Table Of ContentNo one likes a know-it-all. Most of us realize there’s no such thing— About the Author
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to understand everything there is to know. So when you come across Ann Logue is a lecturer in finance at the University of Illinois at
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with concentrations in finance and accounting from the University of
You understand that the quest for knowledge is a never-ending one,
Chicago. In addition to writing books on finance and investing topics,
and you’re okay with that. You have no desire to know everything, just
Logue has written about industries, executives, and current events
the next thing. You know what you don’t know, you’re confident enough
for Barron’s, Entrepreneur, Newsweek Japan, and other publications.
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She lives in Chicago and holds the Chartered Financial Analyst (CFA)
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Publisher, Idiot’s Guides
8627_Options Trading_IC.indd All Pages 6/3/16 11:32 AM
Options Trading
by Ann Logue
A member of Penguin Random House LLC
Publisher: Mike Sanders
Associate Publisher: Billy Fields
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As always, to Rik and Drew.
First American Edition, 2016
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Contents
Part 1: Introduction to Options Trading ...........................................1
1 All About Options ........................................................................3
What Are Options?.........................................................................................................................................4
Why Options Exist .........................................................................................................................................4
Insurance ...........................................................................................................................................................5
Leverage ............................................................................................................................................................5
Speculation .......................................................................................................................................................7
Basic Options Terminology ......................................................................................................................8
Puts and Calls .................................................................................................................................................8
Bid and Ask......................................................................................................................................................9
Long and Short ...............................................................................................................................................9
Strike Price ...................................................................................................................................................11
Expiration Date...........................................................................................................................................12
American and European Options ..........................................................................................................12
Underlying Securities.................................................................................................................................12
Commodity Options ....................................................................................................................................13
Equity Options .............................................................................................................................................13
Index Options ...............................................................................................................................................13
Interest Rate Options .................................................................................................................................14
Miscellaneous Options ..............................................................................................................................14
2 How Options Work .....................................................................17
Reading the Quotes .....................................................................................................................................18
Basics of Orders ..............................................................................................................................................21
Option Transactions ..................................................................................................................................22
Basic Order Types ......................................................................................................................................22
Advanced Order Types..............................................................................................................................23
Floor Execution ............................................................................................................................................24
Marking to Market and Margin ...........................................................................................................24
Moneyness .........................................................................................................................................................25
Open Interest ...................................................................................................................................................26
Expiration and Exercise ............................................................................................................................26
Expiration......................................................................................................................................................26
Exercise ...........................................................................................................................................................27
Delivery and Settlement ...........................................................................................................................27
Extrinsic and Intrinsic Value .................................................................................................................28
Relationships Among Options ..............................................................................................................29
Options Cycle ..................................................................................................................................................29
iv Idiot’s Guides: Options Trading
3 Exchanges, Brokers, and Other Market Institutions ..........33
Pricing and Trading Structures for Options ...............................................................................34
The Role of Market Makers ...................................................................................................................34
The Order of Trade ...................................................................................................................................35
Price Improvement ......................................................................................................................................35
Where to Trade Options ..........................................................................................................................35
Options Exchanges in the United States.............................................................................................36
Over-the-Counter Options ......................................................................................................................39
Finding a Broker ............................................................................................................................................39
Commissions and Trade Execution ......................................................................................................40
Position Limits .............................................................................................................................................40
Choosing a Software Platform ...............................................................................................................41
Futures Commission Merchants ............................................................................................................41
Signing the Options Agreement ..........................................................................................................42
Other Institutions in the Options Game ........................................................................................42
Options Clearing Corporation ................................................................................................................42
Options Industry Council ........................................................................................................................43
The Regulators .............................................................................................................................................43
4 The Greeks ..................................................................................45
Delta ......................................................................................................................................................................46
Delta in Pictures .........................................................................................................................................46
Delta in Use ..................................................................................................................................................47
Gamma ................................................................................................................................................................48
Theta .....................................................................................................................................................................50
Other First Derivatives .............................................................................................................................51
Vega ..................................................................................................................................................................51
Rho ...................................................................................................................................................................52
How to Use the Greeks .............................................................................................................................54
Part 2: Options Valuation and Trading Strategies ........................55
5 The Basics of Options Valuation ............................................57
Put-Call Parity ...............................................................................................................................................58
Basics of Valuation ........................................................................................................................................59
Understanding Pricing with the Binomial Option Model ..................................................60
Pricing in Detail with the Black-Scholes Model .......................................................................61
Value of the Underlying ............................................................................................................................63
Time Value ....................................................................................................................................................64
Interest Rates ................................................................................................................................................64
Contents v
Volatility .........................................................................................................................................................65
American or European? .............................................................................................................................66
The Effect of Dividends ...........................................................................................................................66
Putting Together the Black-Scholes Model ........................................................................................66
Heston Volatility Model ...........................................................................................................................67
6 The VIX and Other Market Indicators ...................................69
Working with Volatility, Implied and Otherwise .....................................................................70
Sentiment ...........................................................................................................................................................71
Put-Call Ratio .............................................................................................................................................71
Put and Call Volume Indicators ............................................................................................................73
Premium Levels ...........................................................................................................................................74
Confidence Index .........................................................................................................................................74
Implied Volatility .........................................................................................................................................74
The VIX..............................................................................................................................................................75
Calculating the VIX ..................................................................................................................................75
Using the VIX ..............................................................................................................................................76
Extending the VIX Concept ....................................................................................................................77
Using Indicators .............................................................................................................................................77
Bullish Strategies ........................................................................................................................................77
Neutral Strategies .......................................................................................................................................78
Bearish Strategies .......................................................................................................................................78
7 Beginning Options Trading .....................................................79
How to Open an Account.........................................................................................................................80
The Options Agreement ............................................................................................................................80
Margin Accounts ........................................................................................................................................80
Accounting in Your Account ..................................................................................................................81
What Do You Want to Do? .....................................................................................................................81
Simple Speculative Strategies ...............................................................................................................82
Covered Calls ................................................................................................................................................82
Playing a Hunch with Weeklys and Binary Options ....................................................................83
Writing Deep Out-of-the-Money Puts ...............................................................................................84
Reducing Transaction Costs with the Wheel Trade .......................................................................84
Hedging ...............................................................................................................................................................85
Closing Out Your Position ......................................................................................................................86
Offsetting Trades ........................................................................................................................................86
Expiring Worthless ....................................................................................................................................86
Exercise and Assignment ..........................................................................................................................87
What About Employee Stock Options? ...........................................................................................87
vi Idiot’s Guides: Options Trading
8 Call Strategies ............................................................................89
Basic Uses of Calls ........................................................................................................................................90
Why Use Long Calls ..................................................................................................................................93
Being Short a Call ......................................................................................................................................93
The Call and Its Premium ......................................................................................................................94
Call Strategies .................................................................................................................................................95
Writing Covered Calls ..............................................................................................................................95
Writing Naked Calls .................................................................................................................................96
Replacement Therapy ................................................................................................................................96
Call Spreads ..................................................................................................................................................96
Butterfly Spreads ......................................................................................................................................100
Condors ........................................................................................................................................................104
How to Think About Calls ..................................................................................................................106
9 Put Strategies ...........................................................................109
Basic Uses of Puts .......................................................................................................................................110
Long Put Strategies ..................................................................................................................................112
Short Put Strategies .................................................................................................................................113
The Put and the Premium .....................................................................................................................114
Put Strategies .................................................................................................................................................114
Protective Puts ...........................................................................................................................................114
Naked Puts ..................................................................................................................................................115
Put Spreads .................................................................................................................................................115
Married Puts .............................................................................................................................................117
Butterflies ....................................................................................................................................................118
Condors .........................................................................................................................................................121
How to Think About Puts ....................................................................................................................124
10 Combination Strategies ..........................................................125
Combination Spreads ...............................................................................................................................126
Back Spread ................................................................................................................................................126
Christmas Tree Spread ...........................................................................................................................127
Box Spread ..................................................................................................................................................127
Straddles and Strangles ..........................................................................................................................127
Straddles ......................................................................................................................................................128
Short Straddle ............................................................................................................................................129
Strangles .......................................................................................................................................................130
