<s> The Bibleof OptionsStrategies
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The Bibleof OptionsStrategiesThe Definitive Guide for Practical Trading Strategies
Guy Cohen
An imprint of Pearson EducationUpper Saddle River, NJ • Boston • Indianapolis • San Francisco • New York •Toronto • Montreal • London • Munich • Paris • Madrid • Capetown • Sydney •Tokyo • Singapore • Mexico City
Library of Congress Number: 2004116072Vice President and Editor-in-Chief: Tim MooreExecutive Editor: Jim BoydEditorial Assistant: Kate E. StephensonDevelopment Editor: Russ HallMarketing Manager: Martin LitkowskiInternational Marketing Manager: Tim GalliganCover Designer: Sandra SchroederManaging Editor: Gina KanouseSenior Project Editor: Sarah KearnsCopy Editor: Ben LawsonIndexer: Larry SweazyCompositor: Interactive Composition CorporationManufacturing Buyer: Dan Uhrig© 2005 by Pearson Education, Inc.Publishing as Financial Times Prentice HallUpper Saddle River, New Jersey 07458Financial Times Prentice Hall offers excellent discounts on this book when ordered in quantity for bulkpurchases or special sales. For more information, please contact U.S. Corporate and Government Sales,1-800-382-3419, corpsales@pearsontechgroup.com. For sales outside the U.S., please contact International Salesat international@pearsoned.com.Company and product names mentioned herein are the trademarks or registered trademarks of theirrespective owners.All rights reserved. No part of this book may be reproduced, in any form or by any means, withoutpermission in writing from the publisher.Printed in the United States of AmericaFirst Printing: March 2005ISBN: 0-13-171066-4Pearson Education LTD.Pearson Education Australia PTY, Limited.Pearson Education Singapore, Pte. Ltd.Pearson Education North Asia, Ltd.Pearson Education Canada, Ltd.Pearson Educatión de Mexico, S.A. de C.V.Pearson Education—JapanPearson Education Malaysia, Pte. Ltd.
To Dominic and Lulu, who keep reminding me of their omission from theAcknowledgments of my first book!
Table of ContentsPrefaceAcknowledgmentsAbout the Author
xxxixxxixxl
1
The Four Basic Options Strategies
1
2
Income Strategies
21
3
Vertical Spreads
89
4
Volatility Strategies
119
5
Sideways Strategies
175
6
Leveraged Strategies
219
7
Synthetic Strategies
239
8
Taxation for Stock and Options Traders
293
Appendix AAppendix B
303317
Index
Strategy TableGlossary
331
Find Your StrategyBy Chapter
1
2
3
The Four Basic Options Strategies
1
1.1 Long Call1.2 Short (Naked) Call1.3 Long Put1.4 Short (Naked) Put
591216
Income Strategies
21
2.1 Covered Call2.2 Short (Naked) Put—Refer to Chapter 1 (1.4)2.3 Bull Put Spread2.4 Bear Call Spread2.5 Long Iron Butterfly2.6 Long Iron Condor2.7 Covered Short Straddle2.8 Covered Short Strangle2.9 Calendar Call2.10 Diagonal Call2.11 Calendar Put2.12 Diagonal Put2.13 Covered Put (Also Known as a Married Put)
23282832364146515763697682
Vertical Spreads
89
3.1 Bull Call Spread3.2 Bear Put Spread3.3 Bull Put Spread—Refer to Chapter 2 (2.3)3.4 Bear Call Spread—Refer to Chapter 2 (2.4)3.5 Bull Call Ladder
9094999999
xiv
Find Your Strategy By Chapter
4
5
6
3.6 Bull Put Ladder3.7 Bear Call Ladder3.8 Bear Put Ladder
104109114
Volatility Strategies
119
4.1 Straddle4.2 Strangle4.3 Strip4.4 Strap4.5 Guts4.6 Short Call Butterfly4.7 Short Put Butterfly4.8 Short Call Condor4.9 Short Put Condor4.10 Short Iron Butterfly4.11 Short Iron Condor
121127132137143148152157161166170
Sideways Strategies
175
5.1 Short Straddle5.2 Short Strangle5.3 Short Guts5.4 Long Call Butterfly5.5 Long Put Butterfly5.6 Long Call Condor5.7 Long Put Condor5.8 Modified Call Butterfly5.9 Modified Put Butterfly5.10 Long Iron Butterfly—Refer to Chapter 2 (2.5)5.11 Long Iron Condor—Refer to Chapter 2 (2.6)
