How to Price and Trade Options: Identify, Analyze, and Execute the Best Trade Probabilities

225 Pages·2015·7.69 MB·English

by  Al Sherbin

HOW TO PRICE
AND
TRADE OPTIONS
Since 1996, Bloomberg Press has published books for fi nancial profession-
als on investing, economics, and policy aff ecting investors. Titles are written
by leading practitioners and authorities, and have been translated into more
than 20 languages.
Th e Bloomberg Financial Series provides both core reference knowledge
and actionable information for fi nancial professionals. Th e books are written
by experts familiar with the work fl ows, challenges, and demands of invest-
ment professionals who trade the markets, manage money, and analyze in-
vestments in their capacity of growing and protecting wealth, hedging risk,
and generating revenue.
For a list of available titles, please visit our Web site at www.wiley.com/
go/bloombergpress.
HOW TO PRICE
AND
TRADE OPTIONS
Identify, Analyze, and
Execute 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.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form
or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as
permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior
written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to
the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax
[phone], or on the Web at www.copyright.com. Requests to the Publisher for permission should
be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ
07030, [phone], fax [phone], or online at www.wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best eff orts
in preparing this book, they make no representations or warranties with respect to the accuracy
or completeness of the contents of this book and specifi cally disclaim any implied warranties of
merchantability or fi tness for a particular purpose. No warranty may be created or extended by sales
representatives or written sales materials. Th e advice and strategies contained herein may not be suitable
for your situation. You should consult with a professional where appropriate. Neither the publisher nor
author shall be liable for any loss of profi t or any other commercial damages, including but not limited
to special, incidental, consequential, or other damages.
For general information on our other products and services or for technical support, please contact our
Customer Care Department within the United States at [phone], outside the United States at
[phone] or fax [phone].
Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material
included with standard print versions of this book may not be included in e-books or in print-on-
demand. If this book refers to media such as a CD or DVD that is not included in the version you
purchased, you may download this material at http://booksupport.wiley.com. For more information
about Wiley products, visit www.wiley.com.
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 fi nancial 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
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
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 eff orts 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 Pa-
mela Van Giessen of John Wiley & Sons and Stephen Isaacs of Bloomberg Press.
Pamela, Stephen, and I conceived this book over some good coff ee and excellent
pastries. Stephen continued on as my support system throughout the process of
writing the book, fi elding (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 infl uence 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. Th ank 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 fi nd 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. Th ank you for sharing your knowl-
edge, 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!” Th ank you for the love and support and the thousands of “it will be
great” e-mails, texts, phone calls, and discussions.

Contents
Introduction xi
CHAPTER 1
Why Trade Options? 1
Strategic without Being Directional 2
A Word about Leverage 2
Options Are a Decaying Asset 5
Insurer or Insured? 6
Probability of Making Money 6
Market Effi ciency 7
Tired, Worn‐Out Metaphors 9
CHAPTER 2
What to Look for in a Broker 11
Brokerages versus Banks 11
Depth of a Broker’s Pockets 12
Trading Risk Management 13
Learning from Recent Events 14
Account Types 14
Commissions 16
Interest Rates 18
Stock Borrow and Loan 19
Trading Platforms 22
Conclusion 24
vii
viii Contents
CHAPTER 3
Building the Foundation 25
Option Pricing Models 26
Option Pricing Model Inputs 27
Historical Data as Input into the Implied Volatility
of an Underlying 29
Implied Volatility as a Predictor of Stock Movement
and Probabilities 30
Th e Distribution Curve 31
Breakout Stocks 45
Actual versus Historical Distribution Curves 50
CHAPTER 4
Trade Probabilities: What to Look For 55
Th e Results 59
How to Calculate Option Probabilities 63
CHAPTER 5
Choosing Your Trades 67
Choosing Your Underlying 67
Making an Assumption 78
CHAPTER 6
Choosing a Strategy 83
Defi ned Risk Trades 85
Credit Spreads 85
Debit Spreads 88
Butterfl y 89
Iron Condor 91
Calendar Spreads 92
Undefi ned Risk Trades 96
Th e Straddle 97
Th e Strangle 97
Short Naked Puts 98
Ratio Spreads and Back Spreads 100
What Time to Expiration Should My Trades Have? 103
Trading Earnings Announcements 105