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Options for everybody
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Options for everybody

Simple. Profitable. Trading.

1st edition

Stefan Deutschmann

I M P R I N T Options for everybody

Simple. Profitable. Trading.

1st edition

© 2018-2019 Stefan Deutschmann.

All rights reserved.

Author: Stefan Deutschmann

E-Mail: stefan1deutschmann@gmail.com

Cover: Samantha Stückroth

E-Mail: s.stueckroth@live.de

Publishing Company: self-published

Printed version (German only): epubli – a part of neopubli GmbH, Berlin

Inhaltsverzeichnis

I M P R I N T

Figures

List of abbreviations

Foreword

1. General information

1.1 A game of probabilities?!

1.2 What is an option?

1.3 Stocks vs. Options

2. Basics

2.1 Main Features of Options Contracts

2.2 Basics: Call vs. Put

2.3 Buying or selling Options?

2.4 Profit Loss (PL) Diagrams

2.5 Repitition: Understanding Call Options

2.6 Repitition: Understanding Put Options

2.7 Option Moneyness (ITM, OTM, ATM)

2.8 Extrinsic & Intrinsic Value

2.9 “The greeks”

2.10 Volatility

2.11 Probability of Profit (POP)

2.12 Standard deviation

2.13 Trading the probabilities

2.14 Bid-Ask-Spread

2.15 Volume & Open Interest

2.16 Nominal value & Buying Power

2.17 Expiration of options & Asignment

2.19 Earnings

2.21 Using correlation for diversification

2.22 Market awareness

2.23 Number of occurences

2.24 The "real" probability

2.25 “Black Swan” Events

3. Strategies

3.1 How do I choose the right strategy?

3.2 Naked Put Options

3.3 Naked Call-Options

3.4 Covered Call

3.5 Vertical Debit Spread

3.6 Long Call Vertical Spread

3.7 Long Put Vertical Spread

3.8 Vertical Credit Spread

3.9 Short Put Vertical Spread

3.10 Short Call Vertical Spread

3.11 Strangle

3.12 Iron Condor

3.13 Straddle

3.14 Iron Fly

4. The 1x1 of the trade

4.1 Opening a trade

4.2 Closing a trade

4.3 Option strategies for beginners

4.4 Which strategies do we not adjust and why?

4.5 Adjustment of loss positions

4.6 Why roll options?

4.7 Holistic consideration of adjusting

4.8 Adjusting a „naked“ Option

4.9 Adjusting Strangles and Straddles

4.10 Why you should not use Stop Loss Orders

5. Trading successfully

5.1 Repetition of the most important basics

5.2 Anxiety and control

5.3 Managing winners

5.4 What is to be considered before entering the trade?

5.5 What is the difference between strategies with and without predefined loss limits?

5.6 How does VIX help you choose the right strategy?

5.7 Procedure and execution of a trade (Option selling)

5.8 Procedure and execution of a trade (earnings trade)

5.9 Procedure and execution of a trade (trading volatility)

5.10 Procedure and execution of a trade („close your eyes and sell puts“)

5.12 Procedure and execution of a trade (Ratio-Spreads)

5.13 Daily routine

6. Cheat-Sheets

Bullish Strategies

6.1 Covered Call

6.2 Long Call Diagonal Spread

6.3 Naked Short Put

6.4 Long Call Vertical Spread

6.5 Short Put Vertical Spread

Baerish Strategies

6.6 Long Put Vertical Spread

6.7 Long Put Diagonal Spread

6.8 Naked Short Call

6.9 Short Call Vertical Spread

Neutral Strategies

 

