Lessons from the Pros

Options

Options – Beware of Greeks Bearing Gifts

The saying Beware of Greeks bearing gifts of course comes from the story of the conquest of Troy by Greek soldiers hidden inside the Trojan horse. In Options parlance, the Greeks are measurements of the effects of the three main forces that affect option prices: price movement of underlying assets, time decay and changing expectations known as implied volatility. If we don’t properly take into account each of the three forces, then the Greeks can bear some unwelcome gifts in the form of trading losses.

Understanding the Three Forces Working in an Option Trade

Our Professional Option Trader program uses our option trader’s blueprint, which helps to ensure that all of the Greeks are properly accounted for. The blueprint provides a framework for selecting from the thousands of options that exist for each stock or ETF and selecting and managing the correct option strategy.

Many new option traders don’t sufficiently understand the power of the forces other than the most well-known one, which is the underlying price. They don’t realize that without selecting a strategy that puts all of the Greeks in your favor, it is quite possible to be correct in your forecast of stock price movement and still be unprofitable with an option trade.

Man planning an option trade

Example and Explanation of a Failed Option Day Trade

This was illustrated by an email that we received recently from a new option trader, who said:

‘I have a question regarding the purchase of some put options recently.  On a Tuesday I bought some Colgate Palmolive (CL) puts at around 10:30 am when the stock price was about 68.45.  I bought 67.5 put options at 1.42 each. These options at that time were 31 days from expiration.  

The stock price dropped nicely throughout the day and closed at 67.84.   

Meanwhile, the price of the puts fell from 1.42 down to 1.34 and I do not understand why [put prices are expected to go up when the underlying asset goes down].

The only thing I can think of is that volatility was high when I bought the puts and dropped after I purchased the puts… but since the stock price was falling, I would have expected volatility to increase, not decrease.

I closed the position the next morning at 1.10 each.’

The trader is on the right track with his thoughts about volatility, meaning implied volatility. There are a few points to make here:

  1. The trader was apparently looking to make a quick day trade, using options as a less-expensive substitute for the underlying stock.
  2. The option chosen was one that both was out of the money and had a very short remaining lifetime of just 31 days. These two factors together meant that the option was very susceptible both to time decay which is very rapid in the last month of an option’s life, and implied volatility which has an outsized impact on an option whose price consists entirely of time value.
  3. This meant that the option chosen was not a good one for a quick day trade.

In this case, the negative impact of changing volatility simply overwhelmed the profitable impact of the underlying price movement resulting in a net loss. So, what could have been done differently?

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Day Trading Options, or Not

If a quick day trade is the plan, options are not the best vehicle precisely because of the effects of the other two Greeks, as demonstrated. Instead, using other non-option vehicles that are one-dimensional, like a strictly leveraged play on the underlying asset, are better for this purpose. These include index futures or single-stock futures.

There is a way to use options as a simple leveraged speculation on the underlying asset, say for a swing trade expected to take several days, but the approach is different than the one seen in the previous example.

For this purpose, selecting a strike price that is significantly in the money (i.e. a put strike price far above the current stock price) is a better choice. Options that are far in the money are composed almost entirely of intrinsic value, which is not affected by time or volatility. Intrinsic value is affected only by stock price movement. The put the trader selected here was out of the money and therefore composed entirely of time value (also called extrinsic value). It is time value that is affected by time decay and volatility.

In this case, for example, instead of choosing the put at the 67.5 strike, the 72.5 strike might have been better. That option would cost roughly three times the cost of the 67.5 strike. It would have had a Delta reading of about two and a half times the Delta of the 67.5 puts. So, for about 3 times the price per option, the trader would have gotten about 2.5 times the profit per dollar of stock movement compared to the 67.5 strike, assuming the stock moved in the right direction. In other words, the in-the-money option was a bit less leveraged than the out-of-the-money one.

This relative lack of leverage, however, is more than made up for by the fact that the 72.5 puts, being far in the money, were composed almost entirely of intrinsic value. Intrinsic value truly does change only in response to stock price change. Using a deeply in the money put (or call, for a bullish speculation) is the closest thing that options offers to a pure leveraged spec on the underlying asset.

Note that in this case the desire was to benefit from stock price movement alone.

This is not where options really shine as a trading instrument. Rather than ignoring or trying to neutralize the effects of time and volatility, it is far better to make them into additional profit centers for a trade. Better to join them than to try to beat them.

Our Option trading program teaches strategies for selecting options that are designed to make each of the Greeks work in the trader’s favor rather, than against them. When that is accomplished it is possible to get the gifts without the grief.


DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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