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Worry-Free O Trading: Ption
Worry-Free O Trading: Ption
TRADING
Sergey Perminov
.
WORRY-FREE OPTION TRADING
by Dr.Sergey Perminov
ISBN 978-0-557-02562-6
.
CONTENT
PREFACE ..................................................................................... 1
Chapter 1. COMMON MISTAKES MADE BY TRADERS........ 3
Chapter 2. STRONG TECHNICAL SIGNALS, IDENTIFIED .... 7
Chapter 3. HOW STOCK OPTIONS WORK, AND WHICH ONE
TO CHOOSE................................................................................. 9
Chapter 4. KEY OPTION STRATEGIES................................... 13
BUY CALL ............................................................................ 15
SELL NAKED PUT ............................................................... 20
BULL CALL SPREAD .......................................................... 34
BUY PUT ............................................................................... 39
BEAR CALL SPREAD.......................................................... 41
BEAR PUT SPREAD............................................................. 43
BUY STRADDLE .................................................................. 45
BUY STRANGLE .................................................................. 47
Chapter 5. HOW TO USE PROBABILITY ESTIMATES IN
OPTION TRADING ................................................................... 49
.
PREFACE
No, this book is not about traveling in time. And it’s not about
fortune-telling. It is about a trading system we developed on the
basis of sound statistical and probability theories – a system which
has proved to be the most certain and consistent tactic to make
profit in any market.
PREFACE 1
Chapter 1
_________________
What kind of market play would fit your requirements and keep
you worry-free? Let us consider a hypothetical situation: you toss
a coin and see what you get. If heads, you lose $1. If tails, you get
$1,000. Would you agree to play this game? Of course, you would
- the answer is obvious. Unfortunately, situations of that simple
kind do not exist in reality.
View the stock market is an ocean, where one wave comes after
another. Take the losses easy. Don't try to convince yourself that a
bad trade will turn soon into a good trade. The stock market offers
endless and overflowing possibilities. Prices keep changing and
create opportunities: missed opportunities exist only in your mind.
Winning traders are able to ride through the downturn periods.
The purpose of trading is to make a net profit in a sequence of
trades.
1
You can find more about the stochastic oscillator and other technical indicators at
http://www.equis.com
This is where our approach is unique: we scan the market data and
select the stocks with strong technical signals. Then we determine
the best suitable trading vehicles – option strategies with better
risk/reward ratio.
The same holds for a put option. Since the buyer (holder) of a put
option has a right to sell stock at the striking price, the seller
(writer) of a put has no choice but to buy that stock if the market
price drops below the strike and the buyer decides to exercise the
option.
2
An exchange traded option contract provides for the right to buy or sell 100
shares of stock and has four specifications: option type (put or call), name of the
underlying stock, expiration date and strike.
Is There Any
Intrinsic Call Option Put Option
Value?
In-the-
Strike < stock Strike > stock
Money Yes
price price
option
At-the-
Strike = stock Strike = stock
Money No
price price
Option
Near-the-
Strike is close Strike is close
Money -
to stock price to stock price
Option
Out-of-the-
Strike > stock Strike < stock
Money Yes
price price
Option
Let’s say the price of Stock ABC is $40 one week before the
expiration. Option with a $40 strike would cost $2. Option with
the same strike but for the next expiration month would cost more:
$4. The option always costs more than the differential between
the strike and the current stock price. The difference exists
because the future underlying stock price may move higher than
$40. If the underlying stock rises, let’s say, to $45, the call
premium rises above $8.
Option prices for any stock depend on its current price and the
market opinion about its movements in the future. The “public”
opinion of market players is reflected in the so-called volatility,
which measures how much the underlying stock is expected to
fluctuate in a given period of time.
Delta. The rate of option price change relative to one unit change
of the price of underlying stock or index. Call options have
positive deltas, while put options have negative deltas.
Theta. A measure of the rate of time value decay that shows how
much an option loses per day.
Strategy in brief: Buy a call option and benefit from the stock
price upturn.
When to use this strategy: you are very bullish on the stock. The
more bullish you are, the higher strike you should choose.
Comments:
No other strategy gives you so much leveraged advantage
with a limited downside risk.
You can participate in the upward price movements by
paying just the option price (a fraction of a stock price) –
that’s all your investment at risk.
This strategy provides a great advantage over the outright
stock purchase when you risk ten times more capital.
15
Profit on Expiration
10
0
110 115 120
-5
-10
Stock Price
1. The higher the strike, the less you pay for participating in
the upward stock price movement. Many call option
buyers intuitively prefer out-of-the-money options. This
is a very common mistake. Absolute price really doesn’t
matter! However, keep in mind that the stock might not
swing up that high and your option can stay out-of-the-
money on expiration. You must be very bullish to select
this strike. Besides, prices of options with higher strikes
contain no intrinsic value: all they have is time value (and
not so much of it, compared to other strikes), which
erodes over time.
2. Options with lower strikes contain less time value (which
you overpay for) and are less risky. At the same time,
these options require a higher investment, thus making
you risk more money.
3. Options with more distant expiration dates are less prone
to time value decay. This is a good thing for option
buyers. At the same time, they are less sensitive to the
underlying stock price changes (by having lower deltas),
thus being not so good for short-term speculations.
4. Some option traders bet on a difference between the
actual and theoretical, “fair” prices. Assuming that a call
option is “underpriced”, they expect its price to rise soon.
Needless to say, this play can be very risky because the
option price depends on too many factors. The most
important of these factors is the underlying stock price: if
it drops, the option price would fall substantially.
5. When the underlying stock moves higher and option
holder gets an unrealized profit, the following “roll-up”
tactic has become popular: you sell the call option, return
the initial investment and use the remaining proceeds to
buy as many calls with higher strikes as possible. If the
stock continues to surge, you enhance your return
"Buy Call" strategies have much more risk and return than the
"Buy Stock" strategy. Your choice of a strategy is influenced by
two factors: first, your forecasted stock price for the period before
the call option expires; and second, your risk averseness, or how
much extra risk you are willing to take for each additional unit of
profit.
You can see below four price intervals: $99 (break-even for ‘less
bullish’ strategy) to $105 (intersection of ‘moderate bullish’ and
‘very bullish’), $105 to $108 (intersection of ‘less bullish’ and
‘very bullish’), $108 to $110 (intersection of ‘moderate bullish’
and ‘very bullish’), and $110 and up.
Figure 4 also shows that when the price is between $95 (current
stock price) and $99 (break-even for ‘less bullish’ strategy), the
‘buy stock’ strategy is preferred over all ‘buy call’ strategies. To
summarize, the choice of strategies is defined by two things: your
contemplation about the future stock price and your attitude to
risk.
400%
300%
200%
Less Bullish
100%
Moderate Bullish
0%
-100% 105 110 Very Bullish
-200% Buy Stock
-300%
-400% Stock Price on Expiration
10
0
110 115 120
-5
-10
Stock Price on Expiration
Let’s look again at the example presented above. When you sell
one contract of IBM Oct 115 Put at $5.30, your maximum profit is
$530. The loss is the difference between the strike and stock price
at expiration. However, no net loss will be realized if the stock
Thus, considering both volatility and trend, we find out that the
buyer of the put is paying extra because of the overestimated risk
(in fact, the price is unlikely to drop to the CAE area). In this
particular case, the price indeed went up and allowed the writer to
either buy the put back and make money, or to wait for the put to
expire worthless.
Let's compare three "sell naked put" strategies and stock buying.
You can see that "efficient frontier" includes only "sell naked put"
(the black points on the chart) strategies. They clearly dominate
the "Buy stock" strategy (the red point), which is more risky and
less profitable than "very bullish" "naked put" strategy. These
conclusions are based on technical analysis and forecasted
volatility.
Figure 11: Sell Naked Put Strategies Vs. Stock Buying Example – Conclusion
250
Expected Ann. Return (%)
200
150
100
50
0
70 75 80 85 90 95
"No losses" Probability (%)
10.0
8.0
6.0
4.0
2.0
0.0
-2.0 110 115 120
-4.0
-6.0
-8.0 Stock Price
Moderate
Bullish 115 4.4 109.68 5.32 4.50% 3.70% 3.90% 4.40
Very
Bullish 120 2.45 111.63 8.37 7.20% 2.10% 2.10% 2.45
“Sell covered call” strategies are less risky and less profitable
compared to ‘buy stock’ strategy. In our example, such strategies
can be used when the stock price is between $81 (break-even for
‘less bullish’) and $100 (intersection of ‘buy stock’ and ‘very
bullish’ strategies). Depending on the amount risk you are willing
to take for more profit, you can chose between options with
different strikes. ‘Buy call’ strategy is preferable when the stock
price goes above $100. ‘Sell covered call’ strategy is a good
profit-making instrument when you anticipate slight changes in
the stock price either up or down.
