OPTIONS TRADING: THE HIDDEN REALITY RI$K DOCTOR GUIDE TO POSITION ADJUSTMENT AND HEDGING Charles M. Cottle ● OPTIONS: PERCEPTION AND DECEPTION and ● COULDA WOULDA SHOULDA revised and expanded www.RiskDoctor.com www.RiskIllustrated.com Chicago © Charles M. Cottle, 1996-2006 All rights reserved. No part of this publication may be printed, reproduced, stored in a retrieval system, or transmitted, emailed, uploaded in any form or by any means, electronic, mechanical photocopying, recording, or otherwise, without the prior written permission of the publisher. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that neither the author or the publisher is engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers. Published by RiskDoctor, Inc. Library of Congress Cataloging-in-Publication Data Cottle, Charles M. Adapted from: Options: Perception and Deception Position Dissection, Risk Analysis and Defensive Trading Strategies / Charles M. Cottle p. cm. ISBN 1-55738-907-1 ©1996 1. Options (Finance) 2. Risk Management 1. Title HG6024.A3C68 1996 332.63’228__dc20 96-11870 and Coulda Woulda Shoulda ©2001 Printed in the United States of America ISBN 0-9778691-72 First Edition: January 2006 To Sarah, JoJo, Austin and Mom Thanks again to Scott Snyder, Shelly Brown, Brian Schaer for the OptionVantage Software Graphics, Allan Wolff, Adam Frank, Tharma Rajenthiran, Ravindra Ramlakhan, Victor Brancale, Rudi Prenzlin, Roger Kilgore, PJ Scardino, Morgan Parker, Carl Knox and Sarah Williams the angel who revived the Appendix and Chapter 10. Extra Special thanks to Yehudah Grundman of The Kabbalah Centre International, for his support and guidance. Options Trading: The Hidden Reality v PRAISE "Having attended many options seminars I can honestly say that The Ri$k Doctor Webinars have been revolutionary to my options education. Unlike many other so called "options gurus" you do not try to attract people by promising them astronomical returns in fact you almost say the opposite...which is that if I am not prepared to put in the work to educate myself about the pitfalls in options trading it can be a very expensive mistake and I should better forget about trading options altogether. This was the first time I had heard anyone say this to me. The bottom line is that as an ex-market maker and trader you have practiced what you preach......unlike many people out there who have never traded but are more than happy to sell people courses on how to trade. .The way you examine, dissect and manage your risk in your trades has given my trading a significant edge. The weekly Webinars provide a great interactive platform to discuss and review new and old trades directly with you every week! I only wish I had found out about you sooner. In the past I have paid a lot more money to learn a lot less than what you have taught me.” THANK YOU! Tharma London, England “When I think back to my first discussion with Charles in 2001, I like to think that I had "Bambi Legs" as an options trader. I had worked as a clerk on an options floor, attended the expensive seminars, and had a decent grasp of the fundamentals. I had also gone nowhere in 2 years of trading my account and was getting frustrated. What followed for the next several years was a robust education in defining my trading self. From understanding the synthetic relationships inherent in options positions, to managing myself as a trader, Charles was critical in my development. The biggest takeaway for me to this day lies in the fact that Charles was the first teacher or coach who didn't set me up for failure by giving me unrealistic profit expectations. New traders need to define themselves, their risk tolerance, and what strategies mesh with those characteristics. If you've got baseless profit expectations, you'll never find these critical attributes. Charles always had me think about my positions and adjustments constantly in the present by asking: "If I had no position on right now, what would I want." Having a professional in my corner like Charles gave me the confidence to truly discover my trading personality and potential. I don't think I'd be trading for a hedge fund had I not worked with Charles. Don't find yourself asking Coulda Woulda Shoulda!” Justin California ©1996-2006 Charles M. Cottle [email protected] vi Praise “My goal this past year was to master and gain a deeper understanding of options. I am a practicing physician and a trader. It was a stroke of luck to come across the Ri$k Doctor, Charles Cottle, a true genius of options. RD’s approach to options brings to mind a series of