asked prices and trade with interested buyers and sellers at these prices.By doing so, they are making a market.An individual market maker is usually assigned to one or more underlying assets, and each underlying asset has one or more (typically more)market makers assigned to it. When multiple market makers are assignedto an underlying, they are in competition with each other.While market makers must trade with interested parties at the statedbid and asked prices, they are not required to trade an unlimited numberof contracts. The exchanges only require them to honor their prices for acertain number of contracts at a time. For example, most stock optionswould have at least 10 contracts “up” at a time. If an investor wants totrade more than 10 contracts, he will get the stated price for the ﬁrst 10contracts but may have to pay a bit more (if buying) or accept a bit less (ifselling) for any additional contracts.While 10 is a minimum requirement, many of the most heavily tradedoptions markets have hundreds, even thousands, of contracts available atthe posted bid and asked prices. Many online pricing services show howmany contracts are available at the bid and the asked. For example, youmay see a bid of 2.20, an asked of 2.40, and a number like 200 × 500. Thisindicates 200 contracts are available at the bid and 500 contracts are available at the asked.Market makers are kind of like bookies, taking a small piece of the action from all participants. Consulting a computer model that computes options’ fair values, they typically post a bid price just below fair value andan asked price just above fair value. If a seller comes along, offering options at a reasonable price, the market maker buys from them. If a buyer
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THE LANGUAGE OF OPTIONS
comes along, the market maker sells to them. Since the market maker’sselling price is higher than his buying price, he typically makes a proﬁt.The problem for the market maker is that the market is seldom so convenient that a seller comes along immediately after a buyer, and vice versa.Often, a string of orders come at him on the same side. For this reason themarket maker usually works to hedge his position. For example, after taking on a new long position in a call option, the market maker immediatelylooks for any other call options on the same underlying that he can sell atreasonable prices. He will sell an appropriate quantity of these to bring hisdelta back to near zero. Or he may look for any puts that he can buy on thesame underlying. If no such opportunities are available, he will probablysell (short) an appropriate quantity of the underlying itself.As you can see, the market maker is always working to manage hisrisk. The new long call position places the market maker in a net long(positive delta) position, exposing him to losses if the stock were to drop.Not being interested in betting on the stock’s direction, he looks for a wayto neutralize, or hedge, his position. Any of the trades mentioned abovewill accomplish that. A computer model helps the market maker ﬁgure outwhat the appropriate quantity would be.
VOLUME AND OPEN INTERESTVolume is simply the number of contracts traded on a given day. Both volume and open interest are indications of the depth of a market. Neither ismore important than the other. However, volume could be considered amore immediate indication of liquidity.Open interest is the total number of contracts outstanding. To illustrate, say a new standard option contract becomes available. At ﬁrst, itsopen interest is zero. Suppose you put in a buy order and I put in a sell order (both of us to open new positions). We make the trade. Now, open interest is one, because there is one contract open—you have the option tobuy (presuming it’s a call) and I have the obligation to supply, if calledupon, the underlying.Now suppose more buyers and sellers come in, each side opening newpositions, just as we did. This will make open interest go higher as newcontracts are opened.However, if someone with a long position comes in with an order tosell, and gets matched up with someone with a short position who is buying to close, open interest will go down after they trade because contractsare being canceled out.If someone who is closing his or her position gets matched up with
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Volume and Open Interest
23
someone who is opening a position, open interest remains unchanged. Tohelp picture this, suppose you and I are the only parties who have a position in an option. You’re long one contract and I’m short one. Thereforeopen interest is one. What if you sold your contract to an interested thirdparty? Now, you’re out of the position, the third party is long one contract,and I’m short one contract. Open interest is still one.A high open interest simply says that a large number of contracts havetraded during the life of the option, and that there is a potential for theseopen contracts to translate into more volume as traders unwind their positions. (Note the word potential, because traders do not have to unwindtheir positions if they don’t want to; they may hold until expiration andthen exercise.)If there is a large open interest in the nearby, at-the-money options,and it is the ﬁnal day of trading for the nearby options, I have often seenthe underlying stock price be driven toward the at-the-money option during the course of the day. This is one of the few instances when you canobserve the tail (the options) wagging the dog (the stock).For example, say GM stock is trading at 26 and there is a large open interest in the 25 calls, as well as the 25 puts. Today is the ﬁnal day of tradingfor these options. Here is what happens. With the stock at 26, the callshave one point of intrinsic value. Holders of the calls, knowing that theymust make a decision today, put in sell orders because they are interestedin redeeming any value before it is too late. When the market maker absorbs the sell orders, he also sells stock to balance his position, thus transferring downward pressure onto the stock. If enough call option holderssell, the stock may be driven all the way down to 25, at which point it is nolonger worthwhile for remaining call holders to sell.Meanwhile, put option holders have been watching the stock, hopingit will drop below 25 sometime during the day so they can sell for someworthwhile amount. If it does, the put holders will begin selling. In fact,the farther the stock goes below 25, the more put selling is probably goingto be triggered. As put holders sell, it has the opposite effect to that ofcalls. As the market maker absorbs the sell orders, he also buys stock tobalance his position, thus transferring upward pressure onto the stock. Ifenough put holders sell, the stock may be driven back up to 25, at whichpoint it is no longer worthwhile for remaining put holders to sell. Thus thestock is pushed up toward 25 by put selling every time the stock dips below 25, and downward toward 25 by call selling every time it tries to goabove 25.It is not unusual to observe many stocks “locking in” on the price ofthe nearest strike price on an option’s ﬁnal trading day. Is there any wayto take advantage of this? I don’t believe there is. The idea of selling astraddle (selling both calls and puts) on or just prior to the ﬁnal day
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THE LANGUAGE OF OPTIONS
comes to mind, but this is likely to backﬁre on you (by the stock making asigniﬁcant move instead of staying quiet) just often enough to cancel outyour proﬁts in the long run. The one way I have used this knowledge tomy beneﬁt is when I’m one of those call or put holders who is hoping torecover even just a small amount before it is too late. As I look for theright time to sell, I keep in mind that there are many other traders in competition with me, and that I’d better take a decent price when I see it,without delay.
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CHAPTER 2
OptionStrategies
H
aving covered basic options terminology and some of the mechanics, we’ve now laid a foundation for a discussion of optionsstrategies. Strategy might sound like an overall approach totrading the market, but in options parlance, it simply means a kind ofposition (e.g., short calls or long puts). We will begin by discussing single-option strategies, and then move on to more complex strategies thatinvolve multiple options.You may recall there are four single-option strategies:Long callShort callLong putShort putWhen you consider that each of these strategies could be used to complement a position in the underlying, you now have eight single-optionstrategies. Before listing all eight, there are two more terms you need toknow: covered and naked.When an option writer already has a position in the underlying assetthat will fulﬁll his obligation if the option is exercised, he is said to have acovered position. For example, when an investor is short a call option andalso owns the underlying that could be delivered in the event of assignment, his short call option position is said to be covered. Otherwise, withno stock to deliver, a call option position is said to be naked.Likewise, when an investor is short a put option, and he is in a short25
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OPTION STRATEGIES
position in the underlying, his short put option is said to be covered. Otherwise his short put option position is said to be naked.Thus the eight single-option strategies are as follows:Long callShort covered callShort naked callLong call with short stockLong putShort covered putShort naked putLong put with long stockWe’ll now go over each of these strategies in detail, including howeach performs and when you would want to use it. Along the way, we’ll introduce the concept of margin requirements. While these examples referto stock options, the concepts apply just as well to options on every kindof underlying asset.
LONG CALLWe ﬁrst discussed this strategy in the real estate example in Chapter 1. Thebuyer of the option on the property had a long call position.When a call option on stock is purchased, the call option holder controls the stock without actually possessing it, and does so for a fraction ofthe cost. Therefore the long call is a leveraged position in comparison toowning the stock itself. If the stock’s price goes up just a few percentagepoints, it is safe to say that its call options will increase by a greater percentage. Some may even double in value.Other important characteristics of this strategy are its limited riskand unlimited potential. An option buyer can lose only the amount paidfor the option—nothing more. At the same time, the proﬁt potential is theoretically unlimited. A call option’s value rises without limit as the price ofthe underlying goes up.The qualities of leverage, limited risk, and unlimited potential makecall option buying attractive for speculators looking for a quick move tothe upside. I say quick because, remember, the option buyer’s enemy istime decay. Each day, the option loses some of its value. For this reason,call buying works best when the speculator is working in a short timeframe, expecting a move to happen within a few days at the most.The performance graph for the long call illustrates this strategy’s
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Short Covered Call
27
limited risk and unlimited potential (see Figure 2.1). The three linesillustrate how time decay affects the position. The dotted line represents the long call’s theoretical performance as of today, while the solidline represents the performance at expiration (the ﬁnal day of trading),and the dashed line represents the performance midway between todayand expiration.
SHORT COVERED CALLThis strategy is also known as a covered write or buy write. In the real estate example in Chapter 1, the option seller also owned the property, so hehad a short covered call position. When a stock owner sells a call againsthis stock position, he becomes a covered call writer, giving up control overhis stock for a limited time in return for income from the sale of the option. This income is his to keep no matter what happens later.While the speculative call buyer usually holds his position for ashort period of time, the covered call writer often expects to hold hisposition to expiration. If the option is out-of-the-money at that time, itexpires worthless. If the option is in-the-money at expiration, theinvestor may decide to buy the option to close the position and keephis stock or he can do nothing and see his asset called away. Some
FIGURE 2.1 Long Call
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OPTION STRATEGIES
investors keep their stock and repeatedly sell more covered calls aftereach expiration, thus continually adding to their income. A real plus isthat covered writers make money during periods when their stock holdings are going nowhere. The income they can generate can be impressive: Upwards of 40 percent annual returns are typical. Remember,however, such returns are possible only if the stock goes up or remainsat around the same price.Covered writing is a conservative strategy. The sale of call optionsagainst stock holdings reduces the overall variance of returns, thus reducing risk in the traditional sense.The need for a risk-reduction tool is why options were created inthe ﬁrst place, not for speculation. Still, speculators are an importantpart of the equation. Speculators assume the risk that portfolio managers would like to off-load. Thus, options are an essential mechanismfor risk transfer—from those who don’t want it (hedgers) to those whodo (speculators).While covered writing is attractive because of the extra income it generates, it does have a shortcoming. The covered writer has the same downside risk as he did just owning the stock. At the same time, his upsidepotential is limited.The short covered call performance graph illustrates this strategy’sdownside risk and limited potential (see Figure 2.2).
FIGURE 2.2 Short Covered Call
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Short Naked Call
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SHORT NAKED CALLThe naked call seller is interested in the same thing as the covered callseller—income. The difference is that the naked option seller does notown the underlying. If assigned, he has to buy shares on the open marketto deliver. Of course, he has to pay the current market price, whatever it is.The primary difference between being short a naked option and beingshort a covered option is that without the stock to complement the shortcall option, there is nothing to limit the position’s risk if the stock goes up.Selling a naked call gives you precisely the opposite performancecharacteristics from buying a call: unlimited risk and limited potential. Themost an option seller can gain is the amount he was initially paid for theoption—no more. At the same time, he has theoretically unlimited risk, asthe call option’s value goes up with the price of the stock. As losses mount,a point will be reached where you need to buy back the option to close theposition (or be assigned and have to buy stock to deliver, resulting in almost the same monetary outcome).Still, some investors are attracted to the prospect of earning time decay dollars, and the position costs less to put on than a covered write. Infact, your account is credited immediately after the sale of the option. Sowhat stops traders from putting on large positions—as large as they want?They can’t, because brokerage ﬁrms require investors to keep money intheir account to cover potential losses. This cash reserve is called themargin requirement. (Actually, margin requirement is old terminology.The new term, performance requirement, is closer to the mark, but theold term still lives on.)There is a standard formula for computing the requirement for nakedshort options. Without going into detail, the amount required is roughly 5to 20 times the credit received from the sale of the option(s). For example,if you sell an option and receive a $1,000 credit, you can count on having toput up anywhere from $5,000 to $20,000 collateral to support the position.Naked option writers rely on stops to help them control the theoretically unlimited risk. That works well, provided the underlying trades continuously; that is, its price never jumps dramatically. As many investorshave seen, however, a stock can sometimes close the day at one price andopen the next day at a very different price. This kind of risk cannot be controlled using stops. To limit this exposure, some traders stick to writing index options, since indexes don’t have price jumps the way individualstocks do.The performance graph for the short naked call illustrates this strategy’s unlimited risk and limited potential (see Figure 2.3). As you can see,it makes money as long as the underlying price does not go up.
