ome negative, and theta becomes positive. If the stock price falls low
enough, this backspread becomes a very different position than it was with
the stock price at $71. Instead of profiting from higher implied and realized
volatility, the spread needs a lower level of both to profit.
This has important implications. First, gamma traders must approach the
backspread a little differently than they would most spreads. The
backspread traders must keep in mind the dynamic greeks of the position.
With a trade like a long straddle, in which there are no short options, traders
scalping gamma simply buy to cover short deltas as the stock falls and sell
to cover long deltas as the stock rises. The only risks are that the stock may
not move enough to cover theta or that the traders may cover deltas too
soon to maximize profits.
With the backspread, the changing gamma adds one more element of risk.
In this example, buying stock to flatten out delta as the stock falls can
sometimes be a premature move. Traders who buy stock may end up with
more long deltas than they bargained for if the stock falls into negative-
gamma territory.
Exhibit 16.3 shows that with the stock at $68, the delta for this trade is
−2.50. If the traders buy 250 shares at $68, they will be delta neutral. If the
stock subsequently falls to $62 a share, instead of being short 1.46 deltas, as
the figure indicates, they will be long 1.04 because of the 250 shares they
bought. These long deltas start to hurt as the stock continues lower.
Backspreaders must therefore anticipate stock movements to avoid
overhedging. The traders in this example may decide to lean short if the
stock shows signs of weakness.
Leaning short means that if the delta is −2.50 at $68 a share, the traders
may decide to underhedge by buying just 100 or 200 shares. If the stock
continues to fall and negative gamma kicks in, this gives the traders some
cushion to the downside. The short delta of the position moves closer to
being flat as the stock falls. Because there is a long strike and a short strike
in this delta-neutral position, trading ratio spreads is like trading a long and
a short volatility position at the same time. Trading backspreads is not an
exact science. The stock has just as good a chance of rising as it does of
falling, and if it does rise and the traders have underhedged at $68, they will
not participate in all the gains they would have if they had fully hedged by
buying 250 shares of stock. If trading were easy, everyone would do it!
Backspreaders must also be conscious of the volatility of each leg of the
spread. There is an inherent advantage in this example to buying the lower
volatility of the 75 calls and selling the higher volatility of the 70 calls. But
there is also implied risk. Equity prices and IV tend to have an inverse
relationship. When stock prices fall—especially if the drop happens quickly
—IV will often rise. When stock prices rise, IV often falls.
In this backspread example, as the stock price falls to or through the short
strike, vega becomes negative in the face of a potentially rising IV. As the
stock price rises into positive vega turf, there is the risk of IV’s declining. A
dynamic volatility forecast should be part of a backspread-trading plan. One
of the volatility questions traders face in this example is whether the two-
point volatility skew between the two strike prices is enough to compensate
for the potential adverse vega move as the stock price changes.
Put backspreads have the opposite skew/volatility issues. Buying two
lower-strike puts against one higher-strike put means the skew is the other
direction—buying the higher IV and selling the lower. The put backspread
would have long gamma/vega to the downside and short gamma/vega to the
upside. But if the vega firms up as the stock falls into positive-vega
territory, it would be in the trader’s favor. As the stock rises, leading to
negative vega, there is the potential for vega profits if IV indeed falls. There
are a lot of things to consider when trading a backspread. A good trader
needs to think about them all before putting on the trade.
Ratio Vertical Spreads
Definition : An option strategy consisting of more short options than long
options having the same expiration month. Typically, the trader is short calls
(or puts) in one series of options and long a fewer number of calls (or puts)
in another series in the same expiration month on the same option class.
A ratio vertical spread, like a backspread, involves options struck at two
different prices—one long strike and one short. That means that it is a
volatility strategy that may be long or short gamma or vega depending on
where the underlying price is at the time. The ratio vertical spread is
effectively the opposite of a backspread. Let’s study a ratio vertical using
the same options as those used in the backspread example.
With the stock at $71 and one month until March expiration:
In this case, we are buying one ITM call and selling two OTM calls. The
relationship of the stock price to the strike price is not relevant to whether
this spread is considered a ratio vertical spread. Certainly, all these options
could be ITM or OTM at the time the trade is initiated. It is also not
important whether the trade is done for a debit or a credit. If the stock price,
time to expiration, volatility, or number of contracts in the ratio were
different, this could just as easily been a credit ratio vertical.
Exhibit 16.4 illustrates the payout of this strategy if both legs of the 1:2
contract are still open at expiration.
EXHIBIT 16.4 Short ratio spread at expiration.
This strategy is a mirror image of the backspread discussed previously in
this chapter. With limited risk to the downside, the maximum loss to the
trade is the initial debit of 1 if the stock is below $70 at expiration and all
the calls expire. There is a maximum profit potential of 4 if the stock is at
the short strike at expiration. There is unlimited


HIBIT 16.4 Short ratio spread at expiration.
This strategy is a mirror image of the backspread discussed previously in
this chapter. With limited risk to the downside, the maximum loss to the
trade is the initial debit of 1 if the stock is below $70 at expiration and all
the calls expire. There is a maximum profit potential of 4 if the stock is at
the short strike at expiration. There is unlimited loss potential, since a short
net delta is created on the upside, as one short 75 call is covered by the long
70 call, and one is naked. The breakevens are at $71 and $79.
