Option Spread Trading E-Book

Russell Rhoads

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Trading Series
• Sprache: Englisch

Seitenzahl: 464

Veröffentlichungsjahr: 2010

Beschreibung

A practical guide to unlocking the power of option spreads When dealing with option spreads your looking to purchase one option in conjunction with the sale of another option. If managed properly, these spreads can provide experienced investors with the potential for large returns without undertaking a great deal of risk. Option Spread Trading provides a comprehensive, yet easy-to-understand explanation of option spreads, and shows you how to select the best spread strategy for any given market outlook. Along the way, author Russell Rhoads discusses spread strategies that can be used to profit from a strong up or down directional move in a stock, a stagnant market, or a highly volatile market. He also details how you can harness the leverage of options to create a low-risk position that provides the potential for a big profit. * All manner of spreads are covered, from calendar and horizontal spreads to vertical and diagonal spreads * Highlights how you can monitor and adjust an existing spread position and provides tips on how to exit a spread trade * Includes exercises and examples to test and reinforce your knowledge of the concepts presented Option spread trading has become increasingly popular with active traders and investors. Gain a better understanding of this powerful approach with Option Spread Trading as your guide.

Leseprobe

Contents

Cover

Half Title Page

Series

Title Page

Copyright

Dedication

Preface

Acknowledgments

Chapter 1: Essential Option Knowledge

THE OPTION BASICS

IN-AT-OUT OF THE MONEY

INTRINSIC AND TIME VALUE

SPREAD BASICS

THE GREEKS

PAYOFF TABLES AND DIAGRAMS

OPTION PRICING CALCULATORS

Chapter 2: Spreads Using an Underlying Security

COVERED CALL

COVERED CALL USING LEAPS®

SYSTEMATIC COVERED CALL STRATEGIES

CASH-SECURED PUT

SYSTEMATIC CASH-SECURED PUT

PROTECTIVE PUT

THE COLLAR

Chapter 3: Synthetic Positions

PUT-CALL PARITY

SYNTHETIC LONG POSITIONS

SYNTHETIC SHORT POSITIONS

ARBITRAGE IN PUT-CALL PARITY

INDIVIDUALS USING PUT-CALL PARITY

Chapter 4: The Greeks

PRICE-RELATED GREEKS

TIME-RELATED GREEK

VOLATILITY-RELATED GREEK

INTEREST RATE-RELATED GREEK

CONCLUSION

Chapter 5: Straddles

LONG STRADDLE MECHANICS

SHORT STRADDLE

Chapter 6: Strangles

LONG STRANGLE MECHANICS

SHORT STRANGLE MECHANICS

Chapter 7: Bull Spreads

BULL PUT SPREAD

BULL CALL SPREAD

Chapter 8: Bear Spreads

BEAR CALL SPREAD

BEAR PUT SPREAD

Chapter 9: Butterfly Spreads

INTRODUCTION TO BUTTERFLY SPREADS

LONG CALL BUTTERFLY

LONG PUT BUTTERFLY

IRON BUTTERFLY

SHORT STRADDLE COMPARISON

SHORT CALL BUTTERFLY

SHORT PUT BUTTERFLY

REVERSE IRON BUTTERFLY

REVERSE IRON BUTTERFLY VERSUS STRADDLE

Chapter 10: Condor Spreads

INTRODUCTION TO CONDOR SPREADS

LONG CALL CONDOR

LONG PUT CONDOR

IRON CONDOR

IRON CONDOR VERSUS SHORT STRANGLE

SHORT CONDOR SPREADS

REVERSE IRON CONDOR

REVERSE IRON CONDOR VERSUS LONG STRANGLE

Chapter 11: Ratio Spreads

CALL RATIO SPREAD

PUT RATIO SPREAD

RATIO SPREAD COMPARISONS

Chapter 12: Backspreads

CALL BACKSPREAD

PUT BACKSPREAD

BACKSPREAD COMPARISONS

Chapter 13: The Stock Repair Strategy

DOUBLING DOWN ON A POSITION

THE STOCK REPAIR TRADE

Chapter 14: Calendar Spreads

TIME VALUE EFFECT

LONG CALL CALENDAR

LONG PUT CALENDAR

COMBINED CALENDAR SPREAD

Chapter 15: Diagonal Spreads

CALL DIAGONAL SPREAD

LEAPS CALL DIAGONAL SPREAD

PUT DIAGONAL SPREAD

LEAPS PUT DIAGONAL SPREAD

DOUBLE DIAGONAL SPREAD

Chapter 16: Delta Neutral Trading

DELTA REVIEW

DELTA-NEUTRAL POSITIONS

GAMMA

MARKET MAKER TRADING

Chapter 17: Executing a Spread Trade

EXECUTING A STOCK OR OPTION TRADE

A SINGLE OPTION SPREAD

A SPREAD WITH TWO OPTIONS

A SPREAD WITH MULTIPLE LEGS

LEGGING INTO A SPREAD TRADE

About the Author

Index

Option Spread Trading

Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers' professional and personal knowledge and understanding.

The Wiley Trading series features books by traders who have survived the market's ever changing temperament and have prospered—some by reinventing systems, others by getting back to basics. Whether a novice trader, professional or somewhere in-between, these books will provide the advice and strategies needed to prosper today and well into the future.

