many.

Maybe you have done your homework and have discovered that option pricing models are generally based on either some form of the Black-Scholes model, which is a partial differential equation, or the binomial model, which is a decision tree–style model. Your eyes have glazed over already! Calculus! Complex math! Time to find another book to read? Well, hold on a minute. As a retail options trader, you have no need to understand the calculus behind the models. In fact, your (carefully chosen) broker should provide you with all the calculus-induced models you need to trade effectively and profitably! And some do so at no charge to you! Before you think, “No math? Awesome,” I need to burst your bubble. I did not claim there would be no math. I said there would be no complex math. For you to be effective at options trading, instead of the calculus behind the pricing models, you need to understand the odds, or probability theory, behind options. You do not need to become a statistician. You merely need to understand a few basics, which I will address in this book. In fact, it is the probability basis of options that makes trading so much fun (and profitable) for me. I am, and have always been, enamored of games. Games can keep me interested for many hours, days, weeks, and months on end. And when they put money in my pocket, all the better!

You may be thinking, “I do not have a lot of time to devote to this.” While it will take some time and effort to learn to trade options effectively, once you get the hang of it you can trade by devoting 10 minutes per day to it. As I write this book, I am teaching individuals and groups how to trade, I am teaching college finance classes, I am commentating on TV every week, I am speaking at conferences, I am preparing research, I am attempting to be a good father and husband, and, yes, I am trading around 10 minutes per day. My return on capital year-to-date far exceeds the market’s return, which is in turn having a nice year! In fact, my trading has been profitable for each and every one of the 26 years I have traded. I am certainly no trading savant. I have just learned how to effectively take advantage of the probabilities that options provide any investor. We will explore this in detail.

Is it worth the trouble to learn to trade options? Well, that is a personal decision. While there are some people who I believe should stay away from the options markets, they are few and far between. If you like games of chance (in which you have the odds in your favor) and you like to earn money, you might want to put a bit of time into learning to trade options. I believe you will find it fun and rewarding! But be prepared. In my experience, you cannot take the training wheels off until you have been trading for around 18 months, on average. Of course, some people catch on much quicker, and I have coached traders who had never made a trade before to be consistently profitable after only three months of effort. And I recall one person in that group who was simultaneously working 60 hours per week at their systems development job.

As for the fear that the professionals will “clean your clock,” know that options trading is a much less personal experience. It is not “us against them.” I find that retail traders often make money because of the professionals, and not despite the professionals. We talk more about that later.

With all this being said, there are a plethora of books written on the mathematics of options. And there are many people who trade options full-time who are struggling to make money. In this book, I will subscribe to the K.I.S.S. (keep it simple… ) method and stick to only the things you must know to trade effectively and profitably. I hope you will stay with me as we explore the world of options.

CHAPTER 1Why Trade Options?

I am frequently asked, “With so many places to invest and with the complexity of the markets, wouldn’t I be better off letting a professional manage my money rather than trying to trade options myself?” Couple that with money managers asking, “You wouldn’t do your own brain surgery, would you, so why manage your own money?” I understand one’s reluctance to enter the world of self-directed investing. But after 33 years in the business world and over 26 years in trading, I can assure you that no one cares for your money like you do. Many money managers go through a three- to six-month training program and they are off and running trading your hard-earned savings. Compound that with the fact few managers beat the S&P 500 returns (after fees and commissions) on a consistent basis, and you should begin to wonder why you have not been investing your own capital all along.