Fundamentals of Options Market


Options are an investment vehicle that can enhance virtually any investment philosophy. Fundamentals of the Options Market provides a clear, concise picture of this global marketplace. Using examples drawn from

contemporary financial news, this completely accessible guidebook describes why and how these versatile tools can be used to hedge risk and enhance return, while explaining popular products including listed stock options, index options, ...

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Options are an investment vehicle that can enhance virtually any investment philosophy. Fundamentals of the Options Market provides a clear, concise picture of this global marketplace. Using examples drawn from

contemporary financial news, this completely accessible guidebook describes why and how these versatile tools can be used to hedge risk and enhance return, while explaining popular products including listed stock options, index options, and LEAPS.

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Product Details

  • ISBN-13: 9780071363181
  • Publisher: McGraw-Hill Professional Publishing
  • Publication date: 12/19/2000
  • Series: Fundamentals of Investing Series
  • Edition number: 1
  • Pages: 340
  • Product dimensions: 8.50 (w) x 10.70 (h) x 0.76 (d)

Meet the Author

Michael S. Williams is president and CEO of Market Compass, LLC, which specializes in financial education for investors and traders online, via the Internet, and through the PCX Institute. Williams has been an options market maker on the Pacific Exchange (PCX) for nearly a decade. He is a frequent speaker at conferences around the country including the TSAA annual conference, the Options Industry Council seminars, and The Money Show.

Amy S. Hoffman is a founder and vice-president of Market Compass, LLC. She has been an options market maker on the Pacific Exchange (PCX) trading for hedge funds and as an independent market maker. Hoffman's financial career began in 1989 as a compliance officer and in-house trader for a large commodities firm. She is currently an instructor for the PCX Institute and Options Industry Council.

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Read an Excerpt

Chapter 1: Introduction to Options

Why Stock Options?

Most Americans are aware today of the unprecedented explosion that has taken place in stock investing and ownership over the past 10 years. Whether through their retirement plans at work or in their personal investment accounts at home, a rapidly growing number of American households now own stock in publicly traded companies. Also well documented is the fact that an increasing number of individual investors axe actively involved in making their own investment decisions, specifically in the area of buying and selling stock. Less widely known, however, is that alongside this escalating interest in personal investing and portfolio management is a growing curiosity about the potential benefits of stock-option trading.

In fact, evidence shows that the excitement of this new opportunity has led many new online traders to rush into trading with a get-rich-quick mentality. The attitude is "buy low, sell high." New traders are so eager to make money in the marketplace that they commit a majority of their capital to a position without taking the time to analyze the risk/reward profile. At this writing, all evidence indicates that the majority of all day traders are losing money. There are several reasons. First, most day traders do not fully understand risk management. Rather, their primary strategy is essentially based on hope. Second, they are committing too much capital to a position, and they are not treating trading as a business. Instead, they treat it as a lotto game. The California Lotto slogan rings so true with the day-trading herd: "You can't win if you don't play!" How many lotto winners do you know?

On the other hand, those who have been less quick to act (the cautious investors among us) have remained on the sidelines, reflecting on what they have heard concerning the inherent risks of option trading. Having read that options are primarily used for speculation and that most will expire as worthless, these investors turn their backs on options and on the potential that they have for enhancing their investment or trading performance. What we can see, then, is that although stock-option trading is steadily gaining legitimacy, many of today's newcomers-the enthusiastic and cautious alike-do not sufficiently understand stock options in order to use them effectively as components of an overall investment strategy.

As professional options traders, we have been buying and selling options for a living for many years. We understand the risks and rewards of options in a way that the individual investor might not, and from that standpoint, we believe that for both the enthusiastic and cautious investor, a sound education in stock-options trading is a necessary investment. From our vantage point, we get to see how investors are using (and, in some cases, abusing) stock options. In addition, options trading can be risky-especially for those who want to use options speculatively in order to create quick wealth. Yet, at the same time, we are more than familiar with the ways in which options can be used to preserve existing wealth and create predictable sources of income. How you use options is what matters. We would like to encourage the enthusiastic and hesitant investor alike to use this book in order to obtain the real facts about stock options. Our strong belief is that individual investors can and should learn how to use stock options intelligently and prudently-and in so doing, they will make themselves available to new horizons in trading and investing. Consider, after all, that although the consequences of an accident or equipment failure can be devastating, most of us drive cars anyway. We have decided that the benefits derived from driving are worth the risk. In both cases, we are all the more likely to benefit if we learn how to be good drivers and when to follow code. Options trading/investing is much the same.

