Option Fundamentals

9
Calls 11
Puts 11
Call and Put Variables 12
     Strike Price 13
     Expiration 13
     Interest Rates (Rho) 15
     Volatility (Vega) 15
     Decay (Theta) 16
     Intrinsic Value 17
     Settlement 18
Put Option Analogy 19
Call Option Analogy 20
What makes up the Value of an Option 22
     Intrinsic Value 22
     Time Value 22
     Function of Probability 23
     Option Chain Time Values 25
Pricing Increments 26
Bid-Ask Spread 27
Pricing Increments 28

Broken Wing Butterfly Spreads (BWB)

29
Introduction 30
Definition 31
Practical definition of BWB 31
     Ratio Spread portion 32
     Breakeven and maximum profit at expiration 32
     “Tail” purchase portion of trade 33
     Risk and margin without the “tail” 36
     Exact margin guidelines 36
          Maximum Loss 36
          Formula for calculation of margin 38
     How to reduce the risk and margin 39
     Risk Graphs 39
Ratio spreads and the Greeks 40
     Refresher of option’s Greek definitions 41
     Option’s Greeks calculation charts 42
     Charts explained 42
          Cost analysis 44
          Delta analysis 47
          Gamma analysis 48
          Theta & Vega analysis 49
     Why the Greeks work so well 49
The practical use and mechanics of Ratio Spreads 50
     OEX option chain 51
     How Ratio Spreads react in reality to Price 52
          Market stays flat – no time passes 53
          Market runs up – no time passes 54
          Study of 535 put as Index advances 55
          Formula for pricing options after a move 56
               OEX example 57
               OEX example using calls 57
     How Ratio Spreads react in reality to Time 65
          Market stays flat – time passes 65
          Practical example 66
     Illustration of reaction to time and price movement 69
          Setting up an example 70
          How to line up the option chains 70
          What was the profit/loss 73

Broken Wing Butterfly Spreads (BWB) Entry Criteria

75
Introduction, circumstances and considerations 76
Step 1 – Select an underlying 77
     Indexes 77
     Stock 79
Step 2 – Decide bullish, bearish or neutral 79
     OEX option chain 80
     Call vs. put spread for even comparison 81
Step 3 – Select the month(s) 82
     Front month 82
     Back month 83
Step 4 – Determine with which strikes to begin 83
     OEX option chain 84
Step 5 – Calculate the cost of small ATM spread 85
     What is the ATM option trading for? 85
     What do the next 2 OTM options trade for? 85
     What is the net debit/credit? 85
Step 6 – Calculate the cost of a medium width ATM spread 87
     Pricing charts 88
Step 7 – Calculate the cost of a large width ATM spread 87
     What can you expect to see? 90
     Expected range of Ratio and BWB trades 91
          Put skew 93
          Call skew 93
Step 8 – Find the spread in the next month out 94
     April OEX option chain 94
     Same trade one month further out results 95
Step 9 – Determine range if underlying moved 5-6% 95
Step 10 – Calculate spread value after underlying moves 95
     OEX put option chain 96
Step 11 – Compare/contrast price possibilities 99
Step 12 – Determine if front or back month is better 100
     Same month, same strike 100
     Two months, two different strikes 101
     Which month and strike is better? 102
Step 14 – Ratio Spread or Broken Wing Butterfly? 108
     Ratio spread vs. BWB margin 109
     Margin comparison 110
Step 15 – Converting a Ratio Spread to a BWB 110
     Margin reduction 110
     Risk reduction 111
     Conclusion 114
     Important note 115

Broken Wing Butterfly Spreads (BWB) Exit Criteria

117
Introduction and benefits 118
Step 1 – Calculate profit/loss on spread 119
Step 2 – Establish P/L goal and rolling down area 119
Step 3 – Front and Back month maintenance/closing 120
     Front month 121
     Back month 121
Step 4 – Watch the markets 121
Step 5 – How often to recalculate P/L points 122
    Greater than 3 weeks to expiration 122
    Less than 3 weeks to expiration 122
Step 6 – Re-evaluate P/L of the spread 123
    Adjusting for time and price movement 123
    Worksheets 124
Step 7 – After re-evaluation, note where spread loses 125
Step 8 – Some action may be necessary 125
    Exit for breakeven 126
    Roll the trade further OTM 126
    Be patient 127
    Consider the “tail” 127
Step 9 – When to close 128
    Market running in wrong direction 128
    Profit less than 50% of maximum 129
Step 10 – Time to take the trade off 131

Risk Ratio Spreads (Aggressive)

133

Index Options

135
Why use index options? 136
OEX as an example 139

Bonus Chapter: The New Margin Rules

141
Margin: A Definition 142
Old Rules: Basic Option Strategies 143
Major Difference Between Old and New 144
So What Other Positions May be Affected? 145
     Married Puts 145
     Collars 150
     Synthetic Puts 154
     Reverse Collars 159
     Gamma Scalping 164
     Basic Synthetics 170
     Call Time Spreads and Short Call Vertical Spreads 170
     Put Time Spreads and Short Put Vertical Spreads 172
     A Brief Word on Short Time Spreads 174
Things to Avoid 175
     The Conversion 175
     Going out Too Far in Time 176
A Few Last Thoughts 177

Appendix
Terminology 181
Types of Orders 197