ft guide to options - jordan 2011

LENNY JORDAN FINANCIAL TIMES Guides OPTIONS THE PLAIN AND SIMPLE GUIDE TO SUCCESSFUL STRATEGIES SECOND EDITION FT Guides OPTIONS JORDAN FINANCE ‘The Financial Times Guide to Options is a down-to-earth introduction to these fi nancial instruments. Most books on this subject try to blind you with abstract mathematics, so it’s a relief to see a return to common sense and transparency in Lenny Jordan’s book.’ Paul Wilmott, researcher, educator and founder of wilmott.com The Financial Times Guide to Options is a straightforward and practical introduction to the fundamentals of options. It includes only what is essential to basic understanding and presents options theory in conventional terms, with minimum jargon. This thorough guide will give you a basis from which to trade most of the options listed on most of the major exchanges. The Financial Times Guide to Options includes: • Options in everyday life • The basics of calls and puts • Pricing and behaviour • The Greeks and risk assessment: delta • Gamma, theta and Vega • Call spreads and put spreads • One by two directional spreads • Combos and hybrid spreads for market direction • Volatility spreads • Combine straddles and strangles for reduced risk • The calendar spread and the diagonal spread • The interaction of the Greeks • Options performance based on cost • Trouble shooting and common problems • Volatility skews • Futures, synthetics and put-call parity • Conversions, reversals, boxes and options arbitrage ABOUT THE AUTHOR Lenny Jordan has trained countless traders in the options markets of Chicago and London. He was a market maker at the Chicago Board of Trade (CBOT) and at the London International Financial Futures and Options Exchange (LIFFE). He now lectures for London-based exchanges and international banks. He can be reached at lenny@lennyjordan.com. FT Guides OPTIONS The Financial Times Guide to Options will introduce you to the instruments and markets of options, giving you the confi dence to trade successfully. Options are explained in real-life terminology, using everyday examples and accessible language. Introducing three key options markets: stocks, bonds and commodities, the book explains options contracts from straight vanilla options to strangles and butterfl ies and covers the fundamentals of options pricing and trading. Originally published as Options Plain and Simple, this new edition includes: • How the options industry operates and how basic strategies have evolved • Risk management and how to trade safely • Inclusion of new products such as exchange traded funds • Addition of market scenarios and examples • A glossary of key words and further reading Front cover image © Getty Images Visit our website at www.pearson-books.com Visit our website at www.pearson-books.com SECOND EDITION THE PLAIN AND SIMPLE GUIDE TO SUCCESSFUL STRATEGIES CVR_JORD3686_02_SE_CVR.indd 1 16/11/2010 08:57 The Financial Times Guide to Options In an increasingly competitive world, we believe it’s quality of thinking that gives you the edge – an idea that opens new doors, a technique that solves a problem, or an insight that simply makes sense of it all. The more you know, the smarter and faster you can go. That’s why we work with the best minds in business and finance to bring cutting-edge thinking and best learning practice to a global market. Under a range of leading imprints, including Financial Times Prentice Hall, we create world-class print publications and electronic products bringing our readers knowledge, skills and understanding, which can be applied whether studying or at work. To find out more about Pearson Education publications, or tell us about the books you’d like to find, you can visit us at www.pearsoned.co.uk The Financial Times Guide to Options The plain and simple guide to successful strategies Lenny Jordan Second Edition PEARSON EDUCATION LIMITED Edinburgh Gate Harlow CM20 2JE Tel: +44 (0)1279 623623 Fax: +44 (0)1279 431059 Website: www.pearsoned.co.uk First published as Options: Plain and Simple in Great Britain in 2000 Second edition published in Great Britain in 2011 © Pearson Education Limited 2011 The right of Lenny Jordan to be identified as author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. Pearson Education is not responsible for the content of third party internet sites. ISBN: 978-0-273-73686-8 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data A catalog record for this book is available from the Library of Congress All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers. 10 9 8 7 6 5 4 3 2 1 14 13 12 11 10 Typeset in 9pt Stone Serif by 30 Printed and bound in Great Britain by Ashford Colour Press, Gosport This book is dedicated to the memory of my parents P reface / ix About this book / x About the author / xii Acknowledgements / xiii Introduction / xiv PART 1 OPTIONS FUNDAMENTALS / 1 Introduction / 3 1 The basics of calls / 7 2 The basics of puts / 17 3 Pricing and behaviour / 25 4 Volatility and pricing models / 37 5 The Greeks and risk assessment: delta / 47 6 Gamma and theta / 53 7 Vega / 63 PART 2 OPTIONS SPREADS / 67 Introduction / 69 8 Call spreads and put spreads, or one by one directional spreads / 73 9 One by two directional spreads / 85 C ontents 10 Combos and hybrid spreads for market direction / 101 11 Volatility spreads / 109 12 Iron butterflies and iron condors: combining straddles and strangles for reduced risk / 121 13 Butterflies and condors: combining call spreads and put spreads / 131 14 The covered write, the calendar spread and the diagonal spread / 151 PART 3 THINKING ABOUT OPTIONS / 161 Introduction / 163 15 The interaction of the Greeks / 165 16 The cost of the Greeks / 177 17 Options talk 1: technical analysis and the Vix / 183 18 Options talk 2: trading options / 187 19 Option talk 3: troubleshooting and common problems / 193 20 Volatility skews / 199 PART 4 BASIC NON-ESSENTIALS / 217 Introduction / 219 21 Futures, synthetics and put–call parity / 221 22 Conversions, reversals, boxes and options arbitrage / 233 23 