Options the essential guide for getting started in derivatives trading, 10th edition

Michael C Thomsett Options ISBN 978-1-5474-1614-1 e-ISBN (PDF) 978-1-5474-0009-6 e-ISBN (EPUB) 978-1-5474-0011-9 Library of Congress Control Number: 2018949270 Bibliographic information published by the Deutsche Nationalbibliothek The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data are available on the Internet at http://dnb.dnb.de © 2018 Michael C Thomsett Published by Walter de Gruyter Inc., Boston/Berlin www.degruyter.com About De|G PRESS Five Stars as a Rule De|G PRESS, the startup born out of one of the world’s most venerable publishers, De Gruyter, promises to bring you an unbiased, valuable, and meticulously edited work on important topics in the fields of business, information technology, computing, engineering, and mathematics By selecting the finest authors to present, without bias, information necessary for their chosen topic for professionals, in the depth you would hope for, we wish to satisfy your needs and earn our five-star ranking In keeping with these principles, the books you read from De|G PRESS will be practical, efficient and, if we have done our job right, yield many returns on their price We invite businesses to order our books in bulk in print or electronic form as a best solution to meeting the learning needs of your organization, or parts of your organization, in a most cost-effective manner There is no better way to learn about a subject in depth than from a book that is efficient, clear, well organized, and information rich A great book can provide life-changing knowledge We hope that with De|G PRESS books you will find that to be the case Acknowledgments to the Tenth Edition I owe thanks to many options insiders and practitioners who have guided me through the years First, my gratitude must be extended to Karl Weber, the editor who first acquired this book in 1987 when he was at John Wiley & Sons At the time, options was a young industry and he fought for publication of that first edition of the book despite a widespread belief that the market for such a book was tiny Second, I thank the folks at the Chicago Board Options Exchange (CBOE), especially two people who became good friends as well as advisers Marty Kearney and Jim Bittman were my mentors and teachers in many respects over the years Third, thanks to the many readers of the previous nine editions who wrote to the publisher or to me with questions or with discovered errors I appreciate the feedback and the many helpful suggestions Notable among my readers are numerous friends I found and connected with on social media, especially on LinkedIn Fourth, I must mention the unwavering support of my webmaster and partner at Thomsett’s Investment Guide (https://thomsettsguide.com), Michael Stoppa, who has encouraged me to continue with my efforts at education and development of training material for a growing audience of options enthusiasts Fifth, a special thanks go out to the editorial team at my newest publisher, De Gruyter My editor and dedicated fact checker, Jeffrey Pepper, is a determined and relentless publishing professional who insists on simplicity, accuracy, and thorough explanations of the many complexities of options Additional editing and fact checking were executed skillfully by the De Gruyter editorial team, notably including Mary Sudul and Jaya Dalal This team put exceptional energy into editing the book, making sure that I explained myself as well as possible in every word, phrase and paragraph These folks are the best! Michael C Thomsett June 2018 Contents Part I: The