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      How to Price and Trade Options

      Since 1996, Bloomberg Press has published books for financial professionals on investing, economics, and policy affecting investors. Titles are written by leading practitioners and authorities, and have been translated into more than 20 languages.

      The Bloomberg Financial Series provides both core reference knowledge and actionable information for financial professionals. The books are written by experts familiar with the work flows, challenges, and demands of investment professionals who trade the markets, manage money, and analyze investments in their capacity of growing and protecting wealth, hedging risk, and generating revenue.

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      Cover image: Bull Market Financial Data © iStock.com/Henrik5000; Orange Background

      © iStock.com/lovin-you

      Cover design: Wiley

      Copyright © 2015 by Al Sherbin. 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 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.

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       Library of Congress Cataloging-in-Publication Data:

      Sherbin, Al, 1956–

      How to price and trade options: identify, analyze, and execute the best trade probabilities / Al Sherbin.

      pages cm. – (Bloomberg financial series)

      Includes index.

      ISBN 978-1-118-87114-0 (paper/website); ISBN 978-1-118-87103-4 (ePDF); ISBN 978-1-118-87122-5 (ePub)

      1. Options (Finance) 2. Investments. I. Title.

      HG6024.A3S5145 2015

      332.63'2283 – dc23

      2014041593

      As I always teach my children, any project worth doing is worth doing well. With respect to this book, if in the end it is judged to be done well, it is only through the efforts of many whose names do not appear on the cover.

      First, I would like to thank my friend and fellow author, Larry Shover, for both encouraging and inspiring me to write this book and for introducing me to Pamela Van Giessen of John Wiley & Sons and Stephen Isaacs of Bloomberg Press. Pamela, Stephen, and I conceived this book over some good coffee and excellent pastries. Stephen continued on as my support system throughout the process of writing the book, fielding (too) many confused phone calls and setting me back on the right path.

      Special thanks to Judy Howarth, my developmental editor, who always had a quick, concise answer to my questions and who took a rough, raw manuscript from me and somehow returned a book.

      I am quite sure this book would not have come to be without the strong, even-handed guidance I received from Kathy Graham, founder of the HQ Companies Group. Kathy's influence far exceeded this project. She was, and continues to be, a light in the storm of my career. When I am unsure of my path, I turn to her for help. Thank you for bringing me to, and through, this project.

      To my many friends, colleagues, fellow traders, and students, I thank you for teaching me my trade. I find that you often learn the most valuable lessons from the most unexpected people. Only some of you fall into this category, as I knew I would learn much from those close to me. Thank you for sharing your knowledge, support, and encouragement with me even when I continued to whine that I would never get this done.

      Nothing I could say would do justice to what the love and support of my family have meant to me. To my beautiful wife, Kathleen, this is every bit as much your book as mine. As always, you went through every second of sweat, pain, fears, and turmoil as I did. Only, somehow, you managed not to complain! You encouraged me, prodded me, supported me, and loved me until it was complete. To my wonderful children, Mark, Emily, Kevin, Ted, and Kerry, I know for the past many months you could see me, but, at least mentally, I was not always there. Or as one of you so tactfully put it, “Dad, the lights are on, but nobody's home!” Thank you for the love and support and the thousands of “it will be great” e-mails, texts, phone calls, and discussions.

      Introduction

      Options are one of the most powerful money making asset classes ever devised. Yet they were not devised as a money making tool. Rather, their “purpose for being” is to limit portfolio risk. Whether you are talking about a portfolio of one stock, a hundred stocks, stocks mixed with commodities, or a myriad of other combinations, options can be used to either enhance your portfolio’s return on capital, take advantage of leverage to enhance yield, or limit your risk by exchanging a bit of profit potential for the “insurance” a long option provides. But if you are looking to buy an option to limit your risk, someone has to be on the other side of the trade. In years past, the other side of the trade was usually taken by professional options traders. The professional options trader was a mythical creature who made thousands of dollars every day by “picking the pocket” of the poor individual investor. I want to emphasize the word mythical. The professional options trader was merely someone who understood that options trading is nothing more than an exercise in simple probability theory. And this probability theory is easy enough to learn; with a bit of time and effort, most people can master it and use it for their own benefit. Furthermore, today options markets are, for the most part, so efficient that you can trade either side of a narrowly quoted market. Thus, there is no one out there picking anyone’s pockets. Options provide the fairest, most level playing field one can hope for.

      When

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