Conclusions / 241 Questions and answers / 245 Glossary / 303 Further reading / 308 Index / 310 viii Contents What an option is The difference between a commodity, a futures contract and an options contract is illustrated in the following three paragraphs, which will take you a minute and a half to read. Suppose you’re in the market for an oriental rug. You find the rug of your choice at a local shop, you pay the shopkeeper $500, and he transfers the rug to you. You have just traded a commodity. Suppose instead you wish to own the rug, but you prefer to purchase it in one week’s time. You may be on your way to the airport, or maybe you need the short-term use of your money. You and the shopkeeper agree, verbally or in writing, to exchange the same rug for $500 one week from now. You have just traded a futures contract. Alternatively, you may like the rug on offer, but you may want to shop around before making a final decision. You ask the shopkeeper if he will hold the rug in reserve for you for one week. He replies that your proposal will deny him the opportunity of selling the rug, and as compensation, he asks that you pay him $10. You and the shopkeeper agree, verbally or in writing, that for a fee of $10 he will hold the rug for you for one week, and that at any time during the week you may purchase the same rug for a cost of $500, excluding the $10 cost of your agreement. You, on the other hand, are under no obligation to buy the rug. You have just traded an options contract. Preface [...]... a stock, many investors purchase these calls because they approximate price movement of the stock, yet they are less expensive than a stock purchase 1  The basics of calls For both stocks and futures, the limited loss feature of these calls also acts as a built-in stop-loss order Out-of-the-money, in-the-money and at-the-money calls will be discussed in later chapters, but for now let’s return to. .. Times Guide to Options is a straightforward and practical guide to the fundamentals of options It includes only what is essential to basic understanding It presents options theory in conventional terms, with a minimum of jargon It is thorough; not simplistic The purpose of this book is to give you a basis from which to trade most of the options listed on most of the major exchanges Its precursor, Options. .. order to trade most of the options products on the major exchanges The focus of this book is options: it is not a comprehensive guide to trading As professional traders know, trading technique is only gained through experience For this, you should engage a professional adviser to help you to decide the best strategies to use Or better yet, contact me at lenny@lennyjordan.com xi About the author Lenny Jordan. .. banks, corporations and private investors have assets in the form of stocks and bonds that they periodically protect against a decline in value They do this by purchasing put options based on, or derived from, their stocks and bonds These options give them the right to put the amount of an asset’s decline onto the seller of the options They transfer risk 4 Part 1  Options fundamentals Subsequent chapters... guest made the same comment An hour later, I was sorry to hear him say that he had recently lost 84 per cent of an investment in stocks in emerging markets It is an unfortunate and costly reality that few investors know how to protect their investments from downside risk Their sole investment strategy is to select a stock to buy, or a fund to buy into Over the long term, and if value is found at the time... cost of options is paid for up front on most exchanges, the options buyer is forced to be more disciplined than a trader who must simply post margin And he won’t be stopped out Because options have lives of their own, they are indicators of market sentiment Implied volatility, which we will discuss, often anticipates changes in price activity in the underlying contracts Simply knowing about options. .. well as for more advanced topics such as exotic options Because this book is designed to help US and European investors, the examples chosen are from these markets I have traded many products in the US and Europe; all the options strategies discussed in this book are identical, and only the nomenclature or jargon varies part 1 Options fundamentals Introduction Puts We encounter options frequently in our... am an options trader, the strategies presented here are the very same that I have traded time and again, day by day, year after year In fact, you and I have the same goals: to make money and to manage risk About this book Many theoretical concepts are included, but the focus of this book is on practice, not theory I teach how to swing the golf club; not how to design it While it is impossible to coach... price of XYZ increased Many investors purchase these ‘out-of-the-money’ calls, as they are known, because of their lower cost, and because they believe that there is significant upside potential for the underlying Our 100 call, with XYZ at 100, is said to be ‘at the money’ In addition, if XYZ were at 100, calls could also be purchased at 95, 90 and 85 These ‘in-the-money’ calls, as they are known,... who do not wish to trade, can be obtained by reading Part 1 For investors willing to enter the market, Parts 1 and 2 provide enough information to take positions under most market conditions Part 3 presents more sophisticated ways of approaching options Part 4 covers basics that are not essential for most private investors, but which may be useful It is recommended that those willing to commit capital . LENNY JORDAN FINANCIAL TIMES Guides OPTIONS THE PLAIN AND SIMPLE GUIDE TO SUCCESSFUL STRATEGIES SECOND EDITION FT Guides OPTIONS JORDAN FINANCE ‘The Financial Times Guide to Options is. Options Exchange (LIFFE). He now lectures for London-based exchanges and international banks. He can be reached at lenny@lennyjordan.com. FT Guides OPTIONS The Financial Times Guide to Options. sites. ISBN: 97 8-0 -2 7 3-7 368 6-8 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication