ollama-model-training-5060ti/training_data/relevant/text/e31c518dabcb6bca357998ffae46e258d89ff4669a6f7595f7a00aafcf482dde.txt

CHAPTER 4
Option-Specific Risk and Opportunity
New endeavors can be intimidating. The first day at a new job or new school is a challenge. Option trading is no different. When traders first venture into the world of options, they tend to start with what they know—trading direction. Buying stocks is at the heart of the comfort zone for many traders. Buying a call as a substitute for buying a stock is a logical progression. And for the most part, call buying is a pretty straightforward way to take a bullish position in a stock. But it’s not
just
a bullish position. The greeks come into play with the long call, providing both risk and opportunity.
Long ATM Call
Kim is a trader who is bullish on the Walt Disney Company (DIS) over the short term. The time horizon of her forecast is three weeks. Instead of buying 100 shares of Disney at $35.10 per share, Kim decides to buy one Disney March 35 call at $1.10. In this example, March options have 44 days until expiration. How can Kim profit from this position? How can she lose?
Exhibit 4.1
shows the profit and loss (P&(L)) for the call at different time periods. The top line is when the trade is executed; the middle, dotted line is after three weeks have passed; and the bottom, darker line is at expiration. Kim wants Disney to rise in price, which is evident by looking at the graph for any of the three time horizons. She would anticipate a loss if the stock price declines. These expectations are related to the position’s delta, but that is not the only risk exposure Kim has. As indicated by the three different lines in
Exhibit 4.1
, the call loses value over time. This is called
theta risk
. She has other risk exposure as well.
Exhibit 4.2
lists the greeks for the DIS March 35 call.
EXHIBIT 4.1
P&(L) of Disney 35 call.
EXHIBIT 4.2
Greeks for 35 Disney call.
Delta
0.57
Gamma
0.166
Theta
−0.013
Vega
0.048
Rho
0.023
Kim’s immediate directional exposure is quantified by the delta, which is 0.57. Delta is immediate directional exposure because it’s subject to change by the amount of the gamma. The positive gamma of this position helps Kim by increasing the delta as Disney rises and decreasing it as it falls. Kim, however, has time working against her—theta. At this point, she theoretically loses $0.013 per day. Since her call is close to being at-the-money, she would anticipate her theta becoming more negative as expiration approaches if Disney’s share price remains unchanged. She also has positive vega exposure. A one-percentage-point increase in implied volatility (IV) earns Kim just under $0.05. A one-point decrease costs her about $0.05. With so few days until expiration, the 35-strike call has very little rho exposure. A full one-percentage-point change in the interest rate changes her call’s value by only $0.023.
Delta
Some of Kim’s risks warrant more concern than others. With this position, delta is of the greatest concern, followed by theta. Kim expects the call to rise in value and accepts the risk of decline. Delta exposure was her main rationale for establishing the position. She expects to hold it for about three weeks. Kim is willing to accept the trade-off of delta exposure for theta, which will cost her three weeks of erosion of option premium. If the anticipated delta move happens sooner than expected, Kim will have less decay.
Exhibit 4.3
shows the value of her 35 call at various stock prices over time. The left column is the price of Disney. The top row is the number of days until expiration.
EXHIBIT 4.3
Disney 35 call price–time matrix–value.
The effect of delta is evident as the stock rises or falls. When the position is established (44 days until expiration), the change in the option price if the stock were to move from $35 to $36 is 0.62 (1.66 − 1.04). Between stock prices of $36 and $37, the option gains 0.78 (2.44 −1.66). If the stock were to decline in value from $35 to $34, the option loses 0.47 (1.04 − 0.57). The option gains value at a faster rate as the stock rises and loses value at a slower rate as the stock falls. This is the effect of gamma.
Gamma
With this type of position, gamma is an important but secondary consideration. Gamma is most helpful to Kim in developing expectations of what the delta will be as the stock price rises or falls.
Exhibit 4.4
shows the delta at various stock prices over time.