176180184188193198203208212217217
Leveraged Strategies
219
6.1 Call Ratio Backspread6.2 Put Ratio Backspread6.3 Ratio Call Spread6.4 Ratio Put Spread
219224229233
Find Your Strategy By Chapter
7
8
Synthetic Strategies
239
7.1 Collar7.2 Synthetic Call7.3 Synthetic Put7.4 Long Call Synthetic Straddle7.5 Long Put Synthetic Straddle7.6 Short Call Synthetic Straddle7.7 Short Put Synthetic Straddle7.8 Long Synthetic Future7.9 Short Synthetic Future7.10 Long Combo7.11 Short Combo7.12 Long Box
240246250254258263267271275278282286
Taxation for Stock and Options Traders
293
8.1 Tax on Stocks8.2 Tax on Options
294296
Appendix AAppendix B
303317
Index
Strategy TableGlossary
331
xv
Find Your StrategyBy Proficiency
The following strategies are appropriate for novice traders:Novice
Chapter
Page
Long CallLong PutCovered CallSynthetic CallSynthetic Put
11277
51223246250
The following strategies are appropriate for intermediate traders:Intermediate
Chapter
Page
Bear Call SpreadBull Put SpreadBear Call SpreadBull Put SpreadCalendar CallCollarDiagonal CallLong Call ButterflyLong Iron ButterflyLong Iron CondorLong Put ButterflyShort (Naked) PutShort Call ButterflyShort Put ButterflyStraddleStrangle
322327252 and 52 and 551 and 24444
99283299572406318836, 21741, 21719316, 28148152121127
xviii
Find Your Strategy By Proficiency
The following strategies are appropriate for advanced traders:Advanced
Chapter
Page
Bear Call LadderBear Put LadderBull Call LadderBull Put LadderCalendar PutCall Ratio BackspreadCovered PutCovered Short StraddleCovered Short StrangleDiagonal PutLong Call CondorLong Put CondorShort (Naked) CallPut Ratio BackspreadShort Call CondorShort Iron ButterflyShort Iron CondorShort Put CondorShort StraddleShort Strangle
33332622225516444455
1091149910469219824651761982039224157166170161176180
The following strategies are appropriate for expert traders:Expert
Chapter
Page
GutsLong BoxLong Call Synthetic StraddleLong ComboLong Put Synthetic StraddleLong Synthetic FutureModified Call ButterflyModified Put ButterflyRatio Call SpreadRatio Put SpreadShort Call Synthetic StraddleShort Combo
477777556677
143286254278258271208212229233263282
Find Your Strategy By Proficiency
Short GutsShort Put Synthetic StraddleShort Synthetic FutureStrapStrip
57744
184267275137132
xix
Find Your StrategyBy Direction
The following strategies are bullish:Bullish
Chapter
Page
Bear Call LadderBull Call SpreadBull Put SpreadCalendar CallCalendar PutCall Ratio BackspreadCollarCovered CallCovered Short StraddleCovered Short StrangleDiagonal CallDiagonal PutLong CallLong ComboLong Synthetic FutureModified Call ButterflyModified Put ButterflyShort (Naked) PutRatio Put SpreadStrapSynthetic Call
332 and 3226722222177551 and 2647
1099028, 9957692192402346516376527827120821216, 28233137246
Bearish
Chapter
Page
Bear Call SpreadBear Put Spread
2 and 33
32, 9994
The following strategies are bearish:
Find Your Strategy By Direction
Bull Put LadderCovered PutLong PutShort (Naked) CallPut Ratio BackspreadRatio Call SpreadShort ComboShort Synthetic FutureStripSynthetic Put
3211667747
10482129224229282275132250
The following strategies are direction neutral:Direction Neutral
Chapter
Page
Bear Put LadderBull Call LadderGutsLong BoxLong Call ButterflyLong Call CondorLong Call Synthetic StraddleLong Iron ButterflyLong Iron CondorLong Put ButterflyLong Put CondorLong Put Synthetic StraddleShort Call ButterflyShort Call CondorShort Call Synthetic StraddleShort GutsShort Iron ButterflyShort Iron CondorShort Put ButterflyShort Put CondorShort Put Synthetic StraddleShort StraddleShort StrangleStraddleStrangle
33475572 and 52 and 55574475444475544
1149914328618819825436, 21741, 217193203258148157263184166170152161267176180121127
xxi
Find Your StrategyBy Volatility
The following strategies benefit from high volatility once you are in thetrade:High Volatility
Chapter
Page
Bear Call LadderBull Put LadderCalendar CallCall Ratio BackspreadCollarDiagonal CallGutsLong BoxLong Call Synthetic StraddleLong Put Synthetic StraddlePut Ratio BackspreadShort Call ButterflyShort Call CondorShort Iron ButterflyShort Iron CondorShort Put ButterflyShort Put CondorStraddleStrangleStrapStrip
33267247776442 and 42 and 4444444
1091045721924063143286254258224148157166170152161121127137132
Find Your Strategy By Volatility
The following strategies benefit from low volatility once you are in thetrade:Low Volatility
Chapter
Page
Bear Call LadderBull Call LadderLong Call ButterflyLong Call CondorLong Iron ButterflyLong Iron CondorLong Put ButterflyLong Put CondorModified Call ButterflyModified Put ButterflyRatio Call SpreadRatio Put SpreadShort Call Synthetic StraddleShort GutsShort Put Synthetic StraddleShort StraddleShort Strangle
33552 and 52 and 555556675755
1099918819836, 21741, 217193203208212229233263184267176180
xxiii
Find Your StrategyBy Risk / Reward
The following strategies have a capped risk profile:!
Capped Risk
Chapter
Page
Bear Call SpreadBear Call LadderBear Put SpreadBull Call SpreadBull Put SpreadBull Put LadderCalendar CallCalendar PutCall Ratio BackspreadCollarCovered CallDiagonal CallDiagonal PutGutsLong BoxLong CallLong Call ButterflyLong Call CondorLong Call Synthetic StraddleLong Iron ButterflyLong Iron CondorLong PutLong Put ButterflyLong Put CondorLong Put Synthetic Straddle
2 and 33332 and 3322672224715572 and 52 and 51557
32, 99109949028, 991045769219240236376143286518819825436, 21741, 21712193203258
Find Your Strategy By Risk/Reward
Modified Call ButterflyModified Put ButterflyShort (Naked) PutPut Ratio BackspreadShort Call ButterflyShort Call CondorShort Iron ButterflyShort Iron CondorShort Put ButterflyShort Put CondorStraddleStrangleStrapStripSynthetic CallSynthetic Put
551 and 26444444444477
20821216, 28224148157166170152161121127137132246250
The following strategies have an uncapped risk profile:Uncapped Risk
Chapter
Page
Bear Put LadderBull Call LadderCovered PutCovered Short StraddleCovered Short StrangleLong ComboLong Synthetic FutureShort (Naked) CallRatio Call SpreadRatio Put SpreadShort Call Synthetic StraddleShort ComboShort GutsShort Put Synthetic StraddleShort StraddleShort StrangleShort Synthetic Future
33222771667757557
114998246512782719229233263282184267176180275
xxv
xxvi
Find Your Strategy By Risk/Reward
The following strategies offer only a capped reward profile:Capped Reward
Chapter
Page
Bear Call SpreadBear Put SpreadBear Put LadderBull Call SpreadBull Call LadderBull Put SpreadCalendar CallCalendar PutCollarCovered CallCovered PutCovered Short StraddleCovered Short StrangleDiagonal CallDiagonal PutLong BoxLong Call ButterflyLong Call CondorLong Iron ButterflyLong Iron CondorLong Put ButterflyLong Put CondorModified Call ButterflyModified Put ButterflyShort (Naked) CallShort (Naked) PutRatio Call SpreadRatio Put SpreadShort Call ButterflyShort Call CondorShort Call Synthetic StraddleShort GutsShort Iron ButterflyShort Iron CondorShort Put Butterfly
2 and 333332 and 32272222227552 and 52 and 5555511 and 2664475444
32, 9994114909928, 99576924023824651637628618819836, 21741, 217193203208212916, 28229233148157263184166170152
Find Your Strategy By Risk/Reward
Short Put CondorShort Put Synthetic StraddleShort StraddleShort Strangle
4755
161267176180
The following strategies offer an uncapped reward potential:Uncapped Reward
Chapter
Page
Bear Call LadderBull Put LadderCall Ratio BackspreadGutsLong CallLong Call Synthetic StraddleLong ComboLong PutLong Put Synthetic StraddleLong Synthetic FuturePut Ratio BackspreadShort ComboShort Synthetic FutureStraddleStrangleStrapStripSynthetic CallSynthetic Put
3364177177677444477
109114219143525427812258271224282275121127137132246250
xxvii
Find Your StrategyBy Type
The following strategies enable to you capture a regular income:Income
Chapter
Page
Bear Call SpreadBear Put LadderBull Call LadderBull Put SpreadCalendar CallCalendar PutCovered CallCovered PutCovered Short StraddleCovered Short StrangleDiagonal CallDiagonal PutLong Iron ButterflyLong Iron CondorShort (Naked) CallShort (Naked) PutRatio Call SpreadRatio Put SpreadShort GutsShort Put Synthetic StraddleShort StraddleShort Strangle
2 and 3332 and 3222222222 and 52 and 511 and 2665755
32, 991149928, 99576923824651637636, 21741, 217916, 28229233184267176180
Find Your Strategy By Type
The following strategies are for capital gain:Capital Gain
Chapter
Page
Bear Call LadderBear Put SpreadBull Call SpreadBull Put LadderCall Ratio BackspreadCollarGutsLong BoxLong CallLong Call ButterflyLong Call CondorLong Call Synthetic StraddleLong ComboLong PutLong Put ButterflyLong Put CondorLong Put Synthetic StraddleLong Synthetic FutureModified Call ButterflyModified Put ButterflyPut Ratio BackspreadShort Call ButterflyShort Call CondorShort Call Synthetic StraddleShort ComboShort Iron ButterflyShort Iron CondorShort Put ButterflyShort Put CondorShort Synthetic FutureStraddleStrangleStrapStripSynthetic CallSynthetic Put
333367471557715577556447744447444477
1099490104219240143286518819825427812193203258271208212224148157263282166170152161275121127137132246250
xxix
Preface
How to Use This BookOptions give investors so much flexibility that when it came to writing a book namedThe Bible of Options Strategies, I found myself cursing just how flexible they can be!Sixty strategies is a lot of ground to cover, but in reviewing them all again (I’ve doneit several times already!), I was reminded of the beauty of these amazing tradinginstruments.Options give us the ability to do so many things—they enable us to configure ourinvestment aims in any way we like. The benefits of options are often trotted out tonew students or prospective customers as the first salvo of an up-sell campaign, butthey’re worth looking at again, this time from a practical point of view.Options enable us to:■
Control more assets for less money.One option contract represents 100 shares of stock and is usually a fraction of thecost of what you’d pay for the equivalent number of shares.For example, ABCD stock is priced at $26.20 on June 2, 2004.An option to buy ABCD shares (a call option) might be priced at $2.60. Becauseone contract represents 100 shares, we can therefore buy one ABCD call contractfor $260.00 [100 * 2.60]. The alternative would be to buy 100 shares of the stockfor a total sum of $2,620. So, in this example, we can buy ABCD calls options foraround 10% of the stock price in order to control $2,620 of ABCD stock until theappropriate expiration date of the option.
■
Trade with leverage.Because our cost basis is so low, the position is much more sensitive to the underlying stock’s price movements, and hence our percentage returns can be so muchgreater.
■
Trade for income.We can design strategies specifically for the purpose of generating income on aregular basis.
xxxii
Preface■
Profit from declining stocks.We can use puts and calls to ensure that we can make money if the stock goes up,down, or sideways.