Low Volatility
With the stock at $71, gamma and vega are both negative. Just as the
backspread was a long volatility play at this underlying price, this ratio
vertical is a short-vol play here. As in trading a short straddle, the name of
the game is low volatility—meaning both implied and realized.
This strategy may require some gamma hedging. But as with other short
volatility delta-neutral trades, the fewer the negative scalps, the greater the
potential profit. Delta covering should be implemented in situations where
it looks as if the stock will trend deep into negative-gamma territory.
Murphy’s Law of trading dictates that delta covering will likely be wrong at
least as often as it is right.
Ratio Vertical Example
Let’s examine a trade of 20 contracts by 40 contracts. Exhibit 16.5 shows
the greeks for this ratio vertical.
EXHIBIT 16.5 Short ratio vertical spread greeks.
Before we get down to the nitty-gritty of the mechanics and management
of this trade—the how—let’s first look at the motivations for putting the
trade on—the why. For the cost of 1.00 per spread, this trader gets a
leveraged position if the stock rises moderately. The profits max out with
the stock at the short-strike target price—$75—at expiration.
Another possible profit engine is IV. Because of negative vega, there is
the chance of taking a quick profit if IV falls in the interim. But short-term
losses are possible, too. IV can rise, or negative gamma can hurt the trader.
Ultimately, having naked calls makes this trade not very bullish. A big
move north can really hurt.
Basically, this is a delta-neutral-type short-volatility play that wins the
most if the stock is at $75 at expiration. One would think about making this
trade if the mechanics fit the forecast. If this trader were a more bullish than
indicated by the profit and loss diagram, a more-balanced bull call spread
would be a better strategy, eliminating the unlimited upside risk. If upside
risk were acceptable, this trader could get more aggressive by trading the
spread one-by-three. That would result in a credit of 0.05 per spread. There
would then be no ultimate risk below $70 but rather a 0.05 gain. With
double the naked calls, however, there would be double punishment if the
stock rallied strongly beyond the upside breakeven.
Ultimately, mastering options is not about mastering specific strategies.
It’s about having a thorough enough understanding of the instrument to be
flexible enough to tailor a position around a forecast. It’s about minimizing
the unwanted risks and optimizing exposure to the intended risks. Still,
there always exists a trade-off in that where there is the potential for profit,
there is the possibility of loss—you can always be wrong.
Recalling the at-expiration diagram and examining the greeks, the best-
case scenario is intuitive: the stock at $75 at expiration. The biggest theta
would be right at that strike. But that strike price is also the center of the
biggest negative gamma. It is important to guard against upward movement
into negative delta territory, as well as movement lower where the position
has a slightly positive delta. Exhibit 16.6 shows what happens to the greeks
of this trade as the stock price moves.
EXHIBIT 16.6 Ratio vertical spread at various prices for the underlying.
As the stock begins to rise from $71 a share, negative deltas grow fast in
the short term. Careful trend monitoring is necessary to guard against a
rally. The key, however, is not in knowing what will happen but in skillfully
hedging against the unknown. The talented option trader is a disciplined
risk manager, not a clairvoyant.
One of the risks that the trader willingly accepted when placing this trade
was short gamma. But when the stock moves and deltas are created,
decisions have to be made. Did the catalyst(s)—if any—that contributed to
the rise in stock price change the outlook for volatility? If not, the decision
is simply whether or not to hedge by buying stock. However, if it appears
that volatility is on the rise, it is not just a delta decision. A trader may
consider buying some of the short options back to reduce volatility
exposure.
In this example, if the stock rises and it’s feared that volatility may
increase, a good choice may be to buy back some of the short 75-strike
calls. This has the advantage of reducing delta (buy enough deltas to flatten
out) and reducing gamma and vega. Of course, the downside to this strategy
is that in purchasing the calls, a loss is likely to be locked in. Unless a lot of
time has passed or implied volatility has dropped sharply, the calls will
probably be bought at a higher price than they were sold.
If the stock makes a violent move upward, a loss will be incurred.
Whether this loss is locked in by closing all or part of the position, the
account will still be down in value. The decision to buy the calls back at a
loss is based on looking forward. Nothing good can come of looking back.
How Market Makers Manage
Delta-Neutral Positions
While market makers are not position traders per se, they are expert
position managers. For the most part, market makers make their living by
buying the bid and selling the offer. In general, they don’t act; they react.
Most of their trades are initiated by taking the other side of what other
people want to do and then managing the risk of the positions they
accumulate.
The business of a market maker is mu

eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf


ket makers are not position traders per se, they are expert
position managers. For the most part, market makers make their living by
buying the bid and selling the offer. In general, they don’t act; they react.
Most of their trades are initiated by taking the other side of what other
people want to do and then managing the risk of the positions they
accumulate.
The business of a market maker is much like that of a casino. A casino
takes the other side of people’s bets and, in the long run, has a statistical
(theoretical) edge. For market makers, because theoretical value resides in
the middle of the bid and the ask, these accommodating trades lead to a
theoretical profit—that is, the market maker buys below theoretical value
and sells above. Actual profit—cold, hard cash you can take to the bank—
is, however, dependent on sound management of the positions that are
accumulated.
My career as a market maker was on the floor of the Chicago Board
Options Exchange (CBOE) from 1998 to 2005. Because, over all, the trades
I made had a theoretical edge, I hoped to trade as many contracts as
possible on my markets without getting too long or too short in any option
series or any of my greeks.