EXHIBIT 4.4
Disney call price–time matrix–delta.
Kim pays attention to gamma only to gauge her delta. Why is this important to her? In this trade, Kim is focused on direction. Knowing how much her call will rise or fall in step with the stock is her main concern. Notice that her delta tends to get bigger as the stock rises and smaller as the stock falls. As time passes, the delta gravitates toward 1.00 or 0, depending on whether the call is in-the-money (ITM) or out-of-the-money (OTM).
Theta
Option buying is a veritable race against the clock. With each passing day, the option loses theoretical value. Refer back to
Exhibit 4.3
. When three weeks pass and the time to expiration decreases from 44 days to 23, what happens to the call value? If the stock price stays around its original level, theta will be responsible for a loss of about 30 percent of the premium. If Disney is at $35 with 23 days to expiration, the call will be worth $0.73. With a big enough move in either direction, however, theta matters much less.
With 23 days to expiration and Disney at $39, there is only 0.12 of time value—the premium paid over parity for the option. At that point, it is almost all delta exposure. Similarly, if the Disney stock price falls after three weeks to $33, the call will have only 0.10 of time value. Time decay is the least of Kim’s concerns if the stock makes a big move.
Vega
After delta and theta, vega is the next most influential contributor to Kim’s profit or peril. With Disney at $35.10, the 1.10 premium for the 35-strike call represents $1 of time value—all of which is vulnerable to changes in IV. The option’s 1.10 value returns an IV of about 19 percent, given the following inputs:
Stock: $35.10
Strike: 35
Days to expiration: 44
Interest: 5.25 percent
No dividend paid during this period
Consequently, the vega is 0.048. What does the 0.048 vega tell Kim? Given the preceding inputs, for each point the IV rises or falls, the option’s value gains or loses about $0.05.
Some of the inputs, however, will change. Kim anticipates that Disney will rise in price. She may be right or wrong. Either way, it is unlikely that the stock will remain exactly at $35.10 to option expiration. The only certainty is that time will pass.
Both price and time will change Kim’s vega exposure.
Exhibit 4.5
shows the changing vega of the 35 call as time and the underlying price change.
EXHIBIT 4.5
Disney 35 call price–time matrix–vega.
When comparing
Exhibit 4.5
to
Exhibit 4.3
, it’s easy to see that as the time value of the option declines, so does Kim’s exposure to vega. As time passes, vega gets smaller. And as the call becomes more in- or out-of-the-money, vega gets smaller. Since she plans to hold the position for around three weeks, she is not concerned about small fluctuations in IV in the interim.
If indeed the rise in price that Kim anticipates comes to pass, vega becomes even less of a concern. With 23 days to expiration and DIS at $37, the call value is 2.21. The vega is $0.018. If IV decreases as the stock price rises—a common occurrence—the adverse effect of vega will be minimal. Even if IV declines by 5 points, to a historically low IV for DIS, the call loses less than $0.10. That’s less than 5 percent of the new value of the option.
If dividend policy changes or the interest rate changes, the value of Kim’s call will be affected as well. Dividends are often fairly predictable. However, a large unexpected dividend payment can have a significant adverse impact on the value of the call. For example, if a surprise $3 dividend were announced, owning the stock would become greatly preferable to owning the call. This preference would be reflected in the call premium. This is a scenario that an experienced trader like Kim will realize is a possibility, although not a probability. Although she knows it can happen, she will not plan for such an event unless she believes it is likely to happen. Possible reasons for such a belief could be rumors or the company’s historically paying an irregular dividend.
Rho
For all intents and purposes, rho is of no concern to Kim. In recent years, interest rate changes have not been a major issue for option traders. In the Alan Greenspan years of Federal Reserve leadership, changes in the interest rate were usually announced at the regularly scheduled Federal Open Market Committee (FOMC) meetings, with but a few exceptions. Ben Bernanke, likewise, changed interest rates fairly predictably, when he made any rate changes at all. In these more stable periods, if there is no FOMC meeting scheduled during the life of the call, it’s unlikely that rates will change. Even if they do, the rho with 44 days to expiration is only 0.023. This means that if rates change by a whole percentage point—which is four times the most common incremental change—the call value will change by a little more than $0.02. In this case, this is an acceptable risk. With 23 days to expiration, the ATM 35 call has a rho of only 0.011.
Tweaking Greeks
With this position, some risks are of greater concern than others. Kim may want more exposure to some greeks and less to others. What if she is concerned that her forecasted price increase will take longer than three weeks? She may want less exposure to theta. What if she is particularly concerned about a decline in IV? She may want to decrease her vega. Conversely, she may believe IV will rise and therefore want to increase her vega.
Kim has many ways at her disposal to customize her greeks. All of her alternatives come with trade-offs. She can buy more calls, increasing her greek positions in exact proportion. She can buy or sell stock or options against her call, creating a spread. The simplest way to alter her exposure to option greeks is to choose a different call to buy. Instead of buying the ATM call, Kim can buy a call with a different relationship to the current stock price.
Long OTM Call
Kim can reduce her exposure to theta and vega by buying an OTM call. The trade-off here is that she also reduces her immediate delta exposure. Depending on how much Kim believes Disney will rally, this may or may not be a viable trade-off. Imagine that instead of buying one Disney March 35 call, Kim buys one Disney March 37.50 call, for 0.20.
There are a few observations to be made about this alternative position. First, the net premium, and therefore overall risk, is much lower, 0.20 instead of 1.10. From an expiration standpoint, the breakeven at expiration is $37.70 (the strike price plus the call premium). Since Kim plans on exiting the position after about three weeks, the exact break-even point at the expiration of the contract is irrelevant. But the concept is the same: the stock needs to rise significantly.
Exhibit 4.6
shows how Kim’s concerns translate into greeks.
EXHIBIT 4.6
Greeks for Disney 35 and 37.50 calls.
35 Call
37.50 Call
Delta
0.57
0.185
Gamma
0.166
0.119
Theta
−0.013
−0.007
Vega
0.048
0.032
Rho
0.023
0.007
This table compares the ATM call with the OTM call. Kim can reduce her theta to half that of the ATM call position by purchasing an OTM. This is certainly a favorable difference. Her vega is lower with the 37.50 call, too. This may or may not be a favorable difference. That depends on Kim’s opinion of IV.
On the surface, the disparity in delta appears to be a highly unfavorable trade-off. The delta of the 37.50 call is less than one third of the delta of the 35 call, and the whole motive for entering into this trade is to trade direction! Although this strategy is very delta oriented, its core is more focused on gamma and theta.
The gamma of the 37.50 call is about 72 percent that of the 35 call. But the theta of the 37.50 call is about half that of the 35 call. Kim is improving her gamma/theta relationship by buying the OTM, but with the call being so far out-of-the-money and so inexpensive, the theta needs to be taken with a grain of salt. It is ultimately gamma that will make or break this delta play.
The price of the option is 0.20—a rather low premium. In order for the call to gain in value, delta has to go to work with help from gamma. At this point, the delta is small, only 0.185. If Kim’s forecast is correct and there is a big move upward, gamma will cause the delta to increase, and therefore also the premium to increase exponentially. The call’s sensitivity to gamma, however, is dynamic.
Exhibit 4.7
shows how the gamma of the 37.50 call changes as the stock price moves over time. At any point in time, gamma is highest when the call is ATM. However, so is theta. Kim wants to reap as much benefit from gamma as possible while minimizing her exposure to theta. Ideally, she wants Disney to rally through the strike price—through the high gamma and back to the low theta. After three weeks pass, with 23 days until expiration, if Disney is at $37 a share, the gamma almost doubles, to 0.237. When the call is ATM, the delta increases at its fastest rate. As Disney rises above the strike, the gamma figures in the table begin to decline.
EXHIBIT 4.7
Disney 37.50 call price–time matrix–gamma.
