Tuesday, May 10, 2011

Levy, Your Options Handbook

Useful intermediate-level options books are notoriously difficult to write. Theoretically at least, it’s easy enough to write an introductory book that explains how a call differs from a put or how delta can be understood in terms of the number of shares of stock. But that doesn’t get the would-be options trader very far. Jared A. Levy, in Your Options Handbook: The Practical Reference and Strategy Guide to Trading Options (Wiley, 2011), goes a couple of steps beyond the introductory. He not only covers the basics but also guides the reader into the real world of options trading.

One of the strengths of this book is its breadth. It places options trading within the contexts of fundamental and technical analysis, macroeconomics, risk management, and trader psychology. I should note here that, in addition to a brief foreword by Mark Douglas, Levy turns over two chapters to “outside experts.” We hear from Denise Shull on understanding why you need emotions to trade well and from Dean Somes on turning your trading into a business.

Levy limits his discussion to single-expiration trades. Calls (naked and covered), puts, collars, vertical spreads, straddles, butterflies, and condors--no calendars. So there is no need to worry about such thorny subjects as horizontal volatility skew. In fact, it is only in the last chapter that implied volatility is discussed at any length, a discussion that academics would find seriously wanting.

But Levy, it seems, intentionally tries to keep things simple. For instance, in place of the trickier measures of volatility, he relies on ATR. It gives him a down-and-dirty way to set an initial stop on a long call. Let’s say you want to buy GOOG stock, where the average 14-period ATR over the previous month was $45. To stay outside of GOOG’s normal fluctuations you multiply $45 by 1.2. So your acceptable stop-loss in the stock would be $54. (A hypothesis: subtract this ATR stop loss from the stock price and that’s the strike you buy.) But of course you don’t want to buy the stock, you want to buy a call. How do you set a stop loss on a call? Levy’s method is to “take the ATR of the time frame that I want to be in the trade (monthly max); then … multiply it by 1.2 and then multiply by the delta.” (p. 169) Simple. Does it work? I have no idea. I leave it to those with more time than I have right now to test it out.

Levy walks the reader through hypothetical and real directional and volatility trades. Starting with a fundamental or macroeconomic premise, he chooses a trading candidate and an option strategy. Then, of course, in the case of spread trades he has to pick the right strike prices, expiration, and width of spread—some with the help of technicals. And once in the trade he has to monitor it, perhaps using a trailing stop, and decide when to exit. Levy mentions adjusting a position only in passing; basically, he lets violated stops or a decent percentage return get the trader out of his position.

Your Options Handbook is not a must-have book, but it’s a good book. I would recommend it to the relative novice—skip the really basic books and turn to this one. You won’t have a sophisticated understanding of options, but you won’t be swamped with information that you can’t profitably use at this stage of your trading career.

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