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The Option
Trader
Handbook
Strategies and
Trade Adjustments

Second Edition

GEORGE M. JABBOUR, PhD


PHILIP H. BUDWICK, MsF

John Wiley & Sons, Inc.


Copyright 
C 2010 by George M. Jabbour and Philip H. Budwick. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.


Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in


any form or by any means, electronic, mechanical, photocopying, recording, scanning, or
otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright
Act, without either the prior written permission of the Publisher, or authorization through
payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222
Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at
www.copyright.com. Requests to the Publisher for permission should be addressed to the
Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201)
748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best
efforts in preparing this book, they make no representations or warranties with respect to the
accuracy or completeness of the contents of this book and specifically disclaim any implied
warranties of merchantability or fitness for a particular purpose. No warranty may be created
or extended by sales representatives or written sales materials. The advice and strategies
contained herein may not be suitable for your situation. You should consult with a
professional where appropriate. Neither the publisher nor author shall be liable for any loss of
profit or any other commercial damages, including but not limited to special, incidental,
consequential, or other damages.

For general information on our other products and services or for technical support, please
contact our Customer Care Department within the United States at (800) 762-2974, outside the
United States at (317) 572-3993 or fax (317) 572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in
print may not be available in electronic books. For more information about Wiley products,
visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Jabbour, George (George Moussa)


The option trader handbook : strategies and trade adjustments / George M. Jabbour,
Philip H. Budwick. – 2nd ed.
p. cm. – (Wiley trading system)
ISBN 978-0-470-48161-5 (cloth)
1. Options (Finance) 2. Options (Finance)–Prices. 3. Stock options. I. Budwick, Philip.
II. Title.
HG6024.A3J32 2010
332.64 53–dc22
2009041414

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1
To our families: Thank you for all your love and support.
Contents

Preface to the First Edition xiii

Preface to the Second Edition xvii

CHAPTER 1 Trade and Risk Management 1

Introduction 1
The Philosophy of Risk 2
Truth About Reward 5
Risk Management 6
Risk 6
Reward 9
Breakeven Points 11
Trade Management 11
Trading Theme 11
The Theme of Your Portfolio 14
Diversification and Flexibility 15
Trading as a Business 16
Start-Up Phase 16
Growth Phase 19
Mature Phase 20
Just Business, Nothing Personal 21
SCORE—The Formula for Trading Success 21
Select the Investment 22
Choose the Best Strategy 23
Open the Trade with a Plan 24
Remember Your Plan and Stick to It 26
Exit Your Trade 26

v
vi CONTENTS

CHAPTER 2 Tools of the Trader 29

Introduction 29
Option Value 30
Option Pricing 31
Stock Price 31
Strike Price 32
Time to Expiration 32
Volatility 33
Dividends 33
Interest Rates 33
Option Greeks and Risk Management 34
Time Decay 34
Trading Lessons Learned from Time Decay (Theta) 41
Delta/Gamma 43
Deep-in-the-Money Options 46
Implied Volatility 49
Early Assignment 63
Synthetic Positions 65
Synthetic Stock 66
Long Stock 66
Short Stock 67
Synthetic Call 68
Synthetic Put 70
Basic Strategies 71
Long Call 71
Short Call 72
Long Put 73
Short Put 74
Basic Spreads and Combinations 75
Bull Call Spread 75
Bull Put Spread 76
Bear Call Spread 77
Bear Put Spread 78
Long Straddle 78
Long Strangle 79
Short Straddle 80
Short Strangle 81
Advanced Spreads 82
Call Ratio Spread 82
Put Ratio Spread 83
Contents vii

Call Ratio Backspread 84


Put Ratio Backspread 85
Long Butterflies 86
Short Butterflies 87
Long Calendar Spreads 88
Short Calendar Spreads 89
The Greeks and Spread Trades 90
Delta/Gamma 91
Vega 92
Other Greeks and Spreads 93
Valuable Derivative Traders Program 93
Step 1: VEGA and Implied Volatility (IV) 94
Step 2: Delta and Strike Selection 96
Step 3: Theta and How Much Time to Expiration 97
Putting the Program to Work 99
Introduction to Trade Adjustments 100

