THE INTELLIGENT OPTION INVESTORviiCONTENTSAcknowledgments xiIntroduction xiiiPart I: Options for the Intelligent Investor 1 Chapter 1: Option Fundamentals 3 Characteristics and History 4 Directionality 9 Flexibility 20 Chapter 2: The Black-Scholes-Merton Model 29 The BSMs Main Job is to Predict Stock Prices 30 The BSM is Lousy at Its Main Job 39 Chapter 3: The Intelligent Investors Guide to Option Pricing 49 How Option Prices are Determined 50 Time Value versus Intrinsic Value 56 How Changing Market Conditions Affect Option Prices 59Part II: A Sound Intellectual Framework for Assessing Value 75 Chapter 4: The Golden Rule of Valuation 77 The Value of an Asset 78 Cash Flows Generated on Behalf of Owners 80 The Companys Economic Life 82 Time Value of Money: Summing Up Cash Flows Over Time 87 Chapter 5: The Four Drivers of Value 91 Birds Eye View of the Valuation Process 91 A Detailed Look at the Drivers of Value 97viii? ? ?Chapter 6: Understanding and Overcoming Investing Pitfalls 113 Behavioral Biases 114 Structural Impediments 131Part III: Intelligent Option Investing 141 Chapter 7: Finding Mispriced Options 143 Making Sense of Option Quotes 144 Delta: The Most Useful of the Greeks 151 Comparing an Intelligent Valuation Range with a BSM Range 155 Chapter 8: Understanding and Managing Leverage 163 Investment Leverage 164 Simple Ways of Measuring Option Investment Leverage 169 Understanding Leverages Effects on a Portfolio 174 Managing Leverage 183 Chapter 9: Gaining Exposure 187 Long Call 189 Long Put 201 Strangle 205 Straddle 208 Chapter 10: Accepting Exposure 211 Short Put 212 Short Call (Call Spread) 220 Short Straddle/Short Strangle 230 Chapter 11: Mixing Exposure 233 Long Diagonal 235 Short Diagonal 238 Covered Call 240 Protective Puts 248 Collar 258 Chapter 12: Risk and the Intelligent Option Investor 263 Market Risk 263 Valuation Risk 265 Intelligent Option Investing 267Appendix A: Choose Your Battles Wisely 269 Where the BSM Works Best 269 Where the BSM Works Worst 273 Appendix B: The Many Faces of Leverage 282 Operational Leverage 282 Financial Leverage 285 Appendix C: Put-Call Parity 287 Dividend Arbitrage and Put-Call Parity 288Notes 295Index 305Contents? ? ixxiii?You have a tremendous advantage over algorithmic trading models, investment bank trading desks, hedge funds, and anyone who appears on or pays attention to cable business news shows. This book is written to show where that advantage lies and how to exploit it to make confident and suc- cessful investment choices. In doing so, it explains how options work and what they can tell you about the markets estimation of the value of stocks. Even if, after reading it, you decide to stick with straight stock in- vesting and never make an option transaction, understanding how options work will give you a tremendous advantage as an investor. The reason for this is simple: by understanding options, you can understand what the rest of the market is expecting the future price of a stock to be. Understanding what future stock prices are implied by the market is like playing cards with an opponent who always leaves his or her hand face up on the table. You can look at the cards you are dealt, compare them with your opponents, and play the round only when you are sure that you have the winning hand. By incorporating options into your portfolio, you will enjoy an even greater advantage because of a peculiarity about how option prices are determined. Option prices are set by market participants making trans- actions, but those market participants all base their sale and purchase decisions on the same statistical models. These models are like sausage grinders. They contain no intelligence or insight but rather take in a few simple inputs, grind them up in a mechanical way, and spit out an option price of a specific form. An option model does not, for instance, care about the operational details of a company. This oversight can lead to situations that seem to be too good to be true. For instance, I have seen a case in which an investor could commit to buy a strong, profitable company for less than the amount of cash it heldin effect, allowing the investor to pay $0.90 to receive a dollar plus a share of the companys future profits! Although it is true that these kinds of opportunities do not come along every day, they do indeed come along for patient, insightful investors. This example lies at the heart of intelligent option investing, the es- sence of which can be expressed as a three-step process:1. Understanding the value of a stock 2. Comparing that intelligently estimated value with the mechani- cally derived one implied by the option market 3. Tilting the risk-reward balance in ones favor by investing in the best opportunities using a combination of stocks and optionsThe goal of this book is to provide you with the knowledge you need to be an intelligent option invest