As a result of reacting to order flow, market makers can accumulate a
large number of open option series for each class they trade, resulting in a
single position. For example, Exhibit 16.7 shows a position I had in Ford
Motor Co. (F) options as a market maker.
EXHIBIT 16.7 Market-maker position in Ford Motor Co. options.

With all the open strikes, this position is seemingly complex. There is not
a specific name for this type of “spread.” The position was accumulated
over a long period of time by initiating trades via other traders selling
options to me at prices I wanted to buy them—my bid—and buying options
from me at prices I wanted to sell them—my offer. Upon making an option
trade, I needed to hedge directional risk immediately. I usually did so by
offsetting my option trades by taking the opposite delta position in the stock
—especially on big-delta trades. Through this process of providing liquidity
to the market, I built up option-centric risk.
To manage this risk I needed to watch my other greeks. To be sure, trying
to draw a P&L diagram of this position would be a fruitless endeavor.
Exhibit 16.8 shows the risk of this trade in its most distilled form.
EXHIBIT 16.8 Analytics for market-maker position in Ford Motor Co.
(stock at $15.72).
Delta +1,075
Gamma−10,191
Theta +1,708
Vega +7,171
Rho −33,137
The +1,075 delta shows comparatively small directional risk relative to
the −10,191 gamma. Much of the daily task of position management would
be to carefully guard against movement by delta hedging when necessary to
earn the $1,708 per day theta.
Much of the negative gamma/positive theta comes from the combined
1,006 short January 15 calls and puts. (Note that because this position is
traded delta neutral, the net long or short options at each strike is what
matters, not whether the options are calls or puts. Remember that in delta-
neutral trading, a put is a call, and a call is a put.) The positive vega stems
from the fact that the position is long 1,927 January 2003 20-strike options.
Although this position has a lot going on, it can be broken down many
ways. Having long LEAPS options and short front-month options gives this
position the feel of a time spread. One way to think of where most of the
gamma risk is coming from is to bear in mind that the 15 strike is
synthetically short 503 straddles (1,006 options ÷ two). But this position
overall is not like a straddle. There are more strikes involved—a lot more.
There is more short gamma to the downside if the price of Ford falls toward
$12.50. To the upside, the 17.50 strike is long a combined total of 439
options. Looking at just the 15 and 17.50 strikes, we can see something that
looks more like a ratio spread: 1,006:439. If the stock were at $17.50, the
gamma would be around +5,000.
With the stock at $15.72, there is realized volatility risk of F rallying, but
with gamma changing from negative to positive as the stock rallies, the risk
of movement decreases quickly. The 20 strike is short 871 options which
brings the position back to negative-gamma territory. Having alternating
long and short strikes, sometimes called a butterflied position, is a handy
way for market makers to reduce risk. A position is perfectly butterflied if it
has alternating long and short strikes with the same number of contracts.
Through Your Longs to Your Shorts
With market-maker-type positions consisting of many strikes, the greatest
profit is gained if the underlying security moves through the longs to the
shorts. This provides kind of a win-win scenario for greeks traders. In this
situation, traders get the benefit of long gamma as the stock moves higher
or lower through the long strike. They also reap the benefits of theta when
the stock sits at the short strike.
Trading Flat
Most market makers like to trade flat—that is, profit from the bid-ask
spread and strive to lower exposure to direction, time, volatility, and interest
as much as possible. But market makers are at the mercy of customer
orders, or paper, as it’s known in the industry. If someone sells, say, the
March 75 calls to a market maker at the bid, the best-case scenario is that
moments later someone else buys the same number of the same calls—the
March 75s, in this case—from that same market maker at the offer. This is
locking in a profit.
Unfortunately, this scenario seldom plays out this way. In my seven years
as a market maker, I can count on one hand the number of times the option
gods smiled upon me in such a way as to allow me to immediately scalp an
option. Sometimes, the same option will not trade again for a week or
longer. Very low-volume options trade “by appointment only.” A market
maker trading illiquid options may hold the position until it expires, having
no chance to get out at a reasonable


a market maker, I can count on one hand the number of times the option
gods smiled upon me in such a way as to allow me to immediately scalp an
option. Sometimes, the same option will not trade again for a week or
longer. Very low-volume options trade “by appointment only.” A market
maker trading illiquid options may hold the position until it expires, having
no chance to get out at a reasonable price, often taking a loss on the trade.
More typically, if a market maker buys an option, he must sell a different
option to lessen the overall position risk. The skills these traders master are
to lower bids and offers on options when they are long gamma and/or vega
and to raise bids and offers on options when they are short gamma and/or
vega. This raising and lowering of markets is done to manage risk.
Effectively, this is your standard high school economics supply-and-
demand curves in living color. When the market demands (buys) all the
options that are supplied (offered) at a certain price, the price rises. When
the market supplies (sells) all the options demanded (bid) at a price level,
the price falls. The catalyst of supply and demand is the market maker and
his risk tolerance. But instead of the supply and demand for individual
options, it is supply and demand for gamma, theta, and vega. This is trading
option greeks.
Hedging the Risk
Delta is the easiest risk for floor traders to eliminate quickly. It becomes
second nature for veteran floor traders to immediately hedge nearly every
trade with the underlying. Remember, these liquidity providers are in the
business of buying option bids and selling option offers, not speculating on
direction.
