The Option Trader Handbook

1 The Option TraderHandbookStrategies andTrade AdjustmentsGEORGE M. JABBOUR, PhDPHILIP H. BUDWICK, MsFJohn Wiley & Sons, 3/11/04 17:23 Page 3/11/04 17:23 Page xThe Option 3/11/04 17:23 Page iFounded in 1807, John Wiley & Sons is the oldest independentpublishing company in the United States. With offices in North America,Europe, Australia and Asia, Wiley is globally committed to developingand marketing print and electronic products and services for our cus-tomers professional and personal knowledge and Wiley Trading series features books by traders who have sur-vived the market s ever changing temperament and have prospered some by reinventing systems, others by getting back to basics.

2 Whethera novice Trader , professional or somewhere in-between, these bookswill provide the advice and strategies needed to prosper today andwell into the a list of available titles, please visit our Web site at 3/11/04 17:23 Page iiThe Option TraderHandbookStrategies andTrade AdjustmentsGEORGE M. JABBOUR, PhDPHILIP H. BUDWICK, MsFJohn Wiley & Sons, 3/11/04 17:23 Page iiiCopyright 2004 by George Jabbour and Philip Budwick All rights by John Wiley & Sons, Inc., Hoboken, New JerseyPublished simultaneously in CanadaNo part of this publication may be reproduced, stored in a retrieval system, or transmittedin 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 StatesCopyright Act, without either the prior written permission of the Publisher, orauthorization through payment of the appropriate per-copy fee to the Copyright ClearanceCenter, Inc.

3 , 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, oraddressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street,Hoboken, NJ 07030, 201-748-6011, fax of Liability/Disclaimer of Warranty: While the publisher and authors have used theirbest efforts in preparing this book , they make no representations or warranties withrespect to the accuracy or completeness of the contents of this book and specificallydisclaim any implied warranties of merchantability or fitness for a particular purpose. Nowarranty may be created or extended by sales representatives or written sales advice and strategies contained herein may not be suitable for your situation.

4 Youshould consult with a professional where appropriate. Neither the publisher nor authorshall be liable for any loss of profit or any other commercial damages, including but notlimited to special, incidental, consequential, or other general information on our other products and services, or technical support, pleasecontact our Customer Care Department within the United States at 800-762-2974, outsidethe United States at 317-572-3993 or fax also publishes its books in a variety of electronic formats. Some content thatappears in print may not be available in electronic of Congress Cataloging-in-Publication Data:Jabbour, George (George Moussa)The Option Trader Handbook : strategies and trade adjustments / George Jabbour, Philip 0 471 56707 8 (cloth : alk.)

5 Paper)1. Options (Finance) 2. Options (Finance) Prices. 3. Stock options. I. Budwick, Philip. II. Title. J32 '53 dc222003026646 Printed in the United States of 3/11/04 17:23 Page ivon the web at www.. Requests to the Publisher for permission should beFor more information about Wiley products, visit our web site at .vPrefacexiCHAPTER 1 Trade and Risk Management1 Introduction1 The Philosophy of Risk2 Truth about Reward5 Risk Management7 Risk7 Reward10 Breakeven Points11 Trade Management12 Trading Theme12 The Theme of Your Portfolio15 Diversification and Flexibility16 Trading as a Business16 Start-Up Phase17 Growth Phase20 Mature Phase20 Just Business, Nothing Personal21 SCORE The Formula for Trading Success22 Select the Investment22 Choose the Best Strategy24 Open the Trade with a Plan24 Remember Your Plan and Stick to It26 Exit Your Trade27 CHAPTER 2 Tools of the Trader29 Introduction29 Option 3/11/04 17.

6 23 Page vviCONTENTSO ption Pricing31 Stock Price32 Strike Price32 Time to Expiration32 Volatility32 Dividends33 Interest Rates33 Time Value Premium33 Time Decay33 Early Assignment36 Implied Volatility38 Synthetic Positions41 Synthetic Stock42 Synthetic Call44 Synthetic Put46 Basic Strategies47 Long Call47 Short Call48 Long Put48 Short Put50 Basic Spreads and Combinations50 Bull Call Spread51 Bull Put Spread51 Bear Put Spread52 Bear Call Spread53 Long Straddle54 Long Strangle54 Short Straddle56 Short Strangle57 Advanced Spreads58 Call Ratio Spread58 Put Ratio Spread59 Call Ratio Backspread60 Put Ratio Backspread61 Long Butterflies62 Short Butterflies63 CHAPTER 3 Long Stock65 Introduction65 Protective Put66 Stock Moves Higher69 Stock Moves 3/11/04 17.