History of Options

The Earliest History

The use of options in an attempt to ensure economic security or financial gain dates back in our history much farther than most people would expect. The first published account of options use was in Aristotle's Politics, published in 332 B.C. According to Aristotle, Thales, a fellow philosopher, was said to be the creator of options. Thales was not only a great philosopher but also a great astronomer and mathematician. In response to criticism that his profession had no merit, Thales used his ability to read the stars in order to forecast future weather patterns. His skill enabled him to predict a large olive harvest in the coming year.

Thales, however, had little money and was unable to secure the use of the olive presses for their full value, so he put deposits on all of the presses that existed for miles and miles. In doing so, he used a small amount of money to secure the right to use the presses come harvest season. When olive-picking time came around and the presses were in great demand, Thales was able to sell his options for a great deal more than he paid for them. Unknowingly, perhaps, Thales had created the first option contract. He purchased the right to use the presses, not the presses themselves. In doing so, he was able to use considerably less money than he would have if he purchased the presses themselves. Owning the right gave Thales the ability to use the presses during harvest time himself (or to sell his options when, due to the demand, they would be worth considerably more than when he entered the contract). The seller, on the other hand, was happy to sell the right to use the presses, because it ensured that the seller would receive income whether the harvest was successful or not. In securing a price for the presses, however, the seller gave up the right to charge the customers more for use of the presses during a record harvest. Thales' foresight enabled him to reap this benefit. Clearly, then, Thales was able to redeem philosophy and astronomy from any accusations that its practitioners had their heads in the clouds.

Options sprang up again during the tulip mania of 1636. Tulips were first imported into Europe from Turkey in the 1500s. These brightly colored flowers gained in popularity, and the demand increased for all types of bulbs. By the early 17th century, tulips had become a symbol of affluence; demand began to outweigh supply; and tulip bulb prices rose dramatically...