analogies and similarities to the field of medicine as follows. As a medical doctor uses the CAT Scan or MRI to view potential human disease at the tissue or submicroscopic level, the Risk Doctor’s laser-like perception sees below the surface of an option strategy and reveals its true nature. “Primum non nocere” (first do no harm) is one of the most important dictums taught about patient management. Similarly, in his Webinars, the Ri$k Doctor teaches traders to first see and limit downside risks, while developing profitable option strategies, with and without an underlying stock or contract. He does this by teaching his followers to “card up” simple and complex options positions and then to use a variety of synthetic tools to see the true nature and position risks before entering a trade. Floor traders, whom RD has also instructed, sometimes use these very same valuable tools. Lastly, as a surgeon shows how to handle complications, so the RD teaches how to adjust to changing conditions in the real market on an ongoing basis. In the ongoing RD3 Webinar series, the Ri$k Doctor teaches by example, following the market real-time on a day-by-day basis and then posting his adjustments for each strategy as the market moves. He ultimately throws his followers into the fray and challenges each of them to construct an option strategy and make adjustments on their own that are appropriate for the perpetually changing market. In this unique scenario, his students have the opportunity of experiencing an almost real-live market trading experience, of putting their egos and emotions on the line, and then of learning from mistakes and oversights without risking hard-earned money. It’s as real as can be! For those who are serious about perfecting their option trading skills, RD’s Webinar series is like an exciting roller-coaster ride through the ups and downs of the options markets. I do not know of any other place that offers such a unique market ride. It is a sensational training experience!” Murph, MD New Jersey www.RiskDoctor.com www.RiskIllustrated.com vii Coulda Woulda Shoulda PREFACE Note: Hard Cover Printed in Color upgraded version of this Book called: “Options Trading: The Hidden Reality” available at www.riskdoctor.com/books.html. Highlights of what “The Hidden Reality” has that Coulda Woulda Shoulda (CWS) did not: Chapter 1 – More clarification and Color Illustrations Chapter 3 – 2D and 3D Graphs of the Greeks from Options: Perception and Deception (O:PD) Chapter 4 – Graphic Illustrations for Gamma Scalping Chapter 5 – Graphs of the Greeks for Verticals and More on Legging Spreads Chapter 6 – 2D and 3D Graphs of the Greeks for Butterflies, Butterfly Dissection, Skip- Strike-Flies Chapter 7 – Graphics and Dissection of Diagonals, Double Diagonals, Straddle Strangle Swaps and Double Calendars Chapter 9 – Hybrid Hedge (Adapted from Slingshot Article) Chapter 10 – O:PD’s Skew Library Chapter Appendix for Chapter 2’s Option Metamorphosis showing all dissections. WHY ANOTHER OPTIONS BOOK? This book is the revision of Options: Perception and Deception which was geared towards professional Market Makers who trade their own account. Market Makers look at positions differently. Most people reading this book know something about puts and calls. To be able to trade puts and calls, one needs a full grasp of the concepts. The market takes no prisoners. It simply kills those who do not have enough knowledge and are slow to make decisions. Try to solve the following exercise in less than 60 seconds. (In live audience presentations over 90% get the answer wrong.) Exercise: What amount of money is the most that one can lose with the following position? QQQQ is trading at 37.30, The 36 call is going for 1.70 and The 39 put is going for 1.90. A trader buys ten of each. Obviously, this is a good position if there is a large move in either direction but what is the worst-case scenario? Owning ten calls at 1.70 and ten puts at 1.90 is 3.60 ten times making a total investment of $3600 (10 x (1.70 + 1.90) x 100 shares). ©2001 Charles M. Cottle [email protected] viii Coulda Woulda Shoulda Most people figure the answer to be $3600, the limited risk amount invested—the loss is limited to the amount paid. This is incorrect. The answer is only $600 (10 x .60) x 100 shares. The proof and full explanation is in Chapter 1 just following Exhibit 1-9. After learning the market maker methods and grasping the concepts (which may be confusing at first, but it gets easier with practice), it will be possible to answer similar questions in less than 5 seconds.