7 23 Page viContentsviiBear Put Spread74 Rolling from a Protective Put into a Bear Put Spread76 Rolling from a Bear Put Spread into a Protective Put78 Call Replacement80 Stock Moves Higher81 Stock Moves Lower82 Call Replacement versus Protective Put83 Sell Covered Calls83 Stock Moves Higher85 Strike Selection87In the Money Calls88 Time to Expiration91 Scaling-Out Strategy92 Collars94 Opening Position Regular Collar94 Stock Moves Higher Profit Collar97 Ratio Write100 Opening Position101 Stock Moves Higher Regular Ratio Write103 Stock Moves Higher Variable Strike Ratio Write110 Stock Moves Lower Ratio Write/Variable Strike Ratio Write114 Short Straddle/Short Strangle117 Opening Position Short Straddle117 Opening Position Short Strangle121 Stock Moves Higher Short Straddle123 Stock Moves Higher Short Strangle129 Stock Moves Lower Short Straddle/Stock Repair133 Stock Moves Lower Short Strangle137 Call Ratio Spread140 Opening Position143 Stock Moves Higher147 Stock Moves Lower Stock Repair Strategy152 Call Calendar Spread155 Opening Position156 Stock Moves Higher158 CHAPTER 4 Short Stock163 Introduction163 Protective Call Insurance165 Opening Position Protective Call165 Opening Position Protective Call Spread170 Short Stock Protective Call Long 3/11/04 17.

8 23 Page viiviiiCONTENTSS tock Moves Lower Protective Call174 Stock Moves Lower Protective Call Spread177 Rolling between Protective Calls and Protective Call Spreads181 Stock Moves Higher183 Put Replacement185 Stock Moves Lower186 Stock Moves Higher188 Put Replacement versus Protective Call189 Covered Puts190 Stock Moves Lower191 Short Collars196 Opening Position Regular Collar197 Stock Moves Lower Profit Collar199 Put Ratio Write201 Opening Position202 Stock Moves Lower Regular Ratio Write205 Stock Moves Lower Variable Strike Ratio Write210 Put Ratio Spread212 Opening Position212 Stock Moves Lower215 Stock Moves Higher Short Repair Strategy218 CHAPTER 5 Calls and Puts221 Introduction221 Long Call222 Protective Put Stock Moves Higher222 Protective Put Stock Moves Lower224 Call Replacement226 Rolling into a Bull Call Spread Stock Moves Higher229 Rolling into a Bull Call Spread Stock Moves Lower/CallRepair Strategy231 Rolling into a Bear Call Spread232 Short Stock235 Rolling into a Synthetic Straddle236 Rolling into a Calendar Spread237 Rolling into a Ratio Spread240 Stock Moves Lower Call Repair Strategy244 Short Call248 Long Put249 Protective Call250 Put Replacement 3/11/04 17.

9 23 Page viiiContentsixRolling into a Bear Put Spread255 Rolling into a Bull Put Spread259 Long Stock/Synthetic Straddle260 Put Calendar Spread265 Put Ratio Spread267 Short Put273 CHAPTER 6 Spreads277 Introduction277 Bull Call Spreads/Bear Put Spreads277 Protective Puts/Protective Calls278 Convert to Ratio Spreads283 Convert to Butterflies297 Bear Call Spreads/Bull Put Spreads300 Calendar Spreads301 Call Calendar Spread301 Put Calendar Spread305 CHAPTER 7 Combinations311 Introduction311 Long Straddle311 Straps/Strips312 Modified Straps/Strips315 Calendar Straddle318 Rolling a Long Straddle into an Iron Butterfly320 Diagonal Iron Butterfly321 Partial Iron Butterfly322 Long Call/Long Put Adjustments323 Long Strangle323 Diagonal Iron Butterfly324 Calendar Strangle325 Long Call/Long Put Adjustments326 Short Straddle/Short Strangle326 Short Straddle327 Short 3/11/04 17:23 Page 3/11/04 17:23 Page xxiOption trading is both an art and a science.

10 The science of optiontrading is very straightforward and mechanical and involves thespecific steps in establishing a position, pricing, and understand-ing how movements in the underlying stock affect your trades. The art oftrading, on the other hand, involves the use of your imagination and inge-nuity. The market is your canvass and you coordinate different strate-gies and adjustments to create a unique painting, which is your mechanical as Option trading seems, to be truly successful you willneed to apply your own artistic style with respect to developing strate-gies and making trade adjustments. This book is about the art of makingtrade an adjustment to a stock or Option position is one of the mostoverlooked and underutilized skills in trading.