The next hurdle is to trade out of the option-centric risk. This means that
if the market maker is long gamma, he needs to sell options; if he’s short
gamma, he needs to buy some. Same with theta and vega. Market makers
move their bids and offers to avoid being saddled with too much gamma,
theta, and vega risk. Experienced floor traders are good at managing option
risk by not biting off more than they can chew. They strive to never buy or
sell more options than they can spread off by selling or buying other
options. This breed of trader specializes in trading the spread and managing
risk, not in predicting the future. They’re market makers, not market takers.
Trading Skew
There are some trading strategies for which market makers have a natural
propensity that stems from their daily activity of maintaining their
positions. While money managers who manage equity funds get to know
the fundamentals of the stocks they trade very well, options market makers
know the volatility of the option classes they trade. When they adjust their
markets in reacting to order flow, it’s, mechanically, implied volatility that
they are raising or lowering to change theoretical values. They watch this
figure very carefully and trade its subtle changes.
A characteristic of options that many market makers and some other
active professional traders observe and trade is the volatility skew. Savvy
traders watch the implied volatility of the strikes above the at-the-money
(ATM)—referred to as calls , for simplicity—compared with the strikes
below the ATM, referred to as puts . In most stocks, there typically exists a
“normal” volatility skew inherent to options on that stock. When this skew
gets out of line, there may be an opportunity.
Say for a particular option class, the call that is 10 percent OTM typically
trades about four volatility points lower than the put that is 10 percent
OTM. For example, for a $50 stock, the 55 calls are trading at a 21 IV and
the 45 puts are trading at a 25 volatility. If the 45 puts become bid higher,
say, nine points above where the calls are offered—for instance, the puts are
bid at 32 volatility bid while the calls are offered at 23 vol—a trader can
speculate on the skew reverting back to its normal relationship by selling
the puts, buying the calls, and hedging the delta by selling the right amount
of stock.
This position—long a call, short a put with a different strike, and short
stock on a delta-neutral ratio—is called a risk reversal. The motive for risk
reversals is to capture vega as the skew realigns itself. But there are many
risk factors that require careful attention.
First, as in other positions consisting of both long and short strikes, the
gamma, theta, and vega of the position will vary from positive to negative
depending on the price of the underlying. Risk-reversal traders must be
prepared to trade long gamma (and battle time decay) when the stock rallies
closer to the long-call strike and trade short gamma (and assume the risk of
possible increased realized volatility) when the stock moves closer to the
short-put strike.
As for vega, being short implied volatility on the downside and long on
the upside is inherently a potentially bad position whichever way the stock
moves. Why? As equities decline in price, the implied volatility of their
options tends to rise. But the downside is where the risk reversal has its
short vega. Furthermore, as equities rally, their IV tends to fall. That means
the long vega of the upside hurts as well.
When Delta Neutral Isn’t Direction
Indifferent
Many dynamic-volatility option positions, such as the risk reversal, have
vega risk from potential IV changes resulting from the stock’s moving. This
is indirectly a directional risk. While having a delta-neutral position hedges
against the rather straightforward directional risk of the position delta, this
hidden risk of stock movement is left unhedged. In some circumstances, a
delta-lean can help abate some of the vega risk of stock-price movement.
Say an option position has fairly flat greeks at the current stock price. Say
that given the way this particular position is set up, if the stock rises, the
position is still fairly flat, but if the stock falls, short lower-strike options
will lead to negative gamma and vega. One way to partially hedge th


ome circumstances, a
delta-lean can help abate some of the vega risk of stock-price movement.
Say an option position has fairly flat greeks at the current stock price. Say
that given the way this particular position is set up, if the stock rises, the
position is still fairly flat, but if the stock falls, short lower-strike options
will lead to negative gamma and vega. One way to partially hedge this
position is to lean short deltas—that is, instead of maintaining a totally flat
delta, have a slightly short delta. That way, if the stock falls, the trade
profits some on the short stock to partially offset some of the anticipated
vega losses. The trade-off of this hedge is that if the stock rises, the trade
loses on the short delta.
Delta leans are more of an art than a science and should be used as a
hedge only by experienced vol traders. They should be one part of a well-
orchestrated plan to trade the delta, gamma, theta, and vega of a position.
And, to be sure, a delta lean should be entered into a model for simulation
purposes before executing the trade to study the up-and-down risk of the
position. If the lean reduces the overall risk of the position, it should be
implemented. But if it creates a situation where there is an anticipated loss
if the stock moves in either direction and there is little hope of profiting
from the other greeks, the lean is not the answer—closing the position is.
Managing Multiple-Class Risk
Most traders hold option positions in more than one option class. As an
aside, I recommend doing so, capital and experience permitting. In my
experience, having positions in multiple classes psychologically allows for
a certain level of detachment from each individual position. Most traders
can make better decisions if they don’t have all their eggs in one basket.
But holding a portfolio of option positions requires one more layer of risk
management. The trader is concerned about the delta, gamma, theta, vega,
and rho not only of each individual option class but also of the portfolio as a
whole. The trader’s portfolio is actually one big position with a lot of
moving parts. To keep it running like a well-oiled machine requires
monitoring and maintaining each part to make sure they are working
together. To have the individual trades work in harmony with one another, it
is important to keep a well-balanced series of strategies.
Option trading requires diversification, just like conventional linear stock
trading or investing. Diversification of the option portfolio is easily
measured by studying the portfolio greeks. By looking at the net greeks of
the portfolio, the trader can get some idea of exposure to overall risk in
terms of delta, gamma, theta, vega, and rho.