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OPTION STRATEGIES
FIGURE 2.3 Short Naked Call
LONG CALL WITH SHORT STOCKThis is a rare strategy that is seldom used or even discussed. Traders witha short position in a stock can buy calls to protect their short stock position from an adverse price move (to the upside). Then they can participatein the expected down move without worrying about the stock jumping inthe wrong direction. However, it costs money to buy those calls—moneythat subtracts from the proﬁt the investor expects to make. And if the investor wants continued protection after the calls expire, he’ll need to buymore.The performance graph for the long call with short stock illustratesthis strategy’s limited risk and unlimited potential (see Figure 2.4).
LONG PUTThe put option buyer gains the right to sell stock without actually possessing it, and does so for a fraction of the cost of shorting the stock itself.Buying a put is a highly leveraged bearish position. If the stock price goesdown just a few percentage points, its put options will increase by agreater percentage. Some may even double in value.Like the long call, the long put has the characteristics of limited riskand unlimited potential. An option buyer can lose the amount paid for the
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Short Covered Put
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FIGURE 2.4 Long Call with Short Stock
option, and nothing more. At the same time, the proﬁt potential is theoretically unlimited. A put option’s value rises without limit as the price of theunderlying goes down. (Well, it’s not absolutely unlimited, as the furthestthe put could increase in value is if the stock goes to zero.)As with buying calls, the qualities of leverage, limited risk, and unlimited potential make put option buying attractive for speculators lookingfor a quick move to the downside. Again, the option buyer’s enemy is timedecay, so put buying works best when the speculator is looking for a moveto happen fairly quickly.The performance graph for the long put illustrates this strategy’s limited risk and unlimited potential (see Figure 2.5).
SHORT COVERED PUTThis strategy is so seldom used or discussed that the term covered write isuniversally understood to mean buying stock and selling calls. But shorting stock and selling a put is technically also a covered write. The coveredput writer gives up control over his short stock position for a limited timein return for income from the sale of the put.Much as a long stock holder sells call options for extra income whenhe feels the stock price may be stalled, the short stock holder can sell putsfor extra income when he feels the stock may not fall immediately.
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OPTION STRATEGIES
FIGURE 2.5 Long Put
The performance graph of this strategy is a mirror image (in terms ofstock price direction) of the traditional covered write (see Figure 2.6).
SHORT NAKED PUTThe naked put seller is interested in income. With this strategy, the investor is expecting the underlying stock to remain at the same price or goup, thus allowing his short put to expire worthless. If the stock drops, he’slikely to be assigned, and instantly be long shares of the underlying stock.The price he’ll pay for the shares, of course, is the strike price of the puts.So this investor often shorts out-of-the-money puts at a strike price wherehe would consider the stock purchase a bargain.Selling a naked put confers precisely the opposite performance characteristics as buying a put: unlimited risk and limited potential. (Again, notabsolutely unlimited risk, as the furthest your short put can be driven intothe money is if the stock goes to zero.)Still, investors are attracted to the prospects of earning time decaydollars in a bullish to neutral position. As with selling naked calls, your account is credited for the initial sale of the option and your brokerage requires collateral to cover the position.Naked put writers rely on stops to help them control the risk from adownward move in the stock if they are not interested in owning shares of
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Long Put with Long Stock
33
FIGURE 2.6 Short Covered Put
the underlying. That works ﬁne as long as the stock trades continuously.But since a stock can sometimes close at one price and open the next dayat a very different price, this kind of risk cannot be completely controlledusing stops.The performance graph for the short naked put illustrates this strategy’s unlimited risk, limited potential, and shows that it makes money aslong as the stock price does not go down (see Figure 2.7).