6.10 Broken Wing Butterfly

6.11 Butterfly

6.12 Calender Spread

6.13 Iron Condor

6.14 Iron Fly

6.15 Jade Lizard

6.16 Straddle

6.17 Strangle

Bibliography

Figures

Figure 1: CatchMark Timber Trust Inc. (CTT), Preis in USD, vom 15.02.2019 16

Figure 2: Option chain of the SPY 28

Figure 3: Rights and obligations for buyers and sellers 41

Figure 4: P/L-Diagram (Long-Call) 47

Figure 5: P/L-Diagram (Short-Call) 49

Figure 6: P/L-Diagram (Iron Condor) 50

Figure 7: "Moneyness" #1 63

Figure 8: „Moneyness“ #2 64

Figure 9: Intrinsic & extrinsic value or „Moneyness“ 71

Figure 10: Gamma-Change during days into trade 81

Figure 11: : Gamma-Influence on your P/L during the trade 82

Figure 12: Gamma within different strategies 82

Figure 13: Gamma at different strikes 83

Figure 14: Thetadecay over time, combined with premium 88

Figure 15: Verhältnis Ratio of premium / theta decay 88

Figure 16: Vega in different strategies 91

Figure 17: Vega at different strikes and expirations 92

Figure 18: Different IV-Ranks and their interpretations 97

Figure 19: Calculating the IVR 99

Figure 20: Expected Move at IV=15 102

Figure 21: Expected Move at IV=30 102

Figure 22: VIX "Contango" 105

Figure 23: VIX "Backwardation" 106

Figure 24: Graphical representation of the 1st and 2nd standard deviation in the SPY with an IVR of 11 117

Figure 25: Probability of Profit Strangles; 1. vs. 2. standard deviation 119

Figure 26: Strangles; 1. vs. 2. standard deviation (simulation with 1 million USD account size, of which 25% was actively used for trades). 75% were held in cash. 119

Figure 27: Strangles, 1st vs. 2nd standard deviation, graphical 120

Figure 28: P/L-Diagram Short-Put 123

Figure 29: P/L-Diagram Short-Call 124

Figure 30: P/L-Diagram Strangle 125

Figure 31: P/L-Diagram at 10 DTE 127

Figure 32: P/L-Diagram at 45 DTE 128

Figure 33: P/L-Diagram Long-Put 130

Figure 34: P/L-Diagram Long Call 131

Figure 35: Example for narrow spreads, good volume and good open interest in the SPY 139

Figure 36: Example for the required Buying-Power of a Strangles in Canopy (CGC) 150

Figure 37: A healthy "middle course" through diversification 166

Figure 38: Historical vs. implied volatility 182

Figure 39: Sorting of shares according to IVR 184

Figure 40: P/L-Diagram Long-Put 189

Figure 41: P/L-Diagram Naked-Short-Put 192

Figure 42: P/L-Diagram Long-Call 196

Figure 43: P/L-Diagram Naked Short Call 199

Figure 44: P/L-Diagram Vertical Credit Spread (Put) 216

Figure 45: P/L-Diagram Vertical Credit Spread (Call) 218

Figure 46: P/L-Diagram Strangle 225

Figure 47: P/L-Diagram Iron Condor (same width of the Spreads) 228

Figure 48: P/L-Diagram Straddle 232

Figure 49: P/L-Diagram Iron Fly 236

Figure 50: P/L-Diagram Iron Fly (Example) 238

Figure 51: Take-Profit (before rolling) 272

Figure 52: Take-Profit (after rolling) 273

Figure 53: Rolling process based on a chart 285

Figure 54: Rolling process with P/L-Diagram 285

Figure 55: 1-year chart of ROKU 297

Figure 56: Theta decay over time 300

Figure 57: Strength of the theta decay based on different initial values 301

Figure 58: Comparison of trades with 21 / 45 DTE (in SPY) 302

Figure 59: Long-term comparison of different management approaches 303

Figure 60: Management by strategy 305

Figure 61: Strangles 305

Figure 62: Straddles 306

Figure 63: Naked-Put 306

Figure 64: Naked-Call 306

Figure 65: SPY is a fairly priced underlying 310

Figure 66: P/L-Diagram Strangle (green), Iron Condor with 1 USD (yellow) and 5 USD (turquoise) wide strikes 313

