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HighPerformanceOptions TradingOption Volatility& Pricing Strategies
LEONARD YATES
John Wiley & Sons, Inc.
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HighPerformanceOptions Trading
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John Wiley & SonsFounded in 1807, John Wiley & Sons is the oldest independent publishingcompany in the United States. With ofﬁces in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketingprint and electronic products and services for our customers’ professionaland personal knowledge and understanding.The Wiley Trading Series features books by traders who have survived themarket’s everchanging temperament and have prospered—some by reinventing systems, others by getting back to basics. Whether a novice trader,professional or somewhere in between, these books will provide the advice and strategies needed to prosper today and well into the future.For a list of available titles, please visit our Web site at www.WileyFinance.com.
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HighPerformanceOptions TradingOption Volatility& Pricing Strategies
LEONARD YATES
John Wiley & Sons, Inc.
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Copyright © 2003 by Leonard Yates. 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, ortransmitted in any form or by any means, electronic, mechanical, photocopying,recording, scanning, or otherwise, except as permitted under Section 107 or 108 ofthe 1976 United States Copyright Act, without either the prior written permissionof the Publisher, or authorization through payment of the appropriate per-copy feeto the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923,978-750-8400, fax 978-750-4470, or on the web at www.copyright.com. Requests tothe Publisher for permission should be addressed to the Permissions Department,John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax201-748-6008, e-mail: permcoordinator@wiley.com.Limit of Liability/Disclaimer of Warranty: While the publisher and author haveused their best efforts in preparing this book, they make no representations orwarranties with respect to the accuracy or completeness of the contents of thisbook and speciﬁcally disclaim any implied warranties of merchantability or ﬁtnessfor a particular purpose. No warranty may be created or extended by salesrepresentatives or written sales materials. The advice and strategies containedherein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liablefor any loss of proﬁt or any other commercial damages, including but not limitedto special, incidental, consequential, or other damages.For general information on our other products and services, or technical support,please contact our Customer Care Department within the United States at 800762-2974, outside the United States at 317-572-3993 or fax 317-572-4002.Wiley also publishes its books in a variety of electronic formats. Some contentthat appears in print may not be available in electronic books.For more information about Wiley products, visit our web site at www.wiley.com.Library of Congress Cataloging-in-Publication Data:Yates, Leonard.High performance options trading : option volatility & pricingstrategies / Leonard Yates.p. cm.— (A marketplace book)ISBN 0-471-32365-9 (CLOTH/CD-ROM)1. Options (Finance) I. Title. II. Series.HG6024.A3Y38 2003332.64'5—dc212003002428Printed in the United States of America.10
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This book is dedicated to my loving wife, Karen.
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Acknowledgments
Many thanks to Elwood Brent, Jim Graham, Tom Heffernan, and KarenYates for their tremendous help proofreading and editing.L. Y.
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Contents
A Note from the Author
xiii
Introduction
xv
CHAPTER 1
The Language of Options
1
The BasicsListed OptionsNomenclatureLongs and ShortsA Bit More TerminologyOffsetting Option TradesExpiration, Exercise, and AssignmentAmerican versus EuropeanQuotationsThe Special Properties of OptionsTimeVolatilityHow Options Respond to Changing ConditionsThe GreeksThe Role of the Market MakerVolume and Open Interest
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CHAPTER 2
25
Option Strategies
Long CallShort Covered CallShort Naked CallLong Call with Short StockLong PutShort Covered Put
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ix
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CONTENTS
Short Naked PutLong Put with Long StockEquivalent StrategiesCombinational Strategies
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CHAPTER 3
Volatility
43
Volatility Trading—Buying and Selling VolatilityTools of the V-TradeSelling High VolatilityBuying Low VolatilityDelta-Neutral Trading—In a NutshellSeasonal Patterns in the GrainsOther CommoditiesVolatility Skew—What Is It and How Can I Use It?Some Words of Warning about Naked WritingThe Relationship between Volatility and Price
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CHAPTER 4
69
The Option Trader’s Arsenal
Buying Nearby Options—The Swing Trader’s Perfect ToolDebit Spreads—The Calm ApproachStrategies for Trending MarketsThe Horizontal Spread—A Good Strategy in a Sideways MarketCredit Spreads—Say “Don’t Go There”Condors—Two-Winged CreaturesThe Backspread—A Directional Strategy that CostsNothing If You Are WrongCovered Writing—Enhancing Your ReturnsLEAPS—An Alternative to StockThe Synthetic—Another Alternative to StockThe Butterﬂy Spread—When You Have a Narrow Target RangeUsing the Right Option Strategy
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CHAPTER 5
105
Special Situations
Playing TakeoversLetting the Options Market Tip You Off on TakeoversCovered Writing with Convertible SecuritiesInvesting in a Rough Market
697376788285
105107111118
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Contents
CHAPTER 6
Theoretical and Practical Matters
127