CHAPTER 17
Putting the Greeks into Action
This book was intended to arm the reader with the knowledge of the greeks
needed to make better trading decisions. As the preface stated, this book is
not so much a how-to guide as a how-come tutorial. It is step one in a three-
step learning process:
Step One: Study . First, aspiring option traders must learn as much as
possible from books such as this one and from other sources, such as
articles, both in print and online, and from classes both in person and
online. After completing this book, the reader should have a solid base
of knowledge of the greeks.
Step Two: Paper Trade . A truly deep understanding requires practice,
practice, and more practice! Fortunately, much of this practice can be
done without having real money on the line. Paper trading—or
simulated trading—in which one trades real markets but with fake
money is step two in the learning process. I highly recommend paper
trading to kick the tires on various types of strategies and to see how
they might work differently in reality than you thought they would in
theory.
Step Three: Showtime ! Even the most comprehensive academic study
or windfall success with paper profits doesn’t give one a true feel for
how options work in the real world. There are some lessons that must
be learned from the black and the blue. When there’s real money on the
line, you will trade differently—at least in the beginning. It’s human
nature to be cautious with wealth. This is not a bad thing. But emotions
should not override sound judgment. Start small—one or two lots per
trade—until you can make rational decisions based on what you have
learned, keeping emotions in check.
This simple three-step process can take years of diligent work to get it
right. But relax. Getting rich quick is truly a poor motivation for trading
options. Option trading is a beautiful thing! It’s about winning. It’s about
beating the market. It’s about being smart. Don’t get me wrong—wealth can
be a nice by-product. I’ve seen many people who have made a lot of money
trading options, but it takes hard work. For every successful option trader
I’ve met, I’ve met many more who weren’t willing to put in the effort, who
brashly thought this is easy, and failed miserably.
Trading Option Greeks
Traders must take into account all their collective knowledge and
experience with each and every trade. Now that you’re armed with
knowledge of the greeks, use it! The greeks come in handy in many ways.
Choosing between Strategies
A very important use of the greeks is found in selecting the best strategy for
a given situation. Consider a simple bullish thesis on a stock. There are
plenty of bullish option strategies. But given a bullish forecast, which
option strategy should a trader choose? The answer is specific to each
unique opportunity. Trading is situational.
Example 1
Imagine a trader, Arlo, is studying the following chart of Agilent
Technologies Inc. (A). See Exhibit 17.1 .
EXHIBIT 17.1 Agilent Technologies Inc. daily candles.
Source : Chart courtesy of Livevol® Pro ( www.livevol.com )
The stock has been in an uptrend for six weeks or so. Close-to-close
volatility hasn’t increased much. But intraday volatility has increased
greatly as indicated by the larger candles


a trader, Arlo, is studying the following chart of Agilent
Technologies Inc. (A). See Exhibit 17.1 .
EXHIBIT 17.1 Agilent Technologies Inc. daily candles.
Source : Chart courtesy of Livevol® Pro ( www.livevol.com )
The stock has been in an uptrend for six weeks or so. Close-to-close
volatility hasn’t increased much. But intraday volatility has increased
greatly as indicated by the larger candles over the past 10 or so trading
sessions. Earnings is coming up in a week in this example, however implied
volatility has not risen much. It is still “cheap” relative to historical
volatility and past implied volatility. Arlo is bullish. But how does he play
it? He needs to use what he knows about the greeks to guide his decision.
Arlo doesn’t want to hold the trade through earnings, so it will be a short-
term trade. Thus, theta is not much of a concern. The low-priced volatility
guides his strategy selection in terms of vega. Arlo certainly wouldn’t want
a short-vega trade. Not with the prospect of implied volatility potential
rising going into earnings. In fact, he’d actually want a big positive vega
position. That rules out a naked/cash-secured put, put credit spread and the
likes.
He can probably rule out vertical spreads all together. He doesn’t need to
spread off theta. He doesn’t want to spread off vega. Positive gamma is
attractive for this sort of trade. He wouldn’t want to spread that off either.
Plus, the inherent time component of spreads won’t work well here. As
discussed in Chapter 9, the bulk of vertical spreads profits (or losses) take
time to come to fruition. The deltas of a call spread are smaller than an
outright call. Profits would come from both delta and theta, if the stock rises
to the short strike and positive theta kicks in.
The best way for Arlo to play this opportunity is by buying a call. It gives
him all the greeks attributes he wants (comparatively big positive delta,
gamma and vega) and the detriment (negative theta) is not a major issue.
He’d then select among in-the-money (ITM), at-the-money (ATM), and
out-of-the-money (OTM) calls and the various available expiration cycles.
In this case, because positive gamma is attractive and theta is not an issue,
he’d lean toward a front month (in this case, three week) option. The front
month also benefits him in terms of vega. Though the vegas are smaller for
short-term options, if there is a rise in implied volatility leading up to
earnings, the front month will likely rise much more than the rest. Thus, the
trader has a possibility for profits from vega.
Example 2
A trader, Luke, is studying the following chart for United States Steel Corp.
(X). See Exhibit 17.2 .
EXHIBIT 17.2 United States Steel Corp. daily candles.
Source : Chart courtesy of Livevol® Pro ( www.livevol.com )
This stock is in a steady uptrend, which Luke thinks will continue.
Earnings are out and there are no other expected volatility events on the
horizon. Luke thinks that over the next few weeks, United States Steel can
go from its current price of around $31 a share to about $34. Volatility is
midpriced in this example—not cheap, not expensive.
This scenario is different than the previous one. Luke plans to potentially
hold this trade for a few weeks. So, for Luke, theta is an important concern.
He cares somewhat about volatility, too. He doesn’t necessarily want to be
long it in case it falls; he doesn’t want to be short it in case it rises. He’d
like to spread it off; the lower the vega, the better (positive or negative).
Luke really just wants delta play that he can hold for a few weeks without
all the other greeks getting in the way.
For this trade, Luke would likely want to trade a debit call spread with the
long call somewhat ITM and the short call at the $34 strike. This way, Luke
can start off with nearly no theta or vega. He’ll retain some delta, which
will enable the spread to profit if United States Steel rises and as it
approaches the 34 strike, positive theta will kick in.
This spread is superior to a pure long call because of its optimized greeks.
It’s superior to an OTM bull put spread in its vega position and will likely
produce a higher profit with the strikes structured as such too, as it would
have a bigger delta.
Integrating greeks into the process of selecting an option strategy must
come natural to a trader. For any given scenario, there is one position that
best exploits the opportunity. In any option position, traders need to find the
optimal greeks position.
Managing Trades
Once the trade is on, the greeks come in handy for trade management. The
most important rule of trading is Know Thy Risk . Knowing your risk means
knowing the influences that expose your position to profit or peril in both
absolute and incremental terms. At-expiration diagrams reveal, in no
uncertain terms, what the bottom-line risk points are when the option
expires. These tools are especially helpful with simple short-option
strategies and some long-option strategies. Then traders need the greeks.
After all, that’s what greeks are: measurements of option risk. The greeks
give insight into a trade’s exposure to the other pricing factors. Traders must
know the greeks of every trade they make. And they must always know the
net-portfolio greeks at all times. These pricing factors ultimately determine
the success or failure of each trade, each portfolio, and eventually each
trader.
Furthermore, always—and I do mean always—traders must know their up
and down risk, that is, the directional risk of the market moving up or down
certain benchmark intervals. By definition, moves of three standard
deviations or more are very infrequent. But they happen. In this business
anything can happen. Take the “flash crash of 2010 in which the Dow Jones
Industrial Average plunged more than 1,000 points in “a flash.” In my
trading career, I’ve seen some surprises. Traders have to plan for the worst.
It’s not too hard to tell your significant other, “Sorry I’m late, but I hit
un


moves of three standard
deviations or more are very infrequent. But they happen. In this business
anything can happen. Take the “flash crash of 2010 in which the Dow Jones
Industrial Average plunged more than 1,000 points in “a flash.” In my
trading career, I’ve seen some surprises. Traders have to plan for the worst.
It’s not too hard to tell your significant other, “Sorry I’m late, but I hit
unexpected traffic. I just couldn’t plan for it.” But to say, “Sorry, I lost our
life savings, and the kids’ college fund, and our house because the market
made an unexpected move. I couldn’t plan for it,” won’t go over so well.
The fact is, you can plan for it. And as an option trader, you have to. The
bottom line is, expect the unexpected because the unexpected will
sometimes happen. Traders must use the greeks and up and down risk,
instead of relying on other common indicators, such as the HAPI.
The HAPI: The Hope and Pray
Index
So you bought a call spread. At the opening bell the next morning, you find
that the market for the underlying has moved lower—a lot lower. You have
a loss on your hands. What do you do? Keep a positive attitude? Wear your
lucky shirt? Pray to the options gods? When traders finds themselves
hoping and praying—I swear I’ll never do that again if I can just get out of
this position!—it is probably time for them to take their losses and move on
to the next trade. The Hope and Pray Index is a contraindicator. Typically,
the higher it is, the worse the trade.
There are two numbers a trader can control: the entry price and the exit
price. All of the other flashing green and red numbers on the screen are out
of the trader’s control. Savvy traders observe what the market does and
make decisions on whether and when to enter a position and when to exit.
Traders who think about their positions in terms of probability make better
decisions at both of these critical moments.
In entering a trade, traders must consider their forecast, their assessment
of the statistical likelihood of success, the potential payout and loss, and
their own tolerance for risk. Having considered these criteria helps the
traders stay the course and avoid knee-jerk reactions when the market
moves in the wrong direction. Trading is easy when positions make money.
It is how traders deal with adverse positions that separates good traders
from bad.
Good traders are good at losing money. They take losses quickly and let
profits run. Accepting, before entering the trade, the statistical nature of
trading can help traders trade their positions with less emotion. It then
becomes a matter of competent management of those positions based on
their knowledge of the factors affecting option values: the greeks. Learning
to think in terms of probability is among the most difficult challenges for a
new options trader.
Chapter 5 discussed my Would I Do It Now? Rule, in which a trader asks
himself: if I didn’t currently have this position, would I put it on now at
current market prices? This rule is a handy technique to help traders filter
out the noise in their heads that clouds judgment and to help them to make
rational decisions on whether to hold a position, close it out or adjust it.
Adjusting
Sometimes the position a trader starts off with is not the position he or she
should have at present. Sometimes positions need to be changed, or
adjusted, to reflect current market conditions. Adjusting is very important to
option traders. To be good at adjusting, traders need to use the greeks.
Imagine a trader makes the following trade in Halliburton Company
(HAL) when the stock is trading $36.85.
Sell 10 February 35–36–38–39 iron condors at 0.45
February has 10 days until expiration in this example. The greeks for this
trade are as follows:
Delta: −6.80
Gamma: −119.20
Theta: +21.90
Vega: −12.82
The trader has a neutral outlook, which can be inferred by the near-flat
delta. But what if the underlying stock begins to rise? Gamma starts kicking
in. The trader can end up with a short-biased delta that loses exponentially
if the stock continues to climb. If Halliburton rises (or falls for that matter)
the trader needs to recalibrate his outlook. Surely, if the trader becomes
bullish based on recent market activity, he’d want to close the trade. If the
trader is bearish, he’d probably let the negative delta go in hopes of making
back what was lost from negative gamma. But what if the trader is still
neutral?
A neutral trader needs a position that has greeks which reflect that
outlook. The trader would want to get delta back towards zero. Further,
depending on how much the stock rises, theta could start to lose its benefit.
If Halliburton approaches one of the long strikes, theta could move toward
zero, negating the benefit of this sort of trade all together. If after the stock
rises, the trader is still neutral at the new underlying price level, he’d likely
adjust to get delta and theta back to desired territory.
A common adjustment in this scenario is to roll the call-credit-spread legs
of the iron condor up to higher strikes. The trader would buy ten 38 calls
and sell ten 39 calls to close the credit spread. Then the trader would buy 10
of the 39 calls as sell 10 of the 40 calls to establish an adjusted position that
is short a 10 lot of the February 35–36–39–40 iron condor.
This, of course, is just one possible adjustment a trader can make. But the
common theme among all adjustments is that the trader’s greeks must
reflect the trader’s outlook. The position greeks best describe what the
position is—that is, how it profits or loses. When the market changes it
affects the dynamic greeks of a position. If the market changes enough to
make a trader’s position greeks no longer represent his outlook, the trader
must adjust the position (adjust the greeks) to put it back in line with
expectations.
In option trading there are an infinite number of uses for the greeks. From
finding trades, to planning execution, to managing and adjusting th


e market changes it
affects the dynamic greeks of a position. If the market changes enough to
make a trader’s position greeks no longer represent his outlook, the trader
must adjust the position (adjust the greeks) to put it back in line with
expectations.
In option trading there are an infinite number of uses for the greeks. From
finding trades, to planning execution, to managing and adjusting them, to
planning exits; the greeks are truly a trader’s best resource. They help
traders see potential and actual position risk. They help traders project
potential and actual trade profitability too. Without the greeks, a trader is at
a disadvantage in every aspect of option trading. Use the greeks on each
and every trade, and exploit trades to their greatest potential.
I wish you good luck !
For me, trading option greeks has been a labor of love through the good
trades and the bad. To succeed in the long run at greeks trading—or any
endeavor, for that matter—requires enjoying the process. Trading option
greeks can be both challenging and rewarding. And remember, although
option trading is highly statistical and intellectual in nature, a little luck
never hurt! That said, good luck trading!
About the Author Dan Passarelli is an
author, trader, and former member of the
Chicago Board Options Exchange (CBOE)
and CME Group. Dan has written two books
on options trading—Trading Option Greeks
and The Market Taker’s Edge . He is also the
founder and CEO of Market Taker
Mentoring, a leading options education firm
that provides personalized, one-on-one
mentoring for option traders and online
classes. The company web site is
www.markettaker.com .
Dan began his trading career on the floor of the CBOE as an equity
options market maker. He also traded agricultural options and futures on the
floor of the Chicago Board of Trade (now part of CME Group).
In 2005, Dan joined CBOE’s Options Institute and began teaching both
basic and advanced trading concepts to retail traders, brokers, institutional
traders, financial planners and advisers, money managers, and market
makers. In addition to his work with the CBOE, he has taught options
strategies at the Options Industry Council (OIC), the International
Securities Exchange (ISE), CME Group, the Philadelphia Stock Exchange,
and many leading options-based brokerage firms. Dan has been seen on
FOX Business News and other business television programs. Dan also
contributes to financial publications such as TheStreet.com , SFO.com , and
the CBOE blog.
Dan can be reached at his web site, MarketTaker.com , or by e-mail:
dan@markettaker.com . He can be followed on Twitter at
twitter.com/Dan_Passarelli .
