The Bible of Options Strategies: The Definitive Guide for Practical Trading Strategies

PrefacePrefaceHow to Use This Book\ Options give investors so much flexibility that when it came to writing a book named The Bible of Options Strategies, I found myself cursing just how flexible they can be! Sixty strategies is a lot of ground to cover, but in reviewing them all again (I've done it several times already!), I was reminded of the beauty of these amazing trading instruments.\ Options give us the ability to do so many things—they enable us to configure our investment aims in any way we like. The benefits of options are often trotted out to new students or prospective customers as the first salvo of an up-sell campaign, but they're worth looking at again, this time from a practical point of view.\ Options enable us to:\ \ Control more assets for less money.\ One option contract represents 100 shares of stock and is usually a fraction of the cost of what you'd pay for the equivalent number of shares.\ For example, ABCD stock is priced at $26.20 on June 2, 2004.\ An option to buy ABCD shares (a call option) might be priced at $2.60. Because one contract represents 100 shares, we can therefore buy one ABCD call contract for $260.00 100\ • 2.60. The alternative would be to buy 100 shares of the stock for a total sum of $2,620. So, in this example, we can buy ABCD calls options for around 10% of the stock price in order to control $2,620 of ABCD stock until the appropriate expiration date of the option.\ \ Trade with leverage.\ Because our cost basis is so low, the position is much more sensitive to the underlying stock's price movements, and hence our percentage returns can be so much greater.\ \ Trade for income.\ We can design strategies specifically for the purpose of generating income on a regular basis.\ \ Profit from declining stocks.\ We can use puts and calls to ensure that we can make money if the stock goes up, down, or sideways.\ \ Profit from volatility or protection against various factors.\ Different options strategies protect us or enable us to benefit from factors such as time decay, volatility, lack of volatility, and more.\ \ Reduce or eliminate risk.\ Options enable us to substantially reduce our risk of trading, and in certain rare cases, we can even eliminate risk altogether, albeit with the trade-off of very limited profit potential!\ \ \ So, with all the different benefits of options, why on earth would traders not be curious to learn more about them? Well, for a start, the initial barrier to entry is quite high, in that options are reasonably complex instruments to understand for the first time. After you're over that hurdle, though, they become more and more fascinating! The other reason is that there is such a multitude of other investment securities for people to choose from, many will pick what seems like the simplest, rather than what may fit their investment aims the best.\ Given that options can be a challenge, it's my job to make life as simple as possible for you. One of the ways in which I do this is to break things down into pictures so we can see what we're doing. As soon as we can see what we're doing, life becomes much clearer when you're creating options strategies. Everything to do with OptionEasy and all my material is designed to be visual-friendly. This goes back to when I started to learn all about options and the fact that the penny only started to drop when I converted the concepts into pictures. All of a sudden, everything fit into place, and I started to be able to extend logic faster and further than before.\ This book is designed to be a reference book, one that you can pick up any time to learn about and understand a strategy. It isn't an academic workbook. It's a practical book, written for traders, designed to work interactively with your trading activities. As the title suggests, it's a book about options strategies, of which we take on 58! That's not to say you need to learn about each and every one of them, but at least you have the choice!\ In order to make life easier for you, we categorize the strategies into different descriptions for the following criteria:\ Proficiency Level\ Each strategy is assigned a "value" in term of its suitability for different levels of trader. Each level is given an associated icon.\ Strategies suitable for novices\ Strategies suitable for intermediates\ Strategies suitable for advanced traders\ Strategies suitable for expert traders\ The allocations are defined according to a subjective view of complexity, risk, and desirability of the strategy. Therefore, some highly risky and undesirable strategies have been put into the Expert basket in order to warn novices and intermediates away. Also Novice strategies are not exclusive to novice traders. It's simply as question of suitability, and novice strategies are highly relevant and suitable to all levels of trader.\ In some cases, the strategy is not complex at all but is considered unacceptably risky for novice and intermediate traders (at least without a warning). I have tried to be objective here, but I'm mindful not just of my own experiences but also the many students who regularly show me their trading disasters! Conservative by nature, I'm a believer that loss of opportunity is preferable to loss of capital (Joe DiNapoli), and perhaps some of these rankings bear testimony to this philosophy.\ Market Outlook\ This is where we define whether a strategy is suitable to bullish, bearish, or direction neutral outlooks.\ Strategies suitable for bullish market conditions\ Strategies suitable for bearish market conditions\ Strategies suitable for sideways market conditions\ Volatility\ Volatility is one of the most important factors affecting option pricing and therefore option trading. You really should familiarize yourself with the concept, which, forgive the plug, is dealt with in my first book, Options Made Easy.\ Here, we define whether a strategy is suitable for trades anticipating high volatility or low volatility in the markets. Some strategies, such as Straddles, require high volatility after you've placed the trade, so a Straddle would fall into the High Volatility category.