The Trader's Guide to Equity Spreads

483 Pages·2007·10.63 MB·English

by  Randy Frederick

THE
TRADER’S
GUIDE
TO
EQUITY
SPREADS

HOW TO INCREASE RETURNS
AND LOWER RISK
W I T H O P TIO N S T RATE G I E S
R F
A N DY R E D E R I C K
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DOI: 10.1036/0071478116
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C O N T E N T S
Foreword v
Acknowledgments vii
Disclosures ix
Introduction 1
SECTION 1 VALUATION
Chapter 1
Pricing and Movement 9
SECTION 2 VERTICAL SPREADS
Chapter 2
Bullish Spreads 43
Chapter 3
Bearish Spreads 65
SECTION 3 HORIZONTAL SPREADS
Chapter 4
Calendar Spreads 89
Chapter 5
Diagonal Spreads 113
SECTION 4 BUTTERFLY SPREADS
Chapter 6
Standard Butterfl y Spreads 139
Chapter 7
Iron Butterfl y Spreads 181
SECTION 5 CONDOR SPREADS
Chapter 8
Standard Condor Spreads 203
iii
iv CONTENTS
Chapter 9
Iron Condor Spreads 243
SECTION 6 ARBITRAGE SPREADS
Chapter 10
Box Spreads 263
SECTION 7 RATIO SPREADS
Chapter 11
Ratio Spreads and Ratio Backspreads 281
SECTION 8 ADVANCED SPREADS
Chapter 12
Combination Spreads 321
Chapter 13
Albatross Spreads 335
Chapter 14
Ladder Spreads 361
SECTION 9 GUT SPREADS
Chapter 15
Standard Gut Spreads 385
Chapter 16
Gut Iron Butterfl y Spreads 399
Chapter 17
Gut Iron Condor Spreads 413
Chapter 18
Gut Iron Albatross Spreads 427
Conclusion 441
Glossary: Defi nitions and Basics 443
Index 461
F O R E W O R D
M
ay 2000 was a watershed month for the U.S. options industry.
The previous year saw an average daily volume of 1,765,000 equity
option contracts and a trading environment where most options
were listed on one and only one exchange; in 2000 the industry
average rose to 2,670,000 in a relatively unchanged low-volatility
market. Why the change? In May 2000, the International Securities
Exchange (ISE) launched the fi rst fully electronic options exchange
in the United States.
The opening of the ISE brought a level of competition to the
industry that was unheard of prior to May 2000. Within months of
the ISE’s opening, the bid offer spreads in options had narrowed,
customer transaction costs had declined, visible size became avail-
able, and option spreads began trading as a spread package with
the ability to enter multileg orders as a single trade with net debit
or credit. In response to the mere threat of competitive electronic
trading, the industry began to crack the monopoly of singly listed
options, and today most options list on multiple exchanges.
In the seven years since the ISE has been around, options trad-
ing volume has almost tripled. In 2006, average trading volume
soared to 7,350,000, a level we could barely have imagined in 2000.
In fact, daily average trading volume at the ISE today often exceeds
industry volume in 2000. Much of this phenomenal growth has
come due to an increase in spread trading.
Enhanced competition, better liquidity, lower friction, and in-
creased transparency have created the perfect condition for the op-
tions spread trader. Spread trading has always been the logical next
step for the experienced options trader. Spreads, by defi nition, are
managed risk trades. For directional traders they provide a way to
take a risk-managed position. For income-oriented traders they are
the trade of choice, as managing risk is key for options premium
sellers.
The industry has long needed a good book on spread trading.
The Trader’s Guide to Equity Spreads fi lls this need. Randy’s book is a
v
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vi FOREWORD
must-read for the experienced trader. Randy does a detailed analy-
sis of all the possible spreads, while adding the important factor of
overlaying the volatility assumptions. This addition of understand-
ing how the volatility impacts the trade sets Randy’s book apart
from spread writings of the past. Randy brings almost two decades
of trading experience. Few, if any, industry pros have his wealth of
practical knowledge.
I encourage readers to pay special attention to the analysis of
vertical spreads in Chapter 3. Randy explains one of my favorite in-
come strategies—credit put spreads and debit call spreads—in pre-
cise detail. Randy’s use of well-detailed risk graphs makes it easy to
develop a clear understanding of a trade’s risk and reward.
Chapters 5, 6, and 7 are a must-read for butterfl y, iron butterfl y,
condor, and iron condor traders. Before May 2000, these strategies
were out of the reach of individual investors. Today’s market condi-
tions, however, make these trades worth considering.
The investment community has long awaited a good book on
spread trading. Randy’s book fi lls that need. It is the only book on
spread trading a trader should ever need.
Alex Jacobson
International Securities Exchange
A C K N O W L E D G M E N T S
T
his book was made possible by the generous support and encour-
agement of my current employer, CyberTrader, Inc. and The Charles
Schwab Corporation.
I would especially like to thank the following people:
Chuck Speiser, who taught me much about options back in
1993 and 1994.
Mark Burke, who despite some reservations gave me my fi rst
management opportunity in derivatives.
Tim O’Donnell, who taught me many things relating to op-
tions, as well as how to be empathetic when dealing with
people, but mostly for being there as a friend for the past
14 years.
Kevin Green, who taught me a great deal about technical
analysis and active equities trading.
Butch Jones, whose hands-off style and straightforward
approach allowed me much latitude in both defi ning my
ever-changing role and reaching my goals at CyberTrader
and Schwab.
Mike Boccio, who has been a constant pleasure to work with,
and for helping me navigate through the maze of media
and public relations.
Trey Robinson, for relentlessly supporting me in many ways.
All of the various developers and programmers at Cyber-
Trader and Schwab who have been able to piece together
the mountain of ideas, drawings, and fl owcharts I have
provided in order to create one the fi nest option trading
platforms available today.
Most importantly, to my wonderful wife, Kathy, for supporting
me throughout my entire career.
vii
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