7700++ DDVVDD’’ss FFOORR SSAALLEE && EEXXCCHHAANNGGEE wwwwww..ttrraaddeerrss--ssooffttwwaarree..ccoomm wwwwww..ffoorreexx--wwaarreezz..ccoomm wwwwww..ttrraaddiinngg--ssooffttwwaarree--ccoolllleeccttiioonn..ccoomm wwwwww..ttrraaddeessttaattiioonn--ddoowwnnllooaadd--ffrreeee..ccoomm CCoonnttaaccttss aannddrreeyybbbbrrvv@@ggmmaaiill..ccoomm aannddrreeyybbbbrrvv@@yyaannddeexx..rruu SSkkyyppee:: aannddrreeyybbbbrrvv 1029G_fm_i-xiv.qxd 3/11/04 17:23 Page iii The Option Trader Handbook Strategies and Trade Adjustments GEORGE M. JABBOUR, PhD PHILIP H. BUDWICK, MsF John Wiley & Sons, Inc. 1029G_fm_i-xiv.qxd 3/11/04 17:23 Page x 1029G_fm_i-xiv.qxd 3/11/04 17:23 Page i The Option Trader Handbook 1029G_fm_i-xiv.qxd 3/11/04 17:23 Page ii Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in NorthAmerica, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our cus- tomers’ professional and personal knowledge and understanding. The 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. Whether a novice trader, professional or somewhere in-between, these books will provide the advice and strategies needed to prosper today and well into the future. For a list of available titles, please visit our Web site at www.WileyFinance.com. 1029G_fm_i-xiv.qxd 3/11/04 17:23 Page iii The Option Trader Handbook Strategies and Trade Adjustments GEORGE M. JABBOUR, PhD PHILIP H. BUDWICK, MsF John Wiley & Sons, Inc. 1029G_fm_i-xiv.qxd 3/11/04 17:23 Page iv Copyright © 2004 by George Jabbour and Philip Budwick All rights reserved. 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HG6024.A3 J32 2004 332.64'53—dc22 2003026646 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 1029G_fm_i-xiv.qxd 3/11/04 17:23 Page v Contents Preface xi CHAPTER 1 Trade and Risk Management 1 Introduction 1 The Philosophy of Risk 2 Truth about Reward 5 Risk Management 7 Risk 7 Reward 10 Breakeven Points 11 Trade Management 12 Trading Theme 12 The Theme of Your Portfolio 15 Diversification and Flexibility 16 Trading as a Business 16 Start-Up Phase 17 Growth Phase 20 Mature Phase 20 Just Business, Nothing Personal 21 SCORE—The Formula for Trading Success 22 Select the Investment 22 Choose the Best Strategy 24 Open the Trade with a Plan 24 Remember Your Plan and Stick to It 26 Exit Your Trade 27 CHAPTER 2 Tools of the Trader 29 Introduction 29 Option Value 30 v 1029G_fm_i-xiv.qxd 3/11/04 17:23 Page vi vi CONTENTS Option Pricing 31 Stock Price 32 Strike Price 32 Time to Expiration 32 Volatility 32 Dividends 33 Interest Rates 33 Time Value Premium 33 Time Decay 33 Early Assignment 36 Implied Volatility 38 Synthetic Positions 41 Synthetic Stock 42 Synthetic Call 44 Synthetic Put 46 Basic Strategies 47 Long Call 47 Short Call 48 Long Put 48 Short Put 50 Basic Spreads and Combinations 50 Bull Call Spread 51 Bull Put Spread 51 Bear Put Spread 52 Bear Call Spread 53 Long Straddle 54 Long Strangle 54 Short Straddle 56 Short Strangle 57 Advanced Spreads 58 Call Ratio Spread 58 Put Ratio Spread 59 Call Ratio Backspread 60 Put Ratio Backspread 61 Long Butterflies 62 Short Butterflies 63 CHAPTER 3 Long Stock 65 Introduction 65 Protective Put 66 Stock Moves Higher 69 Stock Moves Lower 71