Basics Chapter 1: Calls and Puts: Defining the Field of Play Equity Investments Debt Investments Investments with No Tangible Value: Options Trading Options on Exchanges Calls and Puts The Call Option The Long-Term Call Option Investment Standards for Call Buyers How Call Selling Works The Put Option Option Valuation Picking the Right Stock Intrinsic Value and Time Value Chapter 2: The Life of an Option Expiration and Exercise What is “Clearing”? Bid and Ask Order Entry Types of Orders Who Are the Players? Chapter 3: Opening and Tracking: How It All Works Terms of the Option (Standardized Terms) Strike Price Expiration Date Type of Option Underlying Stock A Note on the Expiration Cycle Opening and Closing Option Trades Using the Daily Options Listings Understanding Option Abbreviations Calculating the Rate of Return for Sellers Chapter 4: Buying Calls: Maximizing the Rosy View Understanding the Limited Life of the Call Judging the Call Call Buying Strategies Strategy 1: Calls for Leverage Strategy 2: Limiting Risks Strategy 3: Planning Future Purchases Strategy 4: Insuring Profits Strategy 5: Premium Buying Strategy 6: Pure Speculation Defining Profit Zones Chapter 5: Buying Puts: The Positive Side of Pessimism The Limited Life of the Put Judging the Put Put Buying Strategies Strategy 1: Gaining Leverage Strategy 2: Limiting Risks Strategy 3: Hedging a Long Position Strategy 4: Pure Speculation Defining Profit Zones Chapter 6: Selling Calls: Conservative and Profitable Selling Uncovered Calls Assessing Uncovered Call Writing Risks A Question of Suitability Selling Covered Calls Assessing Covered Call Writing Risks Calculating the Rate of Return Chapter 7: Selling Puts: The Overlooked Strategy Analyzing Stock Value Evaluating Risks Put Strategies Strategy 1: Producing Income Strategy 2: Using Idle Cash Strategy 3: Buying Stock Strategy 4: Writing a Covered Put on Short Stock Strategy 5: Creating a Tax Put Part II: Closing the Position Chapter 8: Closing Positions: Profit, Exercise, or Roll Defining Possible Outcomes of Closing Options Results for the Buyer Results for the Seller Exercising the Option Timing the Decision Avoiding Exercise Chapter 9: Paper Trading: A Test Run of the Theory The Case for Paper Trading Sites Worth Checking www.Optionsxpress.com marketwatch.com www.investopedia.com Proceeding with a Paper Trading Plan The Dangers of Paper Trading Chapter 10: Calculating the Return: A Complex Aspect to Options Finding a Realistic Method Annualizing Models and Guidelines An Overview of Basic Calculations for Calls You Close the Position and Calculate Option-Based Net Return You Close the Position and Calculate Net Return Based on the Entire Position The Covered Call is Exercised, and You Calculate Option and Stock Profits Separat ely Any Covered Call Outcome Is Computed Strictly Based on Capital on Deposit Anticipating the Likely Return Chapter 11: The Basics of Risk: What Every Trader Needs to Know Volatility as the Definition of Risk Historical Volatility Implied Volatility Pricing Models Risk and Human Nature Confirmation Bias Anchoring Herding Framing Selective Memory Loss Aversion Chapter 12: Strategies in Volatile Markets: Uncertainty as an Advantage Avoiding 10 Common Mistakes Modifying Your Risk Tolerance The Nature of Market Volatility Market Volatility Risk Options in the Volatile Environment Part III: Advanced Strategies Chapter 13: Combinations and Spreads: Creative Risk Management Overview of Advanced Strategies The Spread The Hedge The Straddle The Strangle Vertical Spread Strategies Bull Spreads Bear Spreads Box Spreads Debit and Credit Spreads