Preface
I’ve always been fascinated by trading. When I was young, I’d see traders on television, in their brightly colored jackets, shouting on the seemingly chaotic trading floor, and I’d marvel at them. What a wonderful job that must be! These traders seemed to me to be very different from the rest of us. It’s all so very esoteric.
It is easy to assume that professional traders have closely kept secrets to their ways of trading—something that secures success in trading for them, but is out of reach for everyone else. In fact, nothing could be further from the truth. If there are any “secrets” of professional traders, this book will expose them.
True enough, in years past there have been some barriers to entry to trading success that did indeed make it difficult for nonprofessionals to succeed. For example, commissions, bid-ask spreads, margin requirements, and information flow all favored the professional trader. Now, these barriers are gone. Competition among brokers and exchanges—as well as the ubiquity of information as propagated on the Internet—has torn down those walls. The only barrier left between the Average Joe and the options pro is that of knowledge. Those who have it will succeed; those who do not will fail.
To be sure, the knowledge held by successful traders is not that of what will happen in the future; it is the knowledge of how to manage the uncertainty. No matter what our instincts tell us, we do not know what will happen in the future with regard to the market. As Socrates put it, “The only true wisdom is in knowing you know nothing.” The masters of option trading are masters of managing the risk associated with what they don’t know—the risk of uncertainty.
As an instructor, I’ve talked to many traders who were new to options who told me, “I made a trade based on what I thought was going to happen. I was right, but my position lost money!” Choosing the right strategy makes all the difference when it comes to mastery of risk management and ultimate trading success. Knowing which option strategy is the right strategy for a given situation comes with knowledge and experience.
All option strategies are differentiated by their unique risk characteristics. Some are more sensitive to directional movement of the underlying asset than others; some are more affected by time passing than others. The exact exposure positions have to these market influences determines the success of individual trades and, indeed, the long-term success of the trader who knows how to exploit these risk characteristics. These option-value sensitivities can be controlled when a trader understands the option greeks.
Option greeks are metrics used to measure an option’s sensitivity to influences on its price. This book will provide the reader with an understanding of these metrics, to help the reader truly master the risk of uncertainty associated with option trading.
Successful traders strive to create option positions with risk-reward profiles that benefit them the most in a given situation. A trader’s objectives will dictate the right strategy for the right situation. Traders can tailor a position to fit a specific forecast with respect to the time horizon; the degree of bullishness, bearishness, neutrality, or volatility in the underlying stock; and the desired amount of leverage. Furthermore, they can exploit opportunities unique to options. They can trade option greeks. This opens the door to many new opportunities.
A New Direction
Traders, both professional and retail, need ways to act on their forecasts without the constraints of convention. “Get long, or do nothing” is no longer a viable business model for people active in the market. “Up is good; down is bad” is burned into traders’ minds from the beginning of their market education. This concept has its place in the world of investing, but becoming an active trader in the option market requires thinking in a new direction.
Market makers and other expert option traders look at the market differently from other traders. One fundamental difference is that these traders trade all four directions: up, down, sideways, and volatile.
Trading Strategies
Buying stock is a trading strategy that most people understand. In practical terms, traders who buy stock are generally not concerned with the literal ownership stake in a corporation, just the opportunity to profit if the stock rises. Although it’s important for traders to understand that the price of a stock is largely tied to the success or failure of the corporation, it’s essential to keep in mind exactly what the objective tends to be for trading a stock: to profit from changes in its price. A bullish position can also be taken in the options market. The most basic example is buying a call.
A bearish position can be taken by trading stock or options, as well. If traders expect the value of a stock they own to fall, they will sell the stock. This eliminates the risk of losses from the stock’s falling. If the traders do not own the stock that they think will decline, they can take a more active stance and short it. The short-seller borrows the stock from a party that owns it and then sells the borrowed shares to another party. The goal of selling stock short is to later repurchase the shares at a lower price before returning the stock to its owner. It is simply reversing the order of “buy low/sell high.” The risk is that the stock rises and shares have to be bought at a higher price than that at which they were sold. Although shorting stock can lead to profits when the market cooperates, in the options market, there are alternative ways to profit from falling prices. The most basic example is buying a put.
A trader can use options to take a bullish or bearish position, given a directional forecast. Sideways, nontrending stocks and their antithesis, volatile stocks, can be traded as well. In the later market conditions, profit or loss can be independent of whether the stock rises or falls. Opportunity in option trading is not necessarily black and white—not necessarily up and down. Option trading is nonlinear. Consequently, more opportunities can be exploited by trading options than by trading stock.
Option traders must consider the time period in question, the volatility expected during this period, interest rates, and dividends. Along with the stock price, these factors make up the dynamic components of an option’s value. These individual factors can be isolated, measured, and exploited. Incremental changes in any of these elements as measured by option greeks provide opportunity for option traders. Because of these other influences, direction is not the only tradable element of a forecast. Time, volatility, interest rates—these can all be traded using option greeks. These factors and more will all be discussed at great length throughout this book.
This Second Edition of
Trading Option Greeks
This book addresses the complex price behavior of options by discussing option greeks from both a theoretical and a practical standpoint. There is some tactical discussion throughout, although the objective of this book is to provide education to the reader. This book is meant to be less a how-to manual than a how-come tutorial.
This informative guide will give the retail trader a look inside the mind of a professional trader. It will help the professional trader better understand the essential concepts of his craft. Even the novice trader will be able to apply these concepts to basic options strategies. Comprehensive knowledge of the greeks can help traders to avoid common pitfalls and increase profit potential.
Much of this book is broken down into a discussion of individual strategies. Although the nuances of each specific strategy are not relevant, presenting the material this way allows for a discussion of very specific situations in which greeks come into play. Many of the concepts discussed in a section on one option strategy can be applied to other option strategies.
As in the first edition of
Trading Option Greeks
, Chapter 1 discusses basic option concepts and definitions. It was written to be a review of the basics for the intermediate to advanced trader. For newcomers, it’s essential to understand these concepts before moving forward.
A detailed explanation of option greeks begins in Chapter 2. Be sure to leave a bookmark in this chapter, as you will flip to it several times while reading the rest of the book and while studying the market thereafter. Chapter 3 introduces volatility. The same bookmark advice can be applied here, as well. Chapters 4 and 5 explore the minds of option traders. What are the risks they look out for? What are the opportunities they seek? These chapters also discuss direction-neutral and direction-indifferent trading. The remaining chapters take the reader from concept to application, discussing the strategies for nonlinear trading and the tactical considerations of a successful options trader.
New material in this edition includes updated examples, with more current price information throughout many of the chapters. More detailed discussions are also included to give the reader a deeper understanding of important topics. For example, Chapter 8 has a more elaborate explanation of the effect of dividends on option prices. Chapter 17 of this edition has new material on strategy selection, position management, and adjusting, not featured in the first edition of the book.