Updated and revised to include a decade of growth in the scope and complexity of options, Options Strategies: Profit-Making Techniques for Stock, Stock Index, and Commodity Options, 3rd Edition is a comprehensive guide to options trading strategies written in clear, non-technical language. In addition to insight into options issues like carrying changes, strike prices, commissions, interest rates, and break-even points, new chapters show how to predict the direction of implied volatility. Accessible examples, charts, and graphs will help you obtain the information you need to succeed in the high-risk, high-profit world of options.

Option Strategies

Profit-Making Techniques for Stock, Stock Index, and Commodity Options

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By Courtney Smith

John Wiley & Sons

Copyright © 2008 Courtney Smith
All right reserved.
ISBN: 978-0-470-24779-2

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Chapter One

Introduction

Welcome to the third edition of Option Strategies. This book will take you on a guided tour of the world of option strategies. Options present the investor with a myriad of new strategies. Some are very conservative, such as covered call writing, whereas others are very speculative, such as naked call selling. Options provide more and often better ways to fine-tune your investing strategies to expected market conditions.

This book covers all types of options: stock index, stock, and commodity. Bullish and bearish strategies are covered equally. It will be useful to all options traders and hedgers, from novices to professionals.

DECISION STRUCTURES

A decision structure is an ordered line of inquiry, consisting of a structured series of situations and choices that assist you in analyzing potential trades and in determining your course of action after you have entered a trade. A decision structure is not an exhaustive compilation of all possible strategies but a concise guide to the analysis necessary to deal with the most common possibilities.

In order to achieve your objectives, you must first identify your objectives. This self-evident truth is often forgotten. Two main questions can help you:

1. How much risk are you willing to take? Each person has a subjective criterion of risk. You must have an idea of the level of risk with which you are comfortable so that you can make acceptable investments.

2. What kind of return do you need to take on that level of risk? The greater the risk, the greater should be your prospective reward. Look at competing investments. You might have found a low-risk covered write, but your return might be just above Treasury bills. Why bother with such a trade? Look for those opportunities that have significantly more reward, though they also have more risk.

SIMPLIFICATION OF OPTIONS CALCULATIONS

Most discussions of options calculations are too simple. They highlight the important issues rather than present seemingly irrelevant information. However, in the final analysis, reality is complex.

The major area of simplification has been in the mathematics of options. In general, the calculations given in books and articles have ignored such factors as transaction costs, carrying charges, and taxes. In most cases, this is not critical. However, there is no need to invest in an option trade and lose money because of ignored factors.

The discussions of risk and reward in Chapters 7 to 24 focus on the strategy and usually do not mention carrying charges, unless carrying charges tend to be a major determinant of profitability. For example, carrying charges are rarely going to affect the decision to buy a call, but an arbitrage between an underlying instrument and a reverse conversion is dominated by considerations of carrying charges.

CARRYING CHARGES

Carrying charges, including transaction costs, the bid/ask spread, slippage, and financing costs, must always be considered when deciding on a strategy.

Transaction costs are an ever-present cost of trading. The term transaction costs includes commissions, the bid/ask spread, and slippage. Typically, the largest transaction cost is brokerage commissions. Brokerage houses charge commissions on all transactions. Many option strategies involve the use of options in conjunction with other instruments. For example, a covered call write program in stocks involves the sale of a call against the purchase of the underlying stock. The commission on the stock purchase and on the eventual sale should be considered in the investment decision.

Traders of options on the floors of the various exchanges do not need to consider this factor as much. Their transaction costs are pennies per contract.

Another potential transaction cost is the bid/ask spread of the investment. (The bid is the highest price that someone is willing to pay for the option; the ask is the lowest price at which someone is offering to sell the option.) All options and related instruments have a bid/ask spread. For example, an option may have a last price of 41 1/4, but the bid may be 4 1/8 and the ask may be 4 3/8. In general, most investors will have to pay the ask to buy an option, and will sell at the bid price. This has the effect of inducing slippage in calculations of profits, risks, and break-evens. It is usually wise to include at least one minimum tick or price movement into the costs of your option trade. For example, bond futures options trade in units of 1/64. It would be a good idea to subtract 1/64 from your expected sale price and add 1/64 to your expected purchase price.

The bid/ask spread is a major source of profit for floor traders. They typically look to buy at the bid and sell at the ask. This enables them to execute many strategies that cannot be executed by everybody else. Such strategies as conversions, butterflies, and reversals tend to be the exclusive domain of professional floor traders. These strategies tend to be dominated by transaction costs. The ability to buy at the bid and sell at the offer is a powerful advantage in trading these strategies.

Slippage is the final transaction cost and is related to the bid/ask spread. It is the difference between the price that you expect on the fill of an order and the actual cost. For example, you could expect to get a fill at 1 7/8 on a purchase of a call, but the market is active and volatile and your order is not filled until the market is up to 2 1/8. Very conservative investors should include at least another tick on the expected price as slippage for computing expected returns on a trade.

Carrying charges, often overlooked and/or idealized, represent the costs to carry an open position. Traders should at least consider the opportunity cost of initiation and carrying a particular trade. There are an infinite number of investment possibilities. When you decide to do an option trade, you have implicitly rejected all other investment possibilities. You have eliminated the opportunity to invest elsewhere. Traditionally, the opportunity cost has been quantified as the Treasury-bill rate because it is considered riskless.

Leveraged positions have a finance charge. This finance charge must be considered before initiating a position and while calculating the possible outcomes. For example, a covered write against a stock bought on 50 percent margin will have the profit potential reduced by the financing charges. The term carrying charges or carrying costs is used throughout this book as a shorthand reference to the various costs associated with carrying a trade or position.

The biggest cost of all is probably taxes. This book assumes no taxes on any of the trades when making the various calculations. However, the reader should definitely consider the tax consequences of their trades. This could have a major impact on the long-term efficacy of the trading program.

OVERVIEW OF THE BOOK

The book is divided into two parts. The four chapters of Part One outline the fundamentals of options. This part forms a base for the remainder of the book. Even experienced options traders should scan these chapters to make sure they are using the same terminology as is found in this book.

Part Two contains Chapter 6, which outlines several of the considerations that are important in selecting a strategy. The following chapters discuss each main strategy, the risks and rewards of the strategy, the selection of the various components of the strategy, and the necessary follow-up actions. I have added a new chapter, Chapter 24, which outlines the most critical aspects of trading, psychology, and risk management.

This book is meant to be used every day by the options strategist and trader. Wear it out!

(Continues...)

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Excerpted from Option Strategies by Courtney Smith Copyright © 2008 by Courtney Smith . Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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Courtney D. Smith is Chairman of the Investment Mentoring Institute, an organization devoted to building great investors. He is also President and CIO of Courtney Smith & Co., Inc., which manages money for institutions, family offices, and high-net-worth individuals, and is CEO and Chairman of Greater China Technology, Inc., a company that outsources software development to China. Mr. Smith is the author of six books, including the two previous editions of Option Strategies. He has made over 1,000 TV appearances on shows such as Wall Street Journal Report, Moneyline, and other programs on CNBC, Fox News, Bloomberg, and CNN.