Horizontal and Diagonal Spread Strategies Altering Spread Patterns Varying the Number of Options Expanding the Ratio Strategies with Moneyness Close to Underlying Prices Variations on the Butterfly Multi-Leg Option Orders In Conclusion Chapter 14: Hedges and Straddles: More Creativity The Two Types of Hedges Hedging Beyond Coverage Hedging Option Positions Partial Coverage Strategies Straddle Strategies Middle Loss Zones Middle Profit Zones Theory and Practice of Combined Techniques In Conclusion Chapter 15: Options for Specialized Trading: Leveraging the Technical Approach Swing Trading Basics The Setup Signal Testing the Theory A Strategic View of Option for Swing Trading Selection of Stocks Based on Value A Stock’s Price Volatility Price History (Recent and Potential) The Price-To-Earnings (P/E) Ratio of the Stock Fundamental and Technical Tests of the Company and Stock Price activity 1, Price behavior 1, 2, 3, 4, Price changes 1, 2, 3, 4, 5, 6, 7, 8, – short-term 1, 2, 3, 4, 5, – stock’s 1, – stock’s market 1, Price difference 1, Price direction 1, 2, Price discovery 1, Price history 1, 2, 3, – stock’s 1, Price levels 1, 2, 3, 4, 5, 6, 7, 8, Price long Price manipulation Price momentum, option contracts in times of Price movement 1, 2, 3, 4, 5, 6, 7, 8, – downward 1, 2, 3, 4, 5, – large 1, – mirror 1, – short-term 1, 2, 3, 4, 5, 6, – stock’s 1, 2, – underlying 1, 2, 3, 4, – unfavorable 1, – upward 1, Price patterns 1, 2, Price range 1, 2, 3, 4, 5, 6, 7, 8, – narrow 1, Price relationship 1, Price stock call total 1, 2, Price swings, short-term 1, 2, 3, Price trends 1, 2, 3, 4, Price value 1, 2, 3, 4, Price volatility 1, 2, 3, – stock’s Price-to-earnings 1, Pricing models 1, Products 1, 2, 3, 4, 5, 6, 7, 8, Profit goals 1, 2, Profit margin 1, 2, Profit zone 1, 2, 3, 4, 5, – limited 1, 2, 3, 4, 5, 6, 7, 8, Profitable decision 1, Profiting 1, 2, 3, 4, 5, Profits 1, 2, 3, 4, 5, 6, 7, 8, – call’s – consistent 1, 2, 3, 4, – dividing net cash 1, – dollar 1, – earning 1, – fast 1, 2, 3, – long position 1, 2, – operating – pretax – realized – reported – taking 1, 2, 3, – taxable 1, – total 1, 2, 3, 4, – unrealized 1, Purchase 1, 2, 3, 4, 5, 6, 7, 8, – installment 1, – involving 1, – simultaneous 1, 2, 3, 4, 5, Purchase price 1, 2, 3, 4, 5, 6, 7, 8, – original 1, Purchase stocks 1, 2, 3, Q Qualification of covered calls 1, 2, Qualified covered calls 1, Quarterly dividends 1, 2, 3, 4, 5, 6, 7, R Rate of return for sellers 1, Ratio 1, 2, 3, 4, 5, 6, 7, 8, – price/earnings 1, – single-strike-price 1, Ratio calendar combination spread profit and loss zones Ratio calendar spread 1, 2, 3, Ratio calendar spread profit and loss zones Ratio collar 1, – variable 1, Ratio spreads 1, Ratio write profit and loss zones Real money 1, 2, Rebound 1, 2, 3, 4, 5, 6, 7, 8, Receipts 1, 2, 3, 4, 5, Record, stockholder of 1, 2, 3, Relative volatility 1, 2, Replacement 1, Resistance 1, 2, 3, Return 1, 2, 3, 4, 5, 6, 7, 8, – basic – expected 1, – incremental 1, 2, – likely 1, – rate of 1, 2, 3, 4, 5, 6, 7, 8, Return calculations 1, 2, 3, 4, Return on capital employed 1, Return option sellers 1, Revenue and earnings 1, 2, 3, 4, Revenues 1, 2, 3, 4, 5, 6, 7, 8, Reverse 1, 2, 3, 4, 5, 6, 7, 8, Reverse hedge 1, Reverse hedge profit and loss zones Right ingredients 1, 2, 3, 4, 5, 6, 7, 8, Risk exposure 1, 2, 3, 4, 5, 6, 7, 8, Risk profile 1, 2, 3, 4, 5, 6, Risk stockholders experience 1, Risk tolerance 1, 2, 3, 4, 5, 6, 7, 8, Risks 1, 2, 3, 4, 5, 6, 7, 8, – brokerage – buyer’s 1, 2, – evaluating 1, 2, 3, – hedge 1, 2, – hedge market 1, 2, – high 1, 2, 3, 4, 5, 6, 7, 8, – higher 1, 2, 3, 4, 5, 6, 