Carley Garner and Paul Brittain

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1 1 ' - r~ :. i «V. Trading and Hedging Volatility in the World's Most Lucrative Market Carley Garner and Paul Brittain

2 Contents Introduction xix Chapter 1: Option Basics: A Crash Course in Option Mechanics 1 What Is an Option? 1 Strike Price 2 Intrinsic and Extrinsic Value: Components of an Option Price 3 Intrinsic Value 3 Extrinsic Value 5 Time Value 6 Volatility 7 Trading Volatility 7 Demand 7 The Art of Option Trading 8 Chapter 2: An Option Is an Option Is an Option...Think Again 11 ' Options on Futures, aka Options on Commodities 12 Differences in Underlying 12 Leverage 14 Expiration 16 Dividends 18 Liquidity 18 Nature of Market and Price Movement 19 Standardized Point Value 21 Stock Splits 22 Difference in Option Markets 23 Number of Products 23 Technology: Electronic Versus Open Outcry 23

3 VIII Trading Commodity Options Independent Futures Exchanges 24 Liquidity 24 Different Participants 25 LEAPS 25 Quote Availability 26 Difference.in Tax Treatment 26 Long-Term Versus Short-Term 26 Reporting Tax 27 Difference in Regulators 27 SEC 28 NFA/CFTC 28 Difference in Trading Tools 28 The Greeks 29 Black and Scholes Option Models 32 Conclusion.34 Chapter 3: Long Option Strategies 35 Why Long Options Aren't Always a Great "Option" 35 When to Use Long Options 37 Alternative Uses of Long Option Strategies 38 Factoring in Commission 39 Long Call Option 40 When to Use 40 Profit Profile 40 Risk 40 Long Put Option.. 42 When to Use 42 Profit Profile 42 Risk 42 Neutral Long Option Plays 43 Long Straddle 44 When to Use 44 Profit Profile 45 Risk 45

4 Contents ix Long Strangle 49 When to Use 49 Profit Profile 49 Risk 49 Conclusion of Long Option Strategies 52 Chapter 4: Short Option Strategies 53 Why Sell Options? 54 Theoretically Unlimited Risk: Option Selling Can Be Hazardous to Your Wealth! 55 Short Option Fundamentals 56 The Premise Behind Option Selling 57 Preparing to Sell Options 57 Technical Analysis and Option Selling 58 Option Selling Isn't Always Appropriate 58 Reverse Break-Even 58 The Execution of Option Selling 59 Exercise Me! 60 The Art of Adjustment 61 The Double-Out Rule 61 Sell More Premium 62 Cover with a Futures Position 63 Ratio Writes 63 Short Call Option 64 When to Use 64 Profit Profile 64 Risk 65 Short Put Option 68 When to Use 68 Profit Profile 68 Risk 68 Option Selling Versus Trading Futures 70 Don't Underestimate the Risk of Illiquid Markets 71

5 Trading Commodity Options Short Straddle 72 When to Use 72 Profit Profile 72 Risk 72 The Reverse Break-Even Point 73 Short Strangle 76 When to Use 76 Profit Profile 76 Risk 76 Chapter 5: Credit Spreads 81 Limited Risk Premium Collection 81 Bullish or Bearish? 82 Is Having Limited Risk Worth the Opportunity Cost? 82 The Cons of Credit Spreads 83 Bear Call Spread "...84 When to Use 84 Profit Profile.- 84 Risk 84 Bull Put Spread 87 When to Use 87 Profit Profile 87 Risk 87 Iron Condor 90 When to Use 90 Profit Profile 90 Risk 91 Chapter 6: Limited Risk Option Spreads 95 Bull Call Spread 96 When to Use 97 Profit Profile 98 Risk 98

6 Contents xi Bear Put Spread 100 When to Use 101 Profit Profile 101 Risk 101 Chapter 7: Synthetic Swing Trading 105 Why Swing Trading with Option Spreads? 106 Trading Naked (It's Not What You Think) 107 Understanding the Risk and How to Cope 108 Bull Call Spread with a Naked Leg 109 WhentoUse Profit Profile 109 Risk 110 Bear Put Spread with a Naked Leg 115 When to Use 115 Profit Profile 115 Risk 115 Call Ratio Spread, 119 When to Use 119 Profit Profile 119 Risk 119 Put Ratio Spread 123 When to Use 124 Profit Profile 124 Risk 124 Chapter 8: The Other Ratio Spreads 129 Call Ratio Back Spread 130 When to Use 130 Profit Profile 130 Risk 130 Put Ratio Back Spread 132 When to Use 133 Profit Profile 133 Risk 133

7 xii Trading Commodity Options Chapter 9: Limited Risk Range Trades 139 Why Use Diamond Butterflies? 140 Long Call Iron Butterfly 143 When to Use 143 Profit Profile 144 Risk 144 Long Iron Butterfly Put 147 When to Use 147 Profit Profile 147 Risk : 147 Chapter 10: Synthetic Long Option Plays 151 Why Use Synthetic Positions? : 151 Be "Cheap" 152 Synthetic Long Call Option 153 When to Use..153 Profit Profile 153 Risk, 153 Synthetic Long Put Option 157 When to Use 157 Profit Profile 157 Risk 157 Chapter 11: An Option Trade from Top to Bottom 165 Identifying an Opportunity 165 Chapter 12: The Wizard of Oddz: Applying Option Strategies in the "Real World" 185 Adjusting the Oddz 187 Trading Extremes 187 Take Advantage of Variations on Volatility 189 Avoid Playing Economic or Agricultural Reports 192 Only Buy Options Outright If "The Time Is Right" 193 Chapter 13: Margins and Option Trading 197 How Margin Requirements Are Determined 198 What Happens If I Get a Margin Call? 198 Adjusting Margin Once a Margin Call Occurs 199

8 Contents xiii Chapter 14: Commodity Trading Myths 203 It Is Easy to Make Money Trading 203 I Made Money Paper Trading, So I Will Make Money in the Markets 204 If It Is on TV or in the Newspaper It Must Be True 205 If I Listen to the Experts, How Can I Go Wrong? 206 Appendix 211 Glossary 215 Index 251

How to Trade Options: Strategy Building Blocks

How to Trade Options: Strategy Building Blocks MICHAEL BURKE Important Information and Disclosures This course is provided by TradeStation, a U.S.-based multi-asset brokerage company that seeks to serve