<s> THE
OPTIONS
STRATEGISTHow to Invest and Trade Equity-Related Options
EFFECTIVE STRATEGIES FROM BASIC TO ADVANCEDOPTIONS ON ETFs AND INDEX FUNDSTECHNIQUES TO PROTECT YOUR INVESTMENTS
MARC ALLAIRE
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CONTENTSIntroduction1 Options 101: Basic Terms, Deﬁnitions, and Strategies
ix
1
The Basics
1
Vocabulary and Deﬁnitions
4
Options Pricing: The Basics
10
The Four Basic Options Strategies
11
2 Basic Investment Strategies
29
Covered Writing
30
The Buy/Write
33
Rolling Strategies
39
vCopyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
vi
Contents
Buying Protective Puts
43
Purchasing Call Options
45
Writing Equity Put Options
49
3 Basic Trading Strategies
55
Buying Calls
55
Buying Puts
68
4 Options 401: Option Pricing, Volatility,and a First Greek Letter
77
Option Pricing: Beyond the Basics
78
Volatility or Volatilities
89
The Greeks: Delta
94
The Risks of Early Assignment
100
5 Advanced Investment Strategies
103
Covered Straddles and Combinations
103
The Repair Strategy
111
Leveraging an Equity Position
118
More Later
125
6 Advanced Trading Strategies
127
Bull Call Spreads
127
Bear Put Spreads
135
Credit Spreads
137
Buying Volatility
141
Contents
vii
Strangles
146
Buying Volatility: Call Back Spreads
148
Buying Volatility: Put Back Spreads
151
Selling Volatility: Straddles and Front Spreads
155
Synthetics
159
Buying Calls to Hedge a Short Stock
163
7 Options on Exchange-Traded Funds and on Indices
167
Options on Exchange-Traded Funds
167
Investment Strategies with Options on ETFs
168
Index Options: Special Features
171
Index Options: Investment Strategies
176
Index Options: Trading Strategies
183
8 Hedging Corporate Stock and Options
201
Equity Collars
202
The Two Half-Collars: Buying Puts, Writing Calls
207
Hedging Corporate Stock Options
212
9 Options 901: Advanced Theoretical Notions
217
Calculating Historical Volatility
218
Do the Markets Have the Monday Morning Blues?
220
Calculating Implied Volatility
222
The Market’s Implied Volatility
223
The Greeks: Gamma
227
The Greeks: Theta
230
viii
Contents
The Greeks: Vega
231
The Greeks: Rho
232
The Relationship Among the Greeks
233
Understanding the Black-ScholesOption Pricing Equation
234
A Note on Beta
236
Option Pricing and Interest Rates
236
Extra! Options Offered Below Intrinsic Value!
239
10 Tactical Considerations
241
Risk Management
241
Earning Your Stripes
245
Options in Tax-Deferred Plans
246
Options and Taxes
246
Finding Your Style
249
Index
251
INTRODUCTION
T
HE MAIN PURPOSE OF A BOOK TITLED The Options Strategist is self-explanatory: to present and explain differentoptions strategies. Still, the contents and the structure ofthis book are based on a number of assumptions that wewould like to set out.A major assumption is that people who use options fall into twobroad categories: investors and traders. We made this distinctionseveral years ago in a chapter titled “Investing and Trading Strategies for the Individual Investor,” which appears in Options: Essential Concepts and Trading Strategies. In reality, most options users areneither pure investors nor pure traders. They invest part of theircapital and trade with their “mad money.” This distinction led usto group the investment strategies in Chapters 2 and 5 and the trading strategies in Chapters 3 and 6. Chapter 7, which deals with thespecial features of index options, presents both investing and trading strategies.To understand any option strategy, some theoretical knowledgeis necessary, but many options books present all of the theory before
ixCopyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
x
Introduction
explaining any strategies. By the time readers have plowed throughthe theory, their heads are spinning and they can’t see the connection between the theory and the strategies.We took a different tack. We believe that basic theory is necessaryto understand basic options strategies, and more advanced theoryis required for more advanced strategies. Thus, the basic theory presented in Chapter 1 should help the reader understand the strategies presented in Chapters 2 and 3. The more advanced concepts inChapter 4 lay the groundwork for the strategies in Chapters 5, 6,and 7.Chapter 8 looks at ways to hedge positions in corporate stock andoptions. Some of the strategies in that chapter could have beenincluded with the other advanced strategies, so readers who don’thold any of their employer’s stock should resist the urge to skipChapter 8. Chapter 9 goes back to theoretical notions, with more indepth discussions of volatility, time decay, options valuation, andother concepts that were introduced in earlier chapters. Althoughthis information is helpful, it is not critical in implementing tradingor investing strategies; hence, there are no strategy chapters that follow Chapter 9. Finally, Chapter 10 discusses tactical considerations,since there is more to using options successfully than simply mastering all of the strategies.One goal we did not have was to maximize the number of strategies covered. Instead, we decided to concentrate on strategies theaverage investor can implement. In keeping with this restriction, weadhered to two principles: First, not all strategies are created equaland therefore do not get equal time. Compare the number of pagesdedicated to the various aspects of buying calls to the number allocated to butterﬂy spreads. We know from experience that just abouteverybody who trades options ends up buying calls sooner or later,but very few people ever initiate a butterﬂy. Second, we found itnecessary to present certain strategies just to caution our readersaway from them. This may sound negative, but not losing money isjust as important as establishing proﬁtable positions when investing or trading with options or any ﬁnancial instrument.A participant in one of our seminars said he tried spreads andconcluded that they don’t work. After a little prodding, we foundthat if he had been aware of Regulation FD (full disclosure), a moreaccurate comment would have been, “They didn’t work the way Iexpected them to work,” or “They didn’t work the way I expected