7, – lost opportunity 1, 2, 3, 4, 5, – margin and collateral 1, – maximum 1, 2, 3, 4, 5, – moderate – offset market 1, 2, – offsetting market 1, – personal goal 1, – short position 1, – trading cost 1, Risks of selling calls 1, ROCE (Return on Capital Employed) 1, Roll 1, 2, 3, 4, 5, 6, 7, 8, Rolling 1, 2, 3, 4, 5, 6, Rolling techniques 1, 2, 3, 4, Roll-up 1, Rosy view 1, 2, 3, 4, 5, 6, 7, 8, Rules 1, 2, 3, 4, 5, 6, 7, 8, – antistraddle 1, – special 1, 2, 3, Rumors 1, 2, 3, 4, 5, 6, 7, 8, S Sale 1, 2, 3, 4, 5, 6, 7, 8, Sale price 1, 2, 3, Sales load 1, 2, Sales price, initial 1, 2, Sector 1, 2, 3, 4, 5, Securities 1, 2, 3, 4, 5, 6, 7, 8, – underpriced Selecting stocks 1, 2, 3, 4, 5, 6, 7, 8, Selection of stocks based on value Sellers 1, 2, 3, 4, 5, 6, 7, 8, Selling covered calls 1, 2, 3, 4, 5, 6, 7, 8, Selling uncovered calls 1, 2, 3, 4, Sequence 1, 2, 3, Settlement, orderly 1, 2, Setup 1, 2, 3, 4, Setup signals 1, Share price 1, 2, 3, 4, 5, 6, Short option 1, 2, 3, 4, 5, 6, 7, 8, Short position exercise costs 1, Short position outcomes Short sale position 1, Short sales 1, 2, 3, 4, 5, 6, 7, 8, – protected 1, 2, 3, Short seller 1, 2, 3, 4, 5, 6, Short stock 1, 2, 3, 4, 5, 6, 7, 8, – synthetic 1, 2, 3, Short stock position gains 1, Short straddle profit and loss zones Short straddles 1, 2, Short trades 1, Short-term gains 1, 2, 3, 4, Short-term price aberrations 1, Short-term profits 1, 2, 3, 4, 5, 6, 7, 8, Short-term short calls 1, 2, 3, Side 1, 2, 3, 4, 5, 6, 7, 8, Signals 1, 2, 3, 4, 5, 6, 7, 8, S&P 1, 2, 3, Specialized trading 1, 2, 3, 4, 5, 6, 7, 8, Specified price 1, 2, Speculate 1, 2, 3, 4, 5, 6, 7, 8, Speculating 1, 2, 3, 4, 5, 6, 7, 8, Speculation 1, 2, 3, 4, 5, 6, 7, 8, Speculative position 1, Speculators 1, 2, 3, 4, 5, 6, 7, 8, Spread strategies 1, 2, 3, 4, 5, Spreads 1, 2, 3, 4, 5, 6, 7, 8, – debit 1, – diagonal 1, 2, – horizontal 1, 2, – ratio calendar combination 1, 2, Stock 1, 2, 3, 4, 5, 6, 7, 8, – capital gains on 1, 2, – common 1, 2, 3, 4, 5, 6, 7, – high-value 1, – low-volatility 1, – overpriced 1, 2, 3, 4, – owning 1, 2, 3, – picking 1, 2, 3, 4, 5, 6, 7, – previous day’s – return on 1, – selected – selling 1, 2, 3, 4, 5, 6, 7, 8, – shorting 1, 2, 3, 4, 5, – trade – volatile 1, 2, 3, 4, 5, 6, 7, 8, Stock chart 1, 2, Stock exchanges 1, Stock investments 1, Stock investors 1, 2, 3, 4, Stock losses 1, – downside move offsets – short 1, Stock market 1, 2, 3, 4, 5, 6, 7, 8, Stock market manipulations 1, Stock market momentum 1, Stock market risk 1, Stock market speculation 1, Stock market values 1, Stock market volatility 1, Stock movements 1, Stock ownership 1, 2, 3, Stock portfolio 1, 2, 3, 4, 5, 6, Stock positions 1, 2, 3, 4, 5, 6, 7, – long 1, 2, 3, 4, 5, – short 1, 2, 3, 4, 5, 6, 7, – synthetic 1, – synthetic long 1, – synthetic short Stock price 1, 2, 3, 4, 5, 6, 7, 8, – closing – current 1, 2, 3, 4, – rising 1, 2, – underlying 1, 2, Stock price changes 1, 2, Stock price levels 1, 2, 3, Stock price movement 1, 2, 3, 4, 5, 6, 7, 8, Stock prices and fundamentals 1, Stock profit 1, 2, 3, 4, 5, 6, 7, 8, Stock purchase 1, Stock selection 1, 2, 3, 4, 5, 6, 7, 8, Stock value 1, 2, 3, 4, 5, 6, 7, 8, – underlying 1, 2, Stock volatility 1, Stockbroker Stockcharts.com 1, Stockholders 1, 2, 3, 4, 5, 6, 7, 8, Stock-related decisions 1, Stock’s market price 1, 2, 3, 4, 5, 6, 7, 8, Stock’s market value 1, 2, 3, 4, 5, 6, 7, 8, Stock’s price 1, 2, 3, 4, 5, 6, 7, 8, Stock’s value 1, 2, 3, 4, 5, 6, 7, 8, – underlying 1, 2, 3, 4, 5, Straddle strategies 1, 2, Straddles 1, 2, 3, 4, 5, 6, 7, 8, – long 1, 2, 3, 4, Strangle 1, 2, 3, Strategic view of option for swing