Options Pricing ModelsComing Up with the Right VolatilityVolatility SkewWhat Causes Volatility Skew?Balancing FactorsPut/Call ParityThe Greeks RevisitedTrue Delta and GammaUnderstanding the Limitations of Your ModelDealing with Anomalies and Pricing Difﬁculties
127133134136139139141143144146
CHAPTER 7
149
Tips for Beginners
The Psychological BattleTrading Mistakes and What I LearnedSome Thoughts on How Trading Fits In with Real Life
154156158
CHAPTER 8
Encore
161
Directional Trading Using Pattern RecognitionTiming the Market Using the VIXWhy a VIX Spike Stops a Market Sell-Off
161169179
Starting the Business (on a Shoestring)
185
Business Philosophy
191
Glossary
195
Index
213
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A Note From the Author
I
don’t remember exactly how I discovered options, only that I discovered them in early 1975 while working at IBM. I was immediately captivated by the lure of potential short-term gains and low capitalrequirements. I remember checking stock option prices in the Wall StreetJournal every day. At that time, only call options were available, but thatwas okay; it was a bull market.I opened an account with Rotan-Mosle with $2,000 and immediatelybought short-term calls on about three different stocks. Shocked by howquickly these calls went to half their value, I was glad to sell them for evenmoney a few days later. In the following days and weeks I traded in andout of many positions, but it wasn’t long before my capital was all gone.Ironically, my original options, had I kept them, would have resulted in again of 10 times my initial investment. This was my ﬁrst experience withhow human emotions can get in the way of successful trading.However, I was not discouraged. Even after I was out of the market, Icontinued to study options. I graphed option prices. I kept meticulousrecords to see whether any particular option strategy worked to produceregular gains. Every time I thought I was on to something, I scraped together some capital and traded again—sometimes making gains at ﬁrst,but ultimately losing my capital. And so it went. Over the years, I learnedby direct study of the markets and ﬁrsthand experience. This made it along learning experience. I could have made things easier on myself byreading books on options and trading, but I wasn’t aware of them.When personal computers ﬁrst became available, I bought one and immediately set about programming it to retrieve stock and options pricesand to search through them for potential opportunities. That was the beginning of my work on options software—work that continues to this day.While my ﬁrst programs were intended for my own use, in 1981 I developed a sufﬁciently advanced general-use program and began selling copiesto the public.This book relates all I know about options. It is a product of what I’velearned over 25 years in the options business. While this book is bound toxiii
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A NOTE FROM THE AUTHOR
contain some information that overlaps with other options books you’veread, you’ll be getting my unique perspective—that of an engineer and amateur trader. I understand the mathematics behind options, and I knowhow it applies in practical terms. I’m not a great trader, but I’ve done a lotof trading, and I’ve experienced just about everything that can happen tothe options trader.Happily, I’m in the black for my trading career. Yet I’m not going tohype options to you. Options trading is not easy, and it’s not for everyone.But it is fascinating. And I’m happy to share with you what, to my knowledge, works and what doesn’t. In fact, I’ve tried to keep the whole book ona very practical level, because my purpose is to share with the readereverything he or she needs to know to become a successful options trader.In the latter part of the book, I explain the essential math concepts surrounding options in layman’s terminology. Don’t skip it. This is stuff youneed to know!Enjoy reading this book. I hope it helps you. And may you experiencesuccessful options trading in the years ahead.Len Yates
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Introduction
F
rom high school days, I’ve had a head for ﬁnance and the stock market. And I can’t say that there was a family member or friend who inﬂuenced me in that direction. Rather, I think it was hearing storieslike KFC stock going from 3 to 60 that peaked my interest, although at thattime I lacked the resources to act on my interests.I ﬁrst heard about options when I was ﬁnished with school and working as a young engineer at IBM. I was immediately intrigued by the combination of high leverage and small capital requirements needed to buyoptions. In those days the Chicago Board Options Exchange (CBOE), theonly options exchange at that time, offered options on about 200 stocks,and they only had call options—no put options. That was okay. It was January 1976, and the market was rebounding vigorously from a nasty postNixon bear market.I opened a small account at a full-service brokerage called RotanMosle. (In those days they were all full-service brokerages.) I was assignedto one of the two brokers at the ﬁrm who were familiar with options. Hetried to persuade me to start out using options for covered writing. Covered writing seemed proﬁtable (especially the way they presented it), butthat approach was too slow for my blood. I was determined to buy optionsand make a killing.Personal computers weren’t available yet, so there was no consultinga model to see whether options were fairly priced. You just looked at theoptions listed in the Wall Street Journal or another business daily andpicked them by the seat of the pants. The temptation was great to go forthe cheaper out-of-the-money options, and that’s what I did. I did not understand time decay at that point. It was not until much later that I beganto understand time decay and its effect on these kinds of positions.I bought calls on several popular stocks that were going up. Immediately, the market corrected, and in just three days my calls were worth halftheir original value. This was a shock to my system. I was not prepared forhow fast options could lose value! Nevertheless, I held on and saw thesepositions through to at least breakeven.xv
