More free books @ www.BingEbook.com THE OPTION TRADER’S GUIDE TO PROBABILITY, VOLATILITY, AND TIMING TEAMFLY Team-Fly ® More free books @ www.BingEbook.com Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally commit- ted to developing and marketing print and electronic products and services for our customers’ professional and personal knowl- edge and understanding. The Wiley Trading Series features books by traders who have been able to work with the market’s ever changing temperament and prosper—some by reinventing systems, others by getting back to basics. For the novice trader, professional, or somewhere in between, these books will provide the advice and strategies needed to prosper today and well into the future. For a list of available titles, please visit our Web site at www.WileyFinance.com. More free books @ www.BingEbook.com A Marketplace Book THE OPTION TRADER’S GUIDE TO PROBABILITY, VOLATILITY, AND TIMING Jay Kaeppel John Wiley & Sons, Inc. More free books @ www.BingEbook.com Copyright © 2002 by Jay Kaeppel. All rights reserved. Published by John Wiley & Sons, Inc., New York. Published simultaneously in Canada. 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, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, e-mail: PERMREQ@WILEY.COM. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products visit our Web site at www.wiley.com. ISBN: 0-471-22619-X Printed in the United States of America. 10987654321 More free books @ www.BingEbook.com In loving memory of Arthur H. Kaeppel More free books @ www.BingEbook.com More free books @ www.BingEbook.com Contents Chapter 1 Introduction 1 Who Can Benefit from This Book 1 What Sets This Book Apart 2 Can Options Really Be Simplified? 2 What This Book Provides 2 Overview of Option Trading 3 Understanding Risk by Using Risk Curves 6 Asking the Right Question 9 Analyzing Risk: What Separates the Winners from the Losers 11 Summary 18 Chapter 2 The Basics of Options 21 Option Definitions 21 Options on a Specific Security 26 Intrinsic Value versus Extrinsic Value 30 In-the-Money versus Out-of-the- Money Options 32 Summary 35 Chapter 3 Reasons to Trade Options 37 The Three Primary Uses of Options 37 Leveraging an Opinion on Market Direction 39 vii More free books @ www.BingEbook.com Hedging an Existing Position (and Generating Income) 41 Taking Advantage of Neutral Situations 44 Summary 46 Chapter 4 Option Pricing 47 Theoretical Value 47 Examples of Theoretical Option Pricing 49 Overvalued Options versus Undervalued Options 50 Summary: Theory versus Reality 52 Chapter 5 Time Decay 55 The Effect of Time Decay on the Price of an Option 56 Implications of Time Decay 58 Time Decay Illustrated 58 Summary 62 Chapter 6 Volatility 63 Volatility: The Most Important Concept in Option Trading 63 Historic Volatility Explained 63 Implied Volatility Explained 65 Is Implied Volatility High or Low? Relative Volatility Explained 69 Relative Volatility Ranking 72 Considerations in Selecting Option- Trading Strategies 72 Why Does Volatility Matter? 74 The Effect of Changes in Volatility 77 Summary 80 viii Contents More free books @ www.BingEbook.com Chapter 7 Probability 81 Weighing the Pros and Cons 81 Strategies for a Bullish Scenario 82 Profit/Loss Comparisons 86 Delta 89 Probability Analysis 91 The Correct and Incorrect Ways to Use Probability 95 Summary 96 Chapter 8 Market Timing 99 The Underlying Security Is Expected to Move within a Specific Period 100 The Underlying Is Expected to Move in a Particular Direction but Not in a Specific Time Frame 102 The Underlying Is Expected to Move Significantly but the Direction Is Unknown 103 The Underlying Is Expected to Stay within a Range or Not Move Much in Any Direction 105 Summary 106 Chapter 9 Trading Realities 107 Exercise and Assignment 107 Bid and Ask Prices and the Importance of Option Volume 110 Appreciating the Effect of Bid-Ask Spreads 111 Factors in Dealing with Bid-Ask Spreads 113 A Word on Limit Orders 113 Summary 115 Chapter 10 Important Concepts to Remember 117 Valid Reasons to Trade Options 117 Option Pricing 118 Contents ix More free books @ www.BingEbook.com [...]... books @ www.BingEbook.com x Contents Time Decay 11 8 Volatility 11 9 Probability 12 0 Market Timing 12 0 How to Lose Money Trading Options The Keys to Success in Option Trading Summary 12 8 Chapter 11 13 9 14 8 15 1 Buy a Backspread Key Factors 15 1 Position Taken 15 7 Backspreads versus Naked Calls and Puts Volatility and Backspreads 15 9 Position Management 16 2 Trade Result 16 4 Chapter 14 13 3 Buy a Naked Option. .. what the risk is before they make their trades Jay Kaeppel explains these issues in The Option Trader s Guide to Probability, Volatility, and Timing Kaeppel covers the basics and then goes on to teach how to trade options And he doesn’t do it with get-rich-quick examples and hyperbole He looks at the options market with a thorough analysis of both the risk and the profit potential of the various strategies,... was Through all the years and all the growth and changes, critical elements remain that traders must understand and apply consistently if they hope to succeed in the long run The purpose of this book is to illuminate these concepts and show how to apply them successfully in real-world trading 1 More free books @ www.BingEbook.com 2 The Option Trader s Guide What Sets This Book Apart The primary focus... discuss in detail in Chapter 5, time decay refers to the erosion of an Team-Fly® More free books @ www.BingEbook.com 8 The Option Trader s Guide option price as time passes and option expiration draws nearer The obvious implication from this graph is that the buyer of this option stands to earn a greater profit if the price of the stock rises sooner rather than later As the price of the option erodes... focus of this book is not to teach you about options, but rather to teach you how to successfully trade options Having a textbook understanding of any topic is not the same thing as applying that knowledge in the real world This book is intended to give new traders and returnees to the options market an understanding of what it takes to succeed, as well as a set of guidelines to apply in the real world... strategies, and he does so in a very readable fashion Kaeppel outlines the steps involved in becoming a successful trader He explains the different strategies available and when to use each one He shows how to accurately assess volatility and from there, how to profit by disparities in the implied volatilities of different options His strategies include guidelines for determining when to buy undervalued options... enough information to fully understand the risks involved In the following pages are two case studies of trades that, on the surface, could be touted by market gurus as high -probability, sure-thing, you-can’t-lose trades In fact, most discussions of these strategies fail to answer the right question— “What is my risk on this trade?” Novice traders are quick to latch onto ideas that promise the potential... interesting that those who end up being most successful in this endeavor More free books @ www.BingEbook.com 12 The Option Trader s Guide often spend more time focusing on not losing money than they do on making money One of the keys to option trading success is understanding the risks involved in any trade and then planning to minimize these risks When traders learn about option- trading strategies, they often... mitigate this risk?” According to an old adage in trade, “As long as you minimize losses, profits will take care of themselves.” More free books @ www.BingEbook.com 10 The Option Trader s Guide Most traders new to options are attracted by the lure of easy money This is not all that surprising Most advertisements for option trading play on traders’ desire to make a lot of money fast Traders read ads claiming... www.BingEbook.com Contents xi A Decline in Volatility Is Deadly to Calendar Spreads 17 5 Chapter 15 17 9 Buy a Straddle Chapter 16 Sell a Vertical Spread 19 1 19 9 TE Key Factors 19 1 Position Taken 19 7 Position Management Trade Result 200 Chapter 17 18 8 AM FL Y Key Factors 17 9 Position Taken 18 6 Position Management Trade Result 19 0 2 01 Write a Covered Call 211 Sell a Naked Put Key Factors 2 01 Position Taken 206 . understand just what the risk is before they make their trades. Jay Kaeppel explains these issues in The Option Trader s Guide to Probability, Volatility, and Timing. Kaeppel covers the basics and. by Using Risk Curves 6 Asking the Right Question 9 Analyzing Risk: What Separates the Winners from the Losers 11 Summary 18 Chapter 2 The Basics of Options 21 Option Definitions 21 Options on. 12 0 Market Timing 12 0 How to Lose Money Trading Options 12 1 The Keys to Success in Option Trading 12 5 Summary 12 8 Chapter 11 Overview of Trading Strategy Guides 13 1 The Two Key Elements in Selecting