■
Profit from volatility or protection against various factors.Different options strategies protect us or enable us to benefit from factors such astime decay, volatility, lack of volatility, and more.
■
Reduce or eliminate risk.Options enable us to substantially reduce our risk of trading, and in certain rarecases, we can even eliminate risk altogether, albeit with the trade-off of very limited profit potential!
So, with all the different benefits of options, why on earth would traders not be curious to learn more about them? Well, for a start, the initial barrier to entry is quitehigh, in that options are reasonably complex instruments to understand for the firsttime. After you’re over that hurdle, though, they become more and more fascinating!The other reason is that there is such a multitude of other investment securities forpeople to choose from, many will pick what seems like the simplest, rather than whatmay fit their investment aims the best.Given that options can be a challenge, it’s my job to make life as simple as possible for you. One of the ways in which I do this is to break things down into picturesso we can see what we’re doing. As soon as we can see what we’re doing, lifebecomes much clearer when you’re creating options strategies. Everything to dowith OptionEasy and all my material is designed to be visual-friendly. This goes backto when I started to learn all about options and the fact that the penny only startedto drop when I converted the concepts into pictures. All of a sudden, everything fitinto place, and I started to be able to extend logic faster and further than before.This book is designed to be a reference book, one that you can pick up any timeto learn about and understand a strategy. It isn’t an academic workbook. It’s a practical book, written for traders, designed to work interactively with your tradingactivities. As the title suggests, it’s a book about options strategies, of which we takeon 58! That’s not to say you need to learn about each and every one of them, but atleast you have the choice!In order to make life easier for you, we categorize the strategies into differentdescriptions for the following criteria:
Proficiency LevelEach strategy is assigned a “value” in term of its suitability for different levels oftrader. Each level is given an associated icon.Strategies suitable for novicesStrategies suitable for intermediates
Preface
xxxiii
Strategies suitable for advanced tradersStrategies suitable for expert tradersThe allocations are defined according to a subjective view of complexity, risk, anddesirability of the strategy. Therefore, some highly risky and undesirable strategieshave been put into the Expert basket in order to warn novices and intermediates away.Also Novice strategies are not exclusive to novice traders. It’s simply as question ofsuitability, and novice strategies are highly relevant and suitable to all levels of trader.In some cases, the strategy is not complex at all but is considered unacceptablyrisky for novice and intermediate traders (at least without a warning). I have tried tobe objective here, but I’m mindful not just of my own experiences but also the manystudents who regularly show me their trading disasters! Conservative by nature,I’m a believer that loss of opportunity is preferable to loss of capital (Joe DiNapoli), andperhaps some of these rankings bear testimony to this philosophy.
Market OutlookThis is where we define whether a strategy is suitable to bullish, bearish, or directionneutral outlooks.Strategies suitable for bullish market conditionsStrategies suitable for bearish market conditionsStrategies suitable for sideways market conditions
VolatilityVolatility is one of the most important factors affecting option pricing and thereforeoption trading. You really should familiarize yourself with the concept, which, forgive the plug, is dealt with in my first book, Options Made Easy.Here, we define whether a strategy is suitable for trades anticipating high volatility or low volatility in the markets. Some strategies, such as Straddles, require highvolatility after you’ve placed the trade, so a Straddle would fall into the HighVolatility category.Strategies suitable for high volatility marketsStrategies suitable for low volatility markets
RiskWith any trade you’re looking to make, you must be aware of your potential risk,reward, and breakeven point(s).Some strategies have unlimited risk; others have limited risk, even if that “limited”risk means 100% of the trade. Believe it or not, sometimes with options it’s possible tolose more than 100%. In such cases, or when there is no definable stop to the potentialrisk of a trade, you’re well advised to be aware of such a position in advance!
xxxiv
Preface
Here, we show you which strategies have capped or uncapped risk. Strategieswith uncapped risk aren’t necessarily all bad, but you should at least be aware ofwhat you are getting into. Often you can mitigate such risk with a simple stop lossprovision, in which case you’re not going to liable to uncapped risk. Often, suchuncapped risk scenarios only occur if the stock falls to zero or rises to infinity, whichmostly are rare circumstances, but you’re better off being aware!!
