Options Theory and Trading: A Step-by-Step Guide to Control Risk and Generate Profits

Preface xi

Acknowledgments xv

Part I Understanding Terms and Theory 1

Chapter 1 Options Basics and Terms 3

Calls and Puts 4

Classes and Series 5

In the Money, Out of the Money, and At the Money 7

Premium and Time Decay 9

Intrinsic versus Extrinsic Value 9

Volatility 12

Chapter 2 Calls and Puts 15

Call Options 15

Put Options 16

Chapter 3 Option Theory 19

Option Pricing Models 20

Fundamentals of Pricing Models 21

Types of Pricing Models 25

Inputs of the Options Pricing Model 32

Outputs of the Pricing Model 39

Chapter 4 Option Theory and the Greeks 41

Delta 42

Gamma 52

Vega 57

Theta 68

Second-Tier Greeks 80

Chapter 5 Synthetic Positions 85

Defining Synthetics 86

Synthetic Stock 88

Synthetic Call 96

Synthetic Put 106

Part II Basic Strategies 117

Chapter 6 Introduction to Trading Strategies 119

Directional Trading Strategies 119

In-the-Money, Out-of-the-Money, and At-the-Money Options 123

Leverage and Risk 128

Chapter 7 Covered Call/Buy-Write Strategy 131

Foundations of the Strategy 131

Performance in Different Scenarios 135

Lean 138

Rolling the Position 139

Examples 141

Covered Call/Buy-Write Synopsis 146

Chapter 8 The Covered Put/Sell-Write Strategy 147

Reviewing Selling Short 147

Foundations of the Strategy 148

Performance in Different Scenarios 151

Lean 154

Rolling the Position 157

Examples 157

Covered Put/Sell-Write Synopsis 163

Chapter 9 The Protective Put Strategy 165

Foundations of the Strategy 165

Performance in Different Scenarios 166

Lean 168

When to Use the Protective Put Strategy 170

Examples 172

Protective Put Synopsis 177

Chapter 10 The Synthetic Put/Protective Call Strategy 179

Foundations of the Strategy 179

Performance in Different Scenarios 181

Lean 183

When to Use the Protective Call Strategy 184

Examples 187

Synthetic Put Synopsis 191

Chapter 11 The Collar Strategy 193

Foundations of the Strategy 193

Performance in Different Scenarios 194

Lean 197

Examples 199

Collar Synopsis 204

Part III Advanced Strategies: Spread Trading, Straddles, and Strangles 207

Chapter 12 Vertical Spreads 209

Construction of a Vertical Spread 210

Value and the Vertical Spread 211

Spread Prices Fluctuate 217

Factors that Affect Spread Pricing 218

Rolling the Position 218

Time Decay and Volatility Trading Opportunities 220

An Imaginary Spread Scenario 222

Recap with Special Insights 224

Examples 225

Bull Spread Synopsis 230

Bear Spread Synopsis 231

Chapter 13 Time Spreads 233

Construction of the Time Spread 233

Behavior of the Spread 234

Effects of Stock Price on the Time Spread 236

Effects of Volatility on the Time Spread 237

Buyer Risk and Reward 244

Seller Risk and Reward 245

Rolling the Position 246

Concluding Thoughts 249

Examples 249

Time Spread Synopsis 253

Chapter 14 The Stock Replacement/Covered Call Strategy (Diagonal Spread) 255

When to Use the Diagonal Spread 257

Rolling the Position 259

Conclusion 259

Chapter 15 Straddles 261

What Is a Straddle? 261

Straddle Scenarios 262

How It Works 262

Factors that Affect Straddle Prices 263

Risks and Rewards 266

Break-Even, Maximum Reward, and Maximum Risk 267

Conclusion 271

Examples 271

Long Straddle Synopsis 276

Short Straddle Synopsis 277

Chapter 16 Strangles 279

What Is a Strangle? 280

Strangle Scenarios 281

How It Works 281

Factors that Affect Strangle Prices 282

Risks and Rewards 285

Break-Even, Maximum Reward, and Maximum Risk 285

Conclusion 289

Examples 289

Long Strangle Synopsis 294

Short Strangle Synopsis 294

Part IV Combination Strategies 297

Chapter 17 The Butterfly 299

Constructing the Butterfly 299

Why Use Butterflies? 301

Butterfly and Synthetic Positions 303

What Will a Butterfly Cost? 305

Butterfly and the Greeks 307

Iron Butterfly 309

Long Iron Butterfly 312

Using the Butterfly 312

Long Butterfly Synopsis 313

Short Butterfly Synopsis 314

Chapter 18 The Condor 315

Long Condor 315

Short Condor 316

Why Use Condors? 317

How It Works 320

Condors versus Butterflies 321

Condors and the Greeks 323

Iron Condors 326

How Do We Use Condors? 330

Long Condor Synopsis 331

Short Condor Synopsis 332

Conclusion 335

Appendix: Five Trading Sheets 337

About the Author 343

Index 345