Figure 67: The Greeks: Strangle vs. Iron Condor 313

Figure 68: Influence of the Vega on IC and Strangle 314

Figure 69: Pro/Contra (un)defined risk-strategies 315

Figure 70: Difference in percentage premium at different VIX levels (average premium as a percentage of underlying price) 316

Figure 71: P/L Iron Condor vs. Strangle (low vs. high VIX) 317

Figure 72: Properties of different strategies 320

Figure 73: Volacrush in „BBBY“ before earnings. 328

Figure 74: Selection of the expiration cycle for an earnings trade in BBBY 329

Figure 75: VIX "mean-reverting" 2018 337

Figure 76: Example of a VXXB Trade (Vertical-Spread) 339

Figure 77: Example configuration FinViz 346

Figure 78: Results of the filter criteria at FinViz 348

Figure 79: Setup of a Ratio-Spread 351

Figure 80: P/L-Diagram Put-Ratio-Spread (1xΔ50 Long-Put; 2x Δ30 Short-Put) 352

Figure 81: Profit zone put-ratio spread (buy 1x Δ50 long put, sell 2x Δ30 short put) 353

Figure 82: Example Naked-Short-Put 363

Figure 83: Example Long Call Vertical 365

Figure 84: Example Short Put Vertical 367

Figure 85: Example Long Put Vertical 369

Figure 86: Example Naked Short Call 373

Figure 87: Example Short Call Vertical 375

Figure 88: Example Broken Wing Butterfly 378

Figure 89: Example Butterfly 381

Figure 90: Example Iron Condor 385

Figure 91: Example Iron Fly 388

Figure 92: Example Jade Lizard 390

Figure 93: Example Straddle 392

Figure 94: Example Strangle 394

List of abbreviations

A.M. Ante meridiem

AMC After Market Closing

ATM At-the-Money

Bln. Billion

BMO Before Market Opening

BTC Buying to Open

BTO Buying to Close

DTE Days till experation

ETC Exchange Traded Commodity

ETF Exchange Traded Fund

ETN Exchange Traded Note

USD USD

ITM In-the-Money

IV Implied Volatility

IVR Implied Volatility Rank

Mio. Million

OCC Options Clearing Corporation

OTM Out-of-the-Money

P.M. Post meridiem

P/L Profit/Loss

POP Potential of Profit

STC Selling to Close

STO Selling to Open

SQRT Squareroot

USD United States Dollar

Foreword

A good book always begins with an honest preface. So first of all I would like to thank you for holding my first book in your hands and I hope that you will be satisfied with it in the end. What made me write this book you might ask? I myself have been trading in different approaches to the financial markets for years and, like almost everyone else, had to teach myself everything from the ground up. I didn't have a mentor and I know how frustrating it can be to have to go on this journey alone. There are many offers within the financial world that promise you great wealth or want to make you a professional in a short time. Let's not kid ourselves, 99% of it is complete nonsense and brings you nothing, except empty bags, than you had before. Books are often outdated or simply no longer up to date and seminaires are expensive pleasures that don't tell you a secret in the end.

In 2018 I therefore decided to write this book and to dedicate it to an area that seems to have been somewhat neglected in the German-speaking world. Here in Germany, hardly anyone talks about trading options. I am well aware that "the German" has no great interest in the capital markets, especially not in equities. Often it stays with the savings book - that will have to do. So if the interest in equities is already so low, one can guess that the interest in options must be much lower. Wrongly, I think. Options are a great financial product which, if used correctly, can achieve a clear excess return over simple stock shares. In Germany it is a niche issue. The literature that has appeared in Germany has unfortunately become somewhat outdated, sometimes simply bad and often completely overpriced, or simply not practicable or suitable for the small private investor. Exactly this aspect I would like to try to change.

The intention is therefore to generate as much interest as possible in this subject area and to get more people interested in options.

