1 CONTENTS INTRODUCTION ....................................................................................................... 5 PART 1 BASICS OF OPTIONS THEORY ............................................................ 8 CHAPTER 1 OPTIONS: HISTORY AND HISTORICAL APPROACHES TO PRICING ............. 9 CHAPTER 2 COMPONENTS OF OPTIONS PRICING AND CALCULATION SHORTCUTS .... 19 CHAPTER 3 RATIONAL USE AND CAPITAL PRESERVATION ....................................... 41 CHAPTER 4 THE OTHER SIDE OF THE MARKET: HOW MARKET-MAKERS MANAGE POSITIONS .............................................................................................................. 53 PART 2 TRADING PSYCHOLOGY THROUGH THE PRISM OF BEHAVIORAL FINANCE ...................................................................................... 60 CHAPTER 5 PSYCHOLOGICAL ISSUES OF TRADING AND DECISION MAKING ............... 61 CHAPTER 6 HEURISTICS AND BIASES..................................................................... 67 CHAPTER 7 PROSPECT THEORY ............................................................................ 82 PART 3 FUNDAMENTALS OF DIRECTIONAL OPTIONS TRADING ........ 86 CHAPTER 8 VERTICAL AND RATIO SPREADS ........................................................... 87 CHAPTER 9 PLAYING DEFENSE: ENHANCED OPTION STRATEGIES FOR UNHEDGED POSITIONS ............................................................................................................ 100 CHAPTER 10 LEGGING IN RATIO SPREADS AND BUTTERFLIES ............................... 114 CHAPTER 11 OBSERVATIONS ABOUT BASIC STRATEGIES AND PROBLEMS OF OVERTRADING ...................................................................................................... 119 CHAPTER 12 OTHER DEFENSIVE AND OFFENSIVE STRATEGIES ............................. 125 CHAPTER 13 STRATEGIES BASED ON FINANCING RATES ....................................... 132 PART 4 APPLYING DIRECTIONAL TRADING PRINCIPLES TO MARKET STRATEGIES................................................................................ 141 CHAPTER 14 GENERAL CONSIDERATIONS IN OPTIONS STRATEGIES ....................... 142 CHAPTER 15 MARKET BEHAVIOR SCENARIOS AND INVESTMENT ALTERNATIVES...... 152 CHAPTER 16 BASING OPTIONS STRATEGIES ON CORRELATIONS OF UNDERLYING ASSETS ................................................................................................................. 157 2 CHAPTER 17 OPTIONS, PSYCHOLOGY, TECHNICAL ANALYSIS AND POSITION RISK MANAGEMENT ...................................................................................................... 165 CONCLUSION ........................................................................................................ 179 INDEX ...................................................................................................................... 181 GLOSSARY ............................................................................................................. 185 BIBLIOGRAPGHY ................................................................................................ 197 FOOTNOTES .......................................................................................................... 200 3 ACKNOWLEDGEMENTS I express my gratitude to Donald R. Nichols and Jack Walker who were especially helpful in the final review and editing and in providing great ideas for better structuring of the book. My colleagues Alekper Safarov and Tatyana Tsiryulik were invaluable for their technical support and search for materials. 4 INTRODUCTION Publically traded options have become more accessible, attractive, and essential for personal and professional investors than at any time during the past 30 years. Options contracts now trade on hundreds of domestic and international stocks, commodities, futures, and indices, and they’re available (albeit to qualified investors) through nearly every brokerage firm. They’re more attractive because greater volatility in global markets enhances options’ potential to earn returns and hedge risk. They’re more essential precisely because of that volatility: When markets are volatile, you can profit and protect your portfolio by putting less capital at risk. To all that, we might add another factor—namely, that in some regard market-moving events are becoming more apparent to forecast and time, as was the case in the US during August 2011 and in Europe during the spring of 2012. Investors turn to options to benefit from these new opportunities or to reduce risk while implementing strategies reflecting their market views. The book is ideal for sales professionals, directional investors, and hedgers who want to take advantage of all these opportunities. Those who are new to options may find the recap of theory useful, as main theoretical concepts and their practical implications are condensed in the first two chapters. Some issues that many investors rarely pay attention to are emphasized to help salespeople explain their recommendations. Directional investors hopefully will find valuable the discussion of relative value of different options strategies and their defense in adverse circumstances. Your author has worked in this business more than 20 years and has used options on a variety of underlying instruments while working in the US and Russia. Hence, this book includes examples from options on different underlying assets as well as from developed and emerging markets. Among the issues the book covers are those that arose during the recent crises. In other words, readers may find those observations informative if they’re interested in understanding other options markets and want to be better prepared for events not experienced in their markets. Chapters covering the basics of trading are based on lectures and presentations the author gave to investors who were starting to use options in their trading or hedging in many countries. The part of the book devoted to directional trading condenses your author’s hard-learned lessons as a proprietary options trader when he switched from being an options market-maker who’d managed delta-neutral strategies to a directional investor. Originally, he thought the transition would be relatively easy. That turned out to be a naïve thought. Most OTC and exchange- traded options market-makers have trouble adjusting to directional trading (cash market-makers even more so). Everyone discovers he/they can lose money on any 5 directional options position since they have a nasty tendency to expire before the market makes its predicted turn. Former market-makers suffer a shock when they see profits disappear into the market-maker’s bid / offer spreads. These two incidents alone force many investors to consider optimizing his trading merely just to stay in the game. If you manage money for a fund or want to attract capital under management, those lessons and many others need to be learned under the eagle eye of asset allocators who constantly require stable performance. Needless to say, the adjustment to directional investing is stressful and life becomes easier after gaining the knowledge and experience described in this book. Similar difficulties await investors, including individual investors, who turn to options after gaining experience trading underlying assets. For most such investors, options provide additional leverage in the preferred direction. Although former market-makers have a less-developed sense of direction than investors who traded the underlying assets, the latter have less feel for factors that affect volatility and less insight into selecting the right strike prices and expiration horizon. This book discusses aspects of options trading that both types of investors lack: building a rational selection process in directional trading. Options are well-known instruments, and numerous books describe every facet of this complicated business. However, we’ll look at practical issues, which are less often discussed. The title of the original version of this book—Playing Chess-like Games with Options—reflected how directional options strategies are a multistep undertaking. This book helps you to build upon a series of market scenarios for both the underlying security and its options. Then it assists in identifying opportunities to optimize your available financial resources, thus reducing risks of failure. However, every market participant encounters problems. This book shows ways to defend positions when markets refuse to cooperate. In other words, it reviews well-known aspects of options trading, presents seldom-discussed issues, and builds the multistep investment process required for success in directional trading or advising clients on optimal strategies. One key to success in any type of trading is understanding market psychology, now a highly publicized concept. Managing your personal psychology is less discussed. Psychological issues involving a specific field such as options trading are nearly unheard of. However, attempting to optimize your trading style without understanding the psychological issues you’ll face isn’t practical. This book points out reactions and adjustments that have to be controlled. Adapting concepts from behavioral finance to options trading is an especially helpful aspect of this book. In some ways, this book is built on crumbs of generally known concepts. Some will find the nitty-gritty of options strategies excessively detailed. But those details become valuable once you recognize issues that long have bothered you but 6 which you had no time to explore. Just as no one can fully