For a list of available titles, please visit our Web site at www.WileyFinance.com.

Copyright © 2011 by Russell Rhoads. 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:

Rhoads, Russell, 1967– Option spread trading : a comprehensive guide to strategies and tactics / Russell Rhoads. p. cm. – (Wiley trading series) Includes index. ISBN 978-0-470-61898-1 (hardback); ISBN 978-0-470-94432-5 (ebk); ISBN 978-0-470-94431-8 (ebk); ISBN 978-1-118-018934 (ebk) 1. Options (Finance) I. Title. HG6024.A3R52 2011 332.63′2283–dc22 2010032261

This work is dedicated to the three most important people in my life—my wife Merribeth Ann Rhoads and daughters Margaret Susan and Emerson Arlene. You are my partner, first friend, and little pal.

Preface

In 1973, a smoking break room at the Chicago Board of Trade was transformed into the first listed equity options market in the United States. Call options on 16 stocks were listed for trading. On April 26, 1973 the Chicago Board Options Exchange rang the opening bell for the first time and 911 contracts traded on these 16 stocks. The individuals involved in that first day of trading could never have imagined what the options market has grown to. Doing some quick math, it can be estimated the CBOE now trades 911 contracts in just a few seconds each trading day.

In 2009 the options industry experienced a record volume year, with a streak of seven years of growth and increased growth 16 of the last 17 years. With multiple exchanges now vying for orders from the public, the speed of execution has increased and the cost of trading options has decreased tremendously. The playing field has been leveled to the point where trading for individuals and institutions can compete and win in the options arena.

As an instructor for the Options Institute at the CBOE I have the privilege of interacting with a wide variety of market participants. Since each option trade is at minimum a two-step process and we pack a lot of information into a very short period of time, I often reassure students that trading options is not like riding a bike. When some time has been taken away from option trading, there is always a learning curve that is involved in getting back up to speed. My hope is if a strategy has not been implemented in some time that this book may act as a resource to allow a trader to quickly regain the knowledge to comfortably put on an option spread trade.

This book is written in a modular format, where if a reader would like to explore the mechanics of a condor spread they may turn directly to Chapter 10 and quickly explore what is involved in a condor spread. Each chapter is laid out in a similar format, with several tables and usually at least a couple of examples of how each spread would be constructed, along with the key levels to focus on for each spread.

Before delving fully into spread trades there are a few chapters that cover the basics of option trading that will be useful to refer to while reading spread related chapters. Chapter 1 is a quick overview of essential option knowledge that is focused toward those who understand options, but may need a quick refresher before tackling spread trades. Chapter 2 then covers some very basic spread strategies that involve the underlying instrument as part of the spread. This chapter lays out the mechanics of putting on a very basic position that involves two trading instruments. In Chapter 3 the ability to create similar payoffs using two different approaches is explored. The Greeks are introduced in Chapter 1, but covered extensively in Chapter 4.

The following 10 chapters individually cover a variety of spread strategies. As the book moves along, the more complex strategies become. However, the concept behind each trade is basically the same, combining a variety of positions to create a custom payout.

Toward the end of this book, there are a couple of specialized chapters laying out some useful information for all option traders. First, in Chapter 16, the concept of Delta neutral trading is introduced, along with an example of how market makers basically use isolating price risk when providing liquidity to the market place. Finally, Chapter 17 discusses the issues involved in executing a spread trade.