What is this book and what it isn't? Will this book make you a millionaire? Certainly not, it takes a lot more than just reading a few lines. There has to be so much honesty. Nevertheless, it should help you to provide a well-founded and wide-ranging insight into the world of options. It is essential that you always remain curious and interested. A single book cannot teach everything there is to teach and to know about this specific topic. Not even 1.000 pages would be enough. However, care has been taken to ensure that everything is addressed that you need in order to set up your first trades and to obtain your first experiences of success. However, it is still a non-fiction “entertaining” book, so you will probably not be able to read it like a novel in one piece.

In my opinion, a friendly relationship paired with a bit of humour and numerous examples is more suitable for learning than hours of frontal teaching. I try to live up to this claim here. I, too, was a bloody beginner and know your situation, so you will not be addressed from above, but directly and personally. The ultimate goal must be for you to understand what you have read and to be able to apply it! No one will be helped if you end up depressed and peppering this book in the corner instead of seriously dealing with the future.

It is very difficult to construct such a book conceptually suitable for everyone, since the knowledge to be conveyed seems to be almost infinite. However, the attempt was made to create a logical structure that would first teach you the basics and then later deal with real examples and strategies that you could put into practice. Once again, it is a reference book, so there will be parts that will bore you or perhaps even overwhelm you in the beginning (keyword "the Greeks"). Don't worry about it, it's all the same to everyone, no master has fallen from heaven yet.

The first chapters are theory-based and are intended to give you an understanding of the basic concepts of option trading. The greatest care is taken to convey this knowledge in a simple and practical way, although there are some topics that you simply have to go through. At the end of each section you will receive the most important information in a nutshell after the small hint "Remember". As soon as the strategies and trading approaches are discussed later, you can fall back on the cheat sheets and checklists towards the end of the book, print them out and stick them next to your screen.

Now I wish you lots of fun and good luck with your first steps into the world of options.

Happy Trading,

Stefan.

1. General information
1.1 A game of probabilities?!

At this point you don't have to understand exactly what I will tell you in the following lines. If you've never been exposed to options in your life, it's no big deal. Actually, it might even be an advantage if you haven't had any points of contact yet. But before we even talk about options, I'd like to talk about how casinos and insurance companies make money. Now you're probably thinking, "Wait a second, casinos and insurance companies? What do I care? I'm here to make money." Just listen to me for a moment, after the example, you'll understand a little better what it's all about - promised.

 

That's how casinos make money. It's absolutely simple and you probably already knew it, but they make money with small theoretical probability imbalances in each of the hundreds of games of chance. Simply put, if you know that the probability of a coin toss falling head or tail is 50%, the casino could pay you 10 USD if the coin lands on head, but 11 USD if it lands on tail. Either the casinos set the games so that the odds are in their favor or they either pay out a sum based on the odds of an event.

Let's just have some roulette. Basically a roulette wheel has 36 numbered fields, black and red and probably you have heard in movies "I will go to Vegas and bet everything on red". Most of these roulette tables have either one, two or sometimes three green squares and either a zero, double zero or even triple zero. Have you ever noticed them? Basically, when you go into a casino, these numbers, these double zeros, triple zeros, and all that stuff tend to be in favor of the casino. If you bet on a color, the probability of winning is 1:1, so if you bet 10 USD, you can win 10 USD. Banally speaking, you win 100%. So you first assume that you have a 50% chance of winning, right? The reality is that in most casinos, especially American ones, the probability of hitting black or red every time is only 46.37%. This is due to the additional green areas on the roulette table.

Another question to ask yourself in this context is: Why do casinos have table limits? They have table limits because they increase the number of games a person will play, which increases the house advantage of the casino. Look, the longer you play, the more you can lose. Casinos deliberately set table limits to control how often someone plays a game. The reason they do this is because they don't want you to come around the corner and bet, for example, directly 1 million USD on black or red. The risk would be much too high for the casino in this case. But if you would come for years and bet only 10 USD per game each time, then they would accept this bet in any case, because the statistics clearly play against you here.