CHAPTER 3 Long Stock 105

Introduction 105
Protective Put 106
Stock Moves Higher 109
Stock Moves Lower 111
Bear Put Spread 114
Rolling from a Protective Put into a Bear
Put Spread 116
Rolling from a Bear Put Spread into a
Protective Put 118
Call Replacement 120
Stock Moves Higher 121
Stock Moves Lower 122
Call Replacement versus Protective Put 123
Sell Covered Calls 123
Stock Moves Higher 125
Strike Selection 127
In the Money Calls 128
Time to Expiration 131
Scaling-Out Strategy 132
Collars 134
Opening Position—Regular Collar 134
Stock Moves Higher—Profit Collar 137
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viii CONTENTS

Ratio Write 139


Opening Position 140
Stock Moves Higher—Regular Ratio Write 143
Stock Moves Higher—Variable Strike Ratio Write 149
Stock Moves Lower—Ratio Write/Variable Strike Ratio Write 153
Short Straddle/Short Strangle 156
Opening Position—Short Straddle 156
Opening Position—Short Strangle 160
Stock Moves Higher—Short Straddle 163
Stock Moves Higher—Short Strangle 168
Stock Moves Lower—Short Straddle/Stock Repair 172
Stock Moves Lower—Short Strangle 176
Call Ratio Spread 179
Opening Position 182
Stock Moves Higher 186
Stock Moves Lower—Stock Repair Strategy 191
Call Calendar Spread 193
Opening Position 195
Stock Moves Higher 196

CHAPTER 4 Short Stock 201

Introduction 201
Protective Call—Insurance 203
Opening Position—Protective Call 203
Opening Position—Protective Call Spread 208
Short Stock + Protective Call = Long Put 210
Stock Moves Lower—Protective Call 212
Stock Moves Lower—Protective Call Spread 215
Rolling between Protective Calls and Protective Call Spreads 219
Stock Moves Higher 221
Put Replacement 223
Stock Moves Lower 224
Stock Moves Higher 226
Put Replacement versus Protective Call 227
Covered Puts 228
Stock Moves Lower 229
Short Collars 234
Opening Position—Regular Collar 235
Stock Moves Lower—Profit Collar 237
Contents ix

Put Ratio Write 239


Opening Position 240
Stock Moves Lower—Regular Ratio Write 243
Stock Moves Lower—Variable Strike Ratio Write 248
Put Ratio Spread 250
Opening Position 250
Stock Moves Lower 253
Stock Moves Higher—Short Repair Strategy 256

CHAPTER 5 Calls and Puts 259

Introduction 259
Long Call 260
Protective Put—Stock Moves Higher 260
Protective Put—Stock Moves Lower 262
Call Replacement 264
Rolling into a Bull Call Spread—Stock Moves Higher 267
Rolling into a Bull Call Spread—Stock Moves Lower/Call Repair Strategy 269
Rolling into a Bear Call Spread 271
Short Stock 272
Rolling into a Synthetic Straddle 274
Rolling into a Calendar Spread 276
Rolling into a Ratio Spread 278
Stock Moves Lower—Call Repair Strategy 281
Short Call 285
Long Put 288
Protective Call 288
Underlying Stock Moves Lower 288
Underlying Stock Moves Higher 290
Put Replacement Therapy 292
Rolling into a Bear Put Spread 294
Underlying Stock Moves Lower 294
Underlying Stock Moves Higher—Put
Repair Strategy 295
Rolling into a Bull Put Spread 297
Long Stock/Synthetic Straddle 298
Put Calendar Spread 302
Put Ratio Spread 305
Underlying Stock Moves Lower 305
Underlying Stock Moves Higher—Put Repair Strategy 308
Short Put 311
x CONTENTS

