79 lines
15 KiB
Plaintext
79 lines
15 KiB
Plaintext
CHAPTER 17
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Putting the Greeks into Action
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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:
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Step One: Study
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. 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.
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Step Two: Paper Trade
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. 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.
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Step Three: Showtime
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! 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.
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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.
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Trading Option Greeks
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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.
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Choosing between Strategies
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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.
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Example 1
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Imagine a trader, Arlo, is studying the following chart of Agilent Technologies Inc. (A). See
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Exhibit 17.1
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.
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EXHIBIT 17.1
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Agilent Technologies Inc. daily candles.
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Source
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: Chart courtesy of Livevol
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®
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Pro (
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www.livevol.com
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)
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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.
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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.
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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.
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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.
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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.
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Example 2
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A trader, Luke, is studying the following chart for United States Steel Corp. (X). See
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Exhibit 17.2
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.
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EXHIBIT 17.2
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United States Steel Corp. daily candles.
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Source
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: Chart courtesy of Livevol
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®
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Pro (
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www.livevol.com
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)
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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.
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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.
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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.
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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.
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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.
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Managing Trades
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Once the trade is on, the greeks come in handy for trade management. The most important rule of trading is
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Know Thy Risk
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. 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.
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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.
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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
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can
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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.
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The HAPI: The Hope and Pray Index
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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.
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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.
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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.
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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.
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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.
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Adjusting
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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.
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Imagine a trader makes the following trade in Halliburton Company (HAL) when the stock is trading $36.85.
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Sell 10 February 35–36–38–39 iron condors at 0.45
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February has 10 days until expiration in this example. The greeks for this trade are as follows:
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Delta: −6.80
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Gamma: −119.20
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Theta: +21.90
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Vega: −12.82
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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?
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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.
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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.
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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.
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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.
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I wish you good luck
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!
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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! |