Gamma helps as the stock price declines, too.
Exhibit 4.8
shows the effect of time and gamma on the delta of the 37.50 call.
EXHIBIT 4.8
Disney 37.50 call price–time matrix–delta.
The effect of gamma is readily observable, as the delta at any point in time is always higher at higher stock prices and lower at lower stock prices. Kim benefits greatly when the delta grows from its initial level of 0.185 to above 0.50—above the point of being at-the-money. If the stock moves lower, gamma helps take away the pain of the price decline by decreasing the delta.
While delta, gamma, and theta occupy Kim’s thoughts, it is ultimately dollars and cents that matter. She needs to translate her study of the greeks into cold, hard cash.
Exhibit 4.9
shows the theoretical values of the 37.50 call.
EXHIBIT 4.9
Disney 37.50 call price–time matrix–value.
The sooner the price rise occurs, the better. It means less time for theta to eat away profits. If Kim must hold the position for the entire three weeks, she needs a good pop in the stock to make it worth her while. At a $37 share price, the call is worth about 0.50, assuming all other market influences remain constant. That’s about a 150 percent profit. At $38,
Exhibit 4.9
reveals the call value to be 1.04. That’s a 420 percent profit.
On one hand, it’s hard for a trader like Kim not to get excited about the prospect of making 420 percent on an 8 percent move in a stock. On the other hand, Kim has to put things in perspective. When the position is established, the call has a 0.185 delta. By the trader’s definition of delta, that means the call is estimated to have about an 18.5 percent chance of expiring in-the-money. More than four out of five times, this position will be trading below the strike at expiration.
Although Kim is not likely to hold the position until expiration, this observation tells her something: she’s starting in the hole. She is more likely to lose than to win. She needs to be compensated well for her risk on the winners to make up for the more prevalent losers.
Buying OTM calls can be considered more speculative than buying ITM or ATM calls. Unlike what the at-expiration diagrams would lead one to believe, OTM calls are not simply about direction. There’s a bit more to it. They are really about gamma, time, and the magnitude of the stock’s move (volatility). Long OTM calls require a big move in the right direction for gamma to do its job.
Long ITM Call
Kim also has the alternative to buy an ITM call. Instead of the 35 or 37.50 call, she can buy the 32.50. The 32.50 call shares some of the advantages the 37.50 call has over the 35 call, but its overall greek characteristics make it a very different trade from the two previous alternatives.
Exhibit 4.10
shows a comparison of the greeks of the three different calls.
EXHIBIT 4.10
Greeks for Disney 32.50, 35, and 37.50 calls.
Like the 37.50 call, the 32.50 has a lower gamma, theta, and vega than the ATM 35-strike call. Because the call is ITM, it has a higher delta: 0.862. In this example, Kim can buy the 32.50 call for 3. That’s 0.40 over parity (3 − [35.10 − 32.50] = 0.40). There is not much time value, but more than the 37.50 call has. Thus, theta is of some concern. Ultimately, the ITMs have 0.40 of time value to lose compared with the 0.20 of the OTM calls. Vega is also of some concern, but not as much as in the other alternatives because the vega of the 32.50 is lower than the 35s or the 37.50s. Gamma doesn’t help much as the stock rallies—it will get smaller as the stock price rises. Gamma will, however, slow losses somewhat if the stock declines by decreasing delta at an increasing rate.
In this case, the greek of greatest consequence is delta—it is a more purely directional play than the other alternatives discussed.
Exhibit 4.11
shows the matrix of the delta of the 32.50 call.
EXHIBIT 4.11
Disney 32.50 call price–time matrix–delta.
Because the call starts in-the-money and has a relatively low gamma, the delta remains high even if Disney declines significantly. Gamma doesn’t really kick in until the stock retreats enough to bring the call closer to being at-the-money. At that point, the position will have suffered a big loss, and the higher gamma is of little comfort.
Kim’s motivation for selecting the ITM call above the ATM and OTM calls would be increased delta exposure. The 0.86 delta makes direction the most important concern right out of the gate.
Exhibit 4.12
shows the theoretical values of the 32.50 call.
EXHIBIT 4.12
Disney 32.50 call price–time matrix–value.
Small directional moves contribute to significant leveraged gains or losses. From share price $35 to $36, the call gains 0.90—from 2.91 to 3.81—about a 30 percent gain. However, from $35 to $34, the call loses 0.80, or 27 percent. With only 0.40 of time value, the nondirectional greeks (theta, gamma, and vega) are a secondary consideration.
If this were a deeper ITM call, the delta would start out even higher, closer to 1.00, and the other relevant greeks would be closer to zero. The deeper ITM a call, the more it acts like the stock and the less its option characteristics (greeks) come into play.
Long ATM Put
The beauty of the free market is that two people can study all the available information on the same stock and come up with completely different outlooks. First of all, this provides for entertaining television on the business-news channels when the network juxtaposes an outspoken bullish analyst with an equally unreserved bearish analyst. But differing opinions also make for a robust marketplace. Differing opinions are the oil that greases the machine that is price discovery. From a market standpoint, it’s what makes the world go round.
It is possible that there is another trader, Mick, in the market studying Disney, who arrives at the conclusion that the stock is overpriced. Mick believes the stock will decline in price over the next three weeks. He decides to buy one Disney March 35 put at 0.80. In this example, March has 44 days to expiration.
Mick initiates this long put position to gain downside exposure, but along with his bearish position comes option-specific risk and opportunity. Mick is buying the same month and strike option as Kim did in the first example of this chapter: the March 35 strike. Despite the different directional bias, Mick’s position and Kim’s position share many similarities.
Exhibit 4.13
offers a comparison of the greeks of the Disney March 35 call and the Disney March 35 put.
EXHIBIT 4.13
Greeks for Disney 35 call and 35 put.
Call
Put
Delta
0.57
−0.444
Gamma
0.166
0.174
Theta
−0.013
−0.009
Vega
0.048
0.048
Rho
0.023
−0.015
The first comparison to note is the contrasting deltas. The put delta is negative, in contrast to the call delta. The absolute value of the put delta is close to 1.00 minus the call delta. The put is just slightly OTM, so its delta is just under 0.50, while that of the call is just over 0.50. The disparate, yet related deltas represent the main difference between these two trades.
The difference between the gamma of the 35 put and that of the corresponding call is fairly negligible: 0.174 versus 0.166, respectively. The gamma of this ATM put will enter into the equation in much the same way as the gamma of the ATM call. The put’s negative delta will become more negative as the stock declines, drawing closer to −1.00. It will get less negative as the stock price rises, drawing closer to zero. Gamma is important here, because it helps the delta. Delta, however, still remains the most important greek.
Exhibit 4.14
illustrates how the 35 put delta changes as time and price change.
EXHIBIT 4.14
Disney 35 put price–time matrix–delta.
Since this put is ATM, it starts out with a big enough delta to offer the directional exposure Mick desires. The delta can change, but gamma ensures that it always changes in Mick’s favor.
Exhibit 4.15
shows how the value of the 35 put changes with the stock price.
EXHIBIT 4.15
Disney 35 put price–time matrix–value.
Over time, a decline of only 10 percent in the stock yields high percentage returns. This is due to the leveraged directional nature of this trade—delta.
While the other greeks are not of primary concern, they must be monitored. At the onset, the 0.80 premium is all time value and, therefore subject to the influences of time decay and volatility. This is where trading greeks comes into play.
Conventional trading wisdom says, “Cut your losses early, and let your profits run.” When trading a stock, that advice is intellectually easy to understand, although psychologically difficult to follow. Buyers of options, especially ATM options, must follow this advice from the standpoint of theta. Options are decaying assets. The time premium will be zero at expiration. ATMs decay at an increasing nonlinear rate. Exiting a long position before getting too close to expiration can cut losses caused by an increasing theta. When to cut those losses, however, will differ from trade to trade, situation to situation, and person to person.
When buying options, accepting some loss of premium due to time decay should be part of the trader’s plan. It comes with the territory. In this example, Mick is willing to accept about three weeks of erosion. Mick needs to think about what his put will be worth, not just if the underlying rises or falls but also if it doesn’t move at all. At the time the position is established, the theta is 0.009, just under a penny. If Disney share price is unchanged when three weeks pass, his theta will be higher.
Exhibit 4.16
shows how thetas and theoretical values change over time if DIS stock remains at $35.10.
EXHIBIT 4.16
Disney 35 put—thetas and theoretical values.
Mick needs to be concerned not only about what the theta is now but what it will be when he plans on exiting the position. His plan is to exit the trade in about three weeks, at which point the put theta will be −0.013. If he amortizes his theta over this three-week period, he theoretically loses an average of about 0.01 a day during this time if nothing else changes. The average daily theta is calculated here by subtracting the value of the put at 23 days to expiration from its value when the trade was established to find the loss of premium attributed to time decay, then dividing by the number of days until expiration.
Since the theta doesn’t change much over the first three weeks, Mick can eyeball the theta rather easily. As expiration approaches and theta begins to grow more quickly, he’ll need to do the math.
At nine days to expiration, the theoretical value of Mick’s put is about 0.35, assuming all other variables are held constant. By that time, he will have lost 0.45 (0.80 − 0.35) due to erosion over the 35-day period he held the position if the stock hasn’t moved. Mick’s average daily theta during that period is about 0.0129 (0.45 ÷ 35). The more time he holds the trade, the greater a concern is theta. Mick must weigh his assessment of the likelihood of the option’s gaining value from delta against the risk of erosion. If he holds the trade for 35 days, he must make 0.0129 on average per day from delta to offset theta losses. If the forecast is not realized within the expected time frame or if the forecast changes, Mick needs to act fast to curtail average daily theta losses.
Finding the Right Risk
Mick could lower the theta of his position by selecting a put with a greater number of days to expiration. This alternative has its own set of trade-offs: lower gamma and higher vega than the 44-day put. He could also select an ITM put or an OTM put. Like Kim’s call alternatives, the OTM put would have less exposure to time decay, lower vega, lower gamma, and a lower delta. It would have a lower premium, too. It would require a bigger price decline than the ATM put and would be more speculative.
The ITM put would also have lower theta, vega, and gamma, but it would have a higher delta. It would take on more of the functionality of a short stock position in much the same way that Kim’s ITM call alternative did for a long stock position. In its very essence, however, an option trade, ITM or otherwise, is still fundamentally different than a stock trade.
Stock has a 1.00 delta. The delta of a stock never changes, so it has zero gamma. Stock is not subject to time decay and has no volatility component to its pricing. Even though ITM options have deltas that approach 1.00 and other greeks that are relatively low, they have two important differences from an equity. The first is that the greeks of options are dynamic. The second is the built-in leverage feature of options.
The relationship of an option’s strike price to the stock price can change constantly. Options that are ITM now may be OTM tomorrow and vice versa. Greeks that are not in play at the moment may be later. Even if there is no time value in the option now because it is so far away-from-the-money, there is the potential for time premium to become a component of the option’s price if the stock moves closer to the strike price. Gamma, theta, and vega always have the potential to come into play.
Since options are leveraged by nature, small moves in the stock can provide big profits or big losses. Options can also curtail big losses if used for hedging. Long option positions can reap triple-digit percentage gains quickly with a favorable move in the underlying. Even though 100 percent of the premium can be lost just as easily, one option contract will have far less nominal exposure than a similar position in the stock.
It’s All About Volatility
What are Kim and Mick really trading? Volatility. The motivation for buying an option as opposed to buying or shorting the stock is volatility. To some degree, these options have exposure to both flavors of volatility—implied volatility and historical volatility (HV). The positions in each of the examples have positive vega. Their values are influenced, in part, by IV. Over time, IV begins to lose its significance if the option is no longer close to being at-the-money.
The main objective of each of these trades is to profit from the volatility of the stock’s price movement, called future stock volatility or future realized volatility. The strategies discussed in this chapter are contingent on volatility being one directional. The bigger the move in the trader’s forecasted direction the better. Volatility in the form of an adverse directional move results in a decline in premium. The gamma in these long option positions makes volatility in the right direction more beneficial and volatility in the wrong direction less costly.
This phenomenon is hardly unique to the long call and the long put. Although some basic strategies, such as the ones studied in this chapter, depend on a particular direction, many don’t. Except for interest rate strategies and perhaps some arbitrage strategies, all option trades are volatility trades in one way or another. In general, option strategies can be divided into two groups: volatility-buying strategies and volatility-selling strategies. The following is a breakdown of common option strategies into categories of volatility-buying strategies and volatility-selling strategies:
Volatility-Selling Strategies
Volatility-Buying Strategies
Short Call, Short Put, Covered Call, Covered Put, Bull Call Spread, Bear Call Spread, Bull Put Spread, Bear Put Spread, Short Straddle, Short Strangle, Guts, Ratio Call Spread, Calendar, Butterfly, Iron Butterfly, Broken-Wing Butterfly, Condor, Iron Condor, Diagonals, Double Diagonals, Risk Reversals/Collars.
Long Call, Long Put, Bull Call Spread, Bear Call Spread, Bull Put Spread, Bear Put Spread, Long Straddle, Long Strangle, Guts, Back Spread, Calendar, Butterfly, Iron Butterfly, Broken-Wing Butterfly, Condor, Iron Condor, Diagonals, Double Diagonals, Risk Reversals/Collars.
Long option strategies appear in the volatility-buying group because they have positive gamma and positive vega. Short option strategies appear in the volatility-selling group because of negative gamma and vega. There are some strategies that appear in both groups—for example, the butterfly/condor family, which is typically associated with income generation. These particular volatility strategies are commonly instituted as volatility-selling strategies. However, depending on whether the position is bought or sold and where the stock price is in relation to the strike prices, the position could fall into either group. Some strategies, like the vertical spread family—bull and bear call and put spreads—and risk reversal/collar spreads naturally fall into either category, depending on where the stock is in relation to the strikes. The calendar spread family is unique in that it can have characteristics of each group at the same time.
Direction Neutral, Direction Biased, and Direction Indifferent
As typically traded, volatility-selling option strategies are direction neutral. This means that the position has the greatest results if the underlying price remains in a range—that is, neutral. Although some option-selling strategies—for example, a naked put—may have a positive or negative delta in the short term, profit potential is decidedly limited. This means that if traders are expecting a big move, they are typically better off with option-buying strategies.
Option-buying strategies can be either direction biased or direction indifferent. Direction-biased strategies have been shown throughout this chapter. They are delta trades. Direction-indifferent strategies are those that benefit from increased volatility in the underlying but where the direction of the move is irrelevant to the profitability of the trade. Movement in either direction creates a winner.
Are You a Buyer or a Seller?
The question is: which is better, selling volatility or buying volatility? I have attended option seminars with instructors (many of whom I regard with great respect) teaching that volatility-selling strategies, or income-generating strategies, are superior to buying options. I also know option gurus that tout the superiority of buying options. The answer to the question of which is better is simple: it’s all a matter of personal preference.
When I began trading on the floor of Chicago Board Options Exchange (CBOE) in the 1990s, I quickly became aware of a dichotomy among my market-making peers. Those making markets on the floor of the exchange at that time were divided into two groups: teenie buyers and teenie sellers.
