A No Frills Approach to Learn Option Trading Successfully Part 1

in How To's Investing Trade by Travis — June 1, 2011 at 9:27 pm | 0 comments

With all the interest in the previous post on how to learn options trading, this begins a 5 part series on a “no-frills” approach to learn success in option trading. We started off by mentioning some things to do and, just as importantly, what not to do when you begin your options eduction. The purpose of this series is for you to develop a knowledge base in order to make informed decisions and develop your own option trading strategies. As I’ve said before, do not get suckered into buying something or following someone else’s strategy because of “how easy it is to make money option trading.” That is a sure fire way to fail and loss of money. Again, we will dive straight in. If you can get through the first part of this series and you still have an interest in option trading, then continue your education, otherwise, possibly look for other avenues for your investment objectives.

More Greeks!

We will start with arguably the most important aspect of option trading and those are the greeks. The greeks, appropriately named, involved the variables used to price an option as given in the Black-Scholes model. (Don’t worry about that for now, it’s a fairly complex formula). The greeks consist of the follow variables:

Vega – the change in option price due to changes in the volatility of the underlying stock.
Theta – the time value (or time decay) of an option.
Delta – the change in option price due to the change in the underlying stock price.
Gamma – the change in Delta due to the change in the underlying stock price.
Rho – the change in option price due to a change in interest rates.

1.) Vega

Vega is listed first since I believe it is the most critical part of option trading. Whenever you access an option, the vega should be one of the first things you look at when choosing an option for a trade. For the purist, vega and volatility are actually different, where vega is associated with the option and volatility is associated with the stock, but its much simpler to think of them as the same. I will go further in-depth into Implied Volatility and Historical Volatility later on. Put simply, vega is the risk associated with owning or selling an option. If a given stock is known for dramatic day to day changes, such as a small tech stock, then the volatility is high thus giving a high price on the option. The opposite is also true in a stock such as a large blue chip that stays within a tight trading range. The given stock is known to not move very much so the “risk” factor is low giving a cheaper option price. When you think vega, think how much and how fast does this stock move? As vega rises so will the price of the option and visa-versa.

Another note, do not let a stock with high volatility deter you from making a trade if it fits within your options strategy. The media types and “pros” on channels such as CNBC will often say, “stay away from this or that stock because the volatility is high and it’s too risky.” Well, that may be true, but if you have an option strategy which requires a stock with high volatility, do not be afraid to analyze an options trade.

Ok, Great…but how does this apply to the real world? Since vega is the only greek we know so far, let’s assume all the other greeks do not change value and stay constant. The most common times we see big swings in vega and volatility are before and after earnings reports and less common occurrences with take-over news, FDA acceptance/denial, and major local, national, or global news. Another common theme is a slow rise in volatility from the day or two after an earnings release until the next earnings release three months later. Make sense? Now let’s look at a couple of graphical examples of shifts in vega and volatility.

Here is F5 Networks (FFIV) for the past couple of months with the stock price on top of the chart and volatility on the bottom. First, note the slow rise in volatility from the previous earnings release at the end of January to to the latest earnings in April. Over that course of time, the volatility rose over 50%. This is a bit of an extreme example, but nonetheless shows the point of how a stock’s volatility will rise going into the next earnings season. Next, see the big drop in the stocks volatility after the April earnings release? The volatility is at 60.6 before earnings then drops to 40.6 after earnings or a 33% drop in one day! Even if you had a great trade and predicted the stock would go up as it did, you may have lost money or not profited to your full potential because you were involved in what is known as volatility crush.

To make this a little more clear, let’s see how volatility crush would change your profit or loss on a trade. We are going to assume everything is constant but volatility changes. In the previous example, the stock’s price went up and 1 day passed, but we will ignore that for now. Again, I’m going to treat the movement in volatility and vega the same even though it is not as precise, this makes it a bit easier to learn. Let’s say you buy an option of FFIV today…Here is what would happen if you were on the wrong side of the trade and vega dropped 33%. See in the lower left hand corner how the volatility is adjusted to go from 41.02 to 27.02? That is about a 33% drop. In the center of the graph where the cursors lays, the white line shows the profit graph without the drop in volatility while the red lines gives the loss with a drop in volatility. As you can see, on this trade which originally cost about $880, it is now down almost $200 without anything else happening other than the volatility drop.

Don’t let any of this scare you. Guess what? There are option strategies that can also allow you to profit from a volatility crush. We will dig deeper into vega and volatility later in this series, but hopefully you now have a basic understanding of what it means to have a change in vega with regards to option price. If you don’t fully understand, don’t worry, there are whole books written on the subject. Remember, this is just an introduction to vega and volatility.

2.) Theta

Theta or the time decay of an option is the amount the option price changes with the passage of time. All options have expiration dates and thus all have a time value component. A difficult aspect for beginning options traders to grasp is the timing of option strategies. Simply put, all option strategies must be timed properly. No matter what option strategy is chosen, time is a factor and the time value will change at an increasing rate by the day as the expiration date becomes closer and closer. If you are accustomed to trading stocks, timing a trade is usually not an issue. If it takes another week or two for a stock’s price to reach your expected level, for the most part, no big deal. With option trading, however, that week or two may mean the difference between a nice profit and a maximum loss.

On the graph below you can get an idea of how the time value works. As you can see, the closer the expiration date, the more rapidly the value of the decay becomes.

As with all the greeks, they work with and against each other. Theta and vega and closely tied and you need to be aware of this when choosing an options strategy. A stock with high volatility and high vega will also show high theta values and visa versa. Think of high vega and high theta acting as a premium on an option. Further, as a stock’s volatility moves up and down over time, its theta values will also move up and down but at a decreasing rate. In other words, if an option loses value due to volatility crush it will also be due to a loss in theta. Lastly, if your option trading calls for a volatile stock, be aware that the time decay value will be greater than a non-volatile stock. And just like vega, do not be afraid of a high theta stock. There are options strategies to profit from time decay as we will see later.

3.) Delta

Delta is probably the easiest concept for new option traders to understand since it is closely tied to the movement in the underlying stock. Assuming the other greeks stay the same, delta estimates the change in option value with a $1 change in the underlying stock price. By definition, delta can exhibit both positive and negative values ranging from -1 to 1. As an example (assuming the other greeks remain constant, if an option has a delta value of 0.50 and the underlying stock goes up $6, then the option value will go up $3.00 (0.50*$6=$3.50). Try to think of delta as directional risk in your option trading. If all other greeks stay the same, will a large stock price swing help or hurt my option strategy? While this is a simple concept to understand, we need to go much further in depth to see how an option’s delta changes and its effect on the option value based on the strike price we choose. Strike Price??? Don’t worry, we will get to that in the next segment of the series.

Do not assume delta is constant. Delta values are also subject to changes in volatility and time decay (as well as gamma, see below). Again, depending on the strike price, you may experience “delta decay” as time passes as well as shifts up or down in delta with various changes in vega. These are both fairly advanced topics which will be address in greater detail in an advanced segment to learn option trading.

4.) Gamma

Remember how delta is not constant? Well, we need a value to track that change which is called gamma. Gamma is a measure of the rate of change in delta for a $1 movement in the underlying stock. Delta and gamma are very closely tied, but gamma works with the other greeks as well. A simple example of being tied together, if the deltas of two stocks are the same, but very different vegas, the option with the higher vega will also show a higher gamma. In other words, the higher the risk because of volatility, the greater gamma which in turn moves delta a greater amount. Confused?

Again, assuming vega and theta remain constant, let’s say two stocks both have a delta of 0.50, but their gammas are 0.10 and 0.25. If both underlying stocks go up $1, then the new delta values would be 0.60 (0.50 delta + 0.10 gamma =0.60) and 0.75 (0.50 delta + 0.25 gamma =0.75). Because of the differences in gamma, the two stocks would wind up with deltas of 0.60 and 0.75 respectively. The greater delta thus increasing the value of the 2nd stock’s option at a greater rate.

As you continue your option trading education, there are many options strategies which both take advantage of large delta and gamma values as well as attempting to create a delta-gamma neutral strategy. Delta-gamma neutral basically means keeping those greeks constant as the underlying stock moves up or down. As we progress in the series, more examples of each will be shown.

5.) Rho

Rho measures the amount an option price will change if interest rates were to change by 1%. Since interest rates are held fairly constant, most people do not bother looking at rho and it is widely considered the least important of all the greeks. In option trading, if you are holding a longer term option (know as LEAPS), rho may come into play if the Fed decides to change interest rates over the course of time. But for the most part, interest rates are held stable. Rho is used as the “cost of carry” to own the option. In other words, instead of owning the option, you could be making the going risk-free bond rate in interest.

If any (or all) of this is confusing, that is ok. If you are willing to put more time and effort into your option trading the greeks will become more clear as you begin to understand how each one changes the value of the option with given changes in stock price, volatility, and time. Remember, there are a million different options strategies to take advantage and neutralize any or all of the greeks.

Be proud of yourself for reading this far. If you are telling yourself ok, I kind of get it…then continue on with your option trading education. On the flip side, if you are thinking, this is way to much for me, I suggest moving on to something other than option trading. In the next segment of the series, we will go back to the basics and understand options at the basic level. The idea of this first segment was to help you realize how complex and risky options can become. If you have questions, comments, or ideas please feel free to comment below.

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Tags: greeks investing options trade