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Table of Contents

Introduction xvii
1. Introduction to Options 1
Why Stock Options?
History of Options
The Earliest History
The Birth and Rise of Today's Options Industry
Options: A Conceptual Overview
Example: Undeveloped Land
Example: Property / Health Insurance
2. Characteristics of Stock Options 9
Underlying Security
The Two Types of Stock Options
Call Option
Put Option
Strike Price / Exercise Price Expiration Cycle
Unit of Trade / Contract Size
Option Styles Option Styles: LEAPS and FLEX Options
Option Class Reading Options Quotes
3. Building Blocks 25
Long Stock
Short Stock
Long Call
Short Call
Long Put
Short Put
Graphing an Option Position
4. Pricing Options 37
Option Status Relative to the Underlying Stock
Factors Affecting the Price of an Option Extrinsic Value
Pricing Models: An Overview
Pricing Model Variables
Theoretical Value versus the Marketplace
5. Option Volatility 55
Measures of Volatility
Factors Influencing Implied Volatility
The Importance of Implied Volatility
Volatility's Impact on the Pricing Model
Pricing Models and Price Movement
Standard Deviation
Volatility, Standard Deviation, and Mean
Pricing Models and Option Theoretical Value
6. Introduction to Synthetics 71
Pricing Synthetics
The Synthetic Triangle
Conversion / Reversal
Conversion / Reversal and Free Money
Conversion / Reversal Risks
Interest-Rate Risk
Closing at the Strike
7. The Greeks 85
The Greeks
Delta Probability of an ITM Finish upon Expiration
Delta and Time
The Trouble with Deltas
Gamma and Time
Vega Vega and Time
8. Position Trading 107
Panic Sell-Off Expectation: The Bounce
Market Maker
General Observations on Position Trading
Directional Risk Hedging
Delta Neutral versus Contract Neutral Spreading
Hedging Summary
9. Option Strategies 125
Market Outlooks
Spreads Legging
Bullish Strategies
Bullish: Long Stock
Bullish Long Stock (Margined) Bullish Long Calls
Leveraged Risk
The Delta Position Managing the Position
A Moderately Bullish Bull Spread
Call Bull Spread
Put Bull Spread
Bullish: Ratio Bull Spread (Long)
Managing the Position
Bearish Strategies
Bearish: Short Stock
Bearish: Long Puts
Leveraged Risk
The Delta Position
Managing the Position
Moderately Bearish: Bear Spread
Put Bear Spread
Call Bear Spread
Bearish: Ratio Bear Spread (Long)
Managing the Position
Neutral Strategies
Covered Call Writing / Buy Write
Long-Term Strategy
Short-Term Strategy
Bull Spread Covered Write / Buy Write Horizontal Calendar Spread
Diagonal Calendar Spread Straddle (Short)
Managing the Position
Strangle (Short) Managing the Position
Ratio Bull Spread (Short)
Ratio Bear Spread (Short)
Volatile Strategies ("Backspread")
Straddle (Long)
Market Risks: Analyzing the Greeks
Managing a Long Straddle
Market Risks: Analyzing the Greeks
Managing a Long Strangle
Volatile Strategy Summary
The Truth about Butterflies
Neutral Strategies
Volatile Strategies
Summary Risk-Reduction Strategies
Protecting Unrealized Profit Married Puts
Risk Collar / Fence
Long Underlying Security (Risk Collar / Fence)
Short Underlying Security (Risk Collar)
10. Market Making 231
Who Are Market Makers?
Individual Trader versus Market Maker
Trading Styles
Backspreader Frontspreader
Market Maker Trading: An Overview
Market Making As a Business
A Market Maker's Complex Positioning Profit and Hedging
11. The Marketplace 243
Introduction to Stocks
Historical Quotes
Real-Time Quotes Reading Stock Quotes
The Exchanges
The Specialist System NASDAQ and the Market-Maker System
Options Exchanges Rules of the Option Exchange
The Exchange Floor Staff and Members
The Exchange Staff
Stock Firms / Clerks
Analyzing the Marketplace
Fundamental Analysis
CBOE Volatility Index--VIX
Put-to-Call Ratio
Weighting Indices Using Indices
12. Getting Started 265
Trading Stock
Executing New York Stock Exchange (NYSE) Orders
Executing NASDAQ Stock
Executing NASDAQ Orders
Options Execution
Electronic Floor Broker Execution
Trading Accounts
The Exercise / Assignment Process
Trade Station
The Brokers and Brokerage Firms
Questions to Ask Brokerage Firms
Data Providers
A. Order Types 285
All-or-None (AON) Order
Day Order
Market Order (MKT) Stop Orders
Fill-or-Kill (FOK) Order
Good-Until-Canceled (GTC) Order
Limit Order
Market-on-Close (MOC) Order Market-if-Touched (MIT) Order
B. Strategy Formulas 289
Married Put
Protecting Unrealized Profit
Covered Call Potential
Bull Spread (Long Call Spread)
Bull Spread (Short Put Spread)
Bear Spread (Long Put Spread)
Bear Spread (Short Call Spread)
Ratio Bull Spread (Long)
Ratio Bull Spread (Short)
Ratio Bear Spread (Long)
Ratio Bear Spread (Short)
Long Straddle
Short Straddle
Long Strangle Short Strangle
Long Butterfly
Short Butterfly
Long Iron Butterfly
Short Iron Butterfly
Long Condor
Short Condor Risk Collar/Fence (Risk Conversion)
Risk Collar/Fence (Risk Reversal)
C. Indices 295
Sector Indices
Broad-Based Indices
Foreign Market Indices
D. Expiration Cycles 299
E. Fractions to Decimal Conversion Chart 303
F. The Options Clearing Corporation (OCC) 305
Stock Options Exchanges
G. Intrinsic and Premium Formulas 307
Call Intrinsic Value
Put Intrinsic Value Call Premium Value
Put Premium Value
H. The Black-Scholes Model 309
The Binomial Model
I. Quiz Answers 311
Glossary 319
Index 333
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