CHAPTER 6 Spreads 317

Introduction 317
Bull Call Spreads/Bear Put Spreads 317
Protective Puts/Protective Calls 318
Bull Call Spread—Protective Put 318
Bull Call Spread—Protective Put Spread 320
Bear Put Spread—Protective Call 321
Bear Put Spread—Protective Call Spread 322
Convert to Ratio Spreads 323
Bull Call Spread—Stock Moves Higher 323
Bull Call Spread—Stock Moves Lower/Repair Strategy 326
Bear Put Spread—Stock Moves Lower 330
Bear Put Spread—Stock Moves Higher/Repair Strategy 332
Convert to Butterflies 336
Bull Call Spread 337
Bear Put Spread 338
Bear Call Spreads/Bull Put Spreads 340
Calendar Spreads 340
Call Calendar Spread 341
Stock Moves Higher—Rolling into a Bull Call Spread 341
Stock Moves Higher—Rolling into a Diagonal Ratio Spread 342
Stock Moves Lower—Rolling into a Lower Strike Bull Call Spread 343
Stock Moves Lower—Convert to a Calendar Strangle 344
Put Calendar Spread 345
Stock Moves Lower—Rolling into a Bear Put Spread 345
Stock Moves Lower—Rolling into a Diagonal Ratio Spread 345
Stock Moves Higher—Rolling into a Higher Strike Bear Put Spread 347
Stock Moves Higher—Rolling into a Calendar Strangle 348
Butterfly Spreads 348
Long Butterfly to Long Condor 348

CHAPTER 7 Combinations 353

Introduction 353
Long Straddle 353
Straps/Strips 354
Modified Straps/Strips 357
Calendar Straddle 359
Rolling a Long Straddle into an Iron Butterfly 361
Diagonal Iron Butterfly 363
Contents xi

Partial Iron Butterfly 363


Long Call/Long Put Adjustments 365
Long Strangle 365
Diagonal Iron Butterfly 365
Calendar Strangle 367
Long Call/Long Put Adjustments 367
Short Straddle/Short Strangle 368
Short Straddle 368
Rolling Short Straddle into Iron Butterfly 371
Short Strangle 373

Index 375
Preface to the
First Edition

ption trading is both an art and a science. The science of option

O trading is very straightforward and mechanical and involves the spe-


cific steps in establishing a position, pricing, and understanding how
movements in the underlying stock affect your trades. The art of trading,
on the other hand, involves the use of your imagination and ingenuity. The
market is your canvass and you coordinate different strategies and adjust-
ments to create a unique painting, which is your portfolio. As mechanical
as option trading seems, to be truly successful you will need to apply your
own artistic style with respect to developing strategies and making trade
adjustments. This book is about the art of making trade adjustments.
Making an adjustment to a stock or option position is one of the most
overlooked and underutilized skills in trading. Moreover, it is one area
where your personal style and imagination are valued over any other quan-
titative trading skill. Options give you the flexibility to trade markets in any
direction, or with no direction at all, and for as long or as short a time
period as you want. Just as eight simple musical notes can be combined
to make an infinite number of symphonies and songs, calls and puts also
can be combined in a number of ways, using different expiration dates and
strike prices, to create an almost infinite number of positions and follow-up
adjustments.
Using the right trade adjustment can hedge or even boost your profits,
limit your losses, and create risk-free trades. Trade adjustments can also
be used to repair losing positions. Whether you invest using only stocks,
only options, or both, the information in this book is intended to give you
the tools you need to improve your trading skills and performance.
The material in this book presents the art of trade adjustments in a
logical sequential order. First, we discuss the most important aspect of
investing—risk and trade management. Trade adjustments are tools used
to implement trade and risk management. Therefore, you cannot under-
stand how to use the tools if you are not aware of the theory behind them.

xiii
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and Kitchener
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