\ Strategies suitable for high volatility markets\ Strategies suitable for low volatility markets\ Risk\ With any trade you're looking to make, you must be aware of your potential risk, reward, and breakeven point(s).\ Some strategies have unlimited risk; others have limited risk, even if that "limited" risk means 100% of the trade. Believe it or not, sometimes with options it's possible to lose more than 100%. In such cases, or when there is no definable stop to the potential risk of a trade, you're well advised to be aware of such a position in advance!\ Here, we show you which strategies have capped or uncapped risk. Strategies with uncapped risk aren't necessarily all bad, but you should at least be aware of what you are getting into. Often you can mitigate such risk with a simple stop loss provision, in which case you're not going to liable to uncapped risk. Often, such uncapped risk scenarios only occur if the stock falls to zero or rises to infinity, which mostly are rare circumstances, but you're better off being aware!\ Strategies with capped risk\ Strategies with uncapped risk\ Reward\ Following the risk scenarios described previously, the strategies also have potential reward scenarios, too.\ Just because a strategy has unlimited reward potential doesn't mean that it's necessarily a great strategy, and just because it may have capped reward doesn't mean it's necessarily a bad strategy.\ Strategies with capped reward\ Strategies with uncapped reward\ Strategy Type\ Strategies can be used for income purposes (usually short-term) or to make capital gains. Many traders like the Covered Call because it's suitable for novices and because it's an income strategy that they can use every month.\ Income strategies\ Capital gain strategies\ Strategy Legs\ Each strategy contains different legs. Some have just one, and others have up to four. Each leg must be composed of any one of the basic four option strategies (long or short call or put) or a long or short stock position. Here's how we identify them:\ Long stock\ Short stock\ Long call\ Short call\ Long put\ Short put\ All strategies contain real-life examples at the end of each guide.\ Chapter by Chapter\ In terms of structure, I've tried to make this book as easily navigable as possible, and much of that is solved by matrix-style tables of contents.\ Each chapter contains strategies that are commensurate with a specific style of options trading. Inevitably there's some overlap between chapters for certain strategies, which we address in the appropriate places.\ Chapter 1 addresses the basic strategies, including buying and selling stocks and then buying and selling calls and puts. After you understand those cornerstones and how the pictures relate to each strategy, then you can fast-forward to any part of the book and any strategy you like. All strategy guides are modular and follow the same format, so that you can become familiar with the style and structure of the content.\ Chapter 2 is all about income strategies. An income strategy is when you're effectively a net seller of short-term options, which generates (monthly) income. You have to be careful, though, not to expose yourself to unlimited risk scenarios, which is why we use icons to identify excess risk.\ In Chapter 3, we cover "vertical spreads." A vertical spread is where we buy and sell the same numbers of the same options (calls or puts) but with different strike prices. Obviously, there's some overlap here with other chapters, which is why the chapter is comparatively small.\ Chapter 4 goes into volatility strategies and is bound to be as popular as the income strategies chapter! Here we address those strategies that benefit from increasing volatility after you've placed the trade.\ In Chapter 5, we reverse this and explore those strategies that benefit from decreasing volatility after you've placed the trade. So here we're looking for stocks that we think will be rangebound for some time. Typically these are short-term strategies.\ Chapter 6 identifies the ratio spreads and backspreads, where you're using increasing leverage to increase your returns. These are for advanced and experienced traders only!\ In Chapter 7, we look at synthetic strategies that mainly mimic other strategic goals, using a combination of stock legs, call legs, and put legs. For example, we can replicate owning a stock purely by buying and selling calls and puts in such a way that we hardly pay any cash out. In other words, we've simulated the risk of owning the stock, but with no cash outlay. We can also synthetically re-create straddle positions and other strategies.\ Lastly, in Chapter 8, we investigate some of the taxation issues that will confront you during your trading careers. This is not a definitive tax guide but rather more a flag raiser.\ Strategy by Strategy\ Each strategy is presented in a modular format. In this way, the book should be easy to navigate. The modules are numbered, and the numbering system applies throughout each chapter and each strategy:\ \ The first number refers to the chapter itself. So, all headings in Chapter 2 will start with "2."\ The second number refers to the strategy in question. So, 2.1 refers to the first strategy (Covered Call) in Chapter 2.\ The third number refers to the module. So, 2.1.1 refers to the "Description" module for the first strategy (Covered Call) in Chapter 2. Because the modules are identical throughout the book, each module number is the same throughout all the strategies. Therefore, module "1," which appears as the third decimal place, is always "Description." The modules are outlined as follows:\ x.y.1 Description\ Here, we describe the strategy in both words and pictures. We identify the steps for each leg and some general comments about what the overall position will mean to you.\ \ x.y.2 Context\ This section describes the outlook and rationale for the strategy. We also highlight the net position in your account as a result of the trade as well as identify the effect of time decay and the appropriate time period for the strategy. Stock and option-leg selection are important elements of any trade, so these are covered as well.\ \ x.y.3 Risk Profile\ This section provides, where possible, simple calculations for you to evaluate the risk, reward, and breakeven points for each strategy.