Iron Butterflies and Iron Condors ......................................................................................................133
Collars and Fences .....................................................................................................................................133
Rolls, Jelly and Plain .................................................................................................................................133
Contents vii
Strips and Straps .........................................................................................................................................134
Repair Strategies ........................................................................................................................................134
Option Repair .............................................................................................................................................134
Stock Repair ................................................................................................................................................135
Part 3: Advanced and Synthetic Strategies ..................................137
11 Futures, Forwards, and Related Derivatives ......................139
Defining Futures ........................................................................................................................................140
Types of Futures Contracts ....................................................................................................................140
Options on Futures ...................................................................................................................................141
Forward Contracts ......................................................................................................................................141
Environmental Credits ............................................................................................................................141
Swaps ...................................................................................................................................................................142
Currency Swaps ........................................................................................................................................142
Interest Rate Swaps ..................................................................................................................................143
Commodity Swaps .....................................................................................................................................143
Swaptions ....................................................................................................................................................143
Collateralized Debt Obligations ........................................................................................................143
Credit Default Swaps ................................................................................................................................143
Repurchase Agreements ........................................................................................................................144
LEAPS and Weeklys ................................................................................................................................144
12 Synthetic Securities .................................................................147
Setting Up Synthetics ..............................................................................................................................148
A Synthetic Stock .......................................................................................................................................148
Long Synthetic Stock...............................................................................................................................148
Short Synthetic Stock ..............................................................................................................................150
Synthetic Options .......................................................................................................................................151
A Synthetic Call ........................................................................................................................................152
Long Synthetic Call..................................................................................................................................152
Short Synthetic Call .................................................................................................................................153
A Synthetic Put ..........................................................................................................................................154
Long Synthetic Put ...................................................................................................................................155
Short Synthetic Put ..................................................................................................................................156
The Role of Interest ..................................................................................................................................157
A Reminder About Volatility .................................................................................................................158
Synthetics and Moneyness .....................................................................................................................158
What’s the Downside? ..............................................................................................................................158
viii Idiot’s Guides: Options Trading
Why and How to Use Synthetics .....................................................................................................159
Can’t Borrow Shares to Short ..............................................................................................................159
No Exchange-Traded Product ..............................................................................................................159
Greater Efficiency on Some Hedges ....................................................................................................160
13 Arbitrage .....................................................................................161
The Law of One Price.............................................................................................................................162
Arbitrage Strategies ...................................................................................................................................163
Simple Arbitrage ........................................................................................................................................163
Option Arbitrage .......................................................................................................................................164
Scalping ........................................................................................................................................................164
Synthetic Securities ..................................................................................................................................165
Conversion Arbitrage ...............................................................................................................................165
Reversal ........................................................................................................................................................167
Box Spreads ................................................................................................................................................169
Interest Rate Arbitrage ............................................................................................................................170
Index Arbitrage ..........................................................................................................................................171
Merger Arbitrage ......................................................................................................................................171
Commissions, Taxes, and Other Considerations ....................................................................172
Commissions ................................................................................................................................................172
Dividends ....................................................................................................................................................172
Interest ..........................................................................................................................................................173
Taxes .............................................................................................................................................................173
Problems and Downsides of Arbitrage...............................................................................................173
Pin Risk ........................................................................................................................................................174
High-Frequency Trading .......................................................................................................................174
14 Technical Analysis.....................................................................175
The Basics of Technical Analysis .....................................................................................................176
Intermediate Technical Analysis .......................................................................................................178
Trendlines ...................................................................................................................................................178
Moving Averages ......................................................................................................................................181
Breakouts ......................................................................................................................................................182
Volatility .......................................................................................................................................................182
Reversals ......................................................................................................................................................184
Basic Chart Patterns .................................................................................................................................184
Pennants and Flags ..................................................................................................................................185
Head-and-Shoulders ...............................................................................................................................186
Cup-and-Handle ......................................................................................................................................187
Gaps ...............................................................................................................................................................188
