There are several philosophies used in options trading; premium collection, volatility trading etc. But the one I want to focus on for a while is straight out directional trading.
Yet again there are several means to trade directionally, from straight out option buys to vertical spreads, to just about any other spread you can think of.
All need some consideration of direction, volatility, and size (yes there is a difference) of the anticipated move, and hence the effect of the Greeks… or rather a quantification of risk and reward via the Greeks.
The simplest way to trade direction with options, of course, is straight out option buys, but once more the decision to buy an option is more complicated than straight out stock. We are faced with dozens of alternatives in the form of strike, expiry, and quantity of options relative to an equivalent stock position. Though we may attempt to ignore them, the Greeks will still quantify risk and reward.
Some options educators recommend long-dated, deep In The Money options as a stock replacement strategy, with delta greater 0.7, yet some others recommend short-dated, way Out of The Money options in some hope to hit the occasional home run.
I think it’s kind of futile to make such blanket statements without knowing what it is the trader is trying to do. There are various styles of directional traders, from long-term strategic traders, trend traders, swing traders and day traders. The trader’s goal in taking a trade is going to be important in what strike or expiry he or she selects… or indeed whether an option has an advantage over the underlying; there is no point in complicating a trade for no advantage.
The successful stock trader will have a risk management and position sizing regime in place, so for any trade, a position size will be calculated. In option lingo terms, we can describe this as the number of deltas. As the share delta is 1.0, the number of shares will be the number of deltas exposure in the trade. If a long position size is calculated as 1000 shares, we have 1000 deltas exposure.
If we are considering replacing the stock with options, that is also how we should view our directional exposure, by the number of deltas. For example, if we bought ATM options with a delta of 0.5, we would need 20 contracts to make up the equivalent 1000 deltas of exposure. ITM options with a delta of 0.7 would need 14 contracts to approximate the 1000 deltas and OTM options with a delta of 0.25 would require 40 contracts to do the same.
It is the with other Greeks where things get interesting and how we can define whether there is anything to gain… or lose from option buys. A stock position is not affected by these Greeks, so we know absolutely our profit or loss from a given move. However, options are non-linear and profit or loss parameters exist an in a more chaotic system. We can know profit or loss within a range, with a given move in the underlying, but the randomness of volatility changes and time in the trade make the absolute results more variable.
An examination of each type of trading is beyond the scope of this article and it is my belief that if long options have potential to outperform stock trading, it is in the swing trading time frame or momentum plays, trades of 3 – 20 days duration.
That’s the time frame I want to look at.
In part one of this article, I stated that IF long option buys have any chance of outperforming straight out stock trading, it is the “swing trading” time frame or momentum plays, generally moves that last 3 – 20 trading days. This is my opinion based on my experience and is not to say that one cannot be successful in other time frames, but let’s just say my goal in option trading is outperforming stock trading over the long term; In other time frames, I doubt that the additional contest risk (extra brokerage and bid-ask/spread in the notionally larger position size) and theta risk can be overcome by the advantages of gamma over the long term.
I am quite happy to stand to be corrected on this and I haven’t done a scholarly thesis on this, but this matches the consensus of many other experienced options traders.
Firstly, let’s look at the advantages and disadvantages of options versus stocks as I see it, always working on the assumption that an equal number of deltas is used, as described in Part 1
Stocks have the advantage of being very simple to trade. You buy x number of stocks and that is the number of deltas you have, you can calculate the exact profit or loss that is possible for a given move. For example, if you want to acquire 500 deltas of x stock, you simply buy 500 shares, if your stock goes up to $1 you have made $500 if your stock goes down $1, you lose $500 – easy.
However, to acquire 500 deltas in x‘s options, some qualitative decisions must first be made. Obviously, those deltas are positive so we are looking at calls, but am I going ITM, ATM, OTM? What Delta is the option I want to buy – and why? If the delta of the option is .33 we’re going to need 15 contracts to get our 500 deltas. Fine, but what expiry? How far out to we want to buy – and why?
How will these decisions affect the outcome of the trade?
There is an advantage in a long option position that the absolute maximum risk is known, that is the cost of the options. Stock traders will protest that a stop loss order can be placed on a stock position, however, that does not protect the trader in the event of a large gap. If the stock gaps down 50% overnight, there is no stop loss in the world that will save you. In addition, once the stop loss order is triggered, you are out of the trade; and how often have you been stopped out only to see the stock immediately bounce higher?
Although the maximum loss of the option position may or may not equate to the calculated loss of a stopped out stock position, a maximum loss on the option position does not necessitate the exit of the trade. If that stock bounces back hard, you may still be in the money.
Another advantage for the long option trader is gamma. This is the Greek that measures the change in delta as the stock price moves. If you are long the above calls, all things being equal, the position will increase in deltas as the stock goes up. So if that puppy is going in your favor, you have some automatic pyramiding of the position, and the higher it goes, the longer you get.
Likewise, if the position goes against you, deltas will decrease getting you less and less long as the stock moves down. The stock position never changes its delta, however.
This is good news, the more gamma you have, the more accentuated this effect. There is a flip side to gamma though, which is…
Countering the positive effect of gamma is theta (or time decay). Every day that you are in a long option position, you are losing time value on your option. Actually, it is more complicated than that; the time value will vary in relation to the option’s moneyness and volatility, but as a general principle it is true, an option devalues as time goes by.
Theta has a direct relationship to gamma, so the more gamma you have, so to the more theta you will have.
This is the prime reason I believe swing trading/momentum plays are the spot where long options may have an advantage over stocks; providing one makes intelligent choices regarding strike and expiry. You can acquire sufficient gamma to give you a real boost if you get on a strong move, yet not suffering to any great extent from the effects of theta.
Vega measures the effect of changes in volatility on the price of the option. Stocks don’t have vega, so not a consideration. Whether vega is an advantage or disadvantage to a long option position is… well, it can be either and is not something to be ignored.
If you punt on some calls at what you think is the bottom of a big swoon at very high IVs, you will suffer some degree of premium sag if it starts moving your way, particularly if you buy OTM options and your position gets toward being at the money. You were right and you may be in profit, but it will be like having left the handbrake on.
It is possible to be right on the direction and still lose.
On the other hand, volatility tends to increase on down moves. Buying puts at low IVs can be spectacularly profitable if you catch a high volatility down move, because of vega.
These Greeks are all something to be considered when selecting strikes and expires, or even whether to select a long option at all in a given situation, which goes back to the first point – Complexity.
These points I have only really touched on and there are deeper considerations to these Greeks, such as when and where their effect is greatest.