trading 1, Strategies 1, 2, 3, 4, 5, 6, 7, 8, – appropriate 1, 2, 3, – combination 1, 2, – conservative 1, 2, 3, 4, 5, – highest-risk 1, – high-risk 1, 2, 3, 4, 5, 6, – investment 1, 2, 3, – options-trading 1, – profitable 1, – sensible – swing-trading 1, 2, Strategies in volatile markets 1, 2, 3, 4, 5, 6, 7, 8, Street earnings numbers Strike price 1, 2, 3, 4, 5, 6, 7, 8, Support 1, 2, 3, 4, 5, 6, 7, Swing 1, 2, 3, 4, 5, Swing trade 1, 2, 3, Swing traders 1, 2, 3, 4, Swing trading 1, 2, 3, 4, 5, 6, 7, 8, Synthetic positions 1, 2, 3, 4, 5, 6, 7, 8, Synthetic profit 1, Synthetic straddle 1, 2, 3, 4, Synthetics 1, Systems 1, 2, 3, 4, 5, 6, 7, 8, T Taking partial profits 1, Tax law 1, Tax rate 1, 2, 3, 4, Tax risks Tax rules 1, 2, 3, 4, 5, 6, Tax treatment 1, 2, 3, Taxes 1, 2, 3, 4, 5, 6, 7, 8, Technical approach 1, 2, 3, 4, 5, 6, 7, 8, Technical indicators 1, 2, 3, 4, 5, 6, 7, 8, Technical tests 1, 2, 3, 4, 5, Temptation 1, 2, 3, Terms 1, 2, 3, 4, 5, 6, 7, 8, Test run 1, 2, 3, Tests 1, 2, 3, 4, 5, 6, 7, 8, Time decay 1, 2, 3, 4, 5, 6, 7, 8, Time spread 1, 2, Time value evaporates 1, 2, 3, 4, 5, Time value of money 1, Timing 1, 2, 3, 4, 5, 6, 7, 8, Total capitalization 1, 2, Total return 1, 2, 3, Tracking 1, 2, 3, 4, 5, 6, 7, 8, Trade online Traders 1, 2, 3, 4, 5, 6, 7, 8, – advanced – day 1, Trades 1, 2, 3, 4, 5, 6, 7, 8, – single-option 1, Trading costs 1, 2, 3, 4, 5, 6, 7, 8, Trading days 1, 2, 3, 4, 5, 6, 7, 8, Trading fees 1, 2, 3, 4, 5, 6, 7, 8, Trading range 1, 2, 3, 4, 5, 6, 7, – current 1, 2, – day’s 1, 2, 3, 4, – established 1, Trading strategies, optimal Transaction costs, net return minus 1, Transaction fees 1, 2, 3, 4, 5, 6, 7, 8, Transaction price 1, Transactions 1, 2, 3, 4, 5, 6, 7, 8, Trend 1, 2, 3, 4, 5, 6, 7, 8, Triple option 1, 2, U Unavailable market, risk of 1, Uncertainty 1, 2, 3, 4, 5, 6, 7, 8, Uncovered call profit and loss zones Uncovered calls 1, 2, 3, 4, 5, Uncovered option 1, 2, 3, Underlying price 1, 2, 3, 4, 5, 6, 7, 8, Underlying stock 1, 2, 3, 4, 5, 6, 7, 8, Underlying stock’s market value 1, 2, 3, 4, 5, 6, 7, 8, Underlying stock’s price 1, 2, 3, 4, 5, Understanding option abbreviations Uptrend 1, 2, 3, V Valuable resource 1, 2, 3, 4, 5, 6, 7, 8, Valuation 1, 2, 3, 4, 5, 6, 7, 8, Value 1, 2, 3, 4, 5, 6, 7, 8, – combined 1, 2, – declining market 1, – higher market 1, 2, – increased market 1, – intrinsic value and time 1, 2, – long-term 1, 2, 3, – lost market 1, – position’s 1, – rising market 1, – time and intrinsic 1, 2, 3, 4, Value dollar 1, 2, Value point 1, Variable hedge profit and loss zones Variable hedge strategies, short Variables 1, 2, 3, 4, 5, – fundamental Variations 1, 2, 3, 4, 5, 6, 7, 8, Vertical spread 1, 2, 3, 4, 5, 6, Vertical spread strategies 1, 2, 3, 4, Volatile 1, 2, 3, 4, 5, 6, 7, 8, Volatile environment 1, 2, Volatile markets 1, 2, 3, 4, 5, 6, 7, 8, Volatility 1, 2, 3, 4, 5, 6, 7, 8, – high 1, 2, 3, – low 1, 2, – stock’s 1, 2, 3, 4, Volatility levels 1, 2, 3, 4, Volatility risk 1, 2, Volatility value 1, 2, Volume 1, 2, 3, 4, 5, 6, 7, 8, W, X, Y Wash sale rule 1, Wash sales 1, Wild card of options trading 1, 2, 3, 4, 5, Writers 1, 2, 3, 4, 5, 6, 7, 8, Z Zones – covered call’s profit and loss – defined profit and loss 1, 2, 3, 4, 5, 6, 7, 8, – profit and loss 1, 2, 3, 4, 5, 6, 7, 8, – selling profit and loss Endnotes Capelle-Blancard, G (2010) Are Derivatives Dangerous? 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Introduction to the Tenth Edition Learning options is not an easy proposition The logic of options trading involves thinking in a different, sometimes mind-bending, way In this tenth edition, the book