Introduction
xi
them to work because I didn’t know what to expect from thesestrategies.” This trader’s knowledge of spreads was probably limited to their risk and reward at just two points in time—the day thetrade was initiated and at option expiration. An analysis of anoption strategy is often limited to these two dates, but we have goneto great lengths to analyze how options positions can be expectedto behave between the trade date and option expiration. Most readers will be surprised at how options can behave, especially in a complex position that involves more than one option.Certain advanced trading strategies are presented as equitystrategies in Chapter 6, and others as index option strategies inChapter 7. Readers should keep in mind that call back spreads, forexample, can also be used with equity options, even though the onlyexample in this book involves index options.A few housekeeping items regarding the examples in this book:We used both actual stocks and options prices and ﬁctional ones inour illustrations. Readers ﬁnd it easier to relate to names they know,but to illustrate a point that requires a stock trading at exactly $50,we found it easier to refer to “Nifty Fifty Inc.” trading at therequired level. As of this writing, options priced under $3 trade inﬁve-cent increments (i.e., $2.50, $2.55, $2.60) and options pricedabove $3 in ten-cent intervals (i.e., $3.40, $3.50, $3.60). In exampleswhere we calculated theoretical prices to illustrate a point, we narrowed the pricing increments to a penny (i.e., $3.17 or $5.14), especially where rounding these prices would have obscured the smallchanges we were trying to illustrate. In most instances where wecalculated theoretical prices, we used the options pricing softwareavailable on-line on the website of the Chicago Board OptionsExchange (www.cboe.com under the Trading Tools tab). Readerswill ﬁnd this pricing tool to be adequate for most everyday situations. (And in the spirit of Regulation FD, we note that we do act asan occasional consultant to the CBOE.)Most of our examples make no references to two real-life issues:trading fees and taxes. We are fully aware of the impact these canhave, but illustrations such as “you buy one call option on yourfavorite stock” would not make any economic sense if transactionfees were included. The bad news is that trading options usuallyrequires buying or selling more than one contract. The good newsis that commissions at certain ﬁrms are signiﬁcantly lower than theywere a decade or two ago, and that the breakpoint (the number of
xii
Introduction
contracts at which transaction costs become negligible) has movedsigniﬁcantly lower. As an example, assume commissions of $25 pertrade plus $2 per option, a rate that is neither the lowest availablenor the highest. Buying one option at $2 (a value of $200) wouldgenerate trading fees of $27, or 13.5% of the option’s value. Increasethe size of the trade to ﬁve options and the commission rises to $35,which now represents 3.5% of the total option value. On 10 contracts, fees are $45, and only 2.3% of the options’ value. You get thepicture.As far as taxes, we have made some brief comments in Chapter10. The long and short of it is that options are securities, so tradersand investors will end up with capital gains or losses if they useoptions.It would be futile to try to acknowledge everyone who has furthered our understanding of options during the past two decades.Nonetheless, we would like to speciﬁcally thank Bernard and Denis,who took a chance on a rookie with very little option know-how;Guy and Robin, who helped us develop our presentation skills; Billand Larry, who gave us free rein and let us develop as an optionstrategist; and Curtis, who created a position for us when wedecided that after so many years in the educational ﬁeld, it was timeto get our hands dirty again.We also want to thank the staff of The Options Institute at the Chicago Board Options Exchange who compiled all the data requiredfor our historical analyses.Two people reviewed the ﬁrst draft of this manuscript. MartyKearney, with whom we collaborated on our Understanding LEAPSbook, provided comments that helped us clarify some of the moretechnical points, and detected inaccuracies. Lynda Walker, whomade time in her very busy schedule, tried to curb our run-on sentences and made numerous suggestions to clarify the presentationof the strategies.Finally, Stephen Isaacs, our editor, and Craig Bolt, our project editor, answered our numerous questions, kept us on schedule, andguided us through the process of producing a book.To these and all those who contributed to this book, many thanks.For any remaining errors, of omission or commission, we take fullresponsibility.
C
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OPTIONS 101:BASIC TERMS,DEFINITIONS, ANDSTRATEGIESThe BasicsIt is not necessary to understand the internal workings of an automatic transmission in order to drive a car equipped with one. It is,however, important to know the function of the steering wheel andthe difference between the gas and brake pedals. Much the samecan be said for investing and trading with options: there is no needto calculate second derivatives, but a ﬁrm grasp of the fundamentals is essential. Consider this chapter to be your basic driver’s edu1Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.
2
The Options Strategist
cation. And for those who like to take the transmission apart, werefer you to Chapter 9.Puts and CallsLet’s start with a formal deﬁnition of options. An option gives itsbuyer the right to purchase or to sell a security at a set price until aﬁxed future date. For this right the buyer pays what is referred toas the option’s premium.There are two types of options—puts and calls. Although we willmove on to options on indices and other securities later, this chapter focuses on equity options.Take this example of a call option: a DuPont (ticker symbol DD)January 45 call trading at a price of $3.30. Here is the shorthandform for this option:DD Jan 45 call @ 3.30This call option gives the buyer the right to purchase shares of theunderlying stock, DD, at $45; this, 45, is the exercise, or strike, priceof the option. This is a January option, which means that the rightto purchase DD at $45 will expire some time in January. The last dayon which this right can be exercised will be the third Friday in January. The third Friday applies to all expiration months, so the thirdweek of each month is known in options circles as expiration week.After this date the option is worthless. Finally, $3.30 is the price thebuyer pays to purchase the option. This is also known as theoption’s premium and is always quoted on a per share basis. So$3.30 means $3.30 per share, and since each option contract gives itsbuyer the right to purchase 100 shares of the underlying stock, thecost of purchasing this call would be $330.Our shorthand can be summarized as follows:Underlying stock
Exercise price
DD Jan 45 call @ 3.30Expiration monthFigure 1.1
Premium
Options 101: Basic Terms, Deﬁnitions, and Strategies
3
Now let’s look at a put option on Sears (S): S Nov 40 put @ 1.85.This put option gives its buyer the right to sell 100 shares of S at aprice of $40. This right may be exercised up to and including thethird Friday in November. The cost of acquiring this right is $185per option contract.Note that options grant their buyers rights, but there are no obligations associated with these rights. A call buyer has the right topurchase shares only if he decides to do so. If it makes no economicsense to invoke this right, the call buyer need not do so. Also, forequity options, this right to purchase or to sell may be invoked onany business day from the day the option is purchased until thethird Friday of the expiration month. This unrestricted exercise feature is commonly referred to as an American-style option. Optionswith restricted exercise features are discussed in Chapter 7 in thesection on index options.
The Other Side of the OptionFor every buyer there is a seller. For every option purchased onemust be “sold,” and for every investor who obtains a right, anotherinvestor must assume an obligation. We used quotation marksaround the word “sold” because we prefer to say that options aregranted, or written, rather than sold. In our earlier call option example, there must be a counterpart to the buyer of the DD January 45call, someone who “sold” the option. It could be a trader who hadpurchased the option and then decided to liquidate her position forwhatever reason. Very often, though, the seller did not purchase theoption from someone else and has no position in any DD options.He is, in fact, writing the option. That is, he is taking the oppositeside of the trade.The buyer of the call obtains the right to purchase 100 shares ofDD at $45 until the third Friday in January, and the writer of thatoption assumes the obligation to sell 100 shares of DD at that priceif the buyer decides to invoke his right. This obligation is called acontingent obligation because the writer does not know if he will everhave to meet the obligation. The ﬁnal decision is in the hands of theoption buyer.
4
The Options Strategist
Options Created out of Thin AirAlthough this may look like a headline from your favorite tabloid,it is accurate. When an investor purchases shares of a corporation,he does so from another investor who has decided to sell her shares.Buying 1,000 shares of stock on the New York Stock Exchange doesnot change the number of outstanding shares. Not so for options.Consider this scenario. A stranger comes to your door and says,“I would like to buy your house, and I’m willing to pay signiﬁcantlyabove market value. But since I am not 100 percent ready to closethe deal, I would like you to grant me an option whereby I will beable to buy your house in six months at an agreed-upon price. I amwilling to pay you $5,000 for this option.” You talk this over withyour signiﬁcant other and decide that if this stranger is willing tobuy your house, he can have it at the agreed price and you willgladly move to another neighborhood. If he does not buy the house,then the $5,000 he gave you will go a long way in repairing the leaking roof. You grant the stranger an option on your dwelling.There is now one option outstanding on your house. It was created when someone who wanted to purchase an option was able tocome to terms with someone who was willing to grant it. The samegoes for equity and index options. When two individuals come toan agreement, options are created. One minute there are no optionsoutstanding on Advanced BioGizmo, the next you have purchased10 contracts from another individual who was more than willing togrant these to you. Ten options have been created.Since the terms of listed equity options (strike price, expirationdate, number of shares per contract) are all standardized, only onevariable remains to be negotiated when creating options: the pricepaid by the buyer to the grantor. This makes the negotiation of listedoptions somewhat easier than agreeing on an option on your house(where one must decide if the lawnmower is included, if the closing date can be contingent on ﬁnancing, etc., etc.).
Vocabulary and DeﬁnitionsTo a large extent, understanding options hinges on understandingtheir specialized vocabulary. The following key terms cover thebasics of options trading.
Options 101: Basic Terms, Deﬁnitions, and Strategies
5
Underlying value. Every option is an option on something: twotickets to the big game, a piece of real estate, shares of Monsanto. This book focuses on options on equities, which have astheir underlying value 100 shares of the said stock per optioncontract, options on exchange-traded funds (which representpart ownership in a basket of stock that usually reﬂects thecomposition of a well-known index), and index options whoseunderlying value, an index, is not a security of any type butsimply a number. The special features of index options will bediscussed in Chapter 7.Last trading day. For equity options, the third Friday of the expiration month. This is option traders’ last chance to initiate orliquidate positions in expiring options. By the time investorsget back to their ofﬁces on the following Monday all of the current month’s options will have expired.Expiration date. All options have a known, ﬁnite, life that ends ontheir expiration date, which is deﬁned as the Saturday following the third Friday of the month. This is often confused withthe last trading day. There is very little options traders can doon expiration Saturday except buy groceries and watch Michigan football. This “extra” day harks back to the time when allof the back-ofﬁce procedures were done manually and brokerage ﬁrms needed to balance their books and correct any errorsthat may have occurred on Friday. The week preceding expiration Saturday is known as expiration week. Some think ofstocks as having no expiration date. We prefer to think of stocksas having an unknown expiration date: sometimes they expireworthless, sometime they disappear in exchange for a ﬁxed dollar amount, but most of the time they just keep on going.Expiration cycles. At any one time there will be four different expiration months listed for trading on any one optionable stock.(There may be two additional ones if LEAPS® are available; seeLEAPS entry.) The four months available will vary dependingon which of the three expiration cycles the option class belongsto. The three different cycles are known as the January, the February, and the March cycles. The January cycle consists of January, April, July, and October. The February cycle consists ofFebruary, May, August, and November. The March cycle consists of March, June, September, and December. No matter
6
The Options Strategist
