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title: author: publisher: isbn10 | asin: print isbn13: ebook isbn13: language: subject publication date: lcc: ddc: subject:
The Complete Guide to Option Selling : How Selling Options Can Lead to Stellar Returns in Bull and Bear Markets Cordier, James.; Gross, Michael. McGraw-Hill Professional 0071442081 9780071442084 9780071454520 English Stock options. 2005 HG6042.C675 2005eb 332.63/2283 Stock options.
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Page i THE COMPLETE GUIDE TO OPTION SELLING How Selling Options Can Lead to Stellar Returns in Bull and Bear Markets JAMES CORDIER MICHAEL GROSS
Page ii Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Manufactured in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. 0-07-145452-7 The material in this eBook also appears in the print version of this title: 0-07-144208-1. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps. McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs. For more information, please contact George Hoare, Special Sales, at
[email protected] or (212) 904-4069. TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc. ("McGraw-Hill") and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGrawHill's prior consent. You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms. THE WORK IS PROVIDED "AS IS." McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise. DOI: 10.1036/0071454527
Page v INTRODUCTION Have you ever heard it said that the vast majority of options expire worthless? It is estimated that anywhere from 75 to 80 percent of all options held through expiration will indeed expire worthless. Furthermore, it is estimated that only 10 percent or less of all options will ever be exercised. This being the case, why aren't more investors taking advantage of this phenomenal statistic? Why is the average sit-at-home investor not analyzing endless lists of strike prices seeking the most glowing opportunities for deterioration instead of reviewing mutual fund performance tables or stock price-earnings (P/E) ratios? Why are the majority of futures traders losing money year after year, trying to pick the perfect top or bottom by buying or selling a futures contract or, worse yet, buying an out-of-the-money put or call that has a remote chance of ever showing any kind of profit, let alone a windfall? The answer is the old trading axiom: Fear and greed-fear of risk, fear of the unknown, and most important, fear of that which is not understood. Most brokers or investment advisors, when asked about the strategy of option selling, will reply with a response such as, "You want to stay away from that. It's too risky." Yet, when asked to explain the approach in detail, few can do a thorough job of it. If the investment representatives from the industry cannot explain a particular approach to investing, how can the overall community of investors be expected to understand the approach? "Option selling has unlimited risk" is all that most investors know about the concept. The term unlimited risk is enough to cause most investors to cross it off their list of potential investment strategies without further exploration. What about greed? The other knock on option selling is that it is slow. It is "boring." It has "limited" profit potential. It goes against most investor's instincts to take an "unlimited" risk for the potential for a limited profit. Most traders, especially futures traders, have been taught from their first trading lesson that in order to turn a profit, a series of small losses must be accepted to make that one big gain. It is the potential for this one big gain that keeps traders and gamblers alike coming back time after time and losing money time after time. Taking many losses in order to make one big gain is very difficult, even for the most experienced investor. Why? Because it goes against human nature. Humans are cursed with the emotion of hope when involved in an investment situation. We hope our losses will turn around for us and look for excuses to stay in our position for one more day. Yet, when faced with a winning trade, the anxiety of remaining in the position is almost unbearable. The purpose of this book is to introduce the concept of option selling (or writing) to the average individual investor. It is our belief that the individual investor has been deprived of not only a quality resource on the subject of pure option writing but also a
Page vi concrete blueprint for how to sell options successfully. Selling options for premium has been a favorite strategy of professional and commercial traders for years. After all, somebody has to be selling all those options to the general public, which seems to have an insatiable appetite for buying options all the time. More often than not these are the people making the real money in this business. Many traders' first experience with futures is in buying options. This is so because their brokers told them that this was the "safe" way to trade. "Limited risk" is what they are promised. Indeed, the purchase of options does limit your risk to the amount of money that you invest in these options. Unfortunately, most of the time, the amount that you invest will be the amount that you lose if you use option buying. The odds are stacked tremendously against you. There is a very good chance that your options will expire worthless. Maybe one of your positions made money. You take what is left from that profit and reinvest in buying more options. Now there is a good chance that those options will expire worthless. Even if you manage to profit from a few, eventually the chances are that your luck will run out. When these options are all expired, you have lost your money. However, somebody made money on those options (besides your broker). Somebody took your premium and put it in his account. If you have ever lost money buying options, imagine if you had made a premium for every option you held that expired worthless. Would you be ahead right now? You never had to pick market direction. You never had to decide when to take a profit. You never had to worry when time was going to run out for your position. You wanted time to run out! This book intends to teach you how to do this for yourself. Simple concepts for selling options for premium and controlling risk will be explained not in technical jargon but in simple terms. Our intention is to demystify option selling for the individual investor. The growing popularity of selling options is undeniable. Yet it remains one of the least understood concepts in the trading world. The concept of unlimited risk will be broken down and explained. After knowing the facts, unlimited risk may not be as intimidating as it sounds. This book avoids the same old tired trading philosophies as well as the newest fashionable technical indicators in favor of a fresh, simple approach that has as yet not commanded a book of its own. The book will avoid the dry, complex option theory and industry lingo that plagues many books about options and instead focus on bringing the mystics of option writing into a down-to-earth, commonsense investing approach that the average investor can understand in one reading. If you are looking for complex, number-crunching analysis of deltas and gammas, this book is not for you. We do not intend to show you how to design a computer program to analyze standard deviations and Gann lines and count Elliot waves. We are not writing this book based on mathematical "theory" that we have calculated from the comfortable confines of a classroom or university library.
Page vii The authors of this book are active futures brokers. Both have traded personal accounts and have more than 28 years of combined experience in the futures trading industry. We want to tell it like it is, from the trenches, in a simple straightforward manner. Who really makes money, who loses it, and why? Let us share it with you. How do we know? Because we've seen it all. We've drunk champagne with the winners and helped ease the pain of the losers. And while the focus of this book is on futures options, almost all the strategies discussed can be applied with equal effectiveness to equity options. The differences will be discussed so that you know how to make the conversion successfully, if you choose. It is not our intention in writing this book to put forth the proposition that selling options is the only way to make money investing in commodities, nor do we propose that option selling is appropriate for every investor. It is also not our intention to mislead readers into believing that losses cannot result from selling options. It is simply our belief that after all our years in the industry, all the fundamental and technical analysis, the backwards double-butterfly spreads, Brazilian freezes, Mississippi floods, and "mad cows," this is the only way we've found to profit consistently in the futures market. The information in this book is divided into four parts, with each part containing four to five chapters. Part I explains why option selling is such an effective strategy and covers the basic mechanics of selling time premium, how options work, and the often-misunderstood subject of margins on short options. Part II explores our recommended core strategies for selling options, uncovers some common myths about effective option-writing techniques, points out key factors to consider when selling premium, and covers the all-too-important subject of risk control. Part III is all about analyzing and selecting the optimal markets for selling options. These are observations and techniques that we have come to realize are the most important in determining success or failure in option selling. And finally, Part IV covers how you can get started in selling options by discussing how to find the right broker, answering some common questions about selling time premium, and helping you avoid some of the common pitfalls. Writing options may not be the Holy Grail of futures trading, but in our opinion it's the next best thing. We wrote this book to help you to make money. We will consider it a success if it achieves that end. James Cordier Michael Gross June 14, 2004
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Page 195 PART IV GETTING STARTED
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