Wednesday, February 16, 2011

Rhoads, Option Spread Trading

Option Spread Trading: A Comprehensive Guide to Strategies and Tactics by Russell Rhoads (Wiley, 2011) is a straightforward book. After covering option basics and spreads using an underlying security, it describes in some detail the standard option-only spreads: straddles, strangles, verticals, butterflies, condors, ratios, backspreads, calendars, and diagonals.

Since each chapter is laid out in a similar fashion I can give a sense of the book by focusing on a single option spread. I have chosen the butterfly in its simplest manifestations: long call, long put, iron, short call, short put, and reverse iron.

In each case Rhoads provides two tables. The first describes the inputs and outputs used to create the XYZ butterfly position. The inputs are days to expiration, implied volatility, interest rate, and the price of XYZ. The outputs are the options that make up the butterfly along with their prices and the total cost incurred or credit received upon entry. The second table points out the key levels for this position (up break-even price, down break-even price, maximum dollar gain, maximum gain price, maximum dollar loss, maximum loss prices) and explains how these levels are calculated. For instance, in a long call butterfly the up break-even price is the high strike minus the cost of the spread.

Rhoads compares particular butterfly constructions to other option spreads. For instance, a long call butterfly can be viewed as a combination of a bull call spread and a bear call spread. An iron butterfly can be described as a combination of a bull put spread and a bear call spread. Alternatively, it may be viewed as a “deviation of a short straddle” or as a short straddle with wings. Rhoads also details the advantages and disadvantages of the iron butterfly as opposed to the short straddle.

As you can gather from this short description, Option Spread Trading is not a jazzy book. Nor will it appeal to the reader who wants a step-by-step instruction manual. But it is a solid introduction to the field.

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