which cycle an option class belongs to, the next two availableexpiration months will be listed. Then the next two expirationmonths from the appropriate cycle will also be listed. For example, Advanced Micro Devices (AMD) trades on the Januarycycle. If we are in early April, the following four expirationmonths would be listed for AMD: April and May (the next twoavailable expirations), and July and October (the next twomonths of the January cycle). After the April expiration theMay options would continue trading. June options would thenbe listed (June would now be the second available expirationmonth), and the July and October options would also continuetrading. The easiest way to ﬁnd out to which expiration cycle astock belongs is to pull up an option chain and see what’s listedfor trading.Exercise price (also known as strike price). The price at which thebuyer of an option obtains the right to buy or sell the underlying security. For equity options, strike prices are set at $2.50intervals from $5 (the lowest strike price listed) to $25, and at$5 intervals above $25.Option type, series, and class. There are two types of options: putsand calls. Options with the same expiration and strike pricemake up a series (for example, the December 65s). A class comprises all of the options on one underlying stock or index (allof its series); for example, all Intel options or all options on theStandard & Poor’s 500® Index.LEAPS. An acronym for Long-term Equity AnticiPation Securities.SM Long-term options. In addition to the four short-termexpiration months, some stocks have two additional longerterm options known as LEAPS. All equity LEAPS expire in January and will have terms from 9 to 32 months.Long and short. Words with two different meanings. When referring to option positions or stocks, long signiﬁes an option, or astock has been purchased: I am long the June 50 calls (I havebought these), or I am long shares of IBM. Short refers tooptions that have been written: I am short the January 95 puts(I have written these) or to a stock that has been sold short: Iam short shares of GM. When referring to the overall market(or a particular stock), long or short indicates whether a position is bullish or bearish: “I am long the market” (I have a position that will be proﬁtable if the market goes up) or “I am short
Options 101: Basic Terms, Deﬁnitions, and Strategies
7
the market.” Note that one can be long the market (bullish) bybeing short some options.Holder. The buyer of an option. Someone with a long optionposition.Bid-ask. When posting option quotes, professional traders(known as market makers or specialists) must give a two-sidedmarket: a price at which they are willing to purchase the option(the bid) and a price at which they are willing to sell the option(the ask, or the offer). A buyer who purchases on option at theasked price is said to take out (or lift) the offer. A seller whoaccepts the posted bid is said to hit the bid. The bid-ask spreadrefers to the difference between these two prices, as in: “Thespread on that option is too wide.”Option chain. A listing of all the options on a speciﬁc security,usually presented in two columns, the left one listing calls, theright one puts. This information used to be found only on brokers’ quote terminals but is now widely available on the Internet. “Pull up the chain on Microsoft.”Option premium. The price of an option, paid by the buyer,received by the writer. Quoted on a per share basis, an option’spremium is composed of intrinsic and time value.Intrinsic and time value. Intrinsic value is the amount by which anoption is in-the-money. This is also known as the exercise value.For example, a General Electric (GE) 40 call trading at $4.40when GE is trading at $43 has $3 of intrinsic value; the difference between an option’s premium and its intrinsic value is itstime value; the GE 40 call has $1.40 of time value. Time valueis said to decay as the expiration date approaches and to disappear at expiration. Options very rarely trade below theirintrinsic value as this would create an easy arbitrage opportunity: if the GE 40 call is trading at $2.90, buy it, exercise it, andimmediately sell GE at $43. Total cost to purchase the stockwould be $42.90 ($2.90 to buy the option, $40 payable uponexercise), resulting in a proﬁt of $0.10. An option’s intrinsicvalue is never negative. If GE is trading at $43 and the 45 callat $2.70, the call has no intrinsic value and its premium is composed exclusively of time value.In-the-money, at-the-money, and out-of-the-money. If an option hassome intrinsic value, it is said to be in-the-money. If UnitedTechnologies (UTX) is trading at $64, the September 60 call is
8
The Options Strategist
in-the-money by $4 (it lets its holder buy the stock $4 below thecurrent price), and the October 70 put is in-the-money by $6 (itlets its holder sell the stock $6 above its current price). Optionsare at-the-money when the price of the underlying stock isequal to the option’s strike price: if MBIA Corp. (MBI) is $55,then both the February 55 call and the March 55 put are at-themoney. Calls with an exercise price higher than the price of thestock, and puts with a strike price lower than the current stocklevel, are out-of-the-money: if ICN Pharmaceuticals (ICN) is$27, the April 30 call (and all calls with higher strike prices) areout-of-the-money; the June 25 put (and all puts with lowerexercise prices) are also out-of-the-money. One often hears references to the amount by which options are in- or out-of-themoney: “I just purchased a put that’s $7 in-the-money,” or “I’mgoing to write a call that’s at least $5 out-of-the-money.”Exercise. To invoke the rights conferred by an option. Only buyers of options may exercise these. For example, an investor whopurchased a Chevron Texaco (CVX) 90 call option (granting herthe right to buy 100 shares of CVX at $90) may decide shewants to purchase this stock and add it to her portfolio. Shecontacts her broker and instructs him to exercise her calloption. When an option is exercised, it settles three businessdays later (the same as purchases and sales made on the various stock exchanges), at which point she would have to pay$9,000 and would then receive 100 shares of CVX