The Complete Book of Option Spreads and Combinations: Strategies for Income Generation, Directional Moves, and Risk Reduction (a review)

The Complete Book of Option Spreads and Combinations: Strategies for Income Generation, Directional Moves, and Risk Reduction discusses how investors can use options to achieve their investment goals, particularly when they have an underlying view on the direction of a stock and specific risk and return objectives.

The book covers a variety of well-known option-trading strategies, including vertical spreads, covered calls, covered puts, calendar spreads, straddles, strangles, collars, and butterflies. Among the lesser-known strategies discussed by author Scott Nations—president and chief investment officer of option-based index developer NationsShares—are risk reversal, condors and iron condors, conversion/reversal, and other spreads, including ratio spreads and back spreads.

The author’s target reader is an investor with a solid understanding of equities, a basic understanding of options, and a desire to maximize return or minimize risk on the basis of a view of future market movements. For example, a long vertical spread could be of interest to an investor who wants to benefit from a moderate upside in the stock while limiting upfront investment. In such a case, the investor would buy a call option while selling an out-of-the-money call option. The book presents a balanced view, showing that although a successful strategy can achieve the investor’s objectives, there is no such thing as a free lunch given the trade-offs between risk and return.

The book is clearly written and logically organized. Each chapter contains an easily understandable description of the securities that constitute a particular investing strategy, with both a graphical view and a detailed explanation of the strategy. There is also an in-depth explanation of how to implement each type of trade, possible outcomes, and expected risks and returns. Each chapter concludes with a useful summary that outlines the key points.

One of the book’s strengths is the abundance of ideas that it presents for the active investor’s consideration. Nations lucidly explains how to turn a point of view into a trading position through a combination of options. The attentive reader will come away with a solid knowledge of these trading strategies.

The Complete Book of Option Spreads and Combinations addresses the underlying drivers of value for options in an intuitive manner for the nonquantitative investor. For example, it explains at a high level both volatility and the time value of money and how they can affect the profitability of a trade. Readers are directed to the author’s website to calculate option prices, but quantitative investors may find themselves looking for more technical explanations of options.

Although not explicitly stated by the author, the book pursues a middle course between active management, which assumes investors can outperform the market, and efficient markets, which are likely to price options in a reasonably fair manner. For instance, Nations explains why option prices can vary from their theoretical prices, as in the case of the implied volatility of out-of-the-money options, and how demand for options can affect their prices.

At a theoretical level, the risks and potential payoffs of each strategy are fairly presented. To some extent, however, the book downplays the difficulty of successfully implementing these strategies in practice. For example, some readers might find that they have incurred substantially more risk than they were expecting because they lack the trading experience and discipline to maintain the strategies effectively as the market moves. The field of behavioral finance has demonstrated that investors are subject to psychological forces that often drive decision making that is ultimately not in their best interest. Thus, the actual trading results of a reader who follows the strategies described in the book could differ substantially from the theoretical outcomes that the author presents. In addition, as the book points out, investors who are wrong about the direction of a security can incur significant capital losses.

Although the material is carefully thought through and well presented, much of it can be found in other sources. Given the book’s price of $90, some readers may decide to obtain similar information at far less cost.

In summary, for investors who want to learn more about option-trading strategies, The Complete Book of Option Spreads and Combinations presents a good overview of the subject, with a number of trading strategies that investors can use to help them achieve their desired outcomes.

—A.T.D.