Strategies with capped riskStrategies with uncapped risk
RewardFollowing the risk scenarios described previously, the strategies also have potentialreward scenarios, too.Just because a strategy has unlimited reward potential doesn’t mean that it’s necessarily a great strategy, and just because it may have capped reward doesn’t meanit’s necessarily a bad strategy.Strategies with capped rewardStrategies with uncapped reward
Strategy TypeStrategies can be used for income purposes (usually short-term) or to make capitalgains. Many traders like the Covered Call because it’s suitable for novices andbecause it’s an income strategy that they can use every month.Income strategiesCapital gain strategies
Strategy LegsEach strategy contains different legs. Some have just one, and others have up to four.Each leg must be composed of any one of the basic four option strategies (long orshort call or put) or a long or short stock position. Here’s how we identify them:Long stockShort stockLong callShort callLong putShort putAll strategies contain real-life examples at the end of each guide.
Preface
xxxv
Chapter by ChapterIn terms of structure, I’ve tried to make this book as easily navigable as possible, andmuch of that is solved by matrix-style tables of contents.Each chapter contains strategies that are commensurate with a specific style ofoptions trading. Inevitably there’s some overlap between chapters for certain strategies, which we address in the appropriate places.Chapter 1 addresses the basic strategies, including buying and selling stocks andthen buying and selling calls and puts. After you understand those cornerstonesand how the pictures relate to each strategy, then you can fast-forward to any partof the book and any strategy you like. All strategy guides are modular and followthe same format, so that you can become familiar with the style and structure of thecontent.Chapter 2 is all about income strategies. An income strategy is when you’re effectively a net seller of short-term options, which generates (monthly) income. You haveto be careful, though, not to expose yourself to unlimited risk scenarios, which iswhy we use icons to identify excess risk.In Chapter 3, we cover “vertical spreads.” A vertical spread is where we buy andsell the same numbers of the same options (calls or puts) but with different strikeprices. Obviously, there’s some overlap here with other chapters, which is why thechapter is comparatively small.Chapter 4 goes into volatility strategies and is bound to be as popular as theincome strategies chapter! Here we address those strategies that benefit from increasing volatility after you’ve placed the trade.In Chapter 5, we reverse this and explore those strategies that benefit fromdecreasing volatility after you’ve placed the trade. So here we’re looking for stocksthat we think will be rangebound for some time. Typically these are short-termstrategies.Chapter 6 identifies the ratio spreads and backspreads, where you’re usingincreasing leverage to increase your returns. These are for advanced and experiencedtraders only!In Chapter 7, we look at synthetic strategies that mainly mimic other strategicgoals, using a combination of stock legs, call legs, and put legs. For example, we canreplicate owning a stock purely by buying and selling calls and puts in such a waythat we hardly pay any cash out. In other words, we’ve simulated the risk of owningthe stock, but with no cash outlay. We can also synthetically re-create straddle positions and other strategies.Lastly, in Chapter 8, we investigate some of the taxation issues that will confrontyou during your trading careers. This is not a definitive tax guide but rather more aflag raiser.
xxxvi
Preface
Strategy by StrategyEach strategy is presented in a modular format. In this way, the book should be easyto navigate. The modules are numbered, and the numbering system applies throughout each chapter and each strategy:■
The first number refers to the chapter itself. So, all headings in Chapter 2 willstart with “2.”
■
The second number refers to the strategy in question. So, 2.1 refers to the firststrategy (Covered Call) in Chapter 2.
■
The third number refers to the module. So, 2.1.1 refers to the “Description” module for the first strategy (Covered Call) in Chapter 2. Because the modules areidentical throughout the book, each module number is the same throughout allthe strategies. Therefore, module “1,” which appears as the third decimal place,is always “Description.” The modules are outlined as follows:■
x.y.1
Description
Here, we describe the strategy in both words and pictures. We identify thesteps for each leg and some general comments about what the overall position will mean to you.■
x.y.2
Context
This section describes the outlook and rationale for the strategy. We also highlight the net position in your account as a result of the trade as well as identify the effect of time decay and the appropriate time period for the strategy. Stockand option-leg selection are important elements of any trade, so