Teenie Buyers
Before options traded in decimals (dollars and cents) like they do today, the lowest price increment in which an option could be traded was one sixteenth of a dollar—a
teenie
. Teenie buyers were market makers who would buy back OTM options at one sixteenth to eliminate short positions. They would sometimes even initiate long OTM option positions at a teenie, too. The focus of the teenie-buyer school of thought was the fact that long options have unlimited reward, while short options have unlimited risk. An option purchased so far OTM that it was offered at one sixteenth is unlikely to end up profitable, but it’s an inexpensive lottery ticket. At worst, the trader can only lose a teenie. Teenie buyers felt being short OTM options that could be closed by paying a sixteenth was an unreasonable risk.
Teenie Sellers
Teenie sellers, however, focused on the fact that options offered at one sixteenth were far enough OTM that they were very likely to expire worthless. This appears to be free money, unless the unexpected occurs, in which case potential losses can be unlimited. Teenie sellers would routinely save themselves $6.25 (one sixteenth of a dollar per contract representing 100 shares) by selling their long OTMs at a teenie to close the position. They sometimes would even initiate short OTM contracts at one sixteenth.
These long-option or short-option biases hold for other types of strategies as well. Volatility-selling positions, such as the iron condor, can be constructed to have limited risk. The paradigm for these strategies is they tend to produce winners more often than not. But when the position loses, the trader loses more than he would stand to profit if the trade worked out favorably.
Herein lies the issue of preference. Long-option traders would rather trade Babe Ruth–style. For years, Babe Ruth was the record holder for the most home runs. At the same time, he was also the record holder for the most strikeouts. The born fighters that are option buyers accept the fact that they will have more strikeouts, possibly many more strikeouts, than winning trades. But the strategy dictates that the profit on one winner more than makes up for the string of small losers.
Short-option traders, conversely, like to have everything cool and copacetic. They like the warm and fuzzy feeling they get from the fact that month after month they tend to generate winners. The occasional loser that nullifies a few months of profits is all part of the game.
Options and the Fair Game
There may be a statistical advantage to buying stock as opposed to shorting stock, because the market has historically had a positive annualized return over the long run. A statistical advantage to being either an option buyer or an option seller, however, should not exist in the long run, because the option market prices IV. Assuming an overall efficient market for pricing volatility into options, there should be no statistical advantage to systematically buying or selling options.
1
Consider a game consisting of one six-sided die. Each time a one, two, or three is rolled, the house pays the player $1. Each time a four, five, or six is rolled, the house pays zero. What is the most a player would be willing to pay to play this game? If the player paid nothing, the house would be at a tremendous disadvantage, paying $1 50 percent of the time and nothing the other 50 percent of the time. This would not be a fair game from the house’s perspective, as it would collect no money. If the player paid $1, the player would get his dollar back when one, two, or three came up. Otherwise, he would lose his dollar. This is not a fair game from the player’s perspective.
The chances of winning this game are 3 out of 6, or 50–50. If this game were played thousands of times, one would expect to receive $1 half the time and receive nothing the other half of the time. The average return per roll one would expect to receive would be $0.50, that’s ($1 × 50 percent + $0 × 50 percent). This becomes a fair game with an entrance fee of $0.50.
Now imagine a similar game in which a six-sided die is rolled. This time if a one is rolled, the house pays $1. If any other number is rolled, the house pays nothing. What is a fair price to play this game? The same logic and the same math apply. There is a
percent chance of a one coming up and the player receiving $1. And there is a
percent chance of each of the other five numbers being rolled and the player receiving nothing. Mathematically, this translates to:
percent
percent). Fair value for a chance to play this game is about $0.1667 per roll.
The fair game concept applies to option prices as well. The price of the game, or in this case the price of the option, is determined by the market in the form of IV. The odds are based on the market’s expectations of future volatility. If buying options offered a superior payout based on the odds of success, the market would put upward pressure on prices until this arbitrage opportunity ceased to exist. It’s the same for selling volatility. If selling were a fundamentally better strategy, the market would depress option prices until selling options no longer produced a way to beat the odds. The options market will always equalize imbalances.
Note
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. This is not to say that unique individual opportunities do not exist for overpriced or underpriced options, only that options are not overpriced or underpriced in general. Thus, neither an option-selling nor option-buying methodology should provide an advantage.