Or let's take insurance companys. Imagine you have car insurance for which you pay premiums year after year. How often have you actually used it and how much have you paid in? Insurance companies also work according to the principle of probability, calculate their risk and let you pay a corresponding premium. The statistics are also on the side of the other party.

Why would you care about all this? What would it be like if you could also be the "bank" on the capital markets and exceptionally the probability theory could be used in your favour? Exciting, isn't it? Let's go on this journey together, everything will be explained to you if you are patient and eager to learn.

Remember:

The most reliable and consistent profits are achieved on the basis of probability and statistics.

You can use these for yourself without being a genius á la Beautiful Mind or having studied math.

1.2 What is an option?

First of all, I would like to talk about the absolute basics of option trading. You are probably an absolute beginner or have never heard that options can be traded and what they actually are. It is therefore important that we first understand what constitutes an option or an option contract at all.

Why and for what purpose were options invented? In essence, they are intended to perform "administrative tasks", namely to minimise risk. This gives you the opportunity to hedge yourself, speculate or use the contracts as a form of insurance. For options trading, it is important that we clearly define and understand the benefits and risks of each position we take. So, what is an options contract? Options are simply a legally binding contractual agreement between a buyer and a seller to buy and sell shares at a fixed price over a period of time. This is the serious difference between options and shares in general. Trading at a fixed price and for a fixed period is agreed.

Essentially, there are two types of options, puts and calls. Call options give the holder of the option the right, not the obligation, to buy a stock at a certain time at a certain price. Once again, it gives the owner the right, but not the obligation, that is, if I own a call option, I have the choice, or one would also say "the option", to buy that stock at a certain price over a certain period of time. Understandable, isn't it? It's a little different with put options.

This gives the put holder the right, but not the obligation, to sell shares at a certain price at a certain time. I can enter into a new sale agreement and have the choice to sell shares at a certain price if it reaches or does not reach or breaks through that price and have the choice to enter into the contract with the person from whom I bought the put.

Imagine coupons, it gets less complicated. Suppose we had a cheeseburger voucher for 1 USD. This is the exercise price we already have of 1 USD. The burger shop and I have determined with this coupon that they will sell me a cheeseburger for 1 USD. Until when is this contract valid? This is the expiration date, let's say it's April. Consequently, we know that we can execute this agreement until April to receive the goods for the price mentioned. So this is a call option. If, for whatever reason, on the day I want to redeem this voucher, cheeseburgers cost 5 USD once, then thanks to the voucher, I can still buy the burger for 1 USD. In this case I would exercise my option to pay only 1 USD.

Now let's take a look at the other side. I don't have to redeem options if I bought them, but in this case it's an advantage for me. But let's take the other side of the example and let's assume that on that day I go to the Diner and cheeseburgers cost just 0.50 USD. In this case I wouldn't redeem the voucher because I wouldn't take advantage of it. In this case I would still have a call option on cheeseburgers, but I will not exercise this option as it is not in my interest. Why should I pay more than I have to? Just transfer this example to stocks like Apple or Amazon or whatever you have in mind. The exercise price, the expiration date and the way the logic works are the same for everything you would put in this place.

Once again, very briefly - it is really important that you internalize these basics. With a call option, you buy the stock at a later date at a fixed price (if you want to). It has an expiry date. So it's like a voucher you buy yourself. This concerns the calls. With put options, you sell shares at a later date at a fixed price. So it is exactly the same - only the other way around.

For newcomers, understanding these contractual relationships is really complicated at first, but once you get involved and the node is broken, option contracts are very easy to understand. Don't worry, we'll go into each component so many times throughout this book that it will become flesh and blood for you. You will see, the world of options is not rocket science.

Remember:

Options are a legally binding contractual agreements between a buyer and a seller to buy and sell shares at a fixed price over a specified period of time.

You can either buy or sell options.

As a buyer, you acquire rights; as a seller, you acquire obligations.