I recently decided to study options to understand if a particular negative skew (many small wins, occasional larger losses) strategy fits to my portfolio, which at the moment leans more towards positive skew methods like trend-following that take many small losses compensated by large wins. So it’s not about style drift nor replacing anything in the portfolio of strategies, but only trying to see if I could add additional risk that would be uncorrelated to the current setups. This book looked like an easy read for introduction and studying the basics of options. It was published in 2016.
Options offer significant leverage that comes with risks. A trader can control large blocks of stock for much less capital than buying the stock. One of the main characteristics is time element, where the option buyer is like renting the stock. When buying a stock one needs to get the direction right, but in options it’s necessary to consider the possible timeframe to get there.
An options trader must understand the Greeks well. I have listed them here to have a brief overview of the moving parts that shape option pricing.
Theta – the rate of decline in price due to time decay
Delta – the amount of price move relative to the move in the underlying asset based on the odds of expiring in the money, measured from 0 to 1 for call options and from -1 to 0 for put options
Vega – measures the sensitivity due to changes of volatility in the underlying asset
Gamma – shows the speed of change in Delta when there’s a price move in the underlying asset
Rho – measures the sensitivity due to changes in interest rates
There are longer explanations of the Greeks with examples in the book.
Some interesting points I wrote down for myself:
– Options are usually priced efficiently taking into consideration nearby events, volatility, trends etc. So one needs something unexpected to happen to significantly move the price in his or her favor.
– There will be higher Vega value added to price if there’s earnings announcement before expiration. That value can be replaced by intrinsic value if the stock increases after earnings leaving the option price unchanged.
– A Gamma scalper may buy a low Delta out-of-the-money option for Theta value and profit from Gamma increase without it even getting in the money. There are many different ways to trade volatility, events, trends using options, or even profiting from the market going nowhere.
– Rho hasn’t been considered in the last decade due to stable interest rates. I wonder if we may see that change in the near future.
– Basically, an option buyer needs to overcome all the Greek costs to be profitable so there must be a bigger move than expected. Therefore, the trader needs to know the options potential value when buying it. One can be right about the price move but still not make any money due to time decay or volatility cost. It pays to know the Greeks.
– Selling options without a hedge or a credit spread alike strategy is very risky.
– Position sizing becomes an extremely important part of options trading to stay in the game and not blow up.
– Weekly in the money options make it easier to transform from stocks to options cause you just need to get the direction right.
– When holding a weekly call option in an uptrend, it can be good to lock in profits and roll into a new in the money option to limit risk.
Though it’s not a long read, there is much more in the book about trading options. The authors bring up common mistakes by new options traders, suggestions how to start out, manage risk etc. There are some general principles of profitable trading that also apply to options like looking at win rate with average win / loss ratio. One obviously needs to have a trading edge and a correct mindset to be profitable. It’s a good book to learn the basics and start digging deeper into options.
Options 101 by Holly and Steve Burns book linkShare this post