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INTRODUCTION
After that, I do not remember speciﬁcs; only that the market continuedto rally in ﬁts and starts, and that, despite the fact that I was buying calls, Ilost all my capital in just a few weeks. This was no doubt due to jumping inand out too frequently and at the wrong times.The next time I had some capital to trade was in 1980. PCs were justbeing introduced. I bought a TRS-80 III from Radio Shack. Options stillheld a burning attraction for me, so the ﬁrst thing I wanted to do with mynew PC was write some software to retrieve option prices from DowJones, evaluate spreads, and ﬁnd unusual opportunities. I was determinedto succeed this time. I wanted to prepare myself and employ a systematicapproach, so I “teched up.”It’s amusing to think back on what technology had to offer in thosedays. The early PCs offered a simple programming language called BASIC,which was easy to learn, so I started writing my ﬁrst options programs inBASIC. I stored my work on an ordinary audio cassette player/recorder attached to the PC. It could take several minutes to write my program totape or read my program into memory! Floppy drives were only availableon the more expensive PCs, and they used 8-inch-diameter ﬂoppy disksthat could only hold 360k bytes.I began a subscription to the Dow Jones retrieval service, and used a300-baud modem to connect with it. Can you imagine? That was only 30characters per second—about twice the rate of a fast typist.I was also moving into a more advanced option strategy at that time:horizontal debit spreads (calendar spreads). Intrigued with how that strategy made money over time, I spent several months meticulously plottingthe values of calendar spreads on several different stocks. With thesecharts I proved to myself that the strategy worked and made steady gainsover time. So that was the approach I used, with my new computer program retrieving prices and selecting spreads that were especially good values to start out with.Unfortunately, soon after I started trading with this system, the marketwent into a period of above-average movement. If you’re familiar with calendar spreads, you know that excessive movement is bad for them. Onceagain, my trading capital was gone in a few months (at least it lastedlonger this time). That was when I realized that my test period had coincided with a relatively quiet period in the markets, and that is why thestrategy worked on paper. It was also when I ﬁrst began to realize that noparticular option strategy works all of the time. Rather, each strategy hasits own time and place.However, there was more ground to cover before I was ﬁnally convinced of this. After some time off from trading, the next strategy to capture my imagination was naked writing. Again, I made a thorough study of
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Introduction
xvii
it on paper, then gathered up some trading capital and got started. I experienced several successes at ﬁrst. Then I took a sizable short position inout-of-the-money Howard Johnson call options. They were extremelyovervalued, according to my model. What I did not realize was that therewas a reason for those options to be expensive. In just a few days,Howard Johnson was bought out. I had to cover those options for a muchhigher price, with the result that my account was wiped out. Actually, myaccount was instantly reduced to just a few dollars—which was quite remarkable. I could easily have been hurt much worse and been forced tocome up with more money. That was the last time I wrote naked calls onindividual stocks.I traded in spurts many times over the following years. Each time Ifunded my account and began trading, I lasted only a few months. Inshort, I experienced failure many times before getting to the point ofhaving some success. The process was lengthened, I think, by my notreading many trading books nor attending any seminars. I’m not surewhy I took such an independent path. I guess I just thought I could ﬁgureit out on my own.I’ve done a lot of trading over the years. I’ve had some success withvolatility-based trading, and I’ve had some big successes with directionaltrading during the bear market of 2000–2002. I’ve also had some spectacular roller-coaster rides that I’ll never forget. One time, I funded an account with $2,000, traded it down to just $137, then recovered theaccount all the way up to $10,000, only to lose it all again in a series ofabout eight losses in a row. (That was directional trading using simpleput and call purchases.)I have experienced many home runs on individual stock options, or index options with just a day or two till expiration. I once bought 10 puts onthe XMI index at 1-3/8, and sold them just four hours later for more than 11.During the bubble “pop” of spring 2000, there were many instances when Ibought puts on individual tech stocks and sold them three to ﬁve dayslater for six to eight times my investment. Of course, I realize that the important thing is ﬁnishing with gains, and being able to withdraw moneyfrom my trading account and bank it. Nevertheless, experiences likethese are thrilling and I’ll never forget them.I’ve always been skeptical of technical analysis methods, and I don’tbelieve that very many of them work. For directional trading, I’ve reliedmostly on gut feel and pattern recognition—performed by my own eyesand brain, using a plain bar chart. This has served me well in down markets, but not as well in sideways or up markets. While volatility-based trading is a little boring for my temperament, it works, and I highlyrecommend it to most traders.
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INTRODUCTION
I wrote this book for both new and experienced options traders, inhopes of shortening their road to success, and that they might beneﬁtfrom my mistakes. In this book, I share all the best of what I know aboutoptions trading. High performance options trading has always been mygoal. If it is yours as well, then please accept my advice: “study up” and“tech up” ﬁrst.
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CHAPTER 1
The Languageof Options
I
n the Chicago area, where I live, many people know what options are.That is because several of the world’s largest options exchanges arehere, and many people either work at one of the exchanges or knowsomeone who does.Still, more people are probably unfamiliar with options. And so it happens that when someone asks about my line of work, the discussion invariably leads to the subject of options, and I ﬁnd myself having to tellthem, in the briefest terms, what options are.After a short description, I pause, and the words that often come backto me are “Well, that sounds too complicated for me.” At that point, I usually hesitate to go much further, because I don’t want to make them listento what might be, to them, an arcane subject. But what I want to say, andsometimes do come right out and say, is that options are not really thatcomplicated. Sure, there is a terminology to learn. But I like comparingoptions to the game of chess. Like chess, you can learn all the rules aboutoptions in just about 20 minutes. Then you’re off and running.Admittedly, some practice is needed to become successful. Optionshave a number of strategies to become familiar with, but hardly as manyas chess! Anyone with average intelligence can learn all about options in ashort time.Also, it’s easy to set up an account and begin trading options. Almostevery brokerage that allows you to trade stocks also allows you to tradestock or index options. And almost every brokerage that allows you totrade futures also allows you to trade futures-based options. Establishingan options trading account just requires a little extra paperwork, including1
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THE LANGUAGE OF OPTIONS
signing a statement that you have read and understood the optionsprospectus and are prepared to assume the risks involved.Options are fascinating to trade, and they have some unique qualitiesas a trading vehicle. There are many strategies, some involving the use oftwo or more options in combination, or the use of options along with a position in the underlying security or futures contract, that have extraordinary risk/reward characteristics.However, options trading is not for everyone. While there are someconservative options trading strategies, there are some risky strategies aswell, where your capital can be lost very quickly. It is up to the individual,after learning about options, to decide whether he or she has the temperament for it.
THE BASICSSuppose you agree to sell something. And suppose you and the other partyhave agreed on a price and a time to complete the sale. In such a case, youhave what is called, in the realm of ﬁnance, a forward contract.However, if you agree to let someone have the privilege of buyingsomething from you at a stated price and for a limited time, if and whenthe other party decides to do so, you have sold an option.The holder of the option possesses the right, but not an obligation, tobuy something at a stated price for a limited time. The party who sold theoption is obligated to deliver the goods if the options holder decides to exercise his option.The asset that would be delivered is called the underlying asset, orjust the underlying. The price agreed to is called the strike price or exercise price of the option.For example, let’s say I have a piece of real estate worth $100,000. Icould agree to let someone have an option to buy the property from mefor, say, exactly $100,000 at any time during the next two years. The option’s strike price is therefore $100,000, the underlying is the property itself, and the expiration date is two years from today.Now, why would I enter into such an agreement? After all, if the property increases in value over the next two years, that appreciation would belost to me because I have agreed to sell the property for $100,000. Furthermore, I am locked into owning the property, and may not sell it to anyonefor the next two years—because if the option holder decides to exercise, Iam obligated to deliver the property. So why should I put myself in such aconstrained position?First, for the money I receive. An option has value and won’t be
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The Basics
3
granted without compensation. I may need to receive, for example,$15,000 for this particular option. The $15,000 (should the option buyeragree to that amount) would be mine to keep, regardless of the outcome(whether or not the buyer decides to exercise his option). The price paidfor an option is usually referred to as the premium.The second reason for me to do this is that I may be unwilling, or unable, to sell the property at this time. Under those circumstances, I mightbe happy to at least receive $15,000 immediately, especially if I do not believe that the house is likely to appreciate more than $15,000 over the nexttwo years.What happens at the end of the two-year period, as we approach theexpiration date of the option? If it turns out that the property appreciatesless than $15,000, then I’m better off for having sold the option. If the property appreciates exactly $15,000 during the next two years, I end up withthe same outcome as if I had not sold the option. And if the property appreciates more than $15,000, then I may regret having sold the option.Why might someone want to buy an option? For one thing, leverage.In this example, for just $15,000, an option buyer can have control over a$100,000 asset. Without incurring the hassle of ownership, he has theright to own the property anytime simply by submitting an exercise notice and paying the agreed $100,000. Suppose, during the next two years,he pursues his plans for the property, and those plans don’t come togetherthe way he hoped. He now has greater ﬂexibility in getting out because, infact, he never got in; he never bought the property. He can simply let hisoption expire.Also, the option buyer may believe that the property will appreciatemore than $15,000 during the next two years. If it does, he could exercisehis option and then sell the property for more than $115,000.Another reason to buy an option, rather than the asset itself, is the limited risk. Although real estate doesn’t often drop in price, if the value ofthis property, for whatever reason, were to fall below $100,000, the optionholder is not likely to exercise. Why should he pay $100,000 for somethingthat could be bought, on the open market, for less than $100,000? And ifthe value of the property were to fall to less than $85,000, the option buyerwould be happy that his loss is limited to the $15,000 he paid for the option, rather than having bought the property and now seeing a loss of morethan $15,000.Does the strike price of an option have to be precisely equal to theproperty’s current fair value? Of course not. I could have written (sold) myoption at a strike price of, say $110,000, $10,000 above the current fairvalue. Such an option wouldn’t be worth as much, however, and I probablywould not get $15,000 for it. When an option’s strike price is above the underlying’s current market value, the option is said to be “out of the money.”
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THE LANGUAGE OF OPTIONS
(More on this later. As we will see, I might prefer selling an out-of-themoney option because it gives my asset room to appreciate.)Does this option have to end either in exercise or by letting it expire?No, there is a third possible outcome. If the two parties are willing and canagree on a price, the option seller may buy back his option, effectively canceling it out.Again, to open an option position the buyer (holder) pays the seller(writer) an agreed amount (premium) for the option. This premium is thewriter’s to keep, regardless of the outcome.Table 1.1 summarizes the possible closing option transactions.Note the use of a new term—assigned. When an option holder exercises, an option writer is assigned, meaning he is being called upon to fulﬁll his obligation.
LISTED OPTIONSIn the example above, an option was transacted between two individuals.Its strike price and duration were created by agreement between the twoparties to meet their speciﬁc needs. Its price was also reached by negotiation. The underlying asset was a speciﬁc and unique piece of property. Options that are tailored to a speciﬁc situation, with the terms negotiated, areoften called over-the-counter (OTC) options. As you can imagine, thisprocess is cumbersome, and ﬁnding a willing counter-party usually involves a third party. That’s why these types of options are done primarilyby large institutions.In contrast, individuals are more likely to trade listed options. Theseare standardized contracts traded on exchanges and available on many
TABLE 1.1 Summary of Possible Closing Option TransactionsIf the Option Holder . . .
The Option Writer . . .
ExercisesPays for the assetReceives the asset
Is assignedReceives payment for the assetMust deliver the asset
With the option writer's agreement,sells his option back
Buys the option back, effectively cancelingthe position and eliminating any furtherobligation
Does nothing, allowing his optionto expire
Gets to keep his asset, and no additionalcash changes hands
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Listed Options
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stocks, indexes, bond futures, commodity futures, and currency futures.There are even options on interest rates, inﬂation rates, and the weather.With listed options, you do not need to worry about the trustworthiness of the other party to the transaction. A single clearing agency, such asthe Options Clearing Corporation, stands in the middle of every trade,guaranteeing the transaction to both the buyer and the seller.If an