LONG PUT WITH LONG STOCKThis strategy, often called a married put or protective put, is consideredthe most effective way of hedging long stock positions, as it absolutely limits the downside risk. The only other way of hedging long stock positionsusing options is to sell covered calls, but this only brings in a ﬁnite amountof cash, and therefore only compensates for the stock dropping a certainamount. With puts, stocks may drop indeﬁnitely, and those puts will keepon increasing to compensate.Fund managers, unwilling to sell their stock (often for tax reasons),sometimes buy puts to see their positions through what they think mightbe a rough period. However, note that it costs money to buy those puts,and that subtracts from a fund’s overall returns. And if the fund managerwants continued protection after the puts expire, he’ll need to buy more.
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OPTION STRATEGIES
FIGURE 2.7 Short Naked Put
The performance graph for long put with long stock illustrates thisstrategy’s limited risk and unlimited potential (see Figure 2.8).I have often touted the buying of protective puts during bear markets,especially the great bear market that began in 2000. It’s a shame how manyinvestors passively watched their stock portfolios shrink in value whenthey could have been more active. Using puts, they could have protectedtheir capital. We’ll visit this topic again in Chapter 5.
EQUIVALENT STRATEGIESThe performance curve for all options is one basic shape—ﬂat to the outof-the-money side and sloping 45 degrees to the in-the-money-side. Thereis only one basic shape, and only four ways of showing it—ﬂipped top tobottom and/or ﬂipped left to right. The performance curve of a long put isthe same as that of a long call, only mirror-imaged left to right. The performance curve of a short option position is the same as that of a long optionposition, only mirror-imaged top to bottom.While discussing the eight basic options strategies, if it seemed likeyou saw each performance graph twice, in fact, you did. The performance curve of a stock position is a straight line at 45 degrees. So whena complementary stock position is added to an option position, thestock’s 45-degree line combines with the option’s line to rock the line in
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Equivalent Strategies
FIGURE 2.8 Long Put with Long Stock
such a way that the ﬂat-line portion becomes a 45-degree portion, andthe 45-degree portion becomes a ﬂat line.Therefore, each of the four single-option strategies not involving stockhas a counterpart with an identical performance curve that does involvestock. For example, the long call and long put long stock strategies haveidentical curves. Table 2.1 summarizes the equivalent strategies.How does one decide whether to use a single-option strategy or itscounterpart involving the stock? Well, certainly, if one is in an existingstock position he wants to keep, the correct approach would be to add theappropriate option to the position. But what if the investor is constructinga new position from scratch?A position involving the stock requires more capital and involves moretransactions—two to get in and two to get out. Also, shorting stock has itslimitations (the up-tick rule and how many shares are available to borrow). Therefore, the single-option strategy is often preferable, because itusually accomplishes the same objective and requires less capital.TABLE 2.1 StrategiesSingle-Option Strategy
Equivalent Multi-Option Strategy
Long callShort naked putShort naked callLong put
Long put long stockShort covered callShort covered putLong call short stock
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Combining PositionsIt is possible to visually add together the performance graphs of two simple positions to arrive at the performance graph of a combined position.This process is intuitive. For example, when you add the performancegraph of long stock (ramping upward to the right) to that of short stock(ramping downward to the right), the result is a ﬂat horizontal line. This isthe correct result, because a long stock position and a short stock positioncancel each other out (presuming the same number of shares, of course).(See Figures 2.9 to 2.11.)