Index American-exercise options
Arbitrageurs
At-the-money (ATM) Backspreads
Bear call spread Bear put spread Bernanke, Ben
Black, Fischer Black-Scholes option-pricing model Boxes
building
Bull call spread strengths and limitations Bull put spread Butterflies
long
alternatives example
short
iron
long
short
Buy-to-close order Calendar spreads buying
“free” call, rolling and earning rolling the spread
income-generating, managing strength of
trading volatility term structure buying the front, selling the back
directional approach double calendars ITM or OTM
selling the front, buying the back
Calls
buying
covered
entering
exiting
long ATM
delta
gamma
rho
theta
tweaking greeks vega
long ITM
long OTM
selling
Cash settlement Chicago Board Options Exchange (CBOE) Volatility
Index®
Condors
iron
long
short
long
short
strikes
safe landing selectiveness too close
too far
with high probability of success
Contractual rights and obligations open interest and volume opening and
closing Options Clearing Corporation (OCC) standardized contracts
exercise style expiration month option series, option class, and contract size
option type
premium
quantity
strike price
Credit call spread Debit call spread Delta
dynamic inputs effect of stock price on effect of time on effect of
volatility on moneyness and Delta-neutral trading art and science
direction neutral vs. direction indifferent gamma, theta, and volatility
gamma scalping implied volatility, trading selling
portfolio margining realized volatility, trading reasons for
smileys and frowns Diagonal spreads double
Dividends
basics
and early exercise dividend plays strange deltas
and option pricing pricing model, inputting data into dates, good and bad
dividend size
Estimation, imprecision of European-exercise options Exchange-traded
fund (ETF) options Exercise style Expected volatility CBOE Volatility
Index®
implied
stock
Expiration month Ford Motor Company Fundamental analysis Gamma
dynamic
scalping
Greeks
adjusting
defined
delta
dynamic inputs effect of stock price on effect of time on effect of
volatility on moneyness and
gamma
dynamic
HAPI: Hope and Pray Index managing trades online, caveats with regard
to price vs. value rho
counterintuitive results effect of time on put-call parity
strategies, choosing between theta
effect of moneyness and stock price on effects of volatility and time
on positive or negative taking the day out
trading
vega
effect of implied volatility on effect of moneyness on effect of time
on implied volatility (IV) and
where to find Greenspan, Alan HOLDR options
Implied volatility (IV) trading
selling
and vega
In-the-money (ITM) Index options
Interest, open Interest rate moves, pricing in Intrinsic value Jelly rolls
Long-Term Equity AnticiPation Securities® (LEAPS®) Open interest
Option, definition of Option class
Option prices, measuring incremental changes in factors affecting Option
series
Options Clearing Corporation (OCC) Out-of-the-money (OTM) Parity,
definition of Pin risk
borrowing and lending money boxes
jelly rolls
Premium
Price discovery Price vs. value Pricing model, inputting data into dates,
good and bad dividend size “The Pricing of Options and Corporate
Liabilities” (Black & Scholes) Put-call parity American exercise options
essentials
dividends
synthetic calls and puts, comparing
synthetic stock strategies


-of-the-money (OTM) Parity,
definition of Pin risk
borrowing and lending money boxes
jelly rolls
Premium
Price discovery Price vs. value Pricing model, inputting data into dates,
good and bad dividend size “The Pricing of Options and Corporate
Liabilities” (Black & Scholes) Put-call parity American exercise options
essentials
dividends
synthetic calls and puts, comparing
synthetic stock strategies
theoretical value and interest rate Puts
buying
cash-secured long ATM
married
selling
Ratio spreads and complex spreads delta-neutral positions, management
by market makers through longs to shorts risk, hedging trading flat
multiple-class risk ratio spreads backspreads
vertical
skew, trading Realized volatility trading
Reversion to the mean Rho
counterintuitive results effect of time on and interest rates in planning
trades interest rate moves, pricing in LEAPS
put-call parity and time
trading
Risk and opportunity, option-specific finding the right risk long ATM call
delta
gamma
rho
theta
tweaking greeks vega
long ATM put long ITM call long OTM call options and the fair game
volatility
buying and selling direction neutral, direction biased, and direction
indifferent
Scholes, Myron Sell-to-open transaction Skew
term structure trading
vertical
Spreads
calendar
buying
“free” call, rolling and earning income-generating, managing
strength of
trading volatility term structure
diagonal
double
ratio and complex delta-neutral positions, management by market makers
multiple-class risk ratio
skew, trading
vertical
bear call
bear put
box, building bull call
bull put
credit and debit, interrelations of credit and debit, similarities in and
volatility
wing
butterflies
condors
greeks and
keys to success retail trader vs. pro trades, constructing to maximize
profit
Standard deviation and historical volatility Standard & Poor’s Depositary
Receipts (SPDRs or Spiders) Straddles
long
basic
trading
short
risks with
trading
synthetic
Strangles
long
example
short
premium
risk, limiting
Strategies and At-Expiration Diagrams buy call
buy put
factors affecting option prices, measuring incremental changes in sell call
sell put
Strike price
Supply and demand Synthetic stock strategies
conversion
market makers pin risk
reversal
Technical analysis Teenie buyers
Teenie sellers Theta
effect of moneyness and stock price on effects of volatility and time on
positive or negative risk
taking the day out Time value
Trading strategies Value
Vega
effect of implied volatility on effect of moneyness on effect of time on
implied volatility (IV) and Vertical spreads bear call
bear put
box, building bull call
bull put
credit and debit interrelations of similarities in
and volatility Volatility
buying and selling teenie buyers teenie sellers
calculating data direction neutral, direction biased, and direction
indifferent expected
CBOE Volatility Index®
implied
stock
historical (HV) standard deviation
implied (IV) and direction HV-IV divergence inertia
relationship of HV and IV
selling
supply and demand
realized
trading
skew
term structure vertical
vertical spreads and Volatility charts, studying patterns
implied and realized volatility rise realized volatility falls, implied
volatility falls realized volatility falls, implied volatility remains
constant realized volatility falls, implied volatility rises realized
volatility remains constant, implied volatility falls realized volatility
remains constant, implied volatility remains constant realized
volatility remains constant, implied volatility rises realized volatility
rises, implied volatility falls realized volatility rises, implied
volatility remains constant
Volatility-selling strategies profit potential covered call covered put
gamma-theta relationship greeks and income generation naked
call
short naked puts similarities Would I Do It Now? Rule
Volume
WeeklysSM
Wing spreads
butterflies
directional
long
short
iron
condors
iron
long
short
greeks and
keys to success retail trader vs. pro trades, constructing to maximize
profit Would I Do It Now? Rule