Tuesday, September 8, 2009

Saliba, Option Spread Strategies

Option Spread Strategies: Trading Up, Down, and Sideways Markets (Bloomberg Press, 2009) is a brilliantly structured book. Written by Anthony J. Saliba with Joseph C. Corona and Karen E. Johnson, it describes eight spread strategies in terms a bright novice can understand and someone with a modicum of options experience will relish.

I listened to a Think or Swim webinar the other day and was astounded to learn that only twenty percent of their retail customers use spreads. Since the gurus at TOS focus almost exclusively on spreads in their educational programs, I can only assume that the percentage of spread traders at other firms is even lower. This is really a pity because option spreads offer so much more flexibility than simple calls and puts.

This book covers eight strategies: covered-writes, verticals, collars and reverse-collars, straddles and strangles, butterflies and condors, calendar spreads, ratio spreads, and backspreads. Each chapter follows the same structure. Starting with a brief concept review, the discussion moves on to an overview of the strategy, strategy composition, the Greeks of the strategy, investment objectives, strategy component selection, and trade management. There’s a quiz at the end of the chapter and a final exam at the end of the volume. Each chapter is about thirty pages in length. Since this is an 8-1/2 X 11 book, the layout isn’t crowded; there’s ample room for both text (broken up into bite-size pieces by heads and subheads) and figures. The design is conducive to learning.

Here I’m going to look at a single section from the chapter on vertical spreads to give some sense of the level of the book. The trade management section begins with a piece of sound advice: “One mistake that is consistently made by options traders (probably because they tend to fancy themselves as chess masters) is staying too long in a position or making too many modifications when their market view changes from the initial forecast. The simplest and most effective rule in risk management is this: If the trader is wrong, he should get out!” (p. 56) So, right or wrong, how does the trader exit? Should he exit using the reverse of the original position or its synthetic equivalent? This decision depends on price and liquidity. Price is straightforward, applying the rules set forth earlier in the chapter. Just use the most advantageously priced spread to exit. Liquidity can be a little trickier. “As options move in-the-money, they acquire a larger delta, and this makes hedging them riskier for market makers. Accordingly, market makers will widen the bid-ask spread. . . .” (p. 57) But these in-the-money spreads have synthetic out-of-the-money equivalents, so it is sometimes wise not simply to reverse the position but to exit via a synthetic equivalent.

Now let’s say the trader wants to modify the spread because the price target has been reached prematurely or the size of the directional movement has been underestimated. Here the trader can continue to participate in the move by rolling the spread using a butterfly. Two pages of “T” diagrams show exactly how to roll the spread up or down.

Option Spread Strategies is to my mind a real keeper. It’s not only instructional but belongs on the shelf as a reference work, especially for those “what now?” moments.

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