Less Bullish
Moderate Bullish
Very Bullish
Buy Stock
Strategy in brief: Buy put option with a lower strike and sell
another put with a higher strike producing a net credit.
When to use this strategy: you expect the stock to go up, or at
least you believe it is a bit more likely to rise than to fall.
Comments:
Both options should have the same expiration date.
This is a good position if you want to be in the stock but
are unsure of bullish expectations.
This is the most popular bullish strategy, along with the
“Bull Call Spread”.
0
110 115 120
-2
-4
Stock Price
Figure 18: Bull Put Spread Vs. Stock Buying Example – Results at Expiration
Less Bullish
200%
Moderate
100% Bullish
0% Very Bullish
-100% 110 115 120
Buy Stock
-200%
-300%
-400%
-500% Stock P rice
Strategy in brief: Buy call option with a lower strike and sell
another call with a higher strike producing a net debit
When to use this strategy: you expect the stock to go up or at
least to be a bit more likely to rise than to fall.
Comments:
Both options should have the same expiration date.
This is a good position if you want to be in the stock but
are unsure of bullish expectations.
This is the most popular bullish strategy, along with the
“Bull Put Spread”.
10
8
6
4
2
0
110 115 120
Stock Price
Position Price
Buy One Nov
3.00
50 Call
Sell Two Nov
1.50
55 Call
Both options that you sold are covered: one by the stock itself,
another one by another "leg" of the bull spread. Note that you
haven't spent any extra money yet.
Figure 22: Bullish Call Spreads Vs. Stock Buying Example – Results at
Expiration
Figure 23: Bullish Call Spreads Vs. Stock Buying Example – Profit Potential
Less Bullish
200% Moderate Bullish
0% Very Bullish
-200% 110 115 120 Buy Stock
-400%
-600%
Stock Price
Strategy in brief: Buy a put option and benefit from the stock
price downturn.
When to use this strategy: you are very bearish on the stock.
Comments:
The more bearish you are, the more out-of-the-money
(lower strike) your option should be.
No other position gives you as much leveraged advantage
in a falling stock (with a limited upside risk).
10
0
110 115 120
-5
-10
Stock Price
4
2
0
-2 110 115 120
-4
Stock Price
1. The more bearish you are, the lower strikes you should
select. It gives you more credit and requires more
substantial stock price downward movement to realize
the profit potential.
2. This strategy doesn’t require any investment because this
is a credit spread. It only reduces the buying power of
trader’s margin account.
Strategy in brief: Buy put option with a higher strike and sell
another put option with a lower strike, producing a net debit.
When to use this strategy: you think the stock will go down
somewhat or at least is a bit more likely to fall than to rise.
Comments:
Good position if you want to be in the stock but are
unsure of bearish expectations.
This is the most popular bearish strategy.
4
2
0
-2 110 115 120
-4
Stock Price
Bear put spreads have the following advantages over bear call
spreads:
a. You are not risking early exercise of short
option.
b. Bear put spreads perform much better if the
underlying stock drops quickly.
Strategy in brief: Call option and put option are bought with the
same usually at-the-money strike.
When to use this strategy: you strongly believe that the stock
moves far enough in either direction in the short run.
Comments:
Buy higher/lower strike options if the position can
encounter different probabilities of bullish/ bearish
movements of the stock.
Buy at-the-money options if those probabilities are
almost equal.
10
5
0
-5 110 115 120
-10
-15
Stock Price
5
0
-5 110 115 120
-10
-15
Stock Price
Potential Potential
Profit Loss
Strategy
$1,000 $100
1
Strategy
$50 $100
2
Which one is better? Most people would say the first strategy is
far better. Experienced traders would ask: What are the
probabilities?
Potential Potential
Profit Loss
Amount $1,000 $100
Probability 5% 95%
Potential Potential
Profit Loss
Amount $50 $100
Probability 90% 10%
70%
"No Losses" Probability
60%
50%
40%
30%
20%
10%
0%
$0.00 $1.00 $2.00 $3.00 $4.00
Expected Profit per $1