\ \ x.y.4 Greeks\ This is where we graphically explain each of the "Greeks." The Greeks are simply sensitivities of options to various factors, such as price movement, time decay, volatility, and interest rates. The Greeks are as follows:\ Delta:\ The movement of the option position relative to the movement of the underlying (say, stock) position. The resulting figure gives us an indication of the speed at which the option position is moving relative to the underlying stock position. Therefore, a Delta of 1 means the option position is moving 1 point for every point the stock moves. A Delta of –1 means the option position is moving –1 point for every point the underlying stock moves.\ Typically, at-the-money options move with a Delta of 0.5 for calls and –0.5 for puts, meaning that ATM options move half a point for every 1 point that the underlying asset moves. This does not mean the option leg is moving slower in percentage terms, just in terms of dollar for dollar.\ Delta is another way of expressing the probability of an option expiring in-the-money. This makes sense because an ATM call option has a Delta of 0.5; i.e., 50%, meaning a 50% chance of expiring ITM. A deep ITM call will have a Delta of near 1, or 100%, meaning a near 100% chance of expiration ITM. A very out-of-the-money call option will have a Delta of close to zero, meaning a near zero chance of expiring ITM.\ So, Delta can be interpreted both in terms of the speed of the position and the probability of an option expiring ITM. Some advanced traders like to trade with the sum of their portfolio Delta at zero, otherwise known as Delta-Neutral trading. This is by no means a risk-free method of trading, but it is a style that enables profits to be taken regardless of the direction of market movement. However, this is only really suited to professional-style traders who have the very best technology solutions and a lot of experience.\ Gamma:\ Gamma is mathematically the second derivative of Delta and can be viewed in two ways: either as the acceleration of the option position relative to the underlying stock price, or as the odds of a change in probability of the position expiring ITM (in other words, the odds of a change in Delta). Gamma is effectively an early warning to the fact that Delta could be about to change. Both calls and puts have positive Gammas. Typically, deep OTM and deep ITM options have near zero Gamma because the odds of a change in Delta are very low. Logically, Gamma tends to peak around the strike price.\ Theta:\ Theta stands for the option position's sensitivity to time decay. Long options (i.e., options that you have bought) have negative Theta, meaning that every day you own that option, time decay is eroding the Time Value portion of the option's value. In other words, time decay is hurting the position of an option holder. When you short options, Theta is positive, indicating that time decay is helping the option writer's position.\ Vega:\ Vega stands for the option position's sensitivity to volatility. Options tend to increase in value when the underlying stock's volatility increases. So, volatility helps the owner of an option and hurts the writer of an option. Vega is positive for long option positions and negative for short option positions.\ Rho:\ Rho stands for the option position's sensitivity to interest rates. A positive Rho means that higher interest rates are helping the position, and a negative Rho means that higher interest rates are hurting the position. Rho is the least important of all the Greeks as far as stock options are concerned.\ \ x.y.5 Advantages and Disadvantages\ As indicated, this section highlights the strengths and weaknesses of the strategy in question and the context of suitability for the trader.\ \ x.y.6Exiting the Trade\ This module indicates the steps required to exit the position or to mitigate a loss.\ \ x.y.7 Example\ Every strategy ends with an illustrated example. The examples are all taken from real stocks using real data. However, because they are intended to be objectively indicative of how the strategies work, I have renamed the stock "ABCD" for every example. This helps us keep our minds focused on the structure of the strategy and avoid any preconceived prejudices against the actual stocks that were selected.\ \ \ Tables of Contents\ With so many strategies to choose from, it's crucial that you don't get lost! The multi-tables of contents are designed so that you can find the appropriate strategy easily, without having to thumb your way through the entire book to get there first. Familiarize yourself with this area because it's going to save you a lot of time as you use it later on. In print, we're restricted to two dimensions, but on the web site, you can use the Strategy Matrix completely interactively.\ General Comments\ Within the strategy modules, there are references to concepts and definitions that you'll be able to find in the Glossary. For example, "Trading Plan" is referred to throughout the guides and is defined in the Glossary.\ As options traders, we should definitely acquaint ourselves with the concepts of fundamental and technical analysis. Fundamental analysis involves the interpretation of how economies, sectors, and individual corporations are performing in terms of assets, liabilities, revenues, and profits.\ Technical analysis involves the interpretation of price charts for securities. We really should understand the basic chart patterns such as pennants, flags, head and shoulders, support, resistance, and Fibonacci retracements. Remember, an option is a derivative—it is derived from an underlying security. Therefore, it makes sense for us to understand how that underlying security is likely to move and why.\ I hope you enjoy this reference book and use it for many years to come. By all means, read it from cover to cover, but you'll probably get the best value by dipping in whenever the need arises.\ Good luck.\ Guy Cohen\ © Copyright Pearson Education. All rights reserved.

1The four basic options strategies12Income strategies213Vertical spreads894Volatility strategies1195Sideways strategies1756Leveraged strategies2197Synthetic strategies2398Taxation for stock and options traders293App. AStrategy table303