FIGURE 2.9 Long Stock
FIGURE 2.10 Short Stock
36
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FIGURE 2.11 CombinedWhen an option is involved, there are two line segments to thinkabout, one to either side of the inﬂection point—the point where the option’s performance line suddenly changes slope. For instance, consideradding the performance graph of a short call to that of long stock. (See Figures 2.12 and 2.13.) Left of the inﬂection point, the option’s performance isa ﬂat, horizontal line. When added to the stock’s down-sloping line (to theleft) in that same section of the graph, the result is still a down-sloping line(to the left), because adding a ﬂat, horizontal line to any other line doesnothing to change the shape of the other line. (See Figure 2.14.)
FIGURE 2.12 Short Call(Continued)
37
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OPTION STRATEGIES
FIGURE 2.13 Long Stock
FIGURE 2.14 Combined
Right of the inﬂection point, the downward slope of the option’s performance line cancels out the upward slope of the long stock’s performance line, with the result that the combined position’s performance is aﬂat horizontal line in that section.
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Combinational Strategies
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COMBINATIONAL STRATEGIESHaving discussed single-option strategies, it’s time to begin introducing themulti-option strategies. However, rather than marching on in the samestyle, we’re going to introduce the multi-option strategies in a less formalmanner over the next several chapters. The single-option strategies werecovered in a formal manner for the express purpose of planting the shapeof each single-option performance curve ﬁrmly in your mind. When westart putting two or more options together, you’ll see their combined performance curves form new and interesting shapes.Combinational strategies involve taking positions in two or more different options and, possibly, in the underlying as well. Each strategy is aunique tool. Like combining hydrogen and oxygen to form a unique substance (water), putting options together in various combinations results insome amazingly unique risk/reward proﬁles.For example, the sale of a naked at-the-money option is a very riskystrategy, and the purchase of an out-of-the-money option has a poor probability of success. However, combining these trades (using two options thatare of the same type and in the same expiration month) forms a creditspread—one of the safest and most successful strategies there is. (See Figure 2.15 for an example put credit spread’s performance graph.)Another example is the long straddle. Buy an at-the-money call or putand the chances are good that you will lose all your money (stops notwithstanding). However, buy both a call and a put at the same strike price and
FIGURE 2.15 Credit Spread
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OPTION STRATEGIES
expiration month, and the possibility of losing all your money is practicallynil (the underlying would have to ﬁnish precisely on the strike price). (SeeFigure 2.16.)A straddle is a nifty (and popular) strategy to use when you expect astock to make a big price move to the upside or to the downside—you justdon’t know which.Note that no strategy automatically makes money. New optionstraders often imagine there is a magical combination that will producepositive returns over the long term. There is not. Since each (fairly valued)option has a net zero expected return, no matter how many of them youput together, you will still have a net zero expected return.Any combination of fairly valued options is a fairly valued combination. By deﬁnition, fair value means neither the buyer nor the seller has anadvantage. So, to make money, either your model must reveal that the options are mispriced (which happens pretty often), or you have a directional prediction that comes true. Note that your directional predictionmight be complicated—for example, “The stock will either break outstrongly to the upside or drift lower.” By the way, the best strategy for thiskind of prediction would be a call backspread. We’ll discuss backspreadsin detail later on.Since no particular strategy is suitable for every opportunity, thetrader needs to be able to apply the most appropriate strategy in any givensituation. This requires familiarity with all the various strategies and howthey perform. Tables and diagrams that show which option strategies are
FIGURE 2.16 Long Straddle
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Combinational Strategies
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bullish, bearish, aggressive, moderate, or neutral are somewhat useful, butoften fail to account for all three primary considerations: price direction,time frame, and volatility. A feel for how the various strategies perform isbest gained through experience, and may be accelerated by the use of software that can simulate the performance of any strategy in all three ofthese dimensions.When I stated that options are mispriced fairly often, I was referringnot to the idea that one individual option is mispriced, but to the conceptthat all the options of a given asset are sometimes too expensive or toocheap. It is rare that an individual option is mispriced, and when it happens it is usually such a short-lived event that you would never catch it.However, it is easy to ﬁnd situations when all the options of an assetare collectively expensive or cheap. Buying cheap options and/or sellingexpensive options is called volatility trad