Acknowledgments

There are many people throughout my life that have allowed me to reach the point where I look forward to going to work each day. I am fortunate that I truly enjoy what I get to do on a professional basis day in and day out.

The primary person is my wife Merribeth Rhoads. Her patience and understanding has been a key contribution to the completion of this book in a timely manner. Also, as I write this after just completing this manuscript I am embarking on another book. Her patience is never ending.

My daughters Margaret and Emerson are a constant inspiration to work hard and accomplish as much as I can to set a proper example for them. My first friend and little pal are the driving force behind all I do.

My parents Bobbie (who would have loved to see this on a bookshelf) and Dusty Rhoads were always supportive when I needed it most. Closer to home, my wife's parents John and Arlene Rose have endured a few curve balls thrown at them by this son in law. I appreciate them treating me as one of their own.

Professionally, the staff of the Options Institute at the Chicago Board Options Exchange is probably the best group of people I have worked with in my life. Alphabetically, I want to thank Taja Beane, Jim Bittman, Barbara Kalicki, Peter Lusk, Michelle Kaufman, Marty Kearney, Laura Johnson, Debra Peters, Pam Quintero, and Felecia Tatum. Also, special thanks to Patricia Hoffmann of the CBOE for having the good judgment to hire me for this position.

Finally, Meg Freeborn and Kevin Commins of Wiley have been wonderful to work with. I hope to collaborate on more projects with them in the future.

As a note, in the time I have been at the Options Institute I have instructed several thousand individuals that are interested in options trading and strategies. Many of you have challenged me with your questions and inspired me with your enthusiasm. I really do appreciate the time you give me.

Chapter 2

Spreads Using an Underlying Security

One of the first things that comes to mind and scares people away from option spreads is the thought that a spread with options is some abstract, difficult trade that only the professional traders engage in. This is far from the truth, as many individual traders focus on a small number of spread strategies and attempt to be masters of these strategies. Some traders take this a step further and just focus on one strategy.

There are some simple spreads, with very limited risk, that are a good way to get your feet wet trading options. This chapter will introduce you to a few spreads that combine an underlying security with an option position. Although not the exotic spread that takes into account a variety of strikes and expirations, some of the spreads in this chapter are excellent introductions for inexperienced option traders. Just to keep things interesting, toward the end of the chapter, an option spread is demonstrated that involves two option positions and an underlying security. We then focus on the collar, which involves using a put and call position combined. Also, included with the discussion of a covered call, there is a spread that covers different times and strikes.

COVERED CALL

Many traders’ first experience with a spread trade that involves options is through what is referred to as a covered call. The covered call is a method that allows an owner of a stock to get paid for taking on the obligation of selling their shares at a certain price in the future. If the stock is not over the level set by the option contract, then the income taken in for selling that option is kept and the shares are not sold. Otherwise, if the stock is over this level, the shares are sold. This sale of shares is an action the trader would have done with or without entering into the option trade.

Specifically, a covered call is a position where a trader has sold a call option against shares of an underlying stock they are currently long. For example, if a trader owns 100 shares of XYZ, they may sell 1 call option against the 100 shares of XYZ. This short call is ‘covered’ by the long position in the underlying stock. Hence the name covered call.

When an option is sold short, whether it is a call or a put, the seller has taken on an obligation. If a trader is short a call, they have the obligation to sell a stock at a certain price (the strike price) any time up until the option expires. With a put, if a trader has a short put position, they have the obligation to buy a stock at a certain price any time until the option expires. As a seller of a call against stock a trader owns, the trader has taken on the obligation to sell the stock they own at a set price. For example, if a trader owns 100 shares of XYZ and has sold 1 October 50 Call against 100 shares, they are obligated to sell 100 shares of XYZ at 50, upon exercise of this option by an option holder.

Generally, when there is a level where a trader would be a definite seller of a stock, they would initiate a limit order to sell the stock with the stipulation that it is good until canceled, or open over the course of many trading days. Eventually, this limit order would result in one of two things. If the stock reaches this limit, the order should be executed and the stock sold. The other alternative is the stock does not reach this level and the order would be canceled with no transaction occurring.

For a covered call, a trader writes a call against the stock they own, taking on the obligation to sell their shares at a certain price until the option expires. A covered call is written against long holdings of a stock or exchange traded fund (ETF). Both options on stocks and ETFs are considered equity options. All equity options in the United States are American-style options. American-style options are options that may be exercised anytime until and on the expiration date. For all covered call positions this is a possibility, however, a holder of the stock or ETF who has sold a call option against the security does so with the hope of selling this security at that level. Since the option seller is a willing and comfortable seller of their shares at the level dictated by the call option, early exercise would actually be a welcome occurrence.

Many option strategies are known by more than one name and this holds true for the covered call. It is possible to buy a stock and sell a call option simultaneously in one transaction. This is referred to as a buy-write. The name stems from this being a case where a trader buys the stock and writes an option against that long stock position, as opposed to previously owning a stock and then selling a call against that stock. Placing an order to buy 100 shares of XYZ at 37.50 and sell 1 XYZ January 40 Call at 1.00 at the same time would be called a buy-write.

As an example of a covered call, a trader owns 100 shares of XYZ and the stock is trading at 76.75. He is considering placing an order to sell his shares at 80, but also takes a look at call options to decide if selling calls might be a viable alternative. In this case, December options are 30 days to expiration and the December 80 Call is bid at 1.05. He decides to take in 1.05 by selling 1 of the December 80 Call options and take on the obligation to sell his 100 shares at 80. By selling the call options he is just being paid to take on an obligation to do something he was planning on doing in the first place.

Before going forward, a review of some key levels that exist for this trade is in order. This is actually an exercise that should be undertaken every time a new trade is initiated or considered. The levels are determined at expiration, although a more sophisticated trader may use a pricing calculator to determine potential outcomes.

For this trade, a single break-even point, level of maximum profit, and potential maximum loss should be determined.

The break-even point is calculated by taking the current price of the underlying stock and subtracting the premium received for selling the call option. In this case the break-even point is 75.70 or 76.75 (stock price) – 1.05 (premium received).

The maximum loss would be incurred on this trade if the stock were to go to zero. With XYZ at 0, the total loss on this trade would be the same as the break-even point, or 75.70. The 1.05 premium received would be nice, but not much of a buffer if the stock were to go to zero. Although in the case of this covered call, the potential of realizing a maximum loss this extreme is very low, many spread trades have limited potential loss and this exercise applies more appropriately to those trades.

Finally, the potential maximum profit of this trade should be calculated. In the case of a covered call, the maximum profit is at the call strike of 80.00. At any level above 80.00, the stock would be called away at expiration and the account would receive 80.00 per share. Combining this with the 1.05 received for selling the option gives the account 81.05 in cash, subtracting 76.75 would be a profit of 4.30. This 4.30 is the maximum potential profit from having written a call on XYZ. Table 2.1 is a summary of the key levels from this trade.

TABLE 2.1 Covered Call Key Levels

Key LevelLevelExplanationBreak-even Price75.70Price minus Option PremiumMaximum Loss Price0.00Stock Goes To 0Maximum Dollar Loss75.70Break-even level to 0Maximum Profit Price80.00Call StrikeMaximum Dollar Profit4.30Max Profit Level minus Current Price plus Call Premium

In addition to determining the key levels before a trade is initiated, a payoff diagram is useful to have an idea of where the potential profit or loss of a strategy will be. A profit and loss diagram is a good depiction of what the potential outcome of a trade will be at expiration. In addition to at expiration, the software used at the Options Institute to indicate this outcome has the choice to include the potential profit or loss halfway to expiration.

Figure 2.1 is a profit and loss diagram created to depict the potential outcome of selling the December 80 Call at 1.05 versus being long XYZ from 76.75. There are three lines on this chart, representing different payoffs. The simplest line, the one moving at a nice up slope from left to right represents the payoff of just being long XYZ from the closing price of 76.75. The second line, the non-curved line that looks like a hockey stick, is a depiction of the covered call position at expiration. Starting at the left, it is a parallel line to the stock payoff. When it reaches 80, the option strike price takes a turn and continues flat for any price above 80.

FIGURE 2.1 Profit and Loss for a Covered Call

Finally, the curved line represents the potential profit or loss of this strategy at certain levels halfway to expiration. As the covered call on XYZ was initiated with 30 days to expiration, the curved line depicts the profit or loss on this position when the December options have 15 days until expiration. The curved nature of this line represents the time value left on the option at different price levels. Time takes on different values at different prices for options until expiration.

Something of note from the payoff diagram for the covered call is the level where the line representing the long position in XYZ crosses the payoff of the covered call position. This is 81.05, the level from Table 2.1 of maximum profit for the covered call. There is another term for this level, the point of indifference, where a stock holder would rather hold the long position in the stock as opposed to have written a call on the stock. Above 81.05 a stock holder would have been happier having not written a call on their shares. For this reason, it should be emphasized once again that when writing a call on shares owned, an investor should be willing and happy to sell shares above the strike price of the call.

There are a handful of factors to take into account when choosing which expiration and strike to use with a covered call position. As with all option trades, a price projection of the underlying is a key component to deciding which expiration and strike to use. A second key component is the time frame of any expected move. However, with a covered call there is another piece to the puzzle that should be taken into consideration. This would be how time works, or specifically the theta of the option chosen.

Theta is a measure of, all else staying the same, how much value an option loses for a single unit of time. What is unique regarding Theta is it is not constant over the life of an option. Specifically for options with a strike price close to the price of the underlying, the time value of an option is lost at a greater rate the closer to expiration. Figure 2.2 is a chart of how time value would deteriorate for an at-the-money put or call over the last 90 days of the life of an option.

FIGURE 2.2 Time Value Deterioration

Notice in Figure 2.2 that between 90 and 45 days there is not much loss in time value. After 45 days the loss of time value really starts to accelerate, with the majority of time value being lost in the last 30 days. A goal when selling options should be to maximize the benefit from the option losing time value. When short an option, the loss of time value is working in your favor.

Here is an example of choosing strikes based on theta using a hypothetical stock and a pricing calculator to determine the value of the options. The idea here is to show a 30, 60, and 90 day call option that have all pricing factors the same except the time to expiration. January expiration is 30 days away, February is 60 days off, and March is 90 days away. The stock is XYZ, which is trading at 38.50 and the 40 strike calls are being analyzed. Using similar inputs across the board the Jan 40 Call is trading at .95, the Feb 40 Call is at 1.40, and the Mar 40 Call is at 2.05.

The first thing to notice about the individual option prices is that the Jan 40 Call is not trading at half the price of the Feb 40 Call, nor is it trading at one third the value of the Mar 40 Call. This is another illustration of the non-linear nature of the time value of options.

If a trader was considering a covered call on shares of XYZ for the next 90 days, what would be his best alternative? The first thought may be selling the Mar 40 Call, which has 90 days to expiration. However, there is a more active, flexible, and potentially profitable method to consider.

TABLE 2.2 Comparison of Selling a 90-Day Call One Time or a 30-Day Call Three Times

OptionsPricingJan 40 Call0.95Feb 40 Call1.55Mar 40 Call2.05Trade 1Sell 1 Mar Call2.052.05Trade 2Sell 1 Jan 40 Call0.9530 Days Later:Sell 1 Feb 40 Call0.9530 Days Later:Sell 1 Mar 40 Call0.952.85

Table 2.2 depicts the difference between selling the Mar 40 Call option once for 2.05 (Trade 1) or selling an option three times with 30 days left to expiration over the next 90 days for a total income of 2.85 (Trade 2). For Trade 2, the assumption is in place that all pricing factors, including the underlying stock price, will be the same when each transaction takes place. Although this is far from reality, it is a good illustration of why options expiring in around 30 days may be a preferred choice when selling calls.

Selling an option with less time to expiration is a more active strategy, but it also gives a trader more flexibility. For example, if the XYZ were to trade down to 33.50 in 30 days, a trader may choose the 35 strike call option for the next covered call. If a January call option with only 30 days to expiration was the original transaction, then it will expire with no value and another trade may be entered. In the case of selling the March option with 90 days to expiration, if a decision is made to sell a 35 strike call, then the original short option will need to be covered first.

As with all option trades, the expirations and strikes chosen have a multitude of factors, such as the price projection of the underlying or the time expectation of an event. However, when selling options, the way time works for a trader should always be a consideration and in the case of time deterioration or Theta, the last 30 days usually gives a seller the most bang for their buck.