Augen - Trading Options at Expiration : Strategies and Models for Winning the Endgame

Strategies and Models for Winning the Endgame

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2009 by Pearson Education, Inc.
Publishing as FT Press
Upper Saddle River, New Jersey 07458

This book is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting or other professional services or advice by publishing this book. Each individual situation is unique. Thus, if legal or financial advice or other expert assistance is required in a specific situation, the services of a competent professional should be sought to ensure that the situation has been evaluated carefully and appropriately. The author and the publisher disclaim any liability, loss, or risk resulting directly or indirectly, from the use or application of any of the contents of this book.

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Printed in the United States of America

First Printing March 2009

ISBN-10: 0-13-505872-4
ISBN-13: 978-0-13-505872-5

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Library of Congress Cataloging-in-Publication Data
Augen, Jeffrey.
Trading options at expiration : strategies and models for winning the endgame / Jeff
Augen.
p. cm.
ISBN 0-13-505872-4 (hardback : alk. paper) 1. Options (Finance) 2. Investment
analysis. 3. SecuritiesPrices. 4. Stock price forecasting. I. Title.
HG6024.A3A9226 2009
332.63'2283dc22
2008051445

To Lisathe most independent person I knowwho taught me never to rely on anyone for anything. I only made it this far because of you.

Acknowledgments

Id like to thank everyone who helped turn some good ideas and a few words on paper into a complete book. Foremost is Jim Boyd who first had the idea of a single-topic options trading book. The work would never have taken form without Jims input.

Authors write words and make charts, but finished books are created by project editors. Once again it has been my pleasure to work with Betsy Harris who created a publication-quality document from a rough draft. In that regard I would also like to thank Keith Cline who patiently edited the original text.

Authors rarely step back and take an objective look at their own work. That task fell to Robert Balon and Michael Thomsett, who read every word and contributed valuable ideas. Their comments and enthusiasm for the material gave me confidence that helped shape the presentation.

Finally, I would like to acknowledge the excellent work of the Pearson marketing team and especially Julie Phifer, who always seems willing to put real thought behind new book concepts.

Writing this book and working with a team of focused professionals has been a real privilege. Our goal has been to produce a true source of value creation for the investment community in these turbulent times.

About the Author

Jeff Augen, currently a private investor and writer, has spent over a decade building a unique intellectual property portfolio of databases, algorithms, and associated software for technical analysis of derivatives prices. His work, which includes more than a million lines of computer code, is particularly focused on the identification of subtle anomalies and price distortions.

Augen has a 25-year history in information technology. As a cofounding executive of IBMs Life Sciences Computing business, he defined a growth strategy that resulted in $1.2 billion of new revenue and managed a large portfolio of venture capital investments. From 2002 to 2005, Augen was President and CEO of TurboWorx Inc., a technical computing software company founded by the chairman of the Department of Computer Science at Yale University. He is the author of three previous books: The Option Traders Workbook (FT Press 2008), The Volatility Edge in Options Trading (FT Press 2008) and Bioinformatics in the Post-Genomic Era (Addison-Wesley 2005).

Much of his current work on option pricing is built around algorithms for predicting molecular structures that he developed many years ago as a graduate student in biochemistry.

Introduction and Explanatory Notes

Timing

This book was written during one of the most turbulent times in stock market historythe second half of 2008. During this time frame, trillions of dollars were lost by both bulls and bears as the worlds financial markets melted down. Investors who have never experienced a crashing market often believe that it is easy to generate profits in this environment with short positions. Unfortunately, nothing is ever that simple. The 2008 collapse included single-day bear market rallies as large as 11%large enough to destroy nearly any short position. The answer lies in reducing market exposure and trading only when it makes sense.

Far too many investors have taken the opposite approach by remaining in the market with a portfolio of investments whether they were winning or losing. This approach has its own familiar vocabulary built around terms such as value investing and diversification. It hasnt worked well for most investors. At the time of this writing, U.S. equity markets had just plunged to their 1997 levels, erasing 11 years of gains. Subtracting an additional 30% for inflation and dollar devaluation paints an even darker, but more realistic picture. As a group, long-term stock investors collectively lost an enormous amount of moneytrillions of dollars.

Commodity traders faced similar problems. Oil prices climbed steeply from $27 in January 2004 to $134 in July 2008 before falling back to $50 in November. Long-term bulls actually suffered two significant setbacks during this time frame because the price fluctuated from an interim high of $70 in August 2006 to a low of $45 just five months later. traces the price from January 2004 through the November 2008 decline.

Figure I.1 Weekly U.S. spot price for crude oil 2004/01/02 to 2008/11/14. Price is displayed on the y-axis, key dates are noted on the chart. Source: U.S. Department of Energy, Energy Information Agency, www.eia.doe.gov.

As always, timing is everything. But the more important lesson is that blindly hanging on with a bullish or bearish view is a flawed strategy. Every investment has a window of opportunity; unless that window can be identified, leaving the money invested is somewhat